Industrials/Basic Materials

DuPont – Investor Exodus

Written July 29th, 2015 by

DuPont management may still have the faith that the science based strategy is right, but everyone else seems to disagree.  Trian criticized the company for bloated costs and lack of returns on its R&D spend and we have echoed that in research both before and after the Trian involvement.

The bear case is winning today and it goes as follows: DuPont management takes the proxy win as an endorsement of the strategy and the path the company has followed for the last decade.  The company continues to waste money on ineffective R&D, continues to ignore its high cost base and possibly makes further bolt on acquisitions which disappoint and destroy value.  On this basis you would expect low earnings growth and a continuation of the recent history of negative guidance following too bullish expectations based on optimism around the R&D return and the value of novel products.  On this basis the stock at best moves sideways.

This is perhaps one of the least sophisticated analyses you will see from our group, but it illustrates a point.  In the exhibit below we show the cumulative spend on R&D for the last 20 years, divided by 2014 revenues.  The R&D spend at DuPont over the last 20 years is equivalent to almost 90% of the 2014 revenue level – overshadowing everyone else on the list with 20 year history.  Obviously we are not taking into account portfolio changes, but if you then compare this data with average 20 year TSR, you can see the disconnect.

DuPont will argue that the past is not a good predictor of the future, but we, and clearly many investors, believe that it is.


The bull case is that all this could be fixed and that billions of dollars of value could be unlocked.  We would contend the following:

  • There is at least $3.0 billion of costs that could be cut out of DD without breaking up the company – the number would most likely be higher with a break-up
    • $3bn of costs – if all taken to the bottom line – would be worth $2.40 per share
  • At least $0.75bn of R&D could be abandoned with no impact on earnings
    • 35% of R&D – $0.60 per share
  • The balance of the R&D spend could be managed more effectively to generate a better return
  • Free cash can be deployed in share buyback and the company could buy back as much as 12% of the stock over the next two years including the one-time cash dividend from Chemours
  • Adding this all up gives a conservative $7.00-7.50 per share earnings number in 2018 versus current consensus of $4.50

Perhaps it would take more than 3 years to pull out all of the costs, but the opportunity is clear and this is what Trian was looking for and where the target price north of $100 per share came from.

Those selling the stock today are either convinced that the activists are not willing to have another go and/or that the DuPont board is willing to sit back and hope that a flawed strategy to date can suddenly come right.  We think neither conclusion is right. The bull case is much more believable

Eastman – The Silver Lining of the Propane Cloud

Written July 29th, 2015 by

Placing the wrong bet on propane prices may have been the best thing that could have happened to Eastman!  Eastman is a roll up story and the thesis is that as the company adds complimentary and sometimes overlapping product/technology platforms there are growth and, perhaps more importantly, cost opportunities.

Eastman is delivering on the costs and the improvement in overall operating margin drove a big earnings beat in a weak sales quarter, negatively impacted by price, volumes and currency.  Perhaps the company would have been less focused on the cost opportunity had it not been staring in the face of a major hedging headwind – nothing focuses the mind like having to overcome a major error/hurdle.

The portfolio remains confusing and complex, but the company is delivering. EMN’s well received Q2 results were highlighted by significant margin expansion in the Advanced Materials segment (9 percentage points). This improvement was notable for its magnitude but also in its demonstration that the company is beginning to derive value from its acquisitions, a condition we have previously noted would be necessary to realize the (still material) upside in the name. 50% of the Advanced Materials segment is comprised of legacy Solutia businesses (Performance Films and Interlayers), and the demand outlook here remains strong, though margins are expected to normalize at the blended 1H rate of ~17%.

That this run rate would represent just the fourth highest margin of EMN’s segments speaks to the company’s cash generative capability, and cash flow in Q2 indeed came in well above estimates. The company encouragingly offered a very shareholder-friendly view of capital allocation moving forward, favoring increased dividends and share repurchases with “large acquisitions” on hold “through 2017”, meaning investors will be paid as they wait for the still-considerable upside in the share price ($100 mid-cycle value on our model implies 23% from current levels).  This change in strategy with regard to use of cash is exactly what investors have been asking for and was highlighted in our initial work on the name.

Eastman’s ability to put up very strong earnings in the face of a major hedging headwind should significantly increase confidence in the stock, with the (re)allocation cash a further positive.  Note that EMN has a very low historic average relative multiple (to the S&P500), in absolute terms and relative to other chemical names. Restored/improved confidence could drive the relative multiple higher and our $100 per share fair value would then only be a starting point.

EMN remains one of the most attractively valued names in the Chemical space in our view.



LyondellBasell – Hard To Fault

Written July 28th, 2015 by

First half oil prices were almost half the levels seen in 1H 2014, yet LYB has managed to produce 17% more net income than in the prior year.  EPS growth is greater because of the significant share buyback, which looks set to continue given high free cash flows and high cash on the balance sheet. The company produced good results in the US and better than expected results in Europe given operating limitations in Q2.

LYB could make close to $11 of EPS in 2015, and with the stock trading at 8.2x that number, it is hard to resist.  The stock has underperformed recently because of sentiment around oil, as it did in September and October of last year.  Despite the collapse in oil last year, LYB is putting up better numbers and EPS is further enhanced by the buy-back.  Furthermore, the company has again increased its dividend and now has a yield of 3.5%.  LYB’s ability to buy back 10% of its shares a year offsets the risk of possible lower oil prices and lower near-term US and European ethylene margins in our view and the TSR that LYB could generate looks much more interesting than for others in the space.

LYB’s return on capital has held up while WLK’s has fallen over the last two years (see chart) – WLK, LYB and DOW are exposed to the olefin and polyolefin markets – one of the few commodity subsectors where China does not have a surplus and where Chinese exports are not damaging global pricing.  The difference for both DOW and WLK is that they are exposed to other markets where China is a problems – chlor-alkali and PVC for WLK and chlor-alkali and epoxies for DOW (though DOW is divesting these businesses in 2015 to OLN).


Nervousness around oil has brought LYB back down to a price that looks very attractive given earnings and cash flows.  There is clearly a risk that if oil weakens further you end up fighting a more general negative sentiment, but in our view the stock offers good value here.

The secondary risk would be that the strategy changes – the share buyback stops and LYB embarks on an acquisition spree.  This is unlikely, but would be very unpopular with shareholders most of whom own the stock for the return of cash to shareholders.

Note that consensus estimates going forward do not appear to account properly for the potential share buyback, suggesting that while forward estimates might be vulnerable to lower crude prices relative to natural gas, they have upside from a lower share count.

All of the ethylene names look a bit more interesting here – WLK could increase its dividend and buy back stock, given cash flows and we think the same is possible at DOW – see recent blog.  LYB is probably the cleanest story today, notwithstanding the change of strategy risk suggested above.

Dow Chemical – Neither Fish nor Fowl

Written July 28th, 2015 by

Dow Chemical’s second quarter demonstrated a problem that has concerned investors – both passive and active – for some time.  In the face of apparently very strong US and European basic plastics margins, the company did not do that well.  It will be interesting to see what the more pure play commodity polyethylene names do in the second quarter, as we suspect that they will show a better uplift than Dow.  Dow’s integration upstream into what are labeled “performance” products or “solutions” means that more and more of the commodity base materials within Dow are consumed into next stage derivatives that do not display the same level of cyclical pricing.  Polyethylene pricing may rise, but Dow’s advanced products have much more sticky pricing and do not move as much.

Dow is not displaying the cyclical swings that it used to, and as the chart shows, while returns on capital remain low and very close to the longer-term negative trend, the volatility is more muted.


However, Dow is not really a growth story either.  Dow saw 3% volume growth in Q2 on a like for like basis (excluding business sold and its raw material business related sales/trading), which is not terrible given the state of the global economy, but it is also not a growth story.  It is certainly not enough of a growth story to support the significant R&D investment and capital investments that Dow is making.

The activist initial ideas are likely correct – the company is really two companies – a large efficient commodity chemical company and a large innovation driven growth company.  Dow may not appear to many to be a better company, or pair of companies on that basis, but it may be a much better stock.

  • Both pieces need a better focus on costs – with the commodity piece shedding the overheads associated with trying to “up-sell” and focusing on lowest cost production and highest quality
  • The growth piece needs to focus on an appropriate cost structure as well, and like DuPont needs to understand what it is getting for the R&D investment.

Right now the value investors are not getting their cyclical upside and the rest are not getting the growth.  Tactically the company has a couple of options; start moving down the path suggested, or increase TSR by significantly increasing the cash return to investors – the company has been buying back stock but its dividend remains below where it was on a per share basis before the financial crisis.

Either move would likely be positive for the stock near-term, though we may be looking at relative outperformance versus the sector rather than absolute if the commodity based sell-off continues.

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.


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