E.I. du Pont de Nemours & Company (DD)

Jan 30, 2009 – Review of 2008 4th Quarter and Outlook for Dividend
(DD $24 FCF: Neutral WL: Hold/Sell FV: $33)

With its direct exposure to the automotive original equipment market and the housing markets, Dupont is a poster child for the record contraction of industrial output in the US during the fourth quarter, with company sales volumes falling over 20% - the worst ever quarterly comparison year-over-year for Dupont.

Given the horrific economic and market developments over the last quarter, we wanted to take a particularly close look at Dupont’s results and cash flows.

To their credit, in our opinion, management reacted swiftly to contain the potential damage to the balance sheet by cutting production, sharply reducing capital expenditures and reducing working capital by almost $1 billion.

The fourth quarter earnings number, with all its sundry extraordinary items and adjustments, came in right in the middle of management guidance - which explains the relatively muted reaction in the stock price in response to the earnings announcement.

The company has specific plans to wring another $1.7 billion of free cash flow from operations in 2009; and claims to have all of $2.5 billion of cash flow essentially confirmed for next year - which is where we begin and end our analysis of the dividend.

The dividend represents about $1.5 billion of cash flow - and management seems committed to maintaining it. However, now the dividend represents fully 80%+ of the company's cash flow. All in all, I give the dividend a solid “B” - which I would take to mean that it is reasonably secure over the next 4-6 quarters; but, we will have to see how business conditions develop. Obviously, we do not see nor does the market seem to be discounting any "visibility" in the prospects for a turnaround in autos and building.

Normally, I would associate a 7% dividend yield with a high-probability that the market correctly understands the dim prospects for the dividend. However, these are far from normal times; and I am disposed to conclude that the market is correctly discounting little to no growth in earnings for a protracted period of time for Dupont - with virtually all of the prospective investment return to shareholders in the form of dividend income, which the company is in reasonable financial condition to maintain into the foreseeable future between cash flows and the strength of the company's balance sheet.

As we've mentioned before, we have been impressed with steps management has taken in the last 3-4 years to improve capital efficiency. However, the reality is that in the framework of Economic Value Added, margins have been and will remain low and in line with the capital-intensive nature of the businesses in which Dupont operates (which is why DD hasn’t been and won’t soon be a true growth story – the impressive results in the Ag and Nutrition segment, notwithstanding). Therefore, in our view, maintaining the dividend payout is a relatively efficient use of shareholder capital compared to additional marginal investments in their operating segments, above and beyond an ongoing R&D program and essentially maintenance capital expenditures. To their credit, I believe management understands this very well - which is good news from our perspective.

I have had to reduce our fair value to $33; and rate the shares "Neutral" compared to other opportunities we see in the Materials sector. In retrospect, of course, it would have paid well to use capital loss carry forwards to reduce positions in the stock back in the fall - but in fairness to everyone, it would've been very difficult to foresee the historic collapse of business activity in the US and around the globe, and the leveraged impact this contraction would have on Dupont's profitability.

We will continue to be vigilant about the prospects for Dupont's dividend, in particular; and we are inclined to agree with management that there will be an ultimate recovery in their businesses, which could turn out to be leveraged in its own right in so far as customers in all segments are significantly understocked compared to their usual inventory of Dupont products across business lines (good news / bad news: leverage cuts both ways as we have been so painfully reminded of lately!).

In sum, we continue to be impressed with management, but recognize the limits to how much cash they can produce as time goes by without meaningful improvement in the economy and their end-markets.

Good Luck!
AlphaPuppy