DuPont Considering Alternatives To Spinning Off Its Performance Chemicals Business

During the Goldman Sachs Basic Materials conference held yesterday, DuPont’s (NYSE:DD) CFO, Nick Fanandakis, said that while the announced spin-off of the Performance Chemicals business is on track, the company is also considering other separation alternatives such as a Reverse Morris Trust (RMT) transaction or even a complete sale. We believe that an RMT transaction would create greater value for DuPont shareholders in the long run, compared to a simple spin-off. This is primarily because of cost synergies and better pricing power associated with a merger. ^[1]

DuPont generates annual sales revenue of around $36 billion by supplying high-performance materials and chemicals, electronic materials, high-performance coatings and agricultural products to industries and consumers worldwide. Most products manufactured by DuPont are used as raw materials by other industries, making it a predominantly B2B (business-to-business) based company with the exception of the agriculture and nutrition divisions. Its consolidated adjusted EBITDA margin stood at around 20% last year.

We currently have a $71 price estimate for DuPont, which is ~16.4x our 2014 adjusted diluted EPS estimate of $4.32 for the company.

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Why Spin-Off?

DuPont’s Performance Chemicals division primarily deals in titanium dioxide (TiO2) and fluorochemicals. It has been under-performing the company’s overall portfolio for the last few quarters. This has been primarily due to lower chemical prices, which continued to weigh on its consolidated operating margins during the first quarter of this year as well. Although sales from the division were down marginally (~3%), operating earnings declined more than 20% y-o-y due to thinner margins. According to our estimates, DuPont’s Performance Chemicals adjusted EBITDA margin shrunk by more than 800 basis points last year. ^[2]

In 2009, industrial demand declined sharply due to the global economic downturn, which led to a closure of several manufacturing facilities around the world. As a reaction to the grim situation, governments around the world initiated a variety of stimulus packages to revive the industrial sectors. This led to a sharp growth in infrastructure and housing markets around the world, especially in China. Consequently, the demand for TiO2 – primarily used as a whitening pigment by paint manufacturers, and fluorochemicals – primarily used as refrigerants, surged higher. This was followed by capacity additions by manufacturers to tap the soaring commodity prices. However, after the housing market in China started cooling down in mid-2012, demand for these chemicals slumped and prices fell sharply from their peaks due to excess inventories. Although TiO2 demand has been improving recently, as suggested by the y-o-y volume gains posted by DuPont for five consecutive quarters now, prices continue to remain weak due to an inventory overhang. Refrigerant prices continue to remain subdued as well. ^[3]

In order to reduce the impact of this cyclical volatility, which is inherent to the Performance Chemicals business, on its portfolio, DuPont decided to spin-off the division into a separate company in October last year. However, during the Goldman Sachs Basic Materials conference, Nick Fanandakis said that while the spin-off process is on track for mid-next year completion, the company is also looking at other separation alternatives for the division. ^[1]

What Alternatives?

DuPont’s Nick pointed out to a complete sale or an RMT transaction as potential alternatives for the separation of the Performance Chemicals division. An RMT transaction combines a spin-off transaction with a statutory merger to allow a tax-free transfer of a subsidiary. It is basically a more tax-efficient manner to sell off a subsidiary. In this transaction, the parent company first completes the spin-off of the subsidiary to its shareholders. Then the subsidiary, which is now a separate entity owned by the parent company’s shareholders, merges with a target company to create a larger company. Under section 368 of the Internal Revenue Code, this could largely be a tax-free transaction if the spun-off subsidiary is considered the buyer of the target company. ^[1]

If DuPont takes the RMT route, there could be an opportunity for Tronox (NYSE:TROX) to become the target company. Tronox was formed as a result of the spin-off of Kerr-McGee’s chemicals business in 2006. It primarily deals in TiO2, which makes up more than 85% of its total sales. According to our estimates, Tronox holds the second-highest (around 15%) share in the $14 billion TiO2 market globally. Like other players in the market, it has also been hit badly by lower commodity prices and higher raw material costs over the past few quarters. However, if it enters into an RMT transaction with DuPont, the largest player in the TiO2 market with a 20% share, the merged entity could benefit from cost synergies and increased pricing power. This would result in improved operating margins for the combined entity and unlock greater value for both DuPont and Tronox shareholders. Tronox shares gained more than 7% yesterday on prospects of a merger. ^[4]

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1. DuPont at Goldman Sachs Basic Materials Conference, dupont.com [↩] [↩] [↩]
2. DuPont Reports Q1 Operating EPS of $1.58, dupont.com [↩]
3. Q1 2014 Earnings Call Transcript, dupont.com [↩]
4. Tronox SEC Filings, sec.gov [↩]