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Friday Five: Cost Chemistry in Dow-DuPont Deal

Jeremy Glaser
Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Welcome to The Friday Five, Morningstar's take on five stories in the market this week. Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: First this week, chemical giants Dow and DuPont are set to merge. This is capping off a big year of M&A in the market. What's our take on the deal?

Glaser: When we look back at 2015, M&A is going to be one of those big trends. Across industries, big deals, small deals, a lot of M&A happening. This deal is the capstone: Two $60 billion companies coming together.

After the merger, they are planning on splitting into three companies that will be focused on specialty chemicals, agriculture, and materials. Jeff Stafford, who covers chemicals for Morningstar, thinks this deal is about cost savings. They'll be able to save money on research and development. They'll be able to save money by reducing head count in a lot of places, and that's where you find the synergies in bringing them together.

Often there is hope that when you split companies apart, maybe it unlocks value, and people will be able to put a higher multiple on different businesses that may have better growth prospects. But he doesn't think that's going to be a major factor here. He points to agriculture as a good example. The ag business combined still won't have the same kind of competitive advantages as, say, a Monsanto. So you can't just say, well, Monsanto trades for this multiple and therefore this other company will also trade for that, too. It probably will be at a discount.

But overall he thinks those cost savings probably will be large enough to make a deal like this make sense.

Stipp: In MLPs, Kinder Morgan announced a steep 75% dividend cut. That business is obviously under pressure. You spoke with Josh Peters about this. What's the take there?

Glaser: They had this big 75% cut. Management is completely focused on the balance sheet right now and completely focused on keeping their investment-grade rating, which is very important for them to fund their continued growth projects. We think it's going to be some time before they will be able to bring this dividend back. It's not something that you can kind of keep low for a year or two and then be able to get back to dividend growth. It's going to be a while until these projects are funded, until the balance sheet looks like it's going to be in a better state, and the rating agencies are going to be comfortable enough with that dividend going up again.

As you mentioned, I talked to Josh Peters, the editor of DividendInvestor newsletter, and he says this is a wakeup call to any MLP investors, to any midstream investors, who aren't aware yet of some of the problems that the industry is facing right now.

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That doesn't mean that all MLPs are in trouble, or that all midstream energy shouldn't be owned. But there are some headwinds. You have to be very careful about which MLPs you are buying, and this is probably time to nibble--maybe expand a position slightly--but be very cautious. It's not the time to swing for the fences in energy, to put a huge part of your portfolio in this part of the market. I think what happened with Kinder Morgan is a good example of why that could be so dangerous.

Stipp: The messiness at Yahoo continued this week. They announced they are suspending the spin-off of Alibaba. What's the latest?

Glaser: Our analyst Rick Summer calls it shifting the spotlight in the three ring circus when describing what's happening at Yahoo right now. As you mentioned, they decided against the spin-off of Alibaba. We had talked before about how there were some concerns that it was going to create a tax liability. The IRS hasn't said if it was going to be a tax-free event, and that really gave the board some caution. They decided not to do that. Instead they are extending the time line yet again on how they are going to unlock the value of the entire business. Do you sell a part of the core? What do you do with Yahoo Japan? These are the questions that we've been talking about for years now.

Rick Summer thinks that the shares don't look wildly overvalued right now. The valuation is probably fair. But given how muddled the path forward for Yahoo is, the number of decisions they have to make, and how chaotic this process has been so far, it just doesn't make sense for investors to place their bets there given other options in the marketplace.

Stipp: Last week in The Week Ahead you mentioned Costco was going to be on the radar for investors. They reported results that disappointed this time around. What's going on with Costco?

Glaser: This quarter for Costco shows the challenges of having a high valuation. The quarter actually was not terrible. The headline didn't look great because they did see their profit decline. But that was driven by things that aren't necessarily recurring, like currency. They did have a little bit of weakness in membership and also some of cost associated with the transition away from American Express and into the Visa Citibank partnership, which weighed on their profitability as well.

But same-store sales growth still looked very strong at 6% year-over-year, and that excludes gas and currency impacts. That's a very good number, and they continue to outpace their peers and show why they are a wide-moat company and have this great competitive advantage.

But Ken Perkins, who covers this space for Morningstar, says when you have shares that were so fully valued, and you have anything that's even a little bit of a misstep--even if it's not something major or doesn't really change your thesis--you could very well see a sell-off like we did this week. There just isn't any room for error. There is no margin of safety for investors.

We still don't think that margin of safety is there for Costco. You can believe that fundamentally it's going to be a strong story, that we are going to continue to see strong results, but until the valuation looks more attractive, investors should look elsewhere.

Stipp: Keurig Green Mountain announced they are going private this week in terms that looked pretty good for existing shareholders. What's our take on the deal?

Glaser: They do. It's a $14 billion deal that values the company at $92 per share. This is a massive premium over where the shares were trading and over where our fair value estimate was.

They are being bought out by a consortium that's led by JAB, which owns some other coffee assets like Peet's and Caribou. Maybe they think that they are going to see some synergies here. They think there is lot of growth that the market just isn't pricing in. But we think current shareholders should be pretty happy about this deal and should take the money and run. As a stand-alone, Keurig continues to face a lot of potential headwinds, declining profitability in their hot-beverage business, and a lack of excitement about their cold system.

Another wrinkle to the story is that Coca-Cola owns 17% of Keurig. This doesn't really change our valuation on Coca-Cola either, given that this buyout price is very similar to what their cost basis is. They bought in at a much higher level. So it doesn't amount to much of a gain, and it's a tiny slice of Coke's total market cap, so it doesn't change our opinion of Coke.

Stipp: Great insights on news of the week, Jeremy. Thanks for joining me.

Glaser: You're welcome Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.