"A will finds a way."
- Orison Swett Marden
Kicking Rocks
Rise and shine. There is some good news. The yield curve is a bit steeper, at least here at zero dark thirty...than it was last week. The bond market seems to be pushing out the ten year. That product is now seriously close to giving up 3%. I imagine that at some point, perhaps this morning, we'll witness an equity market reaction. The 2/10 spread however has broadened to more than 51 basis points, which if held will spark some continued life into the banks.
With interest rates nearing a point where they might not be all that helpful to equity markets going forward. With a domestic macro-economic picture that appears to support the Fed's intent on monetary policy. With the ongoing trade conflict with China likely to re-emerge in significance within two or three weeks. With the potential abdication of market leadership exhibited by the tech space, or more specifically...by Apple (AAPL) , and the semi-conductor manufacturers...what rock does one kick over in order to unlock alpha?
Yes, I (along with many) have given you the obvious...certain defense and energy plays. Rising commodity prices, and growth, will of course push the Transports (or at least the railroads) in the right direction, particularly if there are pipeline bottlenecks at points of distribution for domestic crude. There is another stone that for some may still be unturned, or perhaps if already discovered by the investor...deserving of another look.
Deal Makers
Globally, mergers and acquisitions are off to their best start ever for a new year. Over the first quarter, supported by US tax reform, and global economic growth (particularly in Europe), dollar amounts placed on these types of deals came to a rough $1.2T. That's a record. Mergers were sizable indeed but fewer in number. The paradox was seen in the Q1 earnings release that Goldman Sachs (GS) put to the tape. That firm saw a net 5% increase in investment banking year over year. That net only comes after separating a 27% increase for underwriting from 22% decline for advisory services. How bazaar.
There are some deal stocks out there that have behaved poorly. Do they now offer opportunity? Let's dig in. Take General Electric. Please take General Electric (GE) . What is the sum of those parts? Where is their opportunity for a sale? What is the value of what will remain versus liabilities that also remain. I sold my entire long on Friday (which was a bit more than what I consider a full position in the name), and all associated derivative positions. That was more in relief of seeing the name poke it's head above my cost basis than it was a statement on any opportunity provided by a break-up. I simply saw a chance to escape what had been a lousy position for an extended time, with both my principal and some lunch money. I took that route.
How about Qualcomm's (QCOM) pending takeover of NXP Semiconductor (NXPI) ? Both of these names have been punished by not only sector rotation but by the loss of Broadcom (AVGO) as a suitor for (QCOM) . The deal has cleared regulatory hurdles in eight of the nine government regulatory bodies that it needs to get past in order to become reality. This $44B deal that was announced a year and a half ago still has to get through Chinese approval. By the way, the US hearing on placing tariffs on Chinese imports is scheduled for May 15, with possible implementation by May 22. I think the outcome of those proceedings will obviously have great impact on China's approval of this deal moving forward. There is another opportunity out there. One that seems interesting, or should I say is becoming interesting enough to offer investors a second swing at a pitch that they may have missed.
Paradise Lost...and Found?
DowDuPont (DWDP) . The name just does not roll off the tongue. Sounds like maybe the merger that was completed on 31 August of last year between Dow Chemical and DuPont to make one holding company just does not fit, which is good because the firm has made it plain since the beginning that it plans to split into three independent companies.
Something had to be done. The combined entity once the numbers are meshed, runs with a three year earnings per share growth rate of -2%, and a three year sales growth rate of exactly zero. Not exactly the stuff of legend. On the plus side though, for the last quarter sales did grow by more than 54% year over year. The firm's cash position has grown to more than $14B, while total debt has also climbed, though not quite as quickly...to $34B. The combined entity appears more than capable of meeting obligation as it's current ratio stands at a very healthy 1.9, and sans inventory, the quick ratio remains robust at 1.2.
Why Now? If Now?Why get involved now? Well for one, the S&P 500 now trades at 17 times next year's projected earnings, the Dow Jones Industrials at just 16 times. DowDupont trades at 13 times. After last year's run-up, the stock is still down 7% for 2018, though off of the lows.
The elephant in the room is the expected three way break-up. The three independent firms are expected to end up looking like this:
1) Corteva Agriscience. This is currently the agricultural division. This division ran with more than $14B in 2017 pro-forma revenue, and $2.6B in 2017 pro-forma EBITDA. This is the unit that in the event of ongoing trade tensions with China might be impacted the most. The expectation is for this firm to be spun off by June 1 of 2019.
2) Dow. Currently the Materials Science Division, this firm will retain the Dow brand, the Dow diamond logo, and assume the mantle of Dow Chemical's 121 year corporate history. This branch posted a whopping 2017 pro-forma revenue number of $44B, though 2017 pro-forma EBITDA drops to just $9.1B. This division is projected to stand alone by the end the first quarter next year.
3) DuPont. This spin-off will be advertised as a specialty products company, and will assume the 215 year legacy of the old DuPont. Broken out, the portion of the business that this would comprise would have posted pro-form 2017 revenue of $21B, with 2017 pro-forma EBITDA of $5.3B.
Sure Thing?
Of course not. What we are aiming for here is eventual value unlocked three ways that amounts to a significant increase over the value the firm allows as one unit. We do not need to be as exact in this name as we might be in a normal situation. In other words, precision will be impossible, so we're using mortars here, not sniper rifles.
I like the fact that the firm can defend itself short-term. I like the fact the the firm is trading at valuations below that of the S&P 500 and the DJIA. I like the fact that the firm pays you 2.3% just to own the shares. I like the fact that the share price rebounded this month off of a 31.8% re-tracement of the move off of the January 16th adjusted low (deal was announced December 11, 2015) through the January 2018 high.
What I Suggest (...and am likely to do myself)
1) Leg in small. One tenth to one eight of your intended position size is fine. There is still a danger that the share price retests the 61.27 2018 low, and you want to have some dry powder ready if it does.
Optional (Literally)
2) Feeling adventurous? These deals are expected to start moving by early 2019. 2019 January $50 puts were still paying $1.09 on Friday. Knocking a $1.09 off of your basis will leave you some risk should the shares simply collapse. That's the risk/reward ratio that you have to decide for yourself. The June 2018 $60 puts were still paying $0.75 on Friday. Just another idea.
Economics (All Times Eastern)
09:45 - Markit Munufacturing PMI Flash (April): Expecting 55.1, Last 55.6.
08:30 - Markit Services PMI Flash (April): Expecting 54.3, Last 54.0.
10:00 - Existing Home Sales (March): Expecting 5.55M, Last 5.54M SAAR.
Today's Earnings Highlights (Consensus EPS Expectations)
Before the Open: (ALK) (.12), (HAL) (.40), (HAS) (.33), (KMB) (1.68), (LII) (1.10)
After the Close: (GOOGL) (9.28), (AMP) (3.46), (CR) (1.27), (OI) (.58), (AMTD) (.74), (WHR) (2.96)
