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DuPont Is Materially Undervalued

We don't think the market appreciates the company's long-term earnings power.

DuPont de Nemours DD 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’s four business lines 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. 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 Kevlar, which has wide applications in textiles, safety equipment, and transportation. 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 with the move toward lighter-weight 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 for an electric vehicle versus an internal combustion engine vehicle.

In December 2019, DuPont announced a transaction to merge its entire nutrition and biosciences portfolio with International Flavors & Fragrances IFF in a tax-efficient transaction; DuPont shareholders will receive 55.4% of the combined company. We expect the transaction to close by early 2021.

We view the shares as attractively priced relative to our $85 fair value estimate. We think the market undervalues the company's postpandemic long-term earnings power and overestimates potential PFAS liabilities, which presents long-term investors with solid risk/reward potential.

Portfolio Digs a Narrow Moat 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, proprietary product Kevlar has become the material of choice for military and law enforcement safety and protection. Nomex is the material of choice for firefighters due to its heat-resistant properties. Tyvek is the market-leading house-wrap material. For these 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. Even when a product goes off patent, the company develops new applications for that product that allow premium prices to be maintained. Although Kevlar started as a material used for safety and protection, the material is now used in aerospace and automotive vehicles, consumer products, fiber optics, adhesives, sealants, and coatings.

The company’s health and nutrition businesses benefit from switching costs. In the nutrition and biosciences segment, 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.

All in all, we think DuPont has proved its ability to 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 DuPont will outearn its cost of capital over at least the next 10 years.

Competition and Liabilities Are Risks DuPont faces stiff competition across its chemical markets. The company operates in many highly cyclical end markets, including automotive, residential construction, and electronics, and could see a prolonged slowdown in demand in any of these. With the majority of sales outside the United States, the company is exposed to fluctuations in foreign currencies.

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 develop new uses for its products as patents expire, or if its new products fail to generate the same incremental demand growth from its end users, the company's ability to charge a premium for its products would deteriorate.

DuPont, along with former subsidiaries Chemours CC and Corteva CTVA, faces a growing number of PFAS-related environmental cleanup obligations and litigation. Exposure to PFAS chemicals can cause adverse health effects, and we think drinking water levels will eventually become regulated by the U.S. Environmental Protection Agency, spurring additional litigation. The three companies face a risk in the ultimate size of PFAS-related liabilities, which could take decades to resolve.

DuPont faces additional risk in how PFAS-related liabilities would be split among the three companies. Chemours has an agreement to indemnify DuPont and Corteva. However, Chemours has taken both companies to arbitration with the goal of setting a cap on the liabilities that it would have to pay. As a result, the three companies will probably negotiate an agreement to split PFAS-related settlements and environmental cleanup expenses. Further, Chemours was spun off from DuPont with high debt levels. Should Chemours become unable to pay, DuPont and Corteva could be on the hook for all expenses. Ultimately, DuPont remains at risk as long as there are outstanding PFAS-related lawsuits.

Net debt for DuPont was just under $14 billion as of Sept. 30, excluding the $6.25 billion raised by the nutrition and biosciences business in preparation for the merger with IFF. We calculate net debt/trailing 12-month operating EBITDA at roughly 2.7 times. Although this is above management's long-term goal of 2.0-2.5 times, we think it is still manageable. Further, DuPont has $2.4 billion available in its commercial paper and credit facility programs, which should provide stable liquidity through the COVID-19-related slowdown. The company also has no major debt maturities until 2023. As a result, we do not anticipate liquidity issues for DuPont as a result of the coronavirus-related slowdown.

In merging its nutrition and biosciences business with IFF, DuPont will receive a $7.3 billion payment when the deal closes. Management plans to use the proceeds to pay down around $5 billion of debt; we think the remaining proceeds are likely to be used to repurchase shares. As a result, DuPont's financial health should be quickly restored in early 2021 after the deal closes.

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.

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