DSM: There Is Still Upside Left After The 40% YTD Run

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About: Koninklijke DSM N.V. (RDSMY)
by: Belgian And Bullish
Summary

DSM is a very interesting investment for investors that want to ride the 'sustainability'-wave.

While the 42% YTD surge in the share price has made the company significantly more expensive, DSM still offers upside for long-term investors.

DSM is valued as a Materials business rather than a Nutrition group, which is unjustified given the underlying profit distribution.

DSM is an investment that combines favourable global trends, excellent corporate governance, top class management, solid capital allocation, a clean balance sheet and interesting growth prospects.

Executive Summary

Sustainability, global warming, and pollution are all very active themes that are only set to grow in importance in the coming years. DSM (OTCQX:RDSMY) (primary listing in Amsterdam AMS:DSM) is one of the leading players in various fields of sustainability. While the company offers exposure to favourable global trends, excellent corporate governance, top class management, solid capital allocation, a clean balance sheet and interesting growth prospects, the market does not seem to fully value these qualities.

We think DSM is misunderstood by the market, which still views the company as a Materials business rather than a Nutrition group. This observation is based on both valuation multiples as well as the volatility of the share price:

2019E EV/EBITDA

Q418 drawdown

Materials peer group

7.5

-30%

Nutrition peer group

19.7

-11%

DSM

11.2

-24%

Source: Bloomberg

The fact is that DSM today generates 70% of profits in Nutrition and 30% in Materials, so any kind of sum-of-the-parts valuation arrives at a much higher valuation than today’s share price, even after the +42% recent share price run.

While this is appealing in itself, the bigger story is that the proportion of Nutrition will increase from the current 70% to 85-90% based on (1) the fact that DSM has a very promising pipeline of new product launches which are all to be found in the Nutrition segment and (2) they have the balance sheet and desire to acquire in Nutrition rather than in Materials. So, we believe the company will naturally evolve towards an 85-90% profit share from Nutrition which will at that point lead to the question whether it is not more intelligent to simply dispose of the Materials business.

It is difficult to explain why the market so vastly misunderstands the company, but we believe the following factors might be at play:

  • Most sell-side analysts covering the stock are chemicals rather than nutrition analysts, and they focus disproportionally on the Materials segment, even though it represents only 30% of profits.
  • The transformation of DSM is still relatively fresh, and the market is typically slow at adapting to companies that fundamentally transform their portfolios (the very gradual re-rating of Unilever as a case in point). In the minds of many investors, DSM is still a bulk chemical producer.

The biggest risk to our investment case is that we overestimate the quality of the business, which does not have a long track record in its current form.

Afbeeldingsresultaat voor DSM

Source: Company Website

1. Introduction to the company

DSM is a company that has undergone a complete transformation since its inception in 1902. The abbreviation stands for “Dutch State Mines”, referring to its original activity as a state-owned coal mining enterprise. The Dutch State decided to wind down this activity over the period 1950-1980 as (1) they started discovering natural gas reserves and (2) imported coal became cheaper. The last mine was closed in 1973, and DSM gradually shifted to petrochemicals, producing typical bulk chemicals such as polyethylene and polypropylene (plastics commodities). The second and final major shift for the company was away from petrochemicals and into nutritional ingredients. The following milestones are important to keep in mind:

  • 1998: DSM acquires Gist-Brocades, a biotechnology company that was established in 1869. At the time, Gist-Brocades was a major producer of yeasts and antibiotics to the pharmaceutical industry.
  • 2002: DSM sells its petrochemicals business to SABIC for 2.25bn EUR, putting a definite end to the production of commodity/bulk chemicals at DSM.
  • 2003: DSM furthers its switch with the acquisition of Roche’s vitamins & fine chemicals business.

The following figures further visualize DSM’s transformation process:

Source: DSM Investor presentations

Source: DSM Investor presentations

2. The various business segments

In 2018, DSM generated an adjusted EBITDA of 1.5bn EUR, which is for 70% generated by the Nutrition segment, with the remaining 30% accounted for by Materials.

Source: Author's own graphical display based on company financials

2.1 Nutrition – 70% of group EBITDA

DSM is the global #1 in vitamin production, yet the company also has dominant positions in PUFAs, enzymes, eubiotics, dietary supplements, etc. In addition to animal and human nutrition, DSM’s ingredients are also used in the cosmetics industry (mostly sun care and fragrances). In terms of value chain, DSM is forward integrated, producing the active ingredients, but also further adding value through the production of forms and premixes. The slides below provide an excellent overview of DSM’s well-diversified Nutrition business:

Source: DSM Investor presentations

Source: DSM Investor presentations

Source: DSM Investor presentations

Source: DSM Investor presentations

Nutrition represents no less than 70% of group profits and can be further broken down into the following activities:

Source: Author's own graphical display based on company financials

2.1.1. Animal Nutrition – 48% of Nutrition sales

DSM has been a pioneer in feed additives and today features as one of the world’s leading suppliers of vitamins, carotenoids, eubiotics and enzymes to farmers, feedmills and integrators. As such, DSM addresses the world’s increasing need for animal protein, catering to an industry that is professionalizing at a rapid pace, in need of additives that ensure to raise animals in a more efficient and safer way. An example is the industry’s shift away from antibiotics, something DSM foresaw a long time ago and anticipated with its industry-leading range of eubiotics. A couple of product examples in Animal Nutrition:

  • CRINA Poultry Plus: a patented formulation of benzoic acid and essential oils for broiler chickens that improves the gastrointestinal functionality of poultry by stimulating the production of digestive enzymes and improving the balance of gut microflora.
  • Hy-D: a vitamin D3 metabolite that supports bone development, muscle formation and immune response in poultry and swine.
  • Rovimax: a nutritional solution for fish farmers to supply sufficient levels of free nucleotides in aquaculture feeds in order to improve the salmon’s immune system.

Source: DSM Investor presentations

Source: DSM Investor presentations

2.1.2 Human Nutrition – 35% of Nutrition sales

Unsurprisingly, the main product categories DSM produces for Human Nutrition are the same as Animal Nutrition: vitamins, carotenoids, minerals, amino acids, nutraceuticals, nutritional lipids, preservatives, colorants, etc.

Source: DSM Investor presentations

Source: DSM Investor presentations

2.1.3 Personal Care & Aroma Ingredients – 6% of Nutrition sales

This activity offers solutions to personal care, home care and fine fragrance markets. The portfolio includes aroma ingredients, vitamins and natural bio-actives, as well as UV filters, peptides and polymers. DSM operates the largest portfolio of UV filters in the world, capitalizing on the increased use of sunscreen and increasing awareness around skin cancer.

Source: DSM Investor presentations

Source: DSM Investor presentations

2.1.4 DSM Food Specialties – 10% of Nutrition sales

DSM Food Specialties produces hydrocolloids, specialty food enzymes, cultures, bio-preservation solutions, savory ingredients, etc. These solutions focus on five trends: sugar/fat/salt reduction, enhanced taste experience, improved health and wellness, bio-preservation and food chain efficiency; i.e. these are specialty ingredients that find their way to lactose-free milk, sugar-reduced beverages, meat substitutes, gluten-free bread or beer, etc. This segment is entirely geared towards the phenomenal trend in so-called “free-from” food and beverages: consumers increasingly want specialized diets containing zero or a reduced amount of certain ingredients. DSM’s operations are tracking so well with customers that demand has outstripped their capacity for certain products (especially enzymes). Examples of products include:

  • Maxilact lactase breaks down lactose in dairy, making the products suitable for lactose-intolerant consumers. In addition, Maxilact’s natural sweetness allows dairy producers to reduce sugar by 20-50%. “Lactose-free” and “no added sugar” are two of the fastest growing categories in dairy. DSM was the first company to commercialize lactase.
  • Hydrocolloids are a further product category experiencing significant growth. Hydrocolloids are thickeners and stabilizers that dissolve, disperse or swell in water to modify the viscosity of products. DSM produces natural hydrocolloids which gain significant share from traditional, synthetic and animal-derived hydrocolloids.
  • Delvo Guard: a range of clean label, protective cultures that prevent yeast and mold growth in dairy products, extending shelf life without sacrificing taste or texture.
  • ModuMax enhances the taste for products that have lost their taste appeal due to lower fat, salt or sugar content. It is also used in high-protein diets with undesirable taste notes. ModuMax is allergen-free, suitable for vegetarian foods and certified non-GMO.

Source: DSM Investor presentations

Source: DSM Investor presentations

2.2 Materials – 30% of group EBITDA

Materials is the other segment DSM reports and represents roughly 30% of group profitability. The segment in turn consists of three business lines:

Source: Author's own graphical display based on company financials

As was the case for the Nutrition segment, Materials is also a truly global business, with activities nicely split between Europe, Asia and the U.S. Note that DSM is virtually not present in Latam in Materials. In terms of end-markets, it is important to acknowledge that Materials is a strictly more cyclical business than Nutrition, with building & construction, auto and electronics as significant end-markets. Our assessment is that 2/3rd of the Materials segment is cyclical, i.e. for DSM as a group, we deem 80% of profits to be generated in defensive end-markets and 20% in cyclical end-markets.

Source: Author's own graphical display based on company financials

Source: Author's own graphical display based on company financials

DSM characterizes its materials portfolio in the following way:

Source: DSM Investor presentations

We should be aware that in chemicals “maximize returns” is a euphemism for mature, more commoditized activities. As the size of the dots represent the size of the activities, it is clear that at least a significant part of the Materials portfolio represents activities where DSM intends to maximize margins and return on capital. The growth in these business lines is more muted, but the company does hold nice nichy monopoly positions: its products are found in 100% of mobile devices and 90% of cars around the world, whereas 55% of all internet traffic occurs through DSM protected fiber optic cables.

2.2.1 Engineering Plastics – 51% of Materials sales

DSM Engineering Plastics is a global supplier of high-performance thermoplastic solutions that are mostly used in automotive and electronics applications. DSM invented high-temperature polyamides, a product range that has witnessed stellar growth as traditional production materials are steadily replaced by high-performance plastics, especially in automotive, as these polyamides show similar strength but much lower weight than metals.

Source: DSM Investor presentations

While plastics will always sound like a commodity business, it is easy to underestimate the technological nature of this activity. High-performance plastics have undergone a significant evolution over the past few years. The products that are currently used have all been developed over the last 5 years and, as with phones e.g., it would be unthinkable to use plastics devised by technology from 5 years ago. Main application areas are automotive and electronics, where Apple (NASDAQ:AAPL) is a customer example. While Apple is usually a difficult client (they are super demanding), they are a great reference to have and a sign you are able to produce high-spec products. Automotive applications are mostly found where there is high friction and large temperature ranges. A new growth area is cloud computing, as the data centres contain ever more tiny connectors and switches.

2.2.2. Dyneema – 12% of Materials sales

Dyneema was invented in DSM’s laboratory and patented in 1979. It is the world’s strongest fiber, being 15 times as strong as steel on a weight-for-weight basis, or 40% stronger than aramid. Dyneema floats on water and demonstrates an extreme combination of lightness and strength. Today, Dyneema is used in a wide variety of applications:

  • Anchoring of offshore platforms in oil & gas industry
  • Cables used in mooring large ships
  • Bulletproof vests for intelligence agencies, police, military
  • Formula one cars
  • Medical technology (orthopaedic, prosthetics)
  • Sports equipment (kites, fencing, ice hockey, mountaineering, etc.)
  • Cables and lines to attach blades to windmills

The goal for Dyneema is to constantly find new applications and further take share from other high-performance fibers such as aramid. Dyneema is a nice example of DSM’s competence to launch new products that come out of the firm’s own R&D. After being on the market for 40 years, Dyneema still generates double-digit organic growth.

2.2.3. Resins & Functional Materials – 37% of Materials sales

The easiest way to explain this business is to first understand the different kinds of resins that exist. There are solvent-based resins, water-based resins, powder resins and UV-curing resins. Coatings or paints then take the name from their resins, i.e. water-based paint, solvent-based paint, etc.

  • Traditionally, solvent-based coatings have dominated the market. They are made up of liquefying agents that are meant to evaporate via a chemical reaction with oxygen, i.e. moving air around the coating will speed up the process and reduce drying time. The advantage they have over water-based coatings is that they traditionally have been less susceptible to environmental conditions such as temperature and humidity during the curing phase, enabling them to be used in any kind of environment. The big downside to solvent-based coatings is that the chemical curing releases odors, and more importantly, so-called volatile organic compounds ("VOCS") that can be toxic.
  • Increased regulation on the emission of "VOCs" has sharply increased the popularity of water-based coatings, in addition to technological advances that have made water-based paints more robust to varying levels of temperature and humidity.
  • Powder coatings are completely different in that they are mostly used as finishes. They are based on polymer resins, which are in form similar to a uniform powder such as baking flour. They are applied through spray guns rather than rolls or brushes. Powder coating is typically used for coating of metals and MDF, which require a stronger finish.
  • UV curing is the most advanced method, used for inks, adhesives and coatings. It is high-speed, precise and very strong. Therefore, it is mostly used in end-markets such as medical, electronics, 3D printing and automotive.

To sum up, powder coatings and UV curing are used in specific circumstances, whereas water-based and solvent-based coatings are direct competitors where water-based is taking significant share from solvent-based coatings due to increased regulation on VOC emissions.

Source: Author's own graphical display based on company financials

Now, let’s look at how DSM is positioned:

  • As usual, DSM is on the right side of the regulation trade, having pushed for solvent-free coatings since the early days. It has an extensive portfolio of water-borne resins and is not active in solvent-based resins. They have even taken the debate one step further and have recently launched a product (called Sigma Air Pure) with an air purification effect. Sigma Air Pure is claimed to remove up to 70% of the harmful formaldehyde from indoor air. The product is a bio-based technology that DSM co-developed with PPG. This new product nicely plays into the fact that the EU has issued a directive requiring 30% of European paint to be bio-based by 2030.
  • In UV-curing resins, DSM has a distinct position, as it invented the first fiber-optic coating 40 years ago. It is today the global market leader in fiber-optic coatings and c. 55% of all internet traffic occurs through cables that are protected by DSM coatings. These coatings are nowadays increasingly used in additive manufacturing (3D printing). In addition, uptakes of 4G and 5G and the required investments spur demand for DSM’s coatings.
  • As to powder coating resins, DSM once again claims to have invented this space 60y ago and is one of the main players today, especially with its new zero-VOC technology.

Source: DSM Investor presentations

One further example of the shift from solvent-based to water-borne coatings are Chinese containers. 95% of the world’s sea freight containers are made in China and virtually all are painted with solvent-borne coatings, constituting one of the major VOC emission sources in China. DSM founded the Waterborne China Platform back in 2010, and this political action has seen success: in 2016, China has decided to switch to water-based coatings for sea-freight containers in light of its “Blue Skies Policy”. It once again shows DSM’s excellent political relations in China, and this example is one of many reasons why on earnings calls DSM constantly mentions its growth is spurred by China’s “Blue Skies Policy”, which will further support results over the next few years.

2.3 Innovation Center

The Innovation Center serves two functions: first to develop new business, focusing on areas outside the current scope of activities. The second function is to accelerate the innovation power and growth of the core business. In addition, the Innovation Center is responsible for patents, protection of IP, etc.

DSM’s goal is to generate at least 20% of sales from products that were launched via the Innovation Center in the last 5 years, and these products should carry a higher margin than the group average. The company spends no less than 5% of its sales on R&D and estimates this proportion to remain true in the future. Currently, the Innovation Center holds the following noteworthy projects:

  • DSM Biomedical

DSM Biomedical produces biomaterials for the medical technology sector, Medtronic is a large client. DSM’s efforts in the field actually date back more than 25 years, but it was never a major priority. It was merely another application of Dyneema where bits of steel or metal in surgery were replaced by Dyneema, as it was much lighter and more sustainable. This changed in 2012 when they acquired Kensey Nash in the U.S. to focus more on this activity. The Kensey Nash acquisition has been a disappointment, however, as the company has lost a large account over recent years, and performance has been below expectations. DSM paid 12x EV/EBITDA for Kensey Nash. Trading performance has significantly improved recently with 2018 being a stellar year, and the pipeline currently has promising projects, mostly in ophthalmology.

  • DSM Bio-based Products

Bio-based Products captures two alliances that focus on renewable energies and renewable building blocks. In 2012, DSM launched a JV with POET LLC, one of the world’s largest bio-ethanol producers, to commercially develop and license cellulosic bio-ethanol. This is derived from corn crop residue by way of hydrolysis followed by fermentation. In 2011, DSM and Roquette announced they would build a commercial scale plant for the production of bio-based succinic acid, the first non-fossil feedstock that allows customers in the chemical industry to use a bio-based alternative to run their chemical plants.

  • DSM Advanced Solar

DSM’s efforts in the solar market are focused on increasing the yield on solar panels. The main activity consists of the production of anti-reflective coatings, in which DSM is the global market leader. They have recently also launched extremely strong backsheets to extend the life of solar panels that are installed in harsh environments (deserts, tropical environments, floating solar parks, etc.).

As of today, the profit generation of the Innovation Center is meaningless, generating 8mio EUR EBITDA in 2018. These products are in development stage and should increase in importance over the next years.

3. Barriers to entry

As DSM is active across a wide range of products, it is difficult to discuss the barriers to entry in each specific market they operate. We note that vitamin production is their #1 activity, representing roughly half of Nutrition sales, which in turn represents 70% of group profitability. Furthermore, vitamin production consists of a synthesis process where the side-streams develop into other product categories such as aromas, scents, carotenoids, etc. Vitamins are not only DSM’s most important business, it is also the most misunderstood one, especially with respect to barriers to entry, as some market commentators have stated it is not very difficult for Chinese players to enter the market. There are a couple of factors we need to discuss:

  • Every vitamin is different
  • Not all processes are alike
  • The end-markets matter, as well as the roles you play in the value chain
  • The Chinese environment has changed a lot

First of all, it is key to understand that production is very different for each kind of vitamin. The processes range from chemistry to biotechnology to fermentation to bio extraction… it is not like you set up a plant and start producing a variety of vitamins. For starters, there is a big difference between water-soluble vitamins (B and C) and fat-soluble vitamins (A, D, E, K), with the latter being more difficult to produce. Even for the range of B vitamins (there are grosso modo 8 different B vitamins), production of one B vitamin is completely different from another B vitamin. The breadth of DSM’s vitamin offer is unmatched globally. As we said, especially the production of fat-soluble vitamins is highly complex: in order to produce A, D, E or K vitamins, you need to set up a range of plants covering the at least 20 conversion steps necessary to produce the vitamins. Setting up such a complex of plants requires at least 500mio EUR. There are only two players in Europe who own such a complex, BASF (OTCQX:BASFY) [ETR:BASF] and DSM, and it would be completely irrational for anyone to set up a third complex, so a nice and steady duopoly, in my opinion.

Next, not all processes are alike. BASF and DSM actually use a different process to come to the same end products. BASF uses an easier citral process, with fewer side streams. DSM’s process has side streams that produce carotenoids, aromas, intermediates, scents, etc. which are highly valued end products in itself.

Further, the end-markets matter a lot. To give an example, as we said, production of vitamin B and C is less specialized and less capital-intensive than the production of fat-soluble vitamins. However, when it comes to the production of vitamin C for the infant formula market, DSM has a virtual monopoly, serving the globe from their Scotland-based plant. The vitamin C that DSM produces in Scotland is perceived as the most secure and high-quality vitamin C to come by, so whenever Nestlé (OTCPK:NSRGY) (SWX:NESN), Abbott (NYSE:ABT), Danone (OTCQX:DANOY) (EPA:"BN") or Mead Johnson (LON:RB) produce infant formula, they will always source it from DSM. So, even for the important Chinese baby formula market, these players will not use the many Chinese players that exist, simply because they cannot run the risk of messing up with the quality of baby food, especially in a region where scandals with infant formula are still fresh in the minds of many parents. This is different compared to Animal Nutrition, where the sensitivity nature of the product is different. Yes, the products still end up in the food chain, but there is still a big difference between what Danone puts into its baby food versus what farmers use to feed poultry. Next, it also matters what roles you fulfill in the value chain. DSM is completely integrated and mostly produces premixes, so it doesn’t provide its customers with vitamins, but rather with ready-to-go solutions. For instance, DSM will deliver a premixed bag of ingredients to Danone or Nestlé who simply need to add milk and the product is done, i.e. these are highly tailored solutions for the clients.

Lastly, the Chinese environment has changed. China has always been a region with many vitamin players, but they have always focused on the easier, water-soluble vitamins and never really on fat-soluble vitamins. Furthermore, two things have changed over the last decade:

  • The environmental regulation has drastically changed, which has allowed DSM to take significant market share in China, with their best in class production sites. The Blue Skies policy has been great for DSM: the increased regulation has put many local players out of business. DSM claims that, from an environmental regulation point of view, it is today more difficult to set up production in China than in Switzerland, where its European production is based.
  • In the past, vitamin production was an area where China wanted to be active, which was subsidized and incentivized by the state. This is no longer the case, and all local producers are now in the hands of regular business people and shareholders, the state is no longer involved, so the playing field is levelled.

4. Strategy and targets

DSM’s strategy is to generate excellent bottom line results through innovation as a sustainability leader. As we have already talked at length about their sustainability efforts, let’s turn to how this translates financially.

First, let’s have a look at how the company has performed over its prior strategy period 2015-18. We note they have vastly outperformed their targets: they have delivered a +13% adjusted EBITDA CAGR (based on >5% average organic growth and significant margin expansion) vs their high-single digit goal:

Source: DSM Investor presentations

Source: DSM Investor presentations

The “temporary vitamin benefit” refers to a fire at a BASF vitamins plant for citral production, a force majeure that significantly benefited DSM in 2018 as capacity was temporarily impaired and thus prices shot up for a select amount of DSM’s products (mainly vitamin A and E). The company has consistently stripped out this positive effect using normalized vitamin prices. Everything we discuss is based on underlying results, not taking into account the exceptional profitability of 2018. This extreme profitability was temporary and now behind us, but still a very nice tailwind for deleveraging and cash generation.

So, after significantly exceeding expectations the question becomes where do we go from here? DSM has announced new targets for the period 2019-2021 at its Capital Markets Day in June 2018:

Source: DSM Investor presentations

The central target of the new strategy period is to grow FCF at c. +10% p.a. With this target, DSM admits that FCF growth is the one area where they have lagged in the prior strategy period: while all other profitability and top-line metrics were strong over 2015-18, FCF has compounded at a meagre +5% as cash conversion has slipped. It is now improving its cash conversion by focusing on reducing its working capital. Other than cash flow, we note the targets are relatively similar to the prior strategy period, demonstrating the structural attractiveness and momentum of the mix of activities.

One area where we could see outperformance of 2021 targets is adjusted EPS. If DSM does not find suitable acquisitions candidates at attractive multiples, it will increasingly use its excess cash to buy back shares, which could in turn result in an adjusted EPS growth ahead of targets.

5. Management

Feike Sijbesma became CEO of DSM in 2007. Upon graduation at Erasmus University Rotterdam he joined Gist-Brocades where he made his way up and eventually led the Savoury Business. Gist-Brocades was bought by DSM in 1998 and Sijbesma became head of the Food Specialties division. He became member of the Managing Board in 2000 and was responsible for the acquisition and integration of the Roche activities in 2002-2003. The portfolio transformation and repositioning has occurred under his leadership.

Sijbesma receives a lot of credit from the investor community and seems extremely well-connected politically. His clout mostly extends to the World Bank, United Nations and World Economic Forum. Somehow, he also seems to have great China relations. A couple of awards and Board positions:

  • Humanitarian of the year – United Nations (2010)
  • World’s 50 Greatest Leaders – Fortune (2018)
  • Winner Fortune Award Circular Economy Leadership – World Economic Forum (2016)
  • Leader of Change Award – United Nations (2011)
  • Co-Chair of the High-Level Assembly of the Carbon Pricing Leadership Coalition ("CPLC"), convened by the World Bank
  • Vice chairman Global Agenda Council Role of Business in Society World Economic Forum (WEF)
  • Co-Chair Annual Meeting of the New Champions WEF – China
  • Global Climate Leader – World Bank (2017)

Geraldine Matchett has been CFO of DSM since 2014, having served in the same role at Swiss SGS Group (SWX:SGSN) from 2010 to 2014, where she was voted CFO of the year. Prior to joining SGS in 2004, she worked for Deloitte in Switzerland and for KPMG in the UK.

Positive to note is that this week, DSM announced that all members of the executive committee have opted to convert 50% of their gross short-term incentive bonus into DSM shares. To me, this is a clear sign that even at a €100 share price, the management still sees significant long-term upside.

6. Ownership

There are no major reference shareholders nor activists in the stock. Capital Group holds 7.2% of the shares, Sijbesma has 0.09% or 17mio EUR. DSM has never been the subject of activist interest but has routinely been mentioned as a take-over candidate (e.g. Bloomberg article). We note the same has been true for Croda (LON:CRDA), another top-notch consumer ingredients company, though for both companies nothing has ever materialized.

7. Corporate governance

In terms of corporate governance, we think there are two points worth mentioning. Even though Feike Sijbesma receives a lot of credit, we note that:

  • His fixed salary is 920k EUR, which would be more if DSM followed its normal rules for executive pay, comparing salaries to a peer group etc., but apparently, he makes less upon his own request.
  • The roles of Chairman and CEO are split, and this has always been the case. Rob Routs is chairman of the Supervisory Board, his term ends in 2020. Throughout his career, Rob Routs has served in several senior positions at Shell (NYSE:RDS.A).

8. Financials

Below we provide a brief summary of DSM’s main financials. The period is short, as this is the horizon over which we have comparable numbers, since the business portfolio has changed significantly. The 2018 underlying numbers exclude the exceptional profitability from BASF’s plant outage, the stated numbers include the vitamin price effect.

2015

2016

2017

2018 underlying

2018 stated

Sales

7,722

7,920

8,632

8,852

9,267

Sales growth - nominal

9.5%

2.6%

9.0%

2.5%

7.4%

Sales growth - organic

1%

4%

9%

6%

Gross profit

2,309

2,658

2,933

3,405

Gross margin

29.9%

33.6%

34.0%

36.7%

Adj EBITDA

1,075

1,262

1,445

1,532

1,822

Adj EBITDA margin

13.9%

15.9%

16.7%

17.3%

19.7%

Adj EBIT

573

791

957

1,055

1,345

Adj EBIT margin

7.4%

10.0%

11.1%

11.9%

14.5%

EPS

2.1

2.9

3.9

5.8

EPS growth

-9.6%

35.6%

35.2%

48.6%

ROCE

7.6%

10.4%

12.3%

13.3%

16.8%

Net debt/EBITDA

2.16

1.64

0.51

0.07

0.07

Cash from operations

696

1,018

996

1,126

1,391

Source: Company financials

8. Capital allocation

8.1 Debt

DSM has deleveraged very nicely over the past 5 years and turned cash neutral at the end of 2018. This deleveraging is in part due to strong operational cash flow, but even more driven by divestments of non-core activities. We will further discuss these disposals in the M&A section.

Source: Author's own graphical display based on company financials

8.2 Capital return

Buy-back vs. M&A

DSM’s capital allocation priorities have always been clearly communicated to the market:

Source: DSM Company Presentations

DSM surprised the market at its full-year 2018 results with the announcement of a 1bn EUR buyback. The market had rather anticipated DSM to make acquisitions in Nutrition, as they had always stated. The buyback announcement came as a relief as there was certainly a concern in the market that DSM would have to pay an elevated price to acquire in Nutrition, as multiples in this industry in general are quite steep. However, DSM has stated that, even with the buyback, it still has ample room to do M&A. This is correct: if the firm would lever up to 2.5x EBITDA (which is certainly not excessive for a stable, cash generating business like DSM), they would have nearly 4bn EUR to execute deals. We view the buy-back announcement as positive, signalling that DSM is disciplined in its M&A strategy and not willing to pay steep multiples to acquire at any cost. In addition, the balance sheet leaves ample flexibility to execute deals if opportunities would arise at decent valuations.

Dividend

The dividend was held stable during the 2013-2015 period as DSM was putting through many portfolio changes. For 2018, the dividend was hiked by no less than +25%. The current dividend translates to a 2.3% dividend yield and c. 40-50% pay-out ratio.

Source: Author's own graphical display based on company financials

8.3 Capex

Capex as a % of sales has averaged 6.5% of sales, which DSM forecasts to remain the case over the strategy period 2019-2021. 50-60% of capex is related to growth capex, while two-third of capex is spent in the Nutrition segment.

Source: Author's own graphical display based on company financials

8.4 M&A

Acquisitions

DSM has consistently stated it wants to acquire “predominantly in Nutrition”. The market has at times speculated it wants to push the final frontier of its transformation by selling its Materials segment and making further acquisitions in Nutrition.

Over the past couple of years, DSM has made a number of very small acquisitions where it mostly buys technologies, but significant deals have not taken place. Given its recent surprise announcement of a buyback, we think it is clear that transformational M&A is not imminent. However, as we pointed out, DSM does have the ambition to acquire in Nutrition, and it has the balance sheet to do so. DSM has stated in the past it wants its acquisitions to be cash EPS accretive in the first year of close, meeting profitability, sustainability and growth targets of the group.

Disposals

While DSM has been relatively silent on the acquisition front, it has consistently continued the disposal process of its more commoditized and cyclical activities. There are three main activities (Patheon, Sinochem and ChemicaInvest) where DSM has been in the process of disposal over the last years. Rather than selling the activities outright, DSM has chosen to bring these activities in JV structures, gradually selling their interests.

Patheon was formed in 2014 when JLL Partners (private equity) and DSM combined DSM’s Pharmaceutical Products with Patheon’s activities. Patheon is a leading global provider of outsourced pharmaceutical development and contract manufacturing services ranging from formulation development to clinical and commercial-scale manufacturing, packaging and lifecycle management. Patheon was divested in 2017 to Thermo Fisher (NYSE:TMO), with proceeds to DSM of over 2bn EUR, which represents a very nice exit for DSM. This was by far the most important exit for the company.

DSM Sinochem Pharmaceuticals was formed in 2011 as a 50/50 JV between DSM and Sinochem. The company is active in sustainable antibiotics, next-generation statins, anti-infectives and anti-fungals, selling active ingredients. In October 2018, the company was sold to Bain, with DSM receiving 275mio EUR, which represents a book profit of c. 110mio EUR.

ChemicaInvest is a JV between DSM (35% share) and CVC Capital Partners (65%) that initially housed 3 chemical businesses: Fibrant, Aliancys, and AnQore. Together, they generated c. 2bn EUR in sales at a 10-12% EBITDA margin. Fibrant was divested in 2018 to a Chinese company with cash proceeds for DSM of 200mio EUR. Fibrant produces caprolactam, a chemical input that DSM requires in its Engineering Plastics activities, so the divestment agreement contained a clause that secures >80% of DSM’s caprolactam needs up until 2030. This means the ChemicaInvest JV now only holds Aliancys (composite resins) and AnQore (acrylonitrile), which jointly generated c. 700mio EUR in sales at an EBITDA margin of 12%. These businesses will be divested in the near future, which will conclude DSM’s divestment process.

9. Sales growth

Historical growth

While organic growth in the Nutrition segment has been very steady between +5% and 8%, Materials has been significantly more volatile, ranging between -4% in 2015 and +13% in 2017. The EBITDA of Materials is a lot less volatile, however, as the volatility in organic growth is price-driven based on input cost fluctuations, not volume-driven. These price-driven changes in organic growth are then offset by the margin that is more favourable in an environment of deflationary input costs.

Source: Author's own graphical display based on company financials

Future growth – pipeline

To get a better sense of future growth, we take a look at the major projects that should deliver the future organic growth. DSM is a company that stands out in terms of investing in its future organic growth:

  • Clean Cow

Clean Cow represents one of DSM’s most promising projects, where it wants to tackle one of the most well-known environmental problems: methane emissions from cows. Cows emit 500l of methane per day, equivalent to 10% of the energy they would otherwise use for performance and milk production. DSM has developed a special feed solution that reduces enteric methane emissions by at least 30%. It sees an attractive market potential of 1-2bn EUR in sales with launch after 2019.

Source: Author's own graphical display based on company financials

Clean Cow is a project that DSM has worked on for a while now and, as with many innovations, the main bottleneck has been that it is indeed a great innovation, but no one really wanted to pay for it. This has changed over the recent past, with especially the dairy industry (Netherlands, New Zealand, Ireland) showing significant interest. The interest stems from both farmers as well as governments. For governments, the incentive is purely ecological: they make a trade-off between all kinds of policy decisions regarding fossil fuels, clean energy, traffic, etc. and have figured out that an investment in the Clean Cow project (via subsidies or what not) actually achieves their goals in a cost-efficient manner. For the farmers, apparently the incentive is image: larger dairy companies struggle with the negative publicity around the GHG emissions from cows and see Clean Cow as the best way to remedy this.

  • Veramaris

Veramaris is a 50/50 JV between DSM and Evonik ("EVK") focused on animal feed for salmon farming. Over the past years, the steadily increasing consumption of salmon has been fully supported by aquaculture, as wild capture has stagnated due to quota. Many commentators (including DSM) believe these trends are unsustainable in terms of salmon feed, i.e. the growing demand for salmon can only be met through ever-increasing aquaculture but the salmon feed industry is struggling to keep up with demand and alternatives need to be found:

Source: Company Investor Presentations

Source: Company Investor presentations

This anticipated supply/demand gap is exactly why DSM has launched the JV, in addition to many claims that salmon farms often use unsustainable growing methods. The goal of the JV is to produce omega-3 fatty acids (EPA and DHA) as an ecological alternative to fish oil (currently c. 17% of wild catch is used to produce fish oil). DSM’s solution does not use wild-caught fish but produces the omega-3 fatty acids from natural algae.

The JV is currently setting up a production facility in the U.S. (total capex 200mio USD that is split evenly between DSM and Evonik) that will be able to meet 15% of current demand from the aquaculture industry. Construction of the plant is expected to be finished by the summer of this year. The plant will be able to generate c. 150-200mio in sales and apparently clients are already asking DSM to build a second plant to meet their increased demand. DSM management, however, wants to wait and see how the first plant is going.

  • Fermentative stevia

DSM has been working on sugar replacement for years, and stevia is the only real natural identical product to sugar. The problem with stevia is that it currently only comes from plant extracts which have an irregular supply, are too expensive to harvest, and cannot produce the volumes necessary. Therefore, it needs to be fermented to become really big. DSM has worked on this for quite a while and now claims to have the right form. As it happens, Cargill was working on a similar project, and DSM and Cargill found themselves in a complementary situation and decided to team up. They formed it as a 50/50 JV, shared technologies and will go to market together, splitting the profits. In terms of commercial strengths, Cargill has good access to the large beverages players, while DSM delivers the flavours and fragrances companies. Longer-term, the plan is to attack the entire sugar market, but the first in line is the artificial sweetener market, i.e. aspartame and saccharide.

  • Niaga

Niaga (“again” spelled backwards) is focused on the circular economy and wants to create fully recyclable products, especially for materials that currently generate significant amounts of hazardous waste. The first success is fully recyclable carpet, developed and commercialized together with Mohawk (NYSE:MHK). The second step is to produce fully recyclable mattresses through a co-operation with Auping.

Pipeline – financials

As none of these innovations is in ramp-up phase, it is relatively difficult to estimate their future potential in terms of profitability and order of magnitude. What we do know is that Clean Cow, Veramaris and fermentative stevia are the three big projects to watch. As it happens, all three have a fairly similar timing: approvals and plant construction in 2019, first sales in 2020 that will come to full ramp-up in 2021-2022.

In terms of financials, DSM has stated it expects its major innovation projects to deliver 350mio sales and 100mio EBITDA by 2021 and 1bn in sales, 400mio in EBITDA by 2025. The most remarkable aspect of this guidance in my opinion is that implicitly DSM guides for a 40% EBITDA margin on the new projects, whereas they posted a 17% group EBITDA margin for 2018. Analysts have often asked the company why its target is not for significantly more than 1bn in additional sales, as the addressable markets, etc. would warrant a much higher number and DSM admits it is putting a significant haircut on its projections, since R&D/innovation is always very difficult to forecast.

10. Margins

Nutrition

The Nutrition segment has made a significant step-up in margins over the last years, recording a 19.5% EBITDA margin for 2018:

Source: Author's own graphical display based on company financials

The 2021 target of >20% adjusted EBITDA margin implies that margin expansion from current levels will be subdued. However, if we compare DSM’s margins to peers, we are not afraid the business is over-earning:

Source: Author's own graphical display based on company financials

So, while it could be that the group announces further margin expansion after the 2021 period, we would not bank on this, yet are not afraid of artificially inflated margins either. There is probably some slight upside to margins, but the bulk of the expansion has probably materialized.

Materials

While Materials has also delivered a nice margin expansion, it did not develop at the same clip as the Nutrition segment. The 2021 target of 18-20% margins suggests that, here also, further upside to margins is existent but limited.

Source: Author's own graphical display based on company financials

Compared to peers, again it seems the risk that DSM is currently over-earning is limited. We always strive to compare to the relevant segment at peers.

Source: Author's own graphical display based on company financials

11. Cash flow

Since everybody always uses a different definition of free cash flow, we prefer to provide the break-out below. Please note that cash from operations actually amounted to 1,391mio EUR in 2018, but this was favourably impacted by exceptionally high vitamin prices (BASF plant outage), so we take the lower adjusted number to reflect the underlying cash generation. First, we adopt an exceptionally strict definition of FCF we believe no equity investor will ever use, deducting all kinds of capex, dividends and interests paid. Second, we merely subtract maintenance capex from operating cash.

2014

2015

2016

2017

2018

Cash from operations

808

696

1,018

996

1,126

Maintenance capex PP&E

-250

-206

-186

-202

-291

Growth capex PP&E

-306

-252

-227

-247

-355

Intangibles capex

-97

-85

-63

-98

-27

Dividends paid

-175

-174

-190

-200

-225

Interest paid

-302

-303

-151

-135

-58

Free cash flow

-322

-324

201

114

228

Cash from operations

808

696

1,018

996

1,126

Maintenance capex PP&E

-250

-206

-186

-202

-291

Free cash flow

558

490

832

794

835

Source: Company financials - Author own calculations

Depending on the FCF definition one uses, DSM then trades on 1.5% or 5.6% FCF yield. The discussion of which FCF definition is “correct” is irrelevant, the appeal of DSM should be that they incur growth capital expenditures that are expected to generate a high return.

Going forward, we know that FCF growth is the #1 target set forward for the current planning period. FCF growth will be driven by:

  • The net cash position, eliminating interest payments; however, this has already largely materialized in 2018.
  • Profit growth from top-line and margin expansion.
  • A significant driver will be better management of working capital. DSM correctly notes this is an area where they can do better, as cash conversion has slipped over the past years. It sees significant room to improve its working capital management, especially in the Nutrition segment.

Source: Author's own graphical display based on company financials

Source: DSM Company Presentations

12. Return on invested capital

As we just stated, the attraction to DSM is that it generates cash, which it redeploys into R&D and growth capex that should generate a high rate of return. In terms of ROCE, the company has made remarkable progress over the last couple of years and a 16%+ ROCE target for 2021 implies the company expects this journey to be far from over. DSM expects ROCE to increase by c. 100bps in each of the next three years:

Source: Author's own graphical display based on company financials and guidance

13. Valuation

Multiples

Below, we plot the historical multiples for DSM from June 2015 up until 03/09/2019, where we think a couple of remarks are in order:

  • Historical multiples for businesses where the activity mix has changed significantly over time is always very tricky. It is clear that the DSM of 2018 is a completely different company vs the DSM of 2005.
  • Probably the most interesting thing about these charts is the recent volatility in the multiple, with P/E dropping to a low of 12x and EV/EBITDA dropping to 8x. We view the volatility in the multiple as completely unwarranted given the defensive profile of the company, especially in light of its clean balance sheet.
  • We would argue that the current absolute level of multiples (20x P/E, 11x EV/EBITDA) is pretty fair given the activities and prospects. Multiples are certainly not demanding, but definitely not at bargain levels we would like either.

Source: Author's own graphical display based on Bloomberg financials

Source: Author's own graphical display based on Bloomberg financials

Relative valuation, SOTP

While I’m not a huge fan of relative valuations or SOTP, I think it is useful to run the numbers on DSM, as one of the main points of the investment case is that the company is misunderstood: it is still seen as a chemicals company, while it has developed into a Nutrition play. The following numbers prove this point:

Source: Bloomberg

We have taken forward EV/EBITDA 2019, with the choice for this metric as DSM is cash neutral, so using P/E would benefit leveraged companies over the clean balance sheet at DSM (note how easy it would be for DSM to lower its P/E through an acquisition where it levers the balance sheet and buys some EPS). The choice of companies is simply the peer list DSM uses itself in its TSR assessment to calculate long-term executive bonuses.

If we would calculate a super simplistic sum-of-the-parts, arriving at a mixed multiple for DSM using 70% Nutrition multiple and 30% Materials multiple, we arrive at a multiple of 16x, which would translate to a target price of 150 EUR or +50% upside on a stock that has just seen a +42% run. I’m not a big fan of this methodology, as it could simply point to the fact that Nutrition players are overvalued by the market today, but I nevertheless think it is interesting to see that the market currently rather sees DSM as a Materials company than a Nutrition company, which is obviously incorrect.

All companies to the left of DSM are Materials players, all companies to the right are Nutrition:

Source: Author's own graphical display based on Bloomberg financials

We not only see that the market still sees DSM as a Materials play by looking at the multiple, but also by the volatility or the beta of the share price. We simply take a look at the maximum drawdown of each peer in the above list over Q418 when fear gripped the market about multiple macro concerns.

We note that the Materials group had an average drawdown of -30%, the Nutrition group had an average drawdown of -11% and DSM had a drawdown of -24%.

Source: Author's own graphical display based on Bloomberg financials

What are the consensus expectations?

Below we provide Bloomberg consensus for the next two years, in order to check whether the market is not getting ahead of itself so as to limit the risk of future earnings downgrades. Please note the 2018 actuals are on an underlying basis, i.e. excluding the temporary vitamin effect for revenue and EBITDA, but including the effect for EPS, as DSM has not reported EPS on an underlying basis, which was too difficult of an exercise.

2018 act

2019 est

2020 est

Revenue

8,852

9,285

9,746

% growth yoy

4.9%

5.0%

EBITDA

1,532

1,642

1,754

% growth yoy

7.2%

6.8%

EPS

5.84

5.05

5.74

% growth yoy

-13.5%

13.7%

Source: Author's own graphical display based on company financials and Bloomberg projections

Revenue growth at 5% and EBITDA growth at 7% are very much in line with the guidance the company has provided, so we see no big risk here. DSM should be able to generate these growth numbers in the absence of a full-blown recession. The EPS number is a lot more difficult, as we don’t have a proper 2018 base to put a growth number on. It is obvious that EPS for 2019 will decline vs the artificially high 2018 number, but it is hard to estimate by how much. We have tried in several ways to sense-check the feasibility of the consensus EPS estimate and think it is certainly not exaggerated, but remind that EPS is the biggest factor of uncertainty for 2019. The matter is further clouded by the unexpected buy-back announcement which in turn could provide a positive surprise.

14. Risks

What could go wrong?

In our opinion, the biggest risks to the investment case are the following:

  • The biggest risk is that we overestimate the quality of the business. DSM is indeed a Nutrition play but maybe not of the same quality as Givaudan, Kerry, etc. In that case, the market’s assessment in terms of multiple might be simply correct.
  • The Materials segment is cyclical and will make guidance unattainable in the event of a recession. There are 3 cyclical end-markets, each representing c. 6-7% of group sales: automotive, mobile devices and building/construction.
  • DSM’s success could attract more competition, pushing down vitamin prices which can be volatile.
  • There is always a risk of a scandal or a recall such as Greenyard’s listeria issues. Especially for a company like DSM, which is constantly touting sustainability, this can hit the share price hard.
  • Expensive acquisitions.
  • The story is certainly in a way tied to Feike Sijbesma so if he decides to retire, this probably will not be taken well by the market.

15. Conclusions

We think that DSM is a high quality company that is exposed to important global growth themes. The company has several products in the market that play into the global demand for more sustainable consumption and production. The pipeline is furthermore filled with promising high margin projects that are bound to keep DSM's growth story alive.

We believe that the opportunity lies in the fact that DSM has not always had this clear-cut positioning and that it used to be a more diverse chemical player with exposure to cyclical end-markets in the past. While DSM has transformed itself by divesting several divisions, the market has not reacted to this by rerating DSM's trading multiple. While DSM generates 70% of its EBITDA in the nutrition market and currently only has 20% exposure to cyclical end markets, the company is still valued as a materials player rather than a nutrition group.

While the 42% YTD surge in the company's share price has significantly reduced the upside, we still believe that the company is reasonably priced. The company trades at 11x 2019E EBITDA and 20x 2019E EPS, which certainly isn't cheap, we note that other nutritional groups trade at far more expensive multiples.

When we take the exposure to key growth themes, the excellent corporate governance and management, the clean balance sheet and the solid capital allocation into account, we believe that there is still attractive upside for long-term investors. We advise interested investors to place DSM on their watchlist and to do further research on this name, so they can opportunistically start or increase a position in this long-term compounder when the share price shows weakness.

Disclosure: I am/we are long AMS:DSM, EBR:SOLB. 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.