Analysis: DWDP

Before the opening bell on Thursday, DowDuPont (DWDP) reported mixed fourth-quarter earnings results. Revenue of $20.1 billion (flat year over year) missed the consensus of $20.92 billion, and adjusted earnings per share of $0.88 (up 6% year over year) matched the consensus. Operating EBITDA of about $3.9 billion was also flat year over year.

Before getting into the results, we remind members of the key to our DowDuPont thesis, the unlocking of value realized through the company's breakup into three separate entities. But as much as important as this catalyst is, fundamentals matter. The results in this quarter were undoubtedly soft, and the guidance for the first quarter of 2019 was on the lighter side as well. Unfortunately, DWDP is down significantly in trading this morning and deserves to be because the macro challenges the company is facing will cause earnings expectations to be reset. That being said, we want to circle back to our breakup thesis as a reason to hold it. The first leg in company's breakup is nearing. DowDuPont is on track to separate the new Dow on April 1st, followed by the Corteva/DuPont split on June 1st

Back to the quarter, Materials Science net sales were $11.759 billion (consensus $12.258 billion), Operating EBITDA (ex-equity earnings) was $2.056 billion (down 7% year over year), and Operating Margin (ex-equity earnings) declined by 120 basis points year over year to 17.5%. In total year over year for the change in sales, volumes increased 1%; while both currency and local price contributed a 1% negative impact. The results were hurt because the company completely lost its feedstock advantage in the quarter as Brent crude oil dropped to $50 from $80. Additionally, there was a 40% compression in the naphtha to ethane spread driven by the oil price drop, weak gasoline demand, and higher U.S. natural gas prices. The company ended the year with de-stocking challenges, and this will be worked through in the first two quarters of 2019. By the end of the year, operating rates should improve by about 200 to 300 basis points, but this is going to take some time.

Performance Materials & Coatings net sales were $2.196 billion (consensus $2.4 billion), the Operating EBITDA was $421 million, and the Operating EBITDA margin improved 110 basis points to 19.2%. The 7% gain in local price was partially offset by a 6% decline in volumes.

Industrial Intermediates & Infrastructure net sales were $3.695 billion (consensus $3.879 billion), the Operating EBITDA was $553 million (a decline of 18% year over year), and the Operating EBITDA margin declined 400 basis points to 15%. The decline in EBITDA was primarily driven by a contraction in isocyanates that impacted core results, particularly in Polyurethanes. Furthermore, management acknowledged softening in appliance and the automotive end market. Even though DowDuPont typically outperforms the auto builds rate, the industry's sharp decline in the fourth quarter was too challenging.

Packaging and Specialty Plastics net sales were $5.868 billion (consensus $6.163 billion), the Operating EBITDA was $1.104 billion (a decline of 13%), and the Operating EBITDA margin declined 210 basis points to 18.8%. Demand was steady in this division, however the 4% decline in net sales was impacted by a 3% drop in local price, driven by lower polyethylene product prices. Good business, but too much exposure to polyethylene.

At Specialty Products, net sales were $5.457 billion ($5.659 billion consensus), operating EBITDA was $1.784 billion, and operating EBITDA margin expanded by 320 basis points to 32.7%. In total year over year for the change in sales, volumes were flat, local price grew 2%, there was a -1% impact from currency, and a 1% benefit from portfolio/Other.

In Electronics and Imaging, net sales were $1.169 billion (consensus $1.209 billion), Operating EBITDA was $685 million, and Operating EBITDA Margin improved 990 basis points to 58.6%. Weakness in the smartphone market offset semiconductor related gains.

At Nutrition and Biosciences, net sales were $1.628 billion (consensus $1.757 billion), Operating EBITDA was $367 million, and Operating EBITDA Margin expanded 20 basis points to 22.5%. The probiotics business remained strong, with sales increasing 20% in the quarter. However, weakness in Industrial Biosciences was driven by a slowdown in the U.S. and Canada energy markets due to oil prices.  

In Transportation and Advanced Polymers, sales were $1.319 billion (consensus $1.356 billion), Operating EBITDA was $389 million, and Operating EBTIDA Margin expanded 140 basis points to 29.5%. Volume growth was down 5% as automotive and electronic end markets in Europe and Asia Pacific were down due to inventory destocking.

Then in Safety and Construction, net sales were $1.341 billion (consensus $1.352 billion), Operating EBTIDA was $343 million, and Operating EBITDA Margin expanded 340 basis points to 25.6%. Although there were gains related to aerospace and personal protection, these were partially offset by softness in construction related to U.S. residential markets.

In Agriculture, net sales were $2.817 billion (consensus $2.8 billion), Operating EBITDA was $233 million, and Operating EBITDA Margin improved 30 basis points to 8.3%. In total year over year for the change in sales, volumes increased 4%, local price grew by 5%; however, there was a negative 5% and a negative 3% impact from portfolio actions/other. Crop Protection sales of $1.6 billion increased by 6%, with organic sales growth of 10% primarily due to new product launches, which were partially offset by weather-related reduction in demand for nitrogen stabilizer sales in the U.S. and Canada. Seeds sales were $1.2 billion, representing a decline of 4% year over year. Organic sales grew 8% in the quarter, reflecting strong volume growth. The company recently received some soybean approvals that will help drive future growth, however, this appears to be more of a 2020 story.

Looking ahead at first quarter modeling guidance, management expects net sales to be down in the mid-single digit percent, while operating EBITDA will be lower by the low teens percent. By division, Agriculture net sales will be down in the low single digits in the first quarter, with operating EBITDA down by a low single digit percent. But due to seasonal timings, a clearer outlook for Agriculture is to view it on a first half of year basis. It's not that much better, as from a net sales perspective, management expects Agriculture to be down in the low single digit percent, however operating EBITDA is expected to be flat. For Materials Science, net sales in this division is expected to be down by a high single digit percent, with operating EBITDA down in the low-twenties percent. That's the destocking challenge, and the first quarter may be the toughest of 2019. And at Specialty Products, net sales are expected to fall by a low single digit percent, while operating EBITDA will drop by a low single digit percent. It's hard to find anything positive in this guidance, and this weakness will take the stock lower in trading today. We have seen arguments made in that this is management being ultra conservative in order to set up the three separate entities for earnings beats down the road, but we will not attempt to sugar coat how bad this guidance was.

We are not buyers on today's weakness. We will downgrade this rating to a TWO and lower our price target to $70 as the poor fundamentals will lower this sum-of-the-parts valuation. The company has become too levered to the price of oil, even though leadership has said in the past that it was levered to nat gas. Brent's fall to $50 from $80 crushed them. The company has become too levered to housing, the auto business slowed when it previously performed well, and its top of the line plastics business is now in a very challenged industry. DowDuPont is too levered to GDP, China was weak, and Europe was soft, and the strong dollar applied additional pressure. Although 75% of the business met management's targets, 25% was soft due to the destocking challenges.

Despite our low average cost basis, we got this stock terribly wrong. We held on to it during its integration phase because we thought we had found a company with solid fundamental that was realizing a huge amount cost synergy, and most important to our thesis, it had breakup catalyst that we expected will unlock additional value. The cost synergies have come in better than expected, and the break-up is still in play (although we had anticipated a faster than expected timeline), but what we misjudged was the deterioration in business fundamentals that occurred at the very end of 2018. We thought that aggressive $3 billion buyback announcement on the third quarter earnings release was a signal that the stock was ready to turn higher, and we previously expected the Form 10s to inspire some buying, but in hindsight these proved to be false positives because the fundamentals soured. 

There will be people who buy this stock because Fed Chairman Jerome Powell is on hold and the company is a winner from a potential trade deal with China. Plus, the company plans to buyback $1.6 billion worth of stock by the end of this quarter, a huge amount that should provide some support. However, we are not in this camp because of the weak results, the guidance, and the company acting too much like an oil commodity play. Although our outlook has dimmed, we are averse to selling the stock down here because the breakup is just months away and this is still a visible catalyst that will bring out value. It has hurt us to be patient, but we are just a few months away.