DuPont Gets Better End of Deal

DuPont DD plans to merge its nutrition and biosciences business with International Flavors & Fragrances IFF on terms that appear slightly favorable for DuPont shareholders. Our updated $95 fair value estimate for DuPont assumes a 100% probability that the deal will close, as we see little overlap between the two portfolios, as well as a significant cut in the proposed synergy targets. We currently view DuPont as significantly undervalued.

Under the terms of the deal, DuPont shareholders will receive a 55.4% equity stake in the merged company, and DuPont will receive a $7.3 billion dividend payout from the merged company when the transaction closes, which we expect will be by early 2021. Based on our valuation, DuPont is effectively receiving an 18.4 times presynergy multiple, which we view as an attractive valuation.

Although we initially thought that the DuPont assets might command an even higher multiple amid reports of a bidding war between IFF and Kerry Group, the announced terms still represent a good price based on our valuation. We think IFF is overpaying for the DuPont assets, which will benefit DuPont shareholders at the expense of IFF shareholders.

Although we consider the deal modestly value-accretive for DuPont, we’re skeptical that the new company will be able to achieve its revenue and cost-cutting targets. While most of the cost-cutting efforts appear reasonable, such as the elimination of back-office expenses and increased manufacturing efficiencies, we’re skeptical of the revenue synergies. We forecast that management will be able to achieve only about 40% of its total projected EBITDA synergy target. If we were to assume that full synergies are realized, our DuPont fair value estimate would rise an additional $3 per share.

The nutrition and biosciences divestiture is the first major move for the new DuPont, which was created in June after spinning off Dow Chemical and Corteva from DowDuPont. Although further divestitures could come, we saw little operating overlap between the nutrition and health business and the remaining three segments. As such, we think the decision to divest the nutrition and health business makes good strategic sense.

Solid Record of Innovation DuPont de Nemours is a world-renowned chemical company with a history spanning over 200 years and an ever-evolving portfolio. In its current iteration, DuPont is the specialty chemical company created in 2019 from the DowDuPont merger and subsequent separations. The company has four distinct business lines that each generate roughly one fourth of profits and sell products to different end markets. With 15% of sales to the auto industry and no other end market making up over 5%, DuPont is fairly diversified, and we forecast consolidated revenue to grow slightly above global GDP.

DuPont has produced some noteworthy (and high-profit) products over the years. The safety and construction segment invented products such as Lycra and Kevlar, which have wide applications in textiles and safety equipment. Tyvek, broadly used in construction materials, also demonstrates DuPont’s successful product development and innovation. The company has a solid record of innovation, and we think it will be able to replace earnings from older products as they fall out of favor or are leapfrogged by new technologies and as patents expire.

DuPont is well positioned to capture profit growth from secular trends in the coming years. In the transportation and advanced polymer segment, DuPont should benefit from automakers replacing small metal pieces with lighter plastics, a trend that should continue as automakers move toward more lightweight vehicles. In the electronics and imaging segment, DuPont should benefit from the continued growth in semiconductors and a rise in interconnectivity of devices, which will require more electronic components in smartphones, computers, automobiles, and consumer appliances. DuPont is also exposed to the electrification of vehicles as it generates over 50% more revenue per vehicle for an electric vehicle versus an internal combustion engine vehicle.

Patented Products Enjoy Premium Position We award DuPont a narrow economic moat rating for intangible assets based on its patented portfolio of specialty products. The company's success developing innovative materials has created a group of patented products that enjoy a premium position in the market. For example, DuPont's Kevlar, a proprietary product, has become the material of choice for military and law enforcement safety and protection. Nomex is the material of choice for firefighters because of its heat-resistant properties. Tyvek is the market-leading house-wrap material. For these patented products and others, DuPont develops multiple versions for end markets, with products such as Kevlar and Nomex being used in both consumer and industrial applications.

The company’s health and nutrition businesses benefit from switching costs. In the nutrition and biosciences segment (which houses the health and nutrition business), key products include microcrystalline cellulose, which is used to bind dry tablets for roughly half of the prescriptions written each year in Western markets, and functional nonactive ingredients, such as controlled-release polymers. Although there will be significant drug patent expirations over the coming years, we expect the business will continue to hold a high market share due to the high switching costs. As pharmaceutical products shift off patent, generic drug producers look to minimize risk and simplify their regulatory process by using the same ingredients. Any changes to the drugs, including the binder or other ingredients such as the controlled-release polymers, must demonstrate equivalency to the original product, a difficult feat considering the high standards of quality and consistency required by the U.S. Food and Drug Administration. Failure to demonstrate equivalency would mean that the generic product does not pass regulatory approvals. As such, generic drug producers tend to stick with binders and other functional nonactive ingredients already used in most of the patented products.

We think DuPont has proved it can continually generate new products. This keeps profit margins elevated as patents expire and competitors develop generic substitutes. The company’s specialty chemical portfolio, which demands elevated margins, enjoys higher barriers to entry and has stickier customer relationships. We are confident that DuPont will outearn its cost of capital over at least the next 10 years.

Cyclical End Markets DuPont faces stiff competition across its chemical markets. It operates in many highly cyclical end markets, including automotive, residential construction, and electronics, that could see a prolonged slowdown in demand.

Additionally, there is no guarantee that DuPont’s investments in researching and developing new specialty chemical products will bear fruit. If DuPont is unable to develop new products to replace formulas that roll off patent, or if its new products fail to generate the same incremental demand growth from its end users, its ability to charge a premium for its products will deteriorate.

Given its sales outside the United States, the company is exposed to fluctuations in foreign currencies. Like all chemical producers, DuPont continually faces the possibility of environmental and health-related remediation costs, such as asbestos liabilities. It also is at risk for litigation related to PFOA and other related toxic chemical lawsuits and environmental cleanup obligations. Although former subsidiary Chemours faces the bulk of the risk related to the lawsuits, DuPont will probably have to fund part of Chemours’ settlements and environmental cleanup expenses. Ultimately, DuPont remains at risk as long as Chemours faces lawsuits and liabilities related to toxic chemicals while it was still a part of DuPont.

DuPont plans to pay at least $900 million in dividends annually, growing with net income. Management targets a 30%-40% payout ratio for dividends. We forecast DuPont to generate significant free cash flow that will allow it to meet all of its financial obligations, with remaining cash flow to support dividends.

DuPont will receive a $7.3 billion payment from the merged business when the deal with IFF closes. We think any remaining proceeds after paying down debt will probably be used to repurchase shares.