By Min Tang-Varner, CFA
E. I. du Pont de Nemours & Co. (DD) is one of the largest chemical conglomerates we cover. After a comprehensive review, we have awarded the company a narrow economic moat rating, as specialty operations now make up more than half of its earnings. We particularly like DuPont's genetically modified seed business, which over the years has become a formidable competitor to the wide-moat GMO behemoth Monsanto (MON). We think DuPont's other chemical businesses have also demonstrated strong competitive advantages over their peers, primarily thanks to specialized production processes and patents. DuPont successfully replenished the income loss from its pharmaceutical patents expiring, which was a major uncertainty factor that contributed to our original no-moat rating. We think the current portfolio should continue to lead to greater returns over DuPont's invested capital.
Growth in Food and Nutrition Makes Up for Lost Pharma Patent Income
In 2007, DuPont generated $29.4 billion in revenue, 22% of which was from the agriculture, nutrition, and bioscience segments. In 2016, we estimate agriculture alone will bring in $13.7 billion in revenue, or 27% of the total, making it the single-largest segment under DuPont's umbrella. We estimate that the three segments combined will make up more than 35% of DuPont's $50 billion in revenue, and their respective growth rates should outpace those of traditional chemical companies, which tend to sport a GDP-plus type of growth. Furthermore, together with its other specialty chemical businesses--such as safety and protection, performance chemicals, and performance materials--we think the entire company has built up a slew of moat-worthy operations, giving the whole enterprise a long-term set of competitive advantages.
We think the company has done an excellent job replacing the $1 billion revenue and profit loss caused by the roll-off of pharmaceutical patents, which made up roughly 3% of 2007 revenue. These patents were related to hypertension drugs Cozaar and Hyzaar, which DuPont retained after selling its pharmaceutical segment to Bristol-Myers Squibb in 2001. Before these patent expirations, royalty income made up 20%-30% of DuPont's operating income. The large contribution from a sunset income stream gave us some pause in assigning a sustainable economic moat to the company. We originally had reservations about DuPont's ability to generate an additional $1 billion of operating income through its traditionally volatile chemical operations, which typically have an operating margin profile of only 5%-10%. However, the rapid but strategic growth in DuPont's portfolio has mitigated our concern. We think DuPont's hybrid seed and nutrition business (which combined with the recently acquired Danisco food and feed ingredient operations), low-cost production in selected chemicals, and numerous patents in safety and protection equipment should largely compensate for the loss in royalty income in short order.
Seeds Support the Moat
The success of DuPont's portfolio transformation lies foremost with the Pioneer hybrid seed division. Since the Pioneer acquisition in the late 1990s, DuPont has invested heavily to build up its platform of genetically modified organisms. In 2011, DuPont's GMO business generated more than 20% of the company's annual revenue of nearly $40 billion and contributed roughly a third of its earnings before interest and taxes. The economic moat in the segment lies with the long-term research platforms that continue to replenish DuPont's product pipeline. We think the company's collection of germplasm requires an ongoing consistent and expensive investment, which serves both as a pool of new product generation and a deterrent for new entrants in the market. Furthermore, DuPont undertakes rigorous and extensive governmental review for any new trait approval. This lengthy and expensive review process naturally discourages new entrants further, while offering the company patents that ensure better pricing power.
In 2011, the company spent almost $1.25 billion in ongoing research and development support for the GMO business, much as a pharmaceutical company would need to spend to replenish its product pipeline. We think DuPont has made huge strides in closing the gap against chief GMO rival Monsanto. Originally licensed from Monsanto's Roundup Ready technology, DuPont collected an impressive portfolio of germplasm in the past decade, which enables it to maintain a full pipeline of premium traits.
DuPont has several compelling products in its corn and soybean pipelines, and we think these new products should help the company garner premium pricing despite the market saturation in North America. While we think DuPont's corn seeds still lack the above-the-ground and below-the-ground dual-mode protection that Monsanto's SmartStax corn seeds have, DuPont is rapidly gaining ground in the North American market. During the product-launching phase, Monsanto miscalculated its pricing strategy (and favorable weather conditions in the United States didn't help the industry giant), which gave DuPont a crucial two-year window in which to catch up. While DuPont's in-the-seed Herculex Xtra corn seeds may not give farmers a yield advantage compared apples-to-apples with Monsanto's SmartStax Refuge-In-a-Bag corn seed, we think DuPont is making up the yield differential with its customized service platform and effective marketing and pricing strategy.
DuPont's effective marketing model solidifies the company's position in the industry. Over the past few years, we think the effective marketing and distribution strategy has helped the company capture market share from generic seed providers and to some extent boost its reputation among farmers when Monsanto somewhat blundered its new product launch in 2009-10. DuPont is effectively replicating this strategy in Latin America and Europe, furthering its market penetration.
Perfecting Production Process Results in Attractive Returns on Investment
Another source of economic moat for DuPont comes from its performance chemical operation. DuPont has an estimated 1.1 million tons per year capacity in titanium dioxide, relying fully on the chloride manufacturing process. Though heavily dependent on third-party ores (which is not unusual among industry peers), DuPont has perfected its production process over the years, enabling it to use low-purity rutile ores and capture the pricing spread compared with its global peers.
The strength of DuPont's TiO2 operation comes from heavy environmental regulations that protect existing suppliers while discouraging new entrants (except in China, where players tend to be small-scale, high-cost producers). In the meantime, years of poor financial performance have weeded out inefficient producers while empowering the survivors with rational capacity expansion plans and pricing competition. Remaining players have mothballed inefficient or high-cost capacities in Western Europe and the U.S. We think these characteristics foster a positive working environment for DuPont's premium pricing power.
TiO2 is a key chemical pigment for paint, coating, and construction materials. Global TiO2 capacity is fairly concentrated, with five Western players holding more than 65%, while another 27% of capacity is in China. This is in stark contrast with other undifferentiated commodity chemical products. Historically, TiO2 producers tended to increase capacity on a lump-sum basis and work down the overcapacity by undercutting prices. However, as the global demand trend solidifies upward, producers have become more rational, which bodes well for companies like DuPont to enjoy a boost in margins for an extended period.
The physical characteristics of TiO2 pigment are not easily substitutable for paint and coating companies. Prices of TiO2 pigment have increased more than 91% in the past decade. Yet, according to DuPont, current pricing is just approaching the level reached in the 1980s and not nearly close to any peak pricing. We think TiO2 prices will probably have a decent runway in the coming years. For paint and coating companies, TiO2 pigment represents roughly 20% of their raw material costs, up from 17% just a few years back. Commentary from buyers like AkzoNobel--the world's largest paint company--supports our view that expected capacity shortages will continue to support price increases in the next decade. While higher prices may attract additional capacities with higher marginal costs of production (the majority of which are in China, which tends to consume the pigment within its borders rather than flood the global market), we do not think prices are under any imminent pressure of collapsing.
A Wide Array of Specialty Fibers Boosts Pricing Power, Protects Margins
DuPont's differentiated brand and numerous patents in the safety and protection segment naturally protect the company against competition. For example, DuPont's Kevlar is exclusively used to produce high-strength, low-weight safety and protective equipment in autos, body armor, and sports equipment. Developed in the mid-1960s, this synthetic fiber was viewed as a successful replacement for steel in the 1970s with its excellent thermal performance (it maintains its strength and resilience between -196°C and 160°C). Because of its many applications, Kevlar has been in constant short supply over the past few years. In late 2011, DuPont finished the $500 million capacity expansion at its Cooper River plant, which we expect to help the company meet global demand for the product.
DuPont's other polymer products, ranging from Nomex (fire-resistant protective polymers) to Teflon (nonstick coating for cookware) to Tyvek (construction wraps) and other building materials, also boost pricing power. Most important, we think DuPont's continuous innovation will replenish its pool of patents as current ones expire. We expect the patents and branding to form a barrier to entry for peers in the aerospace, military and law enforcement, construction, and automotive markets.
Over the past decade, we think DuPont has demonstrated the ability to position itself for sustainable growth, earning a return above its weighted average cost of capital. We applaud the company's ability to successfully replace pharmaceutical patent profits by expanding its shares in agriculture, performance chemicals, and other innovative products. We think DuPont's hybrid seed and nutrition business, low-cost production in TiO2, and numerous patents in safety and protection equipment should continue to provide a set of competitive advantages over its peers in the decade to come.
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