DuPont Corporation: Sale of Performance Coatings

DuPont Corporation: Sales of Performance Coatings

1. Assess DPC’s fit within DuPont. What are its prospects going forward as a division
within DuPont versus its potential value to an outside party?

CEO, Ellen Kullman, attempted to move DuPont away from commodity chemicals to a
specialty chemical and science-focused products business in order to focus on higher growth and
higher margin segments. Although the DuPont Corporation had publicly stated that its longer-
term performance goals were to achieve 7% sales growth annually and 12% earning margins, the
growth rate in sales of DuPont Performance Coatings (DPC) was expected to be only 3% to 5%.
This is mainly because its business model, economic trend, and intense priced-based
competition. For example, the profit margin for original equipment manufacturers (OEM)
products is set by multiyear contracts with vehicle manufacturers, which made it difficult for
paint suppliers to quickly pass on raw-material price increase. Also, the growth rate of miles
driven and vehicle sales, which are the two key drivers of revenue for motor vehicle aftermarket,
continued to be bearish after financial crisis. All of the facts mentioned above indicated that
there was little possibility for DPC to achieve the firm’s performance goal, that is, 7% sales
growth annually and 12% earning margins. In this sense, we conclude that having DPC didn’t fit
DuPont corporate strategy. On the other hand, for the potential outside parties such as strategic
buyers or financial buyers, there were some attractive points to acquire DPC. In terms of
strategic buyers, they would be able to expect synergies by acquiring DPC. They might be able
to enjoy scales of economies and reduce costs after the deal. For financial buyers, they might be
able to make profits by achieving operating performance improvement, increasing EBITDA and
then selling DPC to third parties. Therefore, it seems that DPC was more attractive and valuable
to outside parties than to the DuPont Corporation.

2. How attractive is DPC as an acquisition from a strategic buyer’s or PE firm’s

perspective? What are the potential risks to such a deal?

Possible strategic buyer in this case is BASF because a potential purchase price of $4 billion
would not be a sizable transaction for other strategic buyers to complete. The benefit for any
strategic buyer making a deal would be to capture both cost and revenue synergies which would
generate incremental FCF. On the other hand, estimation error for the value with synergies is an
important concern. As case mentions, because strategic buyers likely had greater opportunities
for operating synergies with a target company, they were commonly thought to pay more for a
target than financial buyers. However, according to Michael (2013), there is substantial evidence
that acquiring firms tend to overpay for acquisitions, resulting in the target’s shareholders
benefiting at the expense of bidder shareholders. In general, in DCF valuation which is shown in
the case Exhibit 9, the terminal value has a significant impact on the enterprise value. Because
the terminal value is estimated based on the terminal EBITDA multiple, the enterprise value is
sensitive to the multiple. Given this fact, we implemented sensitivity analysis regarding EBITDA
multiple keeping other assumptions constant (see Exhibit 1). We can see that EV varies
corresponding to EBITDA multiple. On the other hand, Aswath (2012) indicates that the mode
value of EV/EBITDA multiples among the U.S. companies in January 2011 is around 4~6 while
the median value is closer to 10 (see Exhibit 2). Although we understand that transaction
multiples tend to be higher than trading multiples in general, it is still possible that EV of DPC is
overpriced by DuPont Corporation. Thus, an important risk for strategic buyers is whether they
can achieve synergies which can justify its purchasing price.

Source of value enhancement for financial buyers to complete the deal includes operating
performance improvement, tax shields by utilizing certain amount of debt, and multiple
arbitrage. Operating performance improvement is achieved through growth in EBITDA such as
enhancing revenue, reducing costs. In terms of tax shields, because DPC as a stand-alone
company was expected to be all equity financed firm, the use of leverage was a potential source
of value for PE sponsors. Especially, leveraged buyout (LBO) which is the purchase of a firm
facilitated by large amounts of debt financing, is one way to benefit from tax shields. However,
Aswath (2012) says the debt level in most leveraged buyout exceeds the optimal debt ratio,
which means that some of the debt will have to be paid off quickly in order for the firm to reduce
its cost of capital and its default risk. This possible financial risk from the use of leverage is an
important risk for financial buyers. Finally, when a sponsor received a higher purchase price
multiple at exit for a target than it paid for it, multiple arbitrage arose. The case mentions that
sponsors might be able to achieve 7.5× to 8.0× EBITDA at exit for DPC, given improvements in
margins and growth as a private firm, which is attractive for financial buyers. However, whether
DPC as a private firm can achieve those multiple in the future depends on various factors such
management team, crude oil price and so on. Therefore, this is also a risk for financial buyers.

3. What minimum bid should Ellen Kullman set if she chooses to sell DPC?

Because the case implies it is more possible that financial buyers buy DPC rather than
strategic buyers, we estimate the minimum bid price for financial buyers. Financial buyers
planned the use of an LBO to acquire DPC. The expected decrease in the debt over time, as the
firm liquidates assets or pay off debt, implies that the cost of equity will also decrease over time..
Since the cost of debt and debt ratio will change over time as well, the cost of capital will also
change in each period. Therefore, in valuing a leveraged buyout we begin with the estimates of
free cash flow to the firm but instead of discounting these cash flows back at a fixed cost of
capital, we discount them back at a cost of capital that will vary from year to year. In order to
deal with this problem, we used Adjusted Present Value (APV) method in this case. The steps
that we used for APV is as follows.

1. Estimate FCF with no leverage assuming the financial buyer will resell the target in 2016
2. Consider the present value of the interest tax savings generated by borrowing a given
amount of money
3. Evaluate present value of selling price at exit at 2016

General APV method for going concern firm would include the effect of borrowing the amount
on the probability that the firm will go bankrupt, and the expected cost of bankruptcy. However,
because financial buyers expect that they will resell the target firm to strategic buyers or
financial buyers in five years, we estimated present value of selling price at exit instead of
estimating bankruptcy cost. Because the case says that over 2010-2011, large buyouts had been
approximately 60% debt financed on average, we assumed 60% debt financed out of total
unlevered value of the firm. We also assume the total debt/EBITDA multiple approaches the
simple average of those among peers within 5 years. The average total debt/EBITDA multiple
(1.58×) was calculated based on the case Exhibit 10. In addition, in terms of tax shield, true
amount of the interest tax shield each year will vary with the cash flows of the firm. In this sense,
we used unlevered cost of capital as a discount-rate for tax shield. Please take a look at Exhibit 3.
We got $ 4.163 billion for the value of the firm including the present value of tax shields and
selling price. Therefore, we recommend to Ellen Kullman that she sets minimum bid price as $
4.163 billion for potential financial buyers.

4. Working from Case Exhibit 9, relative to the stand-alone value, estimate the dollar
increase in DPC’s value if a PE fund can obtain:

(1) 5% revenue growth per annum (versus 4% growth) in each of the next five years and
improve the operating margin to 12% (versus 10%)

As you can see in Exhibit 4, if DPC can improve its growth rate from 4% to 5% and operating
margin from 10% to 12 % after the deal, the levered value of the firm increases to $ 5.108 billion
by almost $ 1 billion from $ 4.163 billion in the base case. From this result, we can confirm that
for financial buyers, it is crucial to improve operating performance and generate positive
incremental FCF as much as possible before it reaches exit timing in order to make money.

(2) The division can be sold at 7.5x EBITDA in five years

As you can see in Exhibit 5, if DPC can improve the EBITDA multiple from 7.0× to 7.5× in five
years, the levered value of the firm increases to $ 4.385 billion by around $200 million from $
4.163 billion in the base case. Therefore, we confirm that if the financial buyer can sell at a
higher multiple than it paid for, there are opportunities to capture multiple arbitrage. The case
mentions that based on potential market expansion, sponsors might look to achieve 7.5× to 8.0×
EBITDA at exit for DPC.

(3) Debt financing equal to 6.0x forward EBITDA can be obtained, and that all available free
cash is used to repay debt in each of the next 5 years

As you can see in Exhibit 6, if debt financing equal to 6.0x forward EBITDA of 2012 can be
obtained, and that all available free cash is used to repay debt in each of the next 5 years, the
levered value of the firm increases to $ 4.281 billion by around $100 million from $ 4.163 billion
in the base case.

Exhibit 1: Sensitivity of Performance Coatings EV with not leverage to EBITDA multiple

(Based on the case Exhibit 9)
Exhibit 2: EV/EBITDA Multiples: U.S. Companies in January 2011

Source: Aswath (2012)

Exhibit 3: APV calculation for minimum bit to financial buyers (base case)
Exhibit 4: APV calculation (5% revenue growth per annum, the operating margin 12%)
Exhibit 5: APV calculation (7.5x EBITDA in five years)
Exhibit 6: APV calculation (Debt financing equal to 6.0x forward EBITDA can be obtained and
all available free cash is used to repay debt in each of the next 5 years)
Reference

● Michael J. Schill (2013), “Business valuation in mergers and acquisitions”, Darden

Business Publishing
● Aswath Damodaran (2012), “Investment Valuation third edition”, Wiley Finance