You Have a Lot to Worry About if You Own This Stock

Neha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When a company that beats Street estimates is awarded with a ratings downgrade, you know you can’t just rely on stories that sugar-coat its earnings report. DuPont (NYSE: DD) is one such case that couldn’t impress UBS with its fourth-quarter performance. Fellow Fool Rich Smith feels the chemical giant deserves this cut, and I couldn’t agree more. In fact, I’d like to add to his observations.

While Rich pin-points DuPont’s high valuations and leverage as turn offs, I’ll pick on things DuPont said during its earnings call that don’t speak well of things to come. CEO Ellen Kullman tried her best to show DuPont in a good light, but whether she succeeded or not is what we need to decide.

Problem of plenty

DuPont further slashed its full-year guidance for its core business, performance chemicals. It expects “sales down moderately and PTOI (pretax operating income) margins to decline by 7 percentage points to 9 percentage points versus near peak margins in 2012.”

As the largest producer of titanium dioxide (TiO2), DuPont takes the biggest hit for demand-supply imbalance in the TiO2 market. Customer destocking might soon end, but threat of inflation and substitutes loom large. Huntsman (NYSE: HUN), which reports on Feb. 12, expects its TiO2 margins to be hit by $350 per ton in its fourth quarter. That the company plans to gradually shift away from the business in the years to come underpins concerns. Feedstock costs for Tronox (NYSE: TROX) surged $1000 per ton year-on-year during the third quarter. It expects the trend to continue this year, and sadly does “not expect to see a significant improvement in the pigment market.” Naturally, as an input maker, Tronox knows better -- yes, Tronox has vertically integrated to be able to procure 100% of its feedstock requirement internally, so it wins both ways.

As for substitutes, Huntsman has openly voiced concerns over how cheap products from China are increasingly gaining popularity among customers from Europe and other markets. Consulting company TZMI not only considers China as a major threat in the years to come, but also feels that the 2011 peak the TiO2 market enjoyed might never return.

Time to take lessons

For its photovoltaic market, this is what DuPont has to say: “it remains volatile due largely to industry overcapacity with uneven growth rates anticipated over the short-term.” In short, this business is another chink in DuPont’s armor. Dow Chemical (NYSE: DOW), which gets 10% of its revenue from similar business, expected demand to pick up from the fourth quarter onwards. Sadly, DuPont’s numbers didn’t confirm.

Dow Chemical has reason to be optimistic anyway. Unlike DuPont, it has made a mark in innovative opportunities such as solar shingles in collaboration with leading homebuilders like D R Horton. This year, rapid capacity expansions and new products are in its cards. With China planning to install 60% higher gigawatts of photovoltaic capacity this year, Dow can aim higher. The same cannot be said for DuPont.

Of costs and claims

At least DuPont’s agriculture business should sail smooth, you may think. Well, almost. It’s good to know that DuPont introduced a record number of agricultural products last year, including 154 corn hybrids. Agriculture has exhibited superb resilience to economic downturns in the past, and could, much to CEO Ellen Kullman’s relief, be DuPont’s best bet for growth in the years to come. But Monsanto (NYSE: MON) won’t let DuPont rise so easily.  

DuPont expects “significant sales increases” for its agriculture business during the first half of the year, but pressured margins because of higher input costs. Interestingly, Monsanto didn’t hint at any cost pressures. Is it that the latter enjoys significant cost advantages as the world’s top seed company? Monsanto’s gross profit rose 12% last quarter for its seeds and genomics segment, and operating profit jumped nearly 50%. Comparatively, DuPont’s agriculture division was still deep in the red for the fourth quarter, though losses narrowed by 21% from last year.

To top that, DuPont’s overhead expenses on claims and lawsuits are only swelling. Its Imprelis settlements reserve has already run up to $900 million (it could double from here), and the case it lost to Monsanto recently could cost over $1 billion.

Tough luck, DuPont!

After gloomy updates, DuPont bumped up its full-year EPS expectations to 2% to 7% higher than 2012. Good try Ms. Kullman, but sorry, I am not impressed.

That earnings would be hard to come by is not a question anymore, and DuPont knows this. So what can a company in such a situation do to show it’s still earning more? Simple -- repurchase shares to reduce the number of shares outstanding, and jack up EPS as a result. Every Foolish investor knows why such buybacks don’t hold water (in terms of adding real shareholder value as buybacks are supposed to). If only DuPont’s higher EPS rode on improved sales or lower costs. Sigh.

DuPont’s shares certainly don’t make me want to dive into the company at this point in time. Challenges are aplenty, but tailwinds are few. You might still want to know how DuPont works its way through hurdles.  Click here to add DuPont to your stock watchlist to stay updated. 

Nehams has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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