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Stranded fat

23 September 2014 By Rob Cox

In the electric utility industry, the term “stranded costs” refers to past investments used to build infrastructure that, as a result of deregulation, may become redundant and of no value. The jargon has surfaced lately in a different, but no less electrifying, context: uppity investor Nelson Peltz’s siege of one of America’s most venerable corporations, DuPont.

The billionaire is enlisting some controversial arithmetic to suggest the $65 billion chemicals giant has grown so bloated over the past 212 years that it can only be saved by being dynamited in two. Central to the thesis that Peltz’s Trian Fund Management has put forward to investors is a determination of whether the so-called stranded costs at DuPont are just a corporate euphemism for fat.

Before plumbing the specifics of Peltz’s arguments, it’s worth considering why DuPont makes a fascinating target for activism in the first place. For starters, it’s a very old company. Frenchman Éleuthère Irénée du Pont broke ground for his first gunpowder mills on Delaware’s Brandywine River in 1802. That potentially means the company has had two centuries to build up excessive costs or sclerotic processes that can be squeezed to benefit the bottom line.

On the other hand, DuPont also has built up a resiliency and pride among its many constituents that will factor into any confrontation. According to DuPont’s official history, after establishing those first mills, the eponymous founder “spent the remainder of his life keeping them, going through explosions, floods, financial straits, pressures from nervous stockholders, and labor difficulties.”

Of course, the long-gone wunderkind DuPont (at 14, he wrote a paper on the manufacture of gunpowder) is not the target of Peltz’s campaign. That would be Ellen Kullman, a Delaware native and quarter-century DuPont veteran who in 2009 became the nineteenth executive to lead the company. Though the company’s shares have nearly doubled, Kullman has struggled of late to meet investor expectations, and in June lowered her full-year outlook for operating earnings.

For Trian, which had been working behind the scenes with DuPont for over a year, this appears to have been the catalyst for going public with its gripes. Last week, the investment firm released a 35-page letter to the DuPont board of directors making all of the usual critiques: disparate businesses, overwhelming complexity, lack of accountability and an inefficient capital structure.

Atop Trian’s litany of complaints, however, is the one that may matter most, a charge that DuPont has up to $4 billion of excess corporate costs. If true, that represents a huge opportunity. Even if only half of these were to fall to the bottom line, after taxes they would be worth some $14 billion to shareholders today. Moreover, if Peltz is correct, he further upends the conventional wisdom that economies of scale are achievable within large conglomerates.

So how does Peltz derive his math? DuPont only has around $1 billion of publicly disclosed unallocated corporate expenses. This, Peltz points out, includes an 18-hole golf club and the Hotel DuPont, which opened in 1913 and was “designed to rival the finest hotels in Europe.” As the hotel boasts, “no expense was spared in the creation of Wilmington’s crowning achievement.”

For its part, DuPont calls the hotel and country club “an immaterial component of total company costs” and is open to divesting them “if appropriate value can be received for shareholders.” It also points out that its average selling, general and administrative expense over the past five years is in line with peers.

Peltz’s remaining $3 billion figure revolves around an extrapolation from a deal DuPont struck with Carlyle Group. The buyout firm acquired DuPont’s coatings business, renamed Axalta, in 2011. At the time, the business reported adjusted EBITDA of $339 million. In August, when Axalta filed to go public, it reported 2011 EBITDA of $568 million. The $229 million difference is made up of “stranded costs” imposed by DuPont’s corporate headquarters on the division.

This “provides a strong read-through to extrapolate true excess corporate costs across the entire portfolio,” argues Peltz. He illustrates this in two ways. First, he notes that the $229 million was equal to 5.3 percent of the coatings division’s sales. If stranded costs of this order can be proportionately allocated across the whole of DuPont’s sales, he gets to $2 billion.

His other calculation is to take the excess allocated corporate cost savings of the coatings business as a percentage of EBITDA and apply that to the entire DuPont portfolio, a number that increases the potential for savings to as high as $2.7 billion.

It’s hard to know whether Peltz’s arithmetic is entirely fair until DuPont gives a full-throated response. Investors, though, believe at least some of it. DuPont’s market value has swelled by about $5 billion since Trian released its white paper. And to its credit, DuPont was already grappling to some degree with the “stranded costs” problem.

In May, Chief Financial Officer Nick Fanandakis told investors that when the company separated the coatings business, it “looked at the residual costs that (were) going to be trapped” with the parent company, and managed to eliminate them in the first year. That’s well and good. The question DuPont will need to answer next is why they ever existed in the first place.

This item has been updated to add comments from DuPont in paragraph nine.


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