The Market's Too Cautious on DuPont and Corteva
We think investors' fears about liability issues are overblown.
While chemical industry investors are paying attention to sustainability risks, sizing the valuation impact to companies from environmental cleanup has proved difficult and created market uncertainty. The risks are intensifying. Lawsuits over health issues and cleanup costs related to polyfluoroalkyl substances have been piling up over the last year and have driven the shares of DuPont (DD) and Corteva (CTVA) lower as investors worry about potential liabilities. Federal regulations in the next several years are likely to drive even more lawsuits and cleanup costs. The chemicals in question are on the same trajectory as asbestos in the early 1970s, and like asbestos, they have created a hazard to investors. We ultimately see nearly $40 billion in remediation costs industrywide, stoking investor fears of increased bankruptcy risk.
However, we think the market is overly pessimistic on the impact to DuPont and Corteva, as their predecessor company never sold the chemicals. We estimate just over $3 billion in remediation costs will fall to them--roughly 5% of their combined market capitalization. Meanwhile, the underlying businesses of the two companies should enjoy several tailwinds, including a rise in vehicle electrification and 5G for DuPont and the launch of several new premium products for Corteva. Where consensus sees caution, we see opportunity for long-term investors to pick up cheap shares of two quality companies.
We Estimate Nearly $40 Billion in Total PFAS-Related Costs Industrywide
Per- and polyfluoroalkyl substances, or PFAS, are a series of synthetically produced chemicals that have been in use since the 1940s. Their resistance to water, oil, and grease has led to use in a wide range of products, including nonstick cookware, food packaging, stain-resistant fabrics and carpets, and water-resistant apparel. The chemicals are also found in aqueous firefighting foams, which are primarily used at military bases and airports. A name-brand PFAS-based product is Teflon, which was widely used in a variety of consumer products.
The U.S. Environmental Protection Agency is creating a federal regulation that limits the levels of PFAS in drinking water. Although some states have already implemented regulations, we think the creation of federal regulations that set a maximum level on PFAS in drinking water will be the catalyst that spurs an avalanche of water testing, cleanup activities, and lawsuits.
Currently, the EPA has a recommended maximum level for PFAS of 70 parts per trillion in drinking water. The process to establish a regulation can take years and will be a political battle, but we expect the 70 ppt recommendation to become law by 2023.
We estimate the total cost will be a little below $40 billion industrywide between cleanup and litigation, including an estimated $2 billion in costs that have already been incurred. We forecast the bulk of costs to come from litigation. We see the total costs being spread across multiple companies, including PFAS producers, companies that manufactured products that contain the chemicals, and consumers that have used the products, such as the U.S. military, which used firefighting foams that contained PFAS.
Once regulations go into effect, we expect many water utilities to test their drinking water and begin cleanup activities. The EPA could then start cleanup immediately for any site where PFAS levels exceed 70 ppt. In total, we estimate just under $11 billion in costs, most of which coming from cleanup activities at over 1,200 sites.
We estimate testing costs of $300 million, which assumes that 1 in every 8 of the more than 50,000 water utilities in the United States is tested. Our assumption is based on a 2017 study that showed roughly 1 in 8 water utilities tested had PFAS levels greater than 5 ppt, which some environmental groups cite as the maximum level to avoid health issues. We think utilities would be eager to test their water, especially as testing costs of roughly $50,000 are relatively small compared with the potential liabilities a water utility could face from not testing.
We estimate there are more than 1,200 sites in the U.S. that will need cleanup based on the same study, which concluded that 1.8% of all water sites sampled had PFAS levels of over 70 ppt, which would exceed the regulation. However, the 1,200 sites would face varying degrees of pollution and thus different levels of cleanup costs.
Litigation is likely to be the largest cost. PFAS have been shown to cause adverse health effects. In response, there have already been multiple lawsuits against PFAS producers, with the largest being a multidistrict lawsuit that is currently in a U.S. district court. Industrywide, we forecast total litigation costs will be around $25 billion, more than double the amount of testing and cleanup.
To forecast litigation costs, we identified comparable cases. Based on our framework of industrywide litigation, cleanup expenses, and adverse health effects, we view asbestos as the most comparable litigation to PFAS. Asbestos-related litigation has been industrywide and ongoing since the 1960s. A criterion for asbestos litigation has been direct exposure, and some of the largest payouts were by sites where there has since been environmental cleanup. Finally, asbestos exposure can cause multiple adverse health effects, similar to PFAS. Asbestos trusts have paid out over $20 billion to more than 3 million plaintiffs, amounting to roughly $7,000 per person. We assume this number for the majority of PFAS plaintiffs.
We forecast $17.5 billion in lawsuits from 2.5 million plaintiffs. We start with the U.S. population of roughly 330 million people. Based on the assumption that 12.5% of water districts test for PFAS levels, we estimate roughly 41 million people as potential plaintiffs. However, not everyone will file a lawsuit. We assume 6% of people will qualify for monetary compensation, which translates to 2.5 million lawsuits.
At $7,000 per person for 2.5 million plaintiffs, this amounts to $17.5 billion. While asbestos is a good proxy for most claims, we think this only captures litigation from plaintiffs who do not live near a plant that produced PFAS chemicals. For plaintiffs who lived near a PFAS chemical plant, we think the award will be substantially higher.
In 2017, DuPont and Chemours paid $670.7 million to settle claims from West Virginia residents who lived near the legacy company’s plant. We assume all 10 of the large cleanup sites, plus an additional former DuPont site, will have similar payouts (adjusted for 2020 real terms), which adds another $7.7 billion in litigation, for a total of just over $25 billion in litigation.
Asbestos lawsuits continue to this day despite starting in the mid-1960s. Similarly, we expect PFAS producers, their downstream customers, and consumers that used PFAS to see additional lawsuits and required cleanup expenses. Asbestos lawsuits began in 1966, even before the U.S. EPA first established regulations in 1972. However, it was 2006 before most asbestos-related trusts were established, likely due to companies being able to delay and appeal legal proceedings for years. We expect a similar timeline for PFAS cleanup and litigation expenses.
Conversely, we think the market views PFAS as a shorter-term series of events, similar to the BP oil spill after the Deepwater Horizon explosion. BP resolved most lawsuits within a decade after the event, as it largely pursued a settlement strategy. While some companies could take the settlement route, we think this is less likely because the source of PFAS is in question for many sites.
For multiple-lawsuit long-term liabilities, the pace of claims is important. Addressing claims in a group can resolve the uncertainty, but it also increases the chance of material value destruction for equity investors, including the risk of bankruptcy. Conversely, claims spread over several years greatly reduces this risk. Alternatively, structuring payments to a trust over time also reduces the risk of bankruptcy.
We Forecast Historical DuPont to Pay Roughly $6.5 Billion in Total PFAS Costs
A growing number of lawsuits creates headline risk for DuPont, Corteva, and Chemours (which we collectively refer to as historical DuPont). Based on our assessment of the legacy company’s exposure, we forecast $6.5 billion in total costs, less than 20% of our industrywide cost forecast and less than half of consensus estimates of $15 billion.
Historical DuPont manufactured PFAS for use in its products, such as Teflon. The company did not directly sell PFAS and did not make or sell the main type of PFAS used in aqueous firefighting foam, or AFFF. These distinctions are key to estimating liabilities because nearly 80% of the biggest cleanup sites come from either AFFF or a chemical plant that was operated by another company, which should result in little to no exposure for historical DuPont.
We see the largest exposure stemming only from historical DuPont plants, which should result in a smaller share of industrywide cleanup costs. Similarly, we see a smaller share of industrywide litigation costs, as we think historical DuPont would not be party to lawsuits where its products were not the source of exposure. We also see some exposure coming from other sites, which include plants that may have made products that contain Teflon. We think historical DuPont will likely have some exposure to these sites, but the costs will be spread among multiple parties.
We forecast $6.5 billion in total costs to historical DuPont, with most costs stemming from its current and former plants. This primarily consists of $4.3 billion in cleanup and litigation costs. Of this, we forecast a little over $800 million in cleanup costs using our estimated costs for large and moderate cleanup sites. We forecast $3.5 billion in litigation expenses using the $670.7 million settlement that historical DuPont paid in 2017 to settle claims related to its West Virginia plant. We apply this amount to the five other historical DuPont plant sites adjusted for 2020 real terms. For its exposure to other sites, we estimate just $0.5 billion of cleanup costs and $1.7 billion of litigation costs.
We Forecast DuPont and Corteva Will Pay $3.25 Billion Combined
In addition to the total cost to historical DuPont, the other key variable is how the cost will be split among the successor companies. In 2015, DuPont spun off Chemours with its PFAS manufacturing assets and most of its PFAS liabilities through an agreement that indemnified DuPont (which still included Corteva at the time) against future expenses.
However, Chemours has continued to revisit the agreement as liabilities rise. In 2017, in conjunction with the West Virginia PFAS settlement, the agreement was modified so that DuPont and Chemours would split the settlement 50/50 and cover future cleanup costs. In 2019, as the number of lawsuits and cleanup estimates continued to rise, Chemours sued DuPont and Corteva (now spun off) to revisit the indemnification agreement. The lawsuit was moved to arbitration as required in the indemnification agreement, which we believe will result in a settlement among the three parties.
Ultimately, we think DuPont and Corteva will agree to fund half of Chemours’ future liabilities, together paying $3.25 billion. Because Chemours was spun off with fairly high debt levels, DuPont and Corteva have some incentive to avoid Chemours declaring bankruptcy and potentially leaving all future costs to the two companies.
While bankruptcy is certainly a risk, our base-case assumption is that Chemours remains solvent, as we expect the liabilities to be paid over many years. For comparison, Owens-Illinois has made $3.6 billion in asbestos payments over the past 20 years, but the single highest payment in a year was just $350 million. We expect a similar cadence of payments for historical DuPont, which reduces the chance that Chemours goes bankrupt. Further, under the terms of its senior secured debt covenants, we calculate that Chemours could pay up to $1.5 billion in a given year, enough of a cushion to remain solvent even if some liabilities were accelerated.
In addition to the agreement with Chemours, DuPont and Corteva have an agreement with each other to split the first $300 million in PFAS-related costs evenly. For all expenses above $300 million, DuPont pays 71% and Corteva pays 29%.
We modeled a base, bull, and bear case based on the total historical DuPont cost and the split among the three companies. Our base case assumes historical DuPont pays a total of $6.5 billion in PFAS costs. We assume DuPont and Corteva settle with Chemours to split the bill evenly, resulting in a $2.2 billion cost to DuPont and $1.05 billion cost to Corteva.
In our bull case, we assume historical DuPont pays a total of $4.3 billion in PFAS costs, assuming it’s only responsible for its own sites. In this scenario, we assume DuPont and Corteva settle with Chemours to split the bill evenly, resulting in a $1.5 billion cost to DuPont and a $0.65 billion cost to Corteva.
In our bear case, we assume historical DuPont pays a total of $8.8 billion in PFAS costs, as the costs unrelated to its own sites are double our base-case estimate. We assume all costs are up front, which would force Chemours into Chapter 7 bankruptcy after only being able to pay $1.5 billion, leaving DuPont and Corteva to pay the remaining $7.3 billion. This results in a $5.1 billion cost to DuPont and a $2.2 billion cost to Corteva.
We See Significant Upside in DuPont as Specialty Chemical Businesses Rebound
The risk for additional PFAS liabilities has been weighing on DuPont’s share price since late 2019, when lawsuits accelerated. However, we believe the liabilities will ultimately cost DuPont just $2.2 billion, or about $3 per share. Even in our bear case, which assumes DuPont pays $5.1 billion, total PFAS costs are just $7 per share. The risk has been exacerbated by Chemours’ arbitration. However, we see the resolution of the arbitration as a catalyst for the stock, as it would remove a source of uncertainty.
Aside from liability concerns, we view DuPont’s underlying specialty chemical businesses as attractive. In its current form, DuPont is the specialty chemical business that was created as a part of the Dow-DuPont merger and subsequent spin-offs. The company has four distinct segments and a fifth, noncore business that consists of smaller businesses that are being divested. The four core segments are evenly balanced, each generating 20%-25% of EBITDA in 2019.
We award DuPont a narrow economic moat rating due to the pricing power of its specialty chemical portfolio, generating excess returns on invested capital. For example, Kevlar is the material of choice for military and law enforcement safety and protection. Similarly, Tyvek is the market-leading housewrap material. Even when a product goes off patent, the company develops new applications for that product that allow premium prices to be maintained. For instance, while Kevlar started as a material used for safety and protection, it is now used in aerospace and automotive vehicles, consumer products, and fiber optics, as well as adhesives, sealants, and coatings.
Corteva’s Shift to Premium Products and Lower Royalties Will Boost Profits
Like DuPont, the risk for additional PFAS liabilities has been weighing on Corteva’s share price since late 2019, when lawsuits began accelerating. Given our base-case view that PFAS liabilities will ultimately cost Corteva just $1.05 billion, this translates to roughly $1.50 per share--about 5% of today’s share price. Even in our bear case, which assumes Corteva pays $2.2 billion, the impact is just $3 per share. Similar to DuPont, we believe a resolution to the Chemours arbitration will be a catalyst for Corteva shares.
Aside from overblown PFAS concerns, we view Corteva’s seed and crop chemical businesses as attractive. Corteva is the agriculture business that was created as a part of the Dow-DuPont merger and subsequent spin-offs. Seeds and crop protection each generate around half of profits. Corteva’s geography skews toward North America, which generates around half of sales.
We award Corteva a wide economic moat rating due to the pricing power of its patented seed and crop chemical portfolio, which generates excess returns on invested capital. Corteva’s ability to commercialize new premium products stems from the research and development spending required for the continual development of new seed and crop chemical formulations. As patents expire and bugs develop resistance to current products, new formulations must be developed for Corteva to maintain its premium pricing. As a result, we look at R&D as a percentage of sales to gauge if a company is investing enough toward future products. Corteva plows back around 8% of sales into R&D, which is in line with peers such as Bayer (Monsanto historically averaged 10% of sales), Syngenta (9% before being acquired by ChemChina), and FMC (7%). This gives us confidence that Corteva is investing enough to develop new products.
Our View of Valuations and Moats Aligns With Sustainalytics’ ESG Risk Ratings
Factoring ESG risks into our valuations typically leads to a reduction to our fair value estimates. However, in some cases, the market sentiment is overly negative, which can create opportunities for investors if the actual impact is smaller than the market discount. We believe this will be the case for PFAS.
Our fair value estimates incorporate risks related to environmental liabilities, which have generally resulted in a mid-single-digit percentage enterprise value reduction. For these reductions, leverage can magnify the impact, such as for O-I Glass, whose asbestos-related liabilities have an outsize impact on equity due to its debt-laden capital structure.
Accompanying our fair value estimate reductions, companies with higher environmental, social, and governance risk tend to have a higher uncertainty rating. This reflects a wider range of outcomes, particularly when we model bear-case scenarios, which often include a greater impact from environmental liabilities and litigation. Our increased uncertainty ratings tend to align with an elevated Sustainalytics ESG Risk Rating.
Similarly, many of the companies with a valuation impact for environmental liabilities tend to have a no-moat rating. While this is not purely due to ESG risk, it is a factor we consider to determine our moat ratings. For moat ratings, we consider whether ESG risk presents a substantial threat of material value destruction. As such, even if the current competitive landscape allows a company to generate excess returns above its cost of capital, ESG risk may prevent a narrow or wide moat rating. For companies that have a narrow or wide moat rating, we still take ESG risk into consideration. However, we see a smaller chance that ESG risk will result in a substantial threat of material value destruction over the next 10 years for a narrow-moat company or 20 years for a wide-moat company.
Seth Goldstein does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.