DuPont – First Merger, Then Spins, and Now the RemainCo

Introduction

It is always interesting to look at companies which are undergoing or have undergone significant change. This includes corporate actions such as divestitures, split-offs, carve-outs, and spin-offs (click here to find the list of upcoming spin-offs). These events could create compelling opportunities where it pays off to do the fundamental work. DuPont certainly fits the mold of a company that has gone through a lot of change in recent years.

  • Activist Proxy Fight (Trian Partners – 2015)
  • New CEO (Ellen Kullman out; Ed Breen in – 2015)
  • Dow Merger (Announced in December 2015; Completed in August 2017)
  • Reorganization
  • Restructuring
  • Dow Spin-Off (April 1, 2019)
  • Corteva Spin-Off (June 1, 2019)

Needless to say, today’s DuPont is much different than the old DuPont. They combined both their legacy commodity chemical and agriculture businesses with Dow. Then, they spun-off the commodity businesses as Dow Inc. and the agriculture businesses as Corteva. Today’s DuPont is made up of parts of four different companies:

  • Legacy DuPont (67% of revenue)
  • Dow (25%)
  • Dow Corning (5%)
  • FMC (3%)

The New DuPont

The new DuPont is a highly diversified, global business, similar to other ‘higher quality’ industrial conglomerates, such as 3M, Honeywell, and Illinois Tool Works. It is comprised of various specialty chemical and industrial businesses and generates 38% of revenue from Asia Pacific, 32% from North America, 25% from Europe, and 5% from Latin America.

They operate the business through four separate segments: Electronics & Imaging, Nutrition & Bioscience, Transportation & Industrial, and Safety & Construction.

DuPont Pro Forma Historical Results

Electronics & Imaging (16% of Revenue, 33% Segment Pro Forma Operating EBITDA Margin)

They are a supplier of materials and systems for various consumer and industrial electronics (phones, computers, etc.). The main business provides materials for fabricating semiconductors and circuits as well as solar cells. This is their shortest cycle business and requires the most R&D (~6%-7% of sales).

Nutrition & Bioscience (28% of Revenue, 23% Segment Pro Forma Operating EBITDA Margin)

They provide various chemicals, formulations, and other technologies (enzymes, biocides, antimicrobials, etc.) for food and beverage, pharma, home and personal care, energy, animal nutrition, and other markets. This is one of their most attractive businesses and benefits from very deep customer relationships and high switching costs.

Transportation & Industrial (24% of Revenue, 28% Segment Pro Forma Operating EBITDA Margin)

Supplies resins, adhesives, lubricants, and other solutions to transportation, healthcare, industrial, and consumer markets. The segment generates attractive margins and is driven by some powerful trends, such as light-weighting vehicles.

Safety & Construction (23% of Revenue, 24% Segment Pro Forma Operating EBITDA Margin)

They provide engineered products and integrated systems for a number of different industries, including construction, worker safety, energy, oil & gas, transportation, medical devices, and water purification.

Non-Core (~10% of Revenue)

The last part of the business is the ‘non-core’ segment. It includes various businesses that were previously included in one of the four segments. Management believes that these businesses are less differentiated, have slow (or negative) growth, more volatile margins, and are better served by a new owner. Overall it is ~10% of sales (~$2 billion) and includes the following businesses:

  • Photovoltaics & Advanced Materials; Hemlock Semi (formerly in the Electronics & Imaging segment)
  • Clean Technologies & Biomaterials (formerly in the Nutrition & Bioscience segment)
  • DuPont Teijin Films JV (formerly in the Transportation & Advanced Polymer segment)
  • Sustainable Solutions (formerly in the Safety & Construction segment)

Competitive Advantages

The new DuPont’s businesses benefit from a handful of competitive advantages that allow for attractive margins and returns on capital.

Switching Costs

In the Nutrition & Bioscience business, they create unique formulations for customers that help improve and/or preserve the quality of the end product. For instance, they help food & beverage companies improve the taste, shelf-life, and nutritional content of their products. DuPont’s solutions are a small cost of the overall manufacturing process but have a big impact on the quality of the finished product. As a result, customers are hesitant to change suppliers and reformulate the product just to save a small fraction of the total cost to manufacture.

Another example of this dynamic at work in the Nutrition & Bioscience business is with pharmaceutical customers. One in three pharmaceutical tablets sold across the globe contains their pharma excipients (helps binds the pill and deliver the active ingredient). DuPont’s technology is a very small overall cost of developing and manufacturing the drug but plays a critical role in its effectiveness.

Another area DuPont possesses switching costs is within the Electronics & Imaging and Transportation & Industrial businesses. Again, in these areas, DuPont creates highly engineered formulations for customers that are a small percentage of the cost to manufacture the end product but produce significant benefits. These benefits could be greater manufacturing efficiency (lower energy/water use) and/or a product with unique features (stronger, lighter, etc.). The overall theme is that DuPont generates a large proportion of sales from products that create significantly more value for customers than what it costs to purchase.

High Cost of Failure

Besides switching costs, DuPont manufactures products that are used in high cost of failure applications and environments. This is most obvious in the Safety & Construction segment where two of their most recognized brands, Tyvek and Kevlar, sit.

While most people associate Tyvek with the wrapping that protects houses (air and water barrier), that is only about 1/3 of the business. The majority of sales are generated from a wide variety of applications, such as medical packaging (tear-resistant, breathable, microbial barrier, etc.) and hazmat suits. Overall, Tyvek is known for producing high-quality barrier applications in can’t fail environments where it isn’t worth the risk to purchase cheaper, commodity products (are you going to buy an off-brand hazmat suit when planning to come in contact with deadly diseases or toxins?).

Similarly, most people associate Kevlar with bullet-proof vests worn by police and military personnel. However, that is only ~1/3 of the business. The other ~2/3 comes from hundreds of different applications including firefighter gear, cut resistant gloves, and aircraft cabin floors, landing gear doors, wing boxes, etc.

Overall, these are environments where using low quality, commodity products could not only result in significant costs but also the loss of life.

Cultural Change

Prior to Ed Breen taking over as CEO, DuPont was known for having a bloated cost structure and unwieldy R&D and capex budgets. Similar to Procter & Gamble (PG), DuPont historically operated with a matrix organization. While matrix organizations make sense in theory (minimize operating costs by leveraging functions across the entire organization), in practice they create redundancies and a lack of accountability.

So there’s a ton of things I liked about it, but it was a very matrix organization. No one, in my opinion, was responsible for the ultimate decisions and performance of the company. Literally almost half the people in the company reported in separate matrix organizations outside the business. A lot of the R&D did, Jonas. A lot of the operations and marketing was literally outside of the businesses. So you sort of had the business presidents sort of like the front end of a company, not controlling any of the back end of the company. So we collapsed everything together. And if you remember, that’s how I took $1 billion of cost out of DuPont literally in my first 3 or 4 months… And then instituting a real culture of returns was something I didn’t feel was embedded in the thinking of the company well enough. So we really drove that into the company. [Emphasis Added]

Ed Breen, Executive Chairman, Sanford Bernstein Strategic Decisions Conference

Investment Opportunity

For investors, the opportunity at DuPont centers around owning a collection of above average businesses run by an intelligent management team.

While some are economically sensitive, their businesses benefit from strong competitive positions and long-term growth drivers. For instance, in the automotive market, they have significantly more content on newer vehicles because of light weighting and electrifying than on traditional internal combustion engine vehicles. In fact, their auto business has outpaced auto builds by ~10% each quarter over the last 3 years. Another example of increasing content is in the consumer electronics market. In a typical cellphone, they only sell about $0.50 worth of content. However, on high-end smartphones, they have about $2.50 and on the newest phones (5G enabled), it is over $5. There are examples of secularly growing markets all across their portfolio. These drivers should allow the consolidated DuPont to grow above nominal GDP over the medium-term.

In terms of the management team, Ed Breen has stayed on as Executive Chairman and will be leading the portfolio and capital allocation strategy. They spend about $900 million per year on R&D (4% of sales) and $1.0 – $1.1 billion per year on capital expenditures. Unlike the way DuPont was previously managed, they keep a sharp eye on these investments.

But where we spend money and we spend pretty heavily, I think, is on R&D and CapEx. And we have a maniacal focus on returns on those 2 piles of cash. So we spend $900 million a year on R&D, which is 4% of sales, and we spend 4% to 5% of sales on CapEx. And we track every single program, the timing of it, who’s responsible, what’s the return going to be on the program. And to me, that’s not that hard to do to track $2 billion of spend, track those programs as you move forward. And that’s what’s really driving, in my opinion, will continue to drive our ROIC up very nicely. We have had great progress the last 3 years significantly driving up ROIC. And we’ll be driving that up in at least mid-30s on an incremental basis and continue to get at least 100 basis point improvement year-over-year as we move forward. [Emphasis Added]

Ed Breen, Executive Chairman, Sanford Bernstein Strategic Decisions Conference

From a portfolio perspective, they recently announced the plan to divest businesses making up ~$2 billion in revenue (~10% of total). Management believes these businesses will be better served under new ownership. Furthermore, Breen has made it clear that there is significant optionality within the portfolio to do additional spin-offs, split-offs (including reverse Morris trust transactions), and carve-outs.

But I’m a big believer and I’ve talked to the Board about this optionality thing. If there really is a path that creates significant value for shareholders by doing some other transaction or so, we would definitely look at it. I’m not going to let ego stand in the way. We’re going to do the right thing. [Emphasis Added]

Ed Breen, Executive Chairman, Sanford Bernstein Strategic Decisions Conference

Housing the four different segments under a conglomerate structure could be beneficial if management is adept at allocating capital and the structure allows the business segments to make long-term investments they might not be able to make as standalone companies. However, odds are that management will do something with these businesses over time. The four segments run independently of each other and have very limited R&D, sales, and operational synergies. As a result, investors should feel comfortable knowing that management is focused on creating sustainable, long-term value per share (compensation tied to Return on Invested Capital).

Conclusion

DuPont RemainCo is very different from the pre-Dow merger DuPont. It doesn’t have the legacy commodity chemical (now part of Dow Inc.) or agriculture businesses (now part of Corteva – click here to read about the recent spin-offs). Rather, it is a collection of above average businesses from legacy DuPont, Dow, Dow Corning, and FMC. These remaining businesses benefit from switching costs and providing products that have a high cost of failure (bulletproof vests, hazmat suits, medical packaging, aerospace parts, etc.).

In the near term, the business has struggled a bit with destocking in the auto (~15% of sales) and semiconductor (~5% of sales from smartphones) industries. This is expected to result in sales declining low single digits in the second quarter and sales up only 2% – 3% for the year on an organic basis. However, this weakness could turn out to be an opportunity for investors to own a collection of above average businesses run by a skilled management team focused on creating long-term per share value at a valuation in-line with the broader market.

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2019-06-19T09:16:13-05:00