Industrials/Basic Materials

DuPont – A Slim Victory but Have Any Lessons Been Learned?

Written May 20th, 2015 by

DuPont may have won the battle, albeit by a small margin, but in our view it is still very much in danger of losing the war.  Beating Trian in the recent proxy fight may be a cause for celebration in the DuPont board room, but if the board does not address a couple of key issues raised by Trian, it may be the last celebration for a while. DuPont’s complexity is hindering the company and is likely causing excessive optimism, resulting in misplaced allocation of capital and broad underperformance both on the earnings front and from a total shareholder return perspective.  Broadly, complex companies fail to achieve meaningfully lower earnings or return on capital volatility, but they do a fairly good job of underperforming their less complex peers, as shown in the chart below.


DuPont has to address two issues that, in our view, arise from complexity, and impact many other companies as well as DuPont; an inflated cost structure, and undervalued specialty businesses.  The cost issues, again in our view, stem from the difficulty of trying to pursue a growth strategy and a low cost strategy under one roof.  More commodity focused competitors push the low cost agenda and drive down the cost curve – this has happened to DuPont in TiO2 and to Dow in ethylene and polyethylene and we can come up with countless other examples.  The erosion of these cost curves and many others have drowned any R&D/”growth initiative” driven gains.

The undervalued specialty business problem is currently acute for DuPont and possibly Dow, as we may be seeing the beginnings of a game of musical chairs in the Ag chemicals space.  Neither DuPont nor Dow can compete in the bidding for Syngenta because their multiples are too low because of the diversity of the portfolios and the additional complexity stock multiple penalties they have been given.  An attempt to buy Syngenta from DuPont today would be a highly dilutive move for shareholders – had DuPont management listened to Trian on day 1, DuPont “Growth Co” would be an independent company today and a much better suitor for Syngenta than Monsanto.

If DuPont returns to business as usual and pays no heed to the advice offered by Trian, we fear that it will be a case of more of the same – poorly thought through investment, both R&D and M&A, leading to more earnings disappointments.  It this scenario there is no reason to own the stock today as it is already expensive on a “business as usual basis”.  Our positive stance on DD relies on the board and management making some major changes to the cost base and major changes to focus, resulting in a more appropriate strategic path or strategic paths.


Industrial Gas Pricing – Talking a Good Game

Written March 3rd, 2015 by

Our recent thoughts on Industrial Gas companies have focused on their ability to pull pricing and cost levers to grow top and bottom lines. We have been particularly focused on APD and what it will need to deliver to justify further share price appreciation from here. Today, Air Products announced another round of price increases in the merchant business, as they have done in the past, but we think that the focus on achieving increases this time will be greater. The company is increasing prices for its North American merchant gas customers effective March 15, 2015 or as contracts expire. Monthly service charges will also be impacted.

As we wrote in the past, we believe that if Air Products is to beat its ambitious targets for 2017, the company will have to place an emphasis on cost and price that it has not in the past. So far, both imperatives have been given their due with the company announcing 500 job cuts in its most recent update. Still, we suspect that even if some 2500 more jobs are cut in the next 1 ½ to 2 years, expectations for APD may be difficult to manage.

With APD now pushing another round of price hikes, we expect that competitors will likely follow suit rather than use this as an opportunity to gain share.  These price increases come on the back of similar increases announced six months ago and more modest increases pushed by Praxair at the end of 2014. APD states that this round of hikes is to pass through higher metals costs for bulk tanks, using similar reasoning to PX in its December announcement. We believe that the more likely motivation is margin expansion given our understanding of recent iron and steel price moves. In either case, the question is still how far can pricing be pushed before customers defect.  Lack of volume growth in the business generally increases the focus on price as a way to grow top and bottom lines.
If the industry moves pricing more meaningfully than in recent years, then the optimistic top line estimates for APD shown below may be attainable.  At the same time the estimates for PX and others will likely be too low. The valuation opportunity is in PX in the US, and possibly Air Liquide in Europe.

Industrial Gases Blog

DuPont – Trian Engages the Big Gun!

Written January 29th, 2015 by

DuPont – Trian Engages the BIG Gun!

Trian, today, announced the formation of Trian Advisory Partners, charged with the following:

“Trian Advisory Partners will provide support to Trian by identifying potential investment opportunities, assisting with due diligence, formulating strategic and operating initiatives for the companies in which Trian invests, and engaging with public company management teams, Boards of Directors, shareholders, and external advisors. Trian Advisory Partners may also join the Boards of Directors of companies in which Trian invests”.

The three founding partners are William R. Johnson – former Chairman and CEO of Heinz; Dennis Kass – former Chairman and CEO of Jennison Associates and former Chairman of Legg Mason; AND Dennis Reilley – former Chairman and CEO of Praxair, current board director at Dow Chemical, current Chairman of Marathon oil, AND FORMER COO of DuPont.

Dennis Reilley is arguably one of the best CEOs in recent memory in the chemical industry and Praxair’s shareholders saw a total shareholder return of around 250% from the day he was announced CEO until the day he retired.  Dennis drove the capital and operating discipline at Praxair that created the superior returns and a business process that, while refined by his successor Steve Angel, is now the blue print for Air Products strategy and Linde’s strategy if we believe recent investor presentations.

Dennis was very quick to recognize which parts of the industrial gas value chain were commoditized or undifferentiated and made these as low cost and efficient as possible.

While there is no mention in Trian’s release about which members of the team will be focused on which investments, current or under consideration, Dennis’s DuPont and operational experience make him the obvious big gun you want in any discussion about restructuring both the company and the way the company operates.

While the DD earnings call contained a great deal of rhetoric about why the company is on track, it is clear that cost cutting is a major part of the story today and clearly Q4 was helped by a significant tax break. The Chemours businesses are getting worse rather than better, and the projections call into question just how much free cash this spin-off company can generate – if any – and how much of any DD dividend or debt share can be carried by Chemours.  In our view, Chemours suffers from the same problem as DuPont overall – too many people. The whole company would benefit from the operational experience that someone like Dennis could bring.

We think that the upside in the stock comes from what can be achieved along the lines proposed by Trian and today’s announcement by Trian gives us more confidence that this can be achieved.  We have discussed possible valuation in prior research.

Ex 1

More of the Same in 2015?

Written January 5th, 2015 by

As we move into the New Year, initial expectations are for a broad continuation of the trends seen in 2014. As published in our monthly Industrials & Materials review, Transport and Packaging stocks were the big winners at the sector level in the past year while Capital Goods, Electrical Equipment and industrial Conglomerates were weak, reflecting relative strength in the US economy and relative weakness abroad.


2015 estimates are currently suggesting similar dynamics will play out over the year – domestically tied Transports and Packaging stocks are showing considerably more optimism than the globally levered machinery stocks.

A recent revision to our Transports index (to include a more representative history) shows the group to be the most expensive in our coverage, but there are instances where it looks like valuation still has room to catch up to above average returns (UNP, CSX). We will look to explore the Transports in greater detail in 2015.

Our stock preferences heading into 2015 include a familiar group of names:

  • AA – The best performer in Industrials & Materials in 2014 (+48%) has long been one of our favorites. No longer cheap on our model, we see solid demand growth and an improved portfolio mix continuing to support AA in 2015.

2014 researchAluminum: Perhaps Too Cautious Too Soon!; Alcoa: Self Help Can Take You Only So Far, Now We Need Pricing

  • CAT – Highly levered to global growth, but valuation/dividend support intact; operating leverage is high, so even a small swing in demand could be material.

2014 researchCAT: Now Mining Matters and Trends are Better

  • DD – Fairly valued on its own fundamentals, upside will come from activist led changes.

2014 research – DuPont Can Be A Bad Stock, If Trian is Right but Gives Up; DuPont: Ag-rivating, But Unlikely to Change Without Action; DuPont: A Cost Initiative Could Be Substantial; DuPont: The Case for $85, But Why We May Need to Be Patient

  • DE – Stock has slightly underperformed since we first wrote on it in August, but appeared to find its floor around $80 as we suggested.

2014 research – Deere: Earnings Risk Still Significant, But Likely Priced In

  • EMN – Valuation compelling, less vulnerable to possible disappointments in ethylene than others.

2014 research – Eastman Chemical: A Good Story, But At Risk of a Complexity “Own Goal”

  • PKG – A 12% relative outperformer since we first published, we think there is still upside in the name based on valuation and the tailwinds of lower crude and an accelerating US economy.

2014 research – Paper & Packaging: PKG and the Containerboard Market; Containerboard Capacity Additions Unlikely to Affect Operating Rates, PKG Well Insulated; The China OCC Question  

  • PX – An unusual opportunity to buy a very high quality company at a substantial discount.

2014 research – Praxair: An Unusual GARPY Opportunity; Industrial Gases: APD Must Focus on Costs, But PX the Better Investment; Air Products and Praxair: A Tale of Two Strategies

  • SWK – Still a cheap stock with strong operating leverage and business momentum; Security margins improving and tactical divestment of underperforming European geographies could change sentiment and shift attention to the company’s strengths.

2014 research – SWK: Business Momentum to Continue; SWK: Upside to Earnings and to Sentiment

US Ethylene Stocks – Too Early to Call

Written December 1st, 2014 by

While it is always tempting to upgrade a stock or a sector when ones competitors are finally throwing in the towel, it is too early to call for US ethylene. The two most exposed ethylene stocks, LYB and WLK, have had a terrible run and are now both trading below our normalized value, but we are still not ready to change our bearish view.

All things being equal, at $70 Brent, European ethylene economics should normalize at around $930 per metric ton cash cost of ethylene (which is around 42 cents per pound) – see Exhibit.  To move US ethylene into Europe as derivatives, we would need a US price lower than that – by 4-5 cents for PVC and by 7-8 cents for polyethylene.  If US ethylene settles at 40 cents on average and derivatives fall in line we would be looking at a 15 cents per pound decline in margins versus 2014. This is roughly a $3.25 per share drop in earnings for LYB and $3.50 for WLK, versus 2014 with LYB possibly getting some offset from Europe.  LYB looks fairly valued on this basis today and WLK still looks expensive.

But…the world is short of propylene and butadiene.  These are major co-products for European ethylene producers and much less so for US producers these days given the strong ethane feedstock bias.  If propylene and butadiene prices remain robust – well above ethylene prices, these will provide a more significant cost offset in Europe and Asia as oil/naphtha prices fall, reducing the effective cost of making ethylene.  For every $100 per ton propylene and butadiene remain above “normal”, the cost of making ethylene falls by $70 per ton on a standard naphtha unit.

The risk to buying LYB and WLK today is that the markets for propylene and butadiene globally remain strong, increasing the co-product credits for both and lowering the cost of making ethylene in Europe and Asia further.  This lowers break-even pricing and US margins further.

This is a complex subject – please contact us directly for more details.


China – Look For The Commodities That Are Less Oversupplied

Written November 21st, 2014 by

China’s interest rate cut has got everyone’s attention today and the markets are rallying as are most commodities.  We have seen interest rate cuts all over the world over the last two years and their impact on economic growth/consumer spending has generally been positive, but not dramatic.  If we assume the same for China, some of these commodity moves may be premature, as even with increased demand in China we have so much global overcapacity that incremental demand from China may not be enough.

Iron ore, for example, is in such significant oversupply that incrementally better demand in China will likely not be enough to make a difference and any price response will be met with a supply response, as we saw with Aluminum through 2012 and 2013 – see chart.   It is unlikely that lower rates in China will lead to significant increases in infrastructure spending, so Iron ore and Steel are going to have to rely on consumer driven demand increases – for example in Autos.

Increases in consumer spending in China and possible also in Europe, as Draghi unlooses every tool in his belt to stimulate growth, would be good for Autos, but also for housing and other consumer goods.

We would focus first on Aluminum as a way to play this change.  We know from the way that prices have moved this year that the global Aluminum market is in better shape that it was a year ago, and growth rates are already strong.  Alcoa would be the big winner here and we still see significant upside in the stock: we continue to believe that it could double.

A second focus might be Titanium Dioxide; DD and HUN in our universe.  This is a commodity very much at the bottom of the cycle, but better autos and housing means better paint demand.  There is an oversupply here and it is focused in China, and it is not obvious how close we might be to a point of inflection.  There is still more capacity coming on line in China and while valuations are interesting for both companies they are not nearly as compelling as they were for Alcoa when we made the initial recommendation to own the stock.  DD is in the process of carving out its TiO2 business, either for sale or for spin, but it will remain part of DD most likely through the middle of 2015.


The Power Of Positive Thinking – APD and the DD read-through

Written October 31st, 2014 by

If the previous management of Air Products had delivered a quarter that included the following, the stock would have been down meaningfully on the day:

  • A year on year decline in operating income from its core gases business
  • A write down of around a third of the value of a business acquired only two years ago
  • A suggestion that two of the (much questioned) China based on-site projects have been delayed by 2 quarters

However, the current management was able to announce exactly this and the stock closed up almost 4%, while already commanding a significant multiple premium to Praxair, which over the last 12 months has delivered growth in its gases portfolio – Exhibit.


What is going on here is “belief”.  Belief that the newly focused APD can drive down costs, allocate capital better and drive better EPS growth than it has in the past.   There were signs of this in the quarter as APD beat estimates, despite the weaker gas numbers.  Very strong results from its Materials and Equipment businesses were largely the cause, but there was also significant focus on cost allowing the company to increase margins.  We are assured that the cost focus will continue.

While we are skeptical as to whether APD can cut costs fast enough to deliver positive earnings surprises given a weaker gas business (which we think will take a couple of years to turn around) that is not the point of this short note.

The point is to highlight the power of a change in sentiment.  APD has almost a 3x multiple premium over PX on 2015 earnings, unheard of at any point in recent history.  The market believes that the change in focus at APD will deliver outsized returns and the stock has been one of the best performers in the space over the last two years.

This change of sentiment will likely take place at DuPont also.  The activist fund in DuPont has the right story in our view – just as the activist fund at APD had 18 months ago.

The issues are what will be the catalyst and when will it happen?  And the answer is simple – we do not know!  What we do know is that there will need to be a catalyst.  DuPont is resisting Trian’s suggestions and, in our view putting up weak numbers and a weak defense.  The war of words has begun.

Catalysts could be: (we are just making stuff up here)

  • A public proxy fight where Trian nominates a couple of very strong board candidates (unlikely that it will come to this)
  • DuPont continues to disappoint on the growth story – increasing shareholder pressure to act
  • A change of management at DD
  • A second activist fund taking a large stake
  • A private equity bid for the company (it is smaller than KO!)

Once the catalyst arrives the stock will stop discounting Trian’s likely failure and start discounting Trian’s likely success.  The stock could appreciate quickly.  We generated a value of $100 per share in a piece that we did on the cost opportunity at the beginning of this month.

The risk to holding the stock is that the company makes a large and poor tactical acquisition to change the game.

The Most Important Question to Ask on Earnings Calls – Q4 Demand!

Written October 21st, 2014 by

We have touched on the subject of inventory drawdown in Q4 in a couple of recent reports, but the more we think about the subject and refer back to history, the more we believe that this could be the most significant year-end surprise across a number of industries, but most significantly those where crude oil is a major input.

Outside the US the economic news is worse, demand growth is slowing in Europe, and in large parts of Asia and Latin America.  Local sellers and distributors will likely look to lower inventories as a consequence of expected lower offtake.  Within our Industrials and Materials universe inventories are not low in absolute terms – see exhibit, but not particularly high as a percent of revenues.


More significantly, with the almost 25% decline in Brent Crude Oil pricing since its summer peak, any international consumer of products made from crude oil or its fractions, will be expecting much lower pricing going forward.  Consequently, if historical behavior is any guide, they will drop purchased volumes immediately (this will have already happened in October) – to the minimums that contracts allow, and wait for pricing to drop.  This behavior was very pronounced among Chinese plastics importers amid the crude oil volatility of the late 1980s and 1990s, and was last seen most obviously in the early months of the GFC, when demand vanished for a quarter or two.  The second chart is a repeat from recent work which shows short periods of negative demand surprises as crude oil prices fall.


As an example, Dow Chemical’s sales in Q3 2008 were 13% higher than the prior year – in Q4 they were 25% lower than the prior year and in Q1 2009 40% lower.  This was a combination of volume and pricing – with part of the volume swing driven by destocking as crude oil prices collapsed and part was the ensuing price response both to lower crude prices and lower demand.  We are not calling for a decline this significant this time, but we do expect a negative surprise for Q4 and possibly Q1 for all chemical producers and possibly for most industrial companies with significant international business.

The counter of course is that lower crude is likely very good for economic growth – longer term things should improve and our expected demand shortfall should be no more than a one or two quarter event.

Further, there are conflicting signals in the US as international chemical pricing specifically could fall much more quickly than US domestic pricing (because the US market is very short of some chemicals today) – it could take a couple of quarters for the US to catch up.  Additionally, given the constraints on rail and road traffic in the US today, consumers of chemicals and plastics will likely be reluctant to play the inventory game because of supply delay fears – at the margin we have seen inventories creep up in the US for supply security reasons in recent months.

Deere – The Floor Looks Robust

Written October 15th, 2014 by

In times when market momentum is very obviously directionally downward, certain stocks inevitably stick out as better insulated to the sell-off. With the S&P shedding more than 5% over the past week, DE has held firm around the $80 level and actually moved up as the market has moved steadily down – our prior work on the company and its historical valuation trends showed little room for further downside in the stock price.


Further downside to earnings remains likely, however, as certain tax incentives expire and farm incomes continue to be pressured by weak commodity pricing – but we retain our belief these effects are largely priced in, and DE’s recent performance offers some early support for this thesis. Notably, reports of bipartisan support for the reinstatement of a US farm equipment tax credit could be a source of marginal upside, though we note DE’s high non-US exposure, where agricultural industries will likely remain volatile but will also continue on the modernizing path that has driven growth for DE over the past decade.

In the more immediate term, history indicates we could see continued outperformance from DE in the fourth quarter – we modify an exhibit from our August report highlighting the company’s strong second half performances, noting that most of this outperformance tends to come in Q4. Additionally, valuation continues to be attractive, both relative to the broader Capital Goods sector and on an S&P relative P/E basis.


In short, farm economics remain a concern, but our belief that any weakness on this front is already priced into the stock has been confirmed by DE’s resilience in the face of the recent broad market sell-off. We believe considerable upside remains, with downside likely limited as demonstrated over the past few weeks, and our return on capital driven model shows a “normal value” of over $120 a share.

HB Fuller – Blaming SAP, But Where Is The Growth?

Written September 25th, 2014 by

HB Fuller is taking a beating this morning after a serious earnings miss.  This was a company we were not paying much attention to given relatively fair value and its only interesting screen was a high level of skepticism, suggesting that investors did not believe that recent high returns on investment were sustainable – seems they were right!

FUL is blaming an SAP integration and implementation delay for the miss and this brings back a sense of nostalgia for us.  In the 1990s we would see at least one company per quarter raise the specter of SAP as a reason why they had disappointed.  It was a more frequent excuse than overspending at times!  And SAP is the gift that keeps giving, as part of the very high expense of separating DD’s performance chemicals business from the rest of DD is unravelling the SAP system such that each company has its own, disconnected from each other.

But – ignoring SAP for a moment and looking at the numbers – there is little evidence in FUL’s numbers that the US is in much of a growth phase.  Adhesives have many industrial applications and consumer/retail end-uses, and for FUL to show only 2% organic growth in the US in this business is concerning.  We think that it is a function of a couple of things that we have talked about at length – the fact that growth IS slow in the US despite all the stimulus and the better employment rates, and specific to FUL, high energy costs drive high prices and high prices drive lower demand as buyers focus on minimizing use, minimizing waste and finding alternates.

Oil prices are falling, and this will likely cause pricing to decline, which ultimately could be good for FUL – however, and see recent research, as oil prices fall we often see coincident apparent demand fall for chemicals (chart), as buyers delay purchases in the hope that lower energy prices mean lower chemical prices in the near future.


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