[DWDP – DowDuPont] Rack & Break; Part 2
Two years after it was announced, the merger between Dow Chemical and DuPont finally close in August 2017, creating the conditions for a three-way spin-off that will take place sometime in the next 2-4 months. This two-step merger/separation process was part of a grand design to drive scale among the businesses that these two companies had in common so that upon spinning off, each of the separate entities could be more focused and better scaled versions of their former selves. Here are some high level financials for each of those three businesses:
[Important note: unlike management, I do not include JV income in my segment EBITDA figures because, for me, it is confusing to combine after-tax JV income with pre-tax wholly owned EBITDA. It seems more straightforward to simply value the after-tax JV income separately]
[Around 1/4 of the Materials Science growth from 2016 to 2017 reflects Dow’s consolidation of the Dow Corning JV, which is reflected in the Performance Materials & Coatings sub-segment]
And this may help you better see the respective contributions of legacy Dow and DuPont to the new entities [the numbers below are, I think, for 2017, while my figures above are for 2018]:
Legacy DuPont accounts for the vast majority of Specialty Products, while legacy Dow is the vast majority of Material Science. Corteva is a more even split of the legacy companies, but I reckon most of the value comes from DuPont Pioneer, the genetically modified seeds business of DuPont. The basic idea is to create greater scale in overlapping business units: fusing germplasm libraries to broaden the combined trait pipeline and leveraging distribution channels to bring them to market; integrating DuPont’s copolymers with Dow’s polyethylene franchise to make better products; procurement and SG&A synergies all around.
Around half of DowDuPont’s segment level EBITDA comes from what will be the New Dow. New Dow is a cyclical, capital intensive hydrocarbon based business whose value comes more from dependable access to low cost feed stock, cost discipline, and responsible capital allocation than it does breakout innovations. It deserves to trade at DowDuPont’s current 8x EBITDA multiple (including pensions). But that still leaves 50% of DWDP profits from businesses with secular growth drivers and considerable R&D content that, in my opinion, should trade anywhere between 10x and 15x EBITDA once liberated from conglomeration.
Against a 2017 EBITDA base of $15bn1, $3.4bn+ of remaining cost synergies – from procurement leverage, cost de-duplication, and manufacturing consolidation – are meaningful. Moreover, those synergies will be disproportionately allocated to the spun-off segments that will command loftier valuation multiples2. There are also revenue synergies that I will ignore in this post.
But the best reason for fragmenting into separate companies ties back to oft-cited benefits of spin-offs generally: focus and incentives. The inspissating bloat at two 100+ year organizations, each with 50,000 employees, is unsurprising, even inevitable. After a decade of portfolio simplification and efficiency extraction, Dow was still lumbering under 8 layers of management. Each of the 5 reporting segments at Dow and 6 at DuPont were aggregations of finer and finer sub-segments addressing disparate end markets: at Dow, agricultural technology, whose bets might require a decade to pay off, competed for capital with an electronics division adapted to 3 years product cycles. At DuPont, the growth contribution of an innovative enzyme that allowed clothes to be laundered in cold water, might be overwhelmed by a tempestuous ag cycle.
Manning the helm of DowDuPont and guiding the spin-off process is Ed Breen, the guy who successfully split up a scandal-ridden Tyco under far more trying conditions3.
Materials Science (New Dow)
There’s a hard way to write this section and an easy way. The hard way is more comprehensive and trudges through one sub-segment after the next, describing how silicones are used in this end market while elastomers are used in that one. The easy way speaks in broad generalities and points to specifics only when they are relevant to valuation. For the duration of this post, I’m going to do us all a favor and choose the easy way. Some of Dow’s business lines, like flexible packaging for food and medical applications, seem cycle resilient and unique4. Others, like intermediate components, are low return and cyclical. Based on disclosures from New Dow’s Form 10 and other data from investor presentations, I estimate that around 20% to 30% of the company’s revenue fit the latter description5.
There are enough specialty lines in the Dow complex that one could, with a straight face, choose to position New Dow as an innovative materials company riding on secular tailwinds that collectively sum to 1.5x-2x GDP growth. If I wanted to sharpen this angle, I could point to growing per capita polyethylene consumption (11 kilos per person worldwide vs. 40 in North America and 28 in Europe) spurred by the ever-growing lifestyle demands of a growing global middle class who will require more sophisticated packaging (polyethylene), more comfortable bedding (polyurethane), bigger buildings (sealants, elastomers), and so on. All of this is true in the general sense that the global economy will continue to grow and growing economies breath life into middle classes that need more stuff per person.
But there is sometimes a difference between what’s true and what matters. And what matters is that after you have exhausted yourself with investor day presentations detailing novel product applications, you are still left with a company whose returns are tightly tethered to business cycles and input costs. Compressed spreads in upstream components have the pressured segment margins this year, notwithstanding the company’s observation that: “Throughout much of the world, economic expansion has gained momentum driven in large part by robust and upbeat fundamentals in consumer and business confidence, employment and wage growth and manufacturing and infrastructure investment activity”.