By Jack Hough
Remember the chief executive with the birthday-party ice sculpture of Michelangelo’s David urinating vodka? That was Dennis Kozlowski, who nearly ran Tyco International into the ground.
The story has a happy ending, not so much for Kozlowski-who did eight years in prison for grand larceny, conspiracy, and fraud-but for investors who bet on his successor. Edward Breen stabilized, slimmed down, and split up Tyco during the decade ended 2012, and made a return of over 700% for shareholders in the process. (He also earned, fair and square, an exit package worth more than Kozlowski had looted.)
Breen’s past success is newly relevant, because today he heads the world’s largest chemical company, DowDuPont (ticker: DWDP), which was formed by an August merger. DowDuPont is no Tyco-it needs restructuring, not resuscitation-so Breen is unlikely to deliver anything close to his past returns. Even so, the shares look likely to return a healthy 15% to 30% over the next year, including dividends.
One similarity between the two companies is that DowDuPont is, just as Tyco was back then, the product of decades of rampant deal making. There are plenty of examples of companies that have bought their way to prosperity, but these are the exceptions, not the rule. Academics who have studied the matter have found that, on average, acquisitions tend to beget subpar returns, and spinoffs, handsome ones.
That makes intuitive sense. Managers who do big takeovers tout the synergies they will unlock, but some have a hidden motivation: the desire to run larger companies. Those who do spinoffs shrink their empires. Presumably, they have solid financial reasons for doing so.
At Tyco, Breen started with a massive debt load and a shattered stock valuation. He slashed costs and used some of the money to pay down debt, while investing some in growth projects. He also left a trail of spinoffs. There’s a medical-products company that’s now part of Medtronic (MDT); an electronics maker now called TE Connectivity (TEL); and ADT, which was bought last year by Apollo Global Management and merged into security concern Protection One. (The rest of Tyco is now Johnson Controls International [JCI] after a reverse merger last year.)
BREEN COMES TO DOWDUPONT via DuPont, where he was named CEO two years ago and had been cutting costs. The combined company has announced a plan to split into three separately traded businesses.
The materials-science division will include packaging, industrial and infrastructure products, coatings, and more. Yearly sales there are pegged at about $40 billion and profit margin, over 20%, based on operating Ebitda, or earnings from continuing operations before interest, taxes, depreciation, and amortization. Specialty products, including ones for the electronics, medical, oil and drug industries, are expected to bring in sales of $21 billion with a 25% margin. And agricultural products, including seeds and weed- and bug-killers, will bring in about $14 billion in sales, with margins over 15%.
DowDuPont says it can cut $3 billion from yearly costs and add $1 billion to revenues by combining sales efforts. “Breen tends to underpromise and overdeliver,” says John Maloney, chief executive at M&R Capital Management, which oversees $525 million, mostly for individuals, families, and estates. Maloney held Tyco shares under Breen and now expects to profit with DowDuPont, especially given what he calls Breen’s knack for making good investments. “You want a CEO who will feed the flowers and starve the weeds,” he says. “I don’t think the revenue upside is factored in by anyone.”
The math on falling costs, meanwhile, bodes well for patient shareholders. DowDuPont could spend $3.5 billion to make the changes necessary to secure that $3 billion a year in savings, according to JPMorgan analyst Jeffrey Zekauskas. It is likely to bear the last of these costs before the end of 2019. That means free cash flow will be understated at first and swell thereafter. Zekauskas predicts $4.10 a share in free cash next year and $5.55 in 2019.
That gives shares, recently $71, a free cash yield of 7.8% based on the 2019 forecast. The average Standard & Poor’s 500 company has a free cash yield of about 5%. A rise in the stock price to Zekauskas’ price target of $80 over the next year would put the 2019 free cash yield at a still-attractive 6.9%. That would work out to a 15% return, including dividends.
However, the pending breakup, which DowDuPont expects to complete within 18 months, makes things more interesting. Investors tend to demand high free cash yields from commodity companies, like the materials portion of DowDuPont, but are willing to settle for lower yields on specialty and agricultural products, given the high margins of the former and the scarcity value of the latter. For example, specialty player Praxair (PX) has a forward free cash yield below 4%, and seed giant Monsanto (MON)—which has agreed to a buyout by Bayer (BAYN.Germany)—is under 5%. Putting DowDuPont at a blended 6% free cash yield in a year results in a share price of $92, notes Zekauskas. That works out to a gain of 30%, plus the 2.6% dividend yield.
Those aren’t post-Kozlowski Tyco returns, but then, DowDuPont comes with a drama-free balance sheet. If anything, analysts complain that the company owes too little. If it wanted to come up to a more typical leverage ratio, it could raise $20 billion. That’s 12% of its stock market value—enough for a big stock buyback or a doozy of a dividend.
The original story can be found here: http://www.barrons.com/articles/dowdupont-buy-it-ahead-of-the-breakup-1508554090