DuPont (DD), trading at a discount to the market and in line with peers, is attractively valued given the company is in the early innings of a multi-year transformation program. Despite already selling one business unit (Performance Coatings) and indicating their willingness to sell another (Performance Chemicals), DuPont still has a significant opportunity to drive margins higher and realize multiple expansion. While superficially, DuPont stock seems to be fairly priced relative to comparable companies given its 13.5x forward P/E and 10.5x trailing EV/EBITDA, the superficial look ignores the company's ability to remove more than $1bn in stranded costs and the fact that a larger percentage of DD's earnings and cash flow will be driven by the less cyclical, higher multiple parts of its businesses going forward.
While DuPont has been the longtime owner of Pioneer, one of the two most prominent US seed companies along with Monsanto (MON), DuPont had long been (and correctly) perceived as a cyclical industrial chemical conglomerate. But over the last 3 years, Chairwoman and CEO Ellen Kullman has taken steps that should change the perception of DuPont as a cyclical industrial chemical conglomerate.
DuPont began its recent transformation from a cyclically driven industrial company to a less cyclical food and agriculture company in earnest through both acquisitions and divestitures. The biggest acquisition was of Danisco in 2011. Danisco expanded DuPont's position within the food ingredient and enzyme markets and DuPont has continued adding to their food businesses since buying out their partner's 28% interest in Solae. DuPont has simultaneously boosted their agriculture business by purchasing 80% of South African seed company Pannar which will help expand their agriculture reach into Africa (a potentially enormous market over the coming decades).
While adding to their food and agriculture related businesses through acquisitions, DuPont has opportunistically looked to sell off their more commoditized business. Kullman started with the sale of the Performance Coatings business and in conjunction with their most recent quarterly report, announced that DuPont is pursuing strategic alternatives for its Performance Chemicals business.
In addition to the M&A focus, DuPont's commitment to becoming increasingly a food and agriculture company is evident in their Capital Expenditure and R&D plans. DuPont has committed to spending $10bn on R&D and introducing 4,000 new products in the food security space by the end of 2020. At DuPont's current R&D spending pace, over 50% of incremental R&D dollars over the next 8 years will be focused on food security.
Margin Expansion Story
Since taking over as CEO, Ellen Kullman has shown a willingness to target costs, even if flow-through to the bottom line has been limited. Over the last three years, DuPont has eliminated more than $1.2bn in costs and for FY13, DuPont is targeting $300mm in restructuring related cost savings and an additional $300mm in productivity savings (in all, ~5% of fixed costs). DuPont's conglomerate structure and the major acquisitions and divestitures completed over the last 3 years should allow the company to continue to eliminate $500mm - $600mm in legacy costs (between restructuring and cost initiatives) over each of the next 3 years driving incremental earnings of $0.30+ in each year - contributing an additional $1.00 of earnings by 2016.
In addition to restructuring benefits, DuPont has faced a number of business specific issues which have impacted corporate margins recently and are likely to reverse over time - particularly in some of DuPont's better businesses. Agriculture (lower seed input costs), Industrial Biosciences (improved ethanol end markets), Nutrition and Health (lapping higher Guar inventory costs) and Safety & Protection (better capacity utilization) all are likely to see margin expansion through 2014.
DuPont's overall corporate margin has also been pressured by declining Pharmaceutical royalty payments since the end of FY09 (dropping by nearly 95%) but with only $62mm of Pharmaceutical royalties in FY12, DuPont is now at the end of the process.
Typical superficial analysis (valuation in line with historically comparable companies) ignores DuPont's transformation process; in my opinion, DuPont should trade at a significant premium to the other chemical companies it is typically comped against. Through its dramatic cost reduction plan and the reversal of some key cost trends, DuPont is likely to see margin expansion well in excess of the other chemical companies arguing for accelerating earnings growth (both on an absolute basis and relative to the group) even if the global industrial economy continues to grow slowly.
The changing nature of DuPont's business could also justify a higher multiple as the comp set changes. While DuPont trades at a modest premium to the industrial chemical companies which typically trade at low teen P/E multiples, it trades at a significant discount to the agriculture, food safety and biotech sectors which trade at high teen P/E multiples.
The combination of accelerating earnings growth driven by DuPont's restructuring programs and margin tailwinds and the argument for a higher multiple (coupled with the recently completed buyback and more buybacks likely to follow) could drive DuPont stock from its current level of $58 up by more than 30% into the mid-to-high $70s within the next 12 months.
Risks to owning DuPont stock include (but are not limited to):
- Slowing global growth which will impact topline and limit margin expansion,
- Failure to divest Performance Chemicals which would bring into doubt the ability for DuPont to move away from cyclical businesses
- Looming fights with activist investors over splitting up the company (Trian owns 2.2% of DuPont)
- An entrenched management team likely eager to keep running a very large company