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Isle Royale is a remote wilderness isolated by the frigid waters of Lake Superior.
Moose first reached the island in the early 20th century. Free from predators the moose population fluctuated based on the weather and food abundance. Then wolves arrived in 1940 by way of an ice bridge from Canada.
During the first decade of observations, the moose and wolf populations operated in the usual predator-prey model. This model suggests that as the prey population rises, so too does the predator population. Then, an inflection point occurs where there are so many predators that the prey population crashes. Less food means a decline in predators too. The cycle then repeats.
Predator-Prey Model in Theory
In the late 1970s, things got interesting. As the wolf population exploded, ecologist wondered if the wolves would drive the island moose into extinction. Before it could happen the wolf population crashed. A hunter and his dog visited the island. The dog brought the parvo virus to the island and the virus decimated the island’s wolf population.
The low wolf population allowed the Moose population to greatly increase. The Wolf population slowly recovered from the parvo virus but not to the extent it should according to the model. The island wolf population had a small gene pool and they were suffering from inbreeding. Then, to make matters worse, the Moose population crashed. A severe outbreak of moose tick combined with a severe winter took the moose population down to 500 animals.
During this time the wolves received an influx of new genes when a lone male crossed a new ice bridge and the wolf population started to recover again. But then the severe winter turned to extreme heat. The moose foraged less, rested more, and had fewer calves. Less moose to eat lead to the latest collapse of the three wolf packs. Now only two breeding females are left. Without future female pups surviving the wolves of Isle Royale may become extinct.
Predator-Prey Model In Action
The chart above is from a 50+ year ecology project on Isle Royale.
The lessons from Isle Royale are that models are good for building expectations and developing reasonable predictions about the future. But the real world doesn’t care about our models. The real world is random.
When we value a company we have to make predictions and expectations about the future. We build a model to help us.
In our models, we try to limit how many predictions we have to make and how far into the future our predictions go. No matter how exhaustive our research is, it is basically an educated guess about the future. We never know when the business equivalent of a dog with the parvo virus will show up. Keeping the number of predictions we have to make to a minimum, we try to reduce as much randomness as we can. But we can never eliminate it.
DowDuPont is the subject of this letter. We’ve built a sum of the parts valuation model; the most basic model we can build. It is our base case. It is what we think is the most likely outcome. But we know that we could drastically be underestimating potential returns and we could also be dramatically overestimating our potential returns. The future is a wide range of potential outcomes. Investing when the total company is cheap and following a manager with a proven track record in creating shareholder value, we think we have tilted the odds in our favor.
Sincerely,
American Money Management LLC
Dividend Stock in Focus
DowDuPont (DWDP): $66.83
prices as of the close August 3, 2018
Our investment in DowDuPont is another special situation. DowDuPont is the result of a merger between two iconic industrial chemical companies, Dow Chemical and DuPont. The two companies have changed how we eat, cook, look, and surf.
- Styrofoam – It keeps the hot side hot and the cold side cold.
- Neoprene – You can’t surf the winter swells without it.
- Nylon – It helped win WW2 and frustrate women everywhere.
- Teflon – What was supposed to be a coolant became a major benefit to kitchens and cooks.
- Silicones – one of Hugh Hefner’s favorite inventions.
Merging together is not the end goal for the DowDuPont. It is the first step in a three-step process.
The second step is integrating and reorganizing the company into 3 distinct business groups.
The third step is then to split the combined company into 3 stand-alone businesses: Materials (Dow), Agriculture (Corteva Agriscience), and Specialty (DuPont).
We think a fourth step will occur. The further split up of the Specialty Co. (DuPont).
Dividend History:
Both Dow Chemical and DuPont paid a consistently growing dividend before the merger. After the merger, the combined company continued paying a dividend. The current yield is 2.29%.
It is still unclear how much of a dividend, if any, each spin-off company will pay. However, we think it is highly probable that each new company will pay a dividend. In an interview with CNBC, CEO Ed Breen and Executive Chairman Andrew Liveris stated that DowDuPont will remain very shareholder friendly with dividends and share buybacks. And each spin-off will be shareholder friendly too.
Catalysts for Dividend Growth & Capital Appreciation:
Ed Breen
Do you remember Dennis Kozlowski?
He was the former CEO of Tyco International. Dennis was convicted in 2005 for essentially stealing $150 million from the company and earning $430 million more by falsely inflating the value of the Company’s stock.
Tyco faced bankruptcy after the corporate scandal but its different businesses were still valuable.
Ed Breen was appointed CEO of Tyco after Dennis was removed. Ed then proceeded to restructure the company by spinning off some business divisions and selling others.
Chart from Goldman Sachs
During this multi-year process, Ed Breen generated over 700% returns for shareholders.
DowDuPont’s stock price is not starting off in the same distressed position as Tyco did, but Ed Breen has the track record proving he knows how to restructure a conglomerate and generate returns for shareholders too.
Agrisciences (Corteva)
We think Corteva will be the highest valued spin-off based on a peer Enterprise Value to EBITDA (EV/EBITDA) multiple. Agriculture biotech companies like Monsanto and Syngenta usually traded at 14-16 x EV/EBITDA multiples because of their branded and patented seed technologies. Agriculture biotech businesses have semi-recurring revenue. Farmers tend to buy the same branded seeds each year because it is costly and time intensive to separate the seeds from the harvest. It is easier to buy the seeds with the traits you need to enhance your yield.
Corteva could also be the first DowDuPont spin-off to be acquired. Monsanto and Syngenta are comparable and competing companies to DowDupont. Both companies were also bought out by larger companies. Syngenta was bought by China National Chemical. Bayer just completed their Monsanto purchase. The agriculture biotech mergers are probably done for now but the need for genetically modified seeds to increase harvest yields will continue. Corteva is an attractive target for any company looking to increase its lead or improve its position within the seed business.
Specialty Co. (DuPont)
The first spin-off will most likely be the Materials Business which will retain the name Dow. The second spin-off will then be the Agriculture business named Corteva Agriscence. The company left standing is Specialty Co and it will take the name DuPont.
The specialty company is an interesting mix of 4 business lines that don’t overlap too much.
From DWDP’s presentation at the Barclays Electronic Materials Conference May 14, 2018
During a spin-off a key item to pay attention to is which company does current management stay with. The thinking is management sees the most value and monetary reward in the company they choose. Ed Breen will stay with Specialty Co. (DuPont). A skilled spin-off CEO heading to a company that has 4 separate business divisions leads us to believe that Ed will further restructure DuPont with more spin-offs, mergers, and selling of business divisions.
Risks:
Less Synergies Than Promised
A key factor for the merger between Dow and DuPont was the large amount of cost and growth synergies that could be removed from the combined company. Management is targeting $3.3 billion in cost and growth synergies. If these cost and growth synergies are not achieved then we have overvalued our investment in DowDuPont. If we overpaid than our expected returns will be lower and if we drastically overpaid then our returns could be negative.
At the Sanford Bernstein Strategic Decisions Conference, Ed Breen raised this year’s cost synergies from $ 1 billion to $1.2 billion. And then in the most recent earnings call, Q2 2018, this target was raised again to $1.4 billion.
Corn and Soybean Tariffs
The U.S. Ships 30% of its Soy Beans to China. President Trump continues to escalate trade tensions with China. In retaliation, China announced a new 25% tariff on mostly agriculture products from the U.S including soybeans, and reduced tariffs on soybeans coming from other Asia-Pacific countries. DowDuPont is a leader in North America for both corn and soybeans.
From DWDP’s Presentation at BMO Capital Markets Farm to Market Conference May 16, 2018
China still needs to import corn and soybeans. If not from the U.S. then most likely from South America. DowDuPont has a leading position selling corn and soybean seeds in these markets. We would expect U.S. sales to shift to other markets but the net effect should be minimal on DowDuPont as they sell their seeds into these markets too. We would expect tariffs and the rearrangement of global supply chains to cause some short-term disruptions.
Valuation:
We’re valuing DowDuPont on a sum of the parts basis. We value each upcoming stand-alone business using a peer Enterprise Value to EBITDA multiple. Then we add each value together, add in management’s projected cost synergies, subtract expected corporate costs, and then subtract debt and pension liabilities to arrive at the total equity value for DowDuPont. We value the combined DowDuPont at $76 per share.
Click to enlarge
At $66.83 per share, DowDuPont is trading at a 13% discount to our estimate. We think more value will come to shareholders after the spin-offs. As stand-alone entities each company will have the flexibility to improve their business, allocate capital as new management sees fit, incentivize management properly, and to be valued directly on its own actions. But right now our model is setting our expectations for $76 per share. We want reality to prove us too conservative in our expectations and we hope buying DowDupont at a discount from intrinsic value will buffer us from too much downside if the company catches its own parvo virus.
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