DowDuPont - When One Plus One Equals Three

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About: DowDuPont Inc. (DWDP)
by: Global Value Finder
Summary

The leading global chemical producer is growing earnings at a double digit rate.

The mega merger between Dow Chemical and DuPont will soon result in multiple spinoffs that will drive significant value to shareholders.

Due to the recent market turmoil, shares are trading on the cheap.

Not every day a mega cap company merges with another mega cap company, only to split into three different companies a year later. But that's precisely what has happened with DowduPont (DWDP). The two giant chemical companies, Dow Chemical and duPont completed their stock for stock merger in September 2017.

Today, the combined entity has three divisions. The materials division, manufacturing anything from plastic to paint and adhesives, represents roughly 55 percent of the company's revenues. The specialty chemicals, which manufactures chemicals for the biopharma and electronics industries represents 25 percent of the company's revenues. Lastly, the Ag division controls the remaining 20 percent of revenues.

The Investment Case In A Nutshell

The Investment case in DowduPont is based on three pillars. The first pillar is revenue growth, accompanied by a significant rise in free cash flow. The second pillar is shareholder friendliness; how DowduPont treats its shareholders well. The third pillar, as with every investment, is a compelling valuation of shares. I will elaborate on each one of these pillars below.

But with every investment, a proper catalyst is the key for unlocking value. Otherwise, you might end up holding cheap shares that will remain cheap for a very long time. With DowduPont, we have the perfect catalyst - an upcoming multi layer spinoff that I believe should increase shareholder value to around 90$ per share.

The risks involved in DWDP are twofold - the lack of success in execution of the spinoffs, or a muted demand for its industrial chemicals due to escalation in the ongoing trade war between China and the U.S.

Numbers Don't Lie

On August 2nd, DowduPont released a fantastic earnings report with revenues of 24.2$ billion, up 17 percent from the same quarter last year. Adjusted net income was 1.37$ a share, up a whopping 41 percent compared to the second quarter of 2017.

All the various divisions of the company generated outstanding results. The Ag division generated revenues of 5.7$ billion and ebitda of 1.7$ billion, up 25 percent and 45 percent, respectively, compared to the same period last year. The division of materials science recorded revenues of 12.6$ billion and ebitda of 2.6$ billion, up 18 percent and 22 percent, respectively, compared to the same period last year. Specialty chemicals generated revenues of 5.9$ billion and ebitda of 1.6$ billion, up 10 percent and 23 percent, respectively, compared to the same period last year. To sum it all up, all divisions are working at full speed.

Valuation

But it gets even better. The investment thesis behind DowduPont isn’t simply a classic value play. It is based on the sum-of-the-parts story. You see, management has reiterated its intentions to float the Ag division and the Specialty division in a form of two spinoffs from the parent company. Following the spinoffs, there will be three trading entities, not one. This will create immense value to shareholders. Take a hard look at the numbers below.

2020E

2019E

2018E

2017

$ Billions

Revenue

15.3

15.0

14.7

14.4

AG

51.9

49.4

47.1

44.0

Materials

26.3

24.6

23.0

21.1

Specialty

93.5

89.0

84.8

79.5

TOT Revenue

5.05

5.02

6.63

% growth

2020E

2019E

2018E

2017

$ Billions

ebitda

2.60

2.55

2.35

2.16

15%

AG

12.46

11.86

10.83

9.68

22%

Materials

6.85

6.40

5.75

5.06

24%

Specialty

ebitda margin

21.90

20.81

18.93

16.90

TOT ebitda

23%

22%

21%

Tot Margin

And then we sum it all up...

Market Value

Ebitda multiple

17.83

7

AG Spin CO

118.64

10

MAT Spin CO

63.98

10

Specialty Spin Co

200.45

TOT Value

160.00

current Value

25%

Upside

The Ag division is estimated to generate revenues of 14.7$ billion this year, resulting at an ebitda of 2.35$ billion, assuming a 15 percent ebitda margin. If you apply a relatively conservative multiple of 7 times ebitda to the figure, you come up with a value of 17.8$ billion to the Ag Spin Co. Now, the materials division is estimated to generate revenues of 47$ billion a year, resulting at an ebitda of 10.8$ billion, assuming a 22 percent ebitda margin. If you apply a relatively conservative multiple of 10 times ebitda to the figure, you come up with a value of 118.6$ billion to the Materials Spin Co.

Lastly, the Specialty division is estimated to generate revenues of 23$ billion a year, resulting at an ebitda of 5.7$ billion, assuming a 24 percent ebitda margin. If you apply a relatively conservative multiple of 10 times ebitda to the figure, you come up with a value of 64$ billion to the Specialty Spin Co.

If you add all that up, you easily reach a total value of 200$ billion, compared to the current enterprise value of only 160$ billion. That's 25 percent upside using very conservative assumptions.

This isn’t the first time that the company has successfully spun off divisions from the parent company. Various chemical companies such as Olin (OLN), Trinseo (TSE), Axalta (AXTA) and Chemours (CC) - all used to operate as commercial divisions within public entities prior to the spinoff process. I am confident that DowduPont will be able to successfully complete these two upcoming spinoffs just as it has done in the past.

Shareholder Friendly

DowduPont treats its shareholders very well. During the past quarter, the company generated cash from operations in the amount of 2.1$ billion, with most of it being returned to the hands of its rightful owners, the shareholders. More specifically, DowduPont has invested a total of 1.1$ billion in repurchasing its own shares, and has paid out 900$ million in dividends.

Treating its shareholders well is an important cornerstone in the company's strategy. Since the completion of the merger between DuPont and Dow chemical, the combined company has paid out a total of 5.6$ billion back to the hands of its shareholders.

What The Market Is Missing

Two unrelated events have caused a significant contraction in the company's earnings multiples. The first event is the escalation in the trade war between China and the U.S, causing a sharp and quick plummet in the market for most of last week. The second event was a profit warning issued by PPG Industries (PPG) on October 9th. The company blamed rising expenses and a soft demand from China for the squeeze in its profit.

Mr. Market then wasted no time in selling shares of any manufacturing company that has to do with materials. I agree that some suspicion is indeed warranted amongst companies such as Sherwin Williams (SHW) and Dutch Akzo Noble (OTCQX:AKZOY) which operate in the paint and coating business. Yet, this announcement by itself does not justify a massive selloff in other industries such as plastic manufacturers or companies which operate in the Ag industry.

As a result of this massive contraction in valuation, DowduPont is trading today for a measly valuation of only 12 times next year's earnings. And that's without even taking into consideration the fantastic spinoff investing theme I discussed earlier. Note how revenues and earnings (white line and green line, respectively) are rising, while valuation (brown line) is quickly contracting. This presents a wonderful entry point for new investors.

Looking Ahead

Synergies are paramount to every successful merger. One of the most interesting benefits of a mega merger between two giants is the ability to locate, and then utilize, synergies in the hundreds of millions. And that's precisely what DowduPont has been doing since the completion of the merger back in September 2017.

Specifically, over the past quarter management was able to locate and utilize synergies in the amount of 375$ million, and is now expecting annual synergies in the amount of 1.4$ billion. This supports the forecast that management has recently provided of a 10 percent increase in revenues and a 12 percent growth in ebitda in the third quarter of 2018.

Risks

As with every investment, DowduPont also has its risks. I believe that the main risk here is an operational risk associated with the spinoffs. A failure, or simply a partial success, in executing the spinoffs will definitely deter investors. Another risk is a decrease in demand for industrial chemicals, which will then hurt the company's top line.

It's interesting to note that even in a worst case scenario, shares of DowduPont should still worth 60$, which is right about where shares are currently trading for today. Even if you assume no spinoffs at all and a single digit decrease in revenues, I still come up with net earnings of of 4$ a share next year. When you apply the average multiple of the chemical sector, which is around 15 times, you arrive at a 60$ per share. Now, that's what I call a margin of safety.

My Bottom Line

The new DowduPont grows its earnings at a double digit rate and treats its shareholders very well. The upcoming spinoffs will provide the much needed catalyst for the shares to reach 90$ per share.

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Disclosure: I am/we are long DWDP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.