An Analysis of E.I.

du Pont de Nemours and Company

A DOW 30 Company Study by James Bax

Submitted to: Dr. R. Brian Balyeat, CFA Department of Finance Xavier University, Cincinnati, OH 22 November 2013

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I. Introductory Description of Company E. I. du Pont de Nemours and Company (DuPont) is a global science and technology firm with expertise in a variety of industries including agriculture, chemicals, plastics, energy, and health care. Started by Eleuthre Irne (E.I.) du Pont in 1802, DuPont began as a manufacturer of gunpowder eventually becoming the primary of supplier of gunpowder to the United States military. Throughout the 20th century, DuPont grew and modernized, while making substantial innovation in the fields of synthetic rubbers and textiles, including the introduction of such wellknown products as nylon, Teflon, Mylar, Kevlar, and Freon. DuPont also began to diversify: starting a pharmaceutical branch in the 1960s, entering into the energy and plastics industries with the acquisition of Conoco in the 1980s, and developing innovations in agricultural production and biosciences through the 1990s and in to today. DuPonts current CEO is Ellen J. Kullman.1 II. Top-down Economic Analysis Figure 1. US Index of Leading Economic Indicators

http://www2.dupont.com/Phoenix_Heritage/en_US/index.html

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What is the Index of Leading Indicators? What are the components of the Index of Leading Indicators? The Index of Leading Indicators is a monthly publication based on 10 economic components that tend to precede changes in the overall economy. The Index of Leading Indicators is often used by investors and businesses to form expectations about the direction of the broader economy in the coming months. The components of the Index of Leading Indicators include: i. S&P 500 stock index ii. The inflation-adjusted monetary supply iii. Long and short interest rate spreads iv. General consumer sentiment v. New residential building permits vi. New orders for non-defense capital goods vii. The speed of delivery of new merchandise to vendors from suppliers viii. Manufacturers new orders for materials and consumer goods ix. Average number of unemployment insurance applications x. Average hours worked per week by workers in manufacturing2 What has been the trend in the Index of Leading Indicators over the last few years and what does that imply about the U.S. economy? The Index of Leading Indicators shows an upwards trend over the last few years. There is a very noticeable exception in late 2008 and into 2009. This drop can be attributed to the 2008 financial crisis. There is also a slight dip in 2011. The implication overall for the U.S. economy is that there will likely be continued broad positive growth. What does the current level of the index predict for near-term outlook for the U.S. as a whole? The current level of the index and the projected trends seems to predict a positive nearterm outlook for the U.S. as a whole. Table 1. The Fed Forecast
Country Contributor Period Country Economic Activity Real GDP (YoY%) CPI (YoY%) Core PCE (YoY%) Unemployment (%) United States Contributor Composite Yearly 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2.7 3.23 2.24 4.6 1.8 2.87 2.16 4.6 -0.3 -2.8 2.5 3.85 -0.35 1.63 2.06 1.19 1.29 5.8 9.3 9.6 1.8 3.17 1.44 8.9 2.8 2.08 1.84 8.1 1.6 1.5 1.3 7.5 2.6 1.8 1.7 6.9 3 2.1 2 6.4

http://www.investopedia.com/terms/c/cili.asp

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What US data series does the Fed forecast? The Fed forecasts year-over-year real growth in GDP, year-over-year growth in the Consumer Price Index, year-over-year changes in Personal Consumption Expenditures, and the Unemployment Rate. Why are these series important? These particular series are important because they provide a broad diagnosis of the state of the US economy. Each data series is indicative of macroeconomic trends such as growth in money supply or consumer sentiment. Understanding these trends is important to providing a more accurate forecast of the short-term direction of the US economy. What do these forecasts indicate about the near-term prospects for the US economy? The Fed forecasts modest positive economic growth in the US as evidenced by a declining Unemployment Rate, increasing GDP growth, and a small uptick in consumer purchases as evidenced in the minor increase in CPI and Core PCE. II. Economic outlook for the Materials Industry What major industrial sector is your firm in? DuPont is part of the Materials/Manufacturing sector. What subsections of the major industrial sector is your firm in? DuPont is a part of the diversified chemicals subsection. Who are some of your major competitors? DuPonts largest competitors include DOW Chemical, Monsanto Co., Shin-Etsu Chemical Co., PPG Industries Inc., and Sherwin-Williams Co. What is the name and description of your firms ETF? DuPont is a member of the S&P 500 Materials Index (S5MATR). The S5MATR ETF is a capitalization-weighted index comprised of companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard materials sector.3 What firms are in your firms ETF? Are these firms reasonable firms for your firms industry ETF? Table 2. List of Firms in the S5MATR Index excluding DuPont
Air Products & Chemical Inc. Ball Corp. Eastman Chemical Co. Airgas Inc. Bemis Co. Inc. Ecolab Inc. Alcoa Inc. CF Industries Holdings Inc. FMC Corp. Allegheny Technologies Inc. Cliffs Natural Resources Inc. Freeport-McMoRan Copper and Gold Inc. Avery Dennison Corp. DOW Chemical Co. International Flavors & Fragrances Co.

http://us.spindices.com/indices/equity/sp-500-materials-sector

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International Paper Co. Newmont Mining Corp. Sealed Air Corp.

LyondellBasell Industries Nucor Corp. Sherwin-Williams Co.

MeadWestvaco Corp. Owens-Illinois Inc. Sigma-Aldrich Corp.

Monsanto Co. PPG Industries Inc. United States Steel Corp.

Mosaic Co. Praxair Inc. Vulcan Materials Co.

The above firms are indeed reasonable for the S5MATR ETF given that the index tracks companies that are all classified by the GICS as part of the materials sector. Figure 2. Comparison of Sector Index to Broader Market Index

How has your industry compared to the broader-based market index? The S5MATR appears to have consistently outpaced the broader-based Wilshire 5000 index over the past decade earning a much greater total return even during the recession of 2008. How did the industry do when the general market was increasing? When the general market was increasing, the S5MATR consistentlyand by a fairly large margin at timesconsistently outpaced the broader market.

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How did the industry do when the general market was falling? The industry index realized more dramatic drops when the market was falling but never fell below the general market. Examples of this trend include the end of 2008 and late 2011. Given your forecast concerning the near-term prospects for the US economy, what is your forecast for the near-term prospects of your firms industry? I believe the S5MATR will continue to outpace the broader-based market index and will increase at a greater rate as gains in manufacturing continue, general GDP growth increases, and inputs such as natural gas and oil remain inexpensive. III: Economic Outlook for DuPont Figure 3. Benchmark of DuPont against its own industry ETF.

How has your firm compared to its industry? DuPont has consistently legged behind the general industry. It appears to have a tendency to underperform.

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How did your firm do when the industry was increasing? In most years DuPont followed the general upward trend in the industry. However, between early 2007 and mid-2008 when the industry saw substantial growth, DuPont legged behind by a considerable margin and even declined. How did your firm do when the industry was falling? DuPont suffered substantially greater losses in the 2008 financial crisis compared to the S5MATR. In several instances over the past 10 years, DuPont declined in value despite an industry increase as seen in 2006, between 2007 and 2008, and late 2012. Given your forecast concerning the near-term prospects for the US economy and your firms industry, what is your forecast for the near-term prospects of your firm? DuPont is well-positioned to benefit from a number of macroeconomic and industry trends. As production of shale derived fuels continues to increase, DuPont will continue to benefit from increasing profit margins as a result of inexpensive domestic inputs, most notably natural gas and oil. Growth in the farm economy will likely continue as demand for agricultural products and seed become imperative to maintaining the ever-increasing global demand for food. Additionally, DuPont benefits from being broadly diversified both in terms of its products as well as where it originates its revenues. This positions DuPont for growth in multiple burgeoning global economies. DuPont also benefits from an extensive product pipeline and general growth in GDP. IV: Variance Decomposition What is the beta for your firm (the slope coefficient from your regression)? 1.13164 Is this what you expected? Why or why not? No. I would have expected DuPont to have a beta less than 1 under the assumption that very large Blue Chip stocks tend to be less volatile than the overall market. What is the variance of the returns for your firm (use the VARP function over cells E4:E264)? This is a weekly variance since your data interval was weekly. 0.0021 Multiply the weekly variance of your firm by 52 to get the annual variance. What was the annual variance for your firm? 0.1084 What is the annual variance (calculate the weekly variance first, then multiply that result times 52) for the RAY Index? 0.0575
4

See Appendix for a summary of regression results

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How does the annual variance for your firm compare to the annual variance for the Russell 3000 Index (RAY)? In other words, how risky is your firm? DuPonts variance is close to double that of the Russell 3000s variance. This would indicate that DuPont is much riskier than the broader market as represented by the Russell 3000 Index. What is the annual variance for the residuals (use the same procedure you did in part e for the RAY Index just over cells L27: L287)? What does the variance of these residuals measure? 0.0348 The variance of the residuals measures the difference between the actual returns of DuPont and the predicted returns as determined by the regression. In other words, this number represents the residual return not related to the market portfolio or unsystematic risk. What proportion of the total variance for your firm is systematic? (please show exactly how you calculated this answer) DuPonts annual variance is 0.1084. After subtracting the annual variance of the residuals (the error term) you are left with 0.0736 (0.1084 0.0384). The proportion of the total variance for DuPont that is systematic is 67.9% (0.0736/0.1084). What proportion of the total variance for your firm is idiosyncratic? (please show exactly how you calculated this answer) The proportion of DuPonts total variance that is idiosyncratic is 32.1% (0.0348/0.1084). What does this mean when you add your firm to a well-diversified portfolio? The systematic portion of DuPonts variance will be integrated into the well-diversified portfolios overall systematic risk (if allocation weights are equal and we assume zero correlation among assets then the riskiness of the portfolio will increase as measured by standard deviation of returns). The idiosyncratic portion of DuPonts variance should dissipate given that the portfolio is well-diversified. Does your result in part j change your perspective on your result in part f? Comparing DuPonts variance to the variance of the Russell 3000 index made it appear that DuPont is a very risky stock. Given that the majority of DuPonts variance is systematic and cannot be necessarily diversified away, my opinion of DuPont as a risky stock in terms of variance has not changed.

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V: Weighted Average Cost of Capital Figure 4. Bloombergs summary display of DuPonts WACC.

What is the WACC for your firm? 8.44 What has been the trend in the WACC over the last few years? What do you think has been driving this trend? WACC has been decreasing over the last few years. One noticeable trend is the substantial drop in cost of debt from 2011 to 2012. Cost of debt decreased from 1.9 to 1.64. What is the capital structure for your firm? (I.e. what percentage of the firms assets is funded by equity, debt, and preferred stock?) 78.1% equity 21.5% debt 0.3% preferred equity

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Comment on the capital structure of the firm. Is the firm primarily funded with debt or equity and why? More than 75% of DuPonts capital structure is composed of equity. Generally speaking, having a high proportion of equity to debt is a sign of strong financial stability and an indicator of high investment quality. Investors tend to invest in firms whose capital structure is mostly equity. While debt and leverage can be beneficial if a firm is able to make more on its investment than it pays in fees and interest, equity provides additional freedom from borrowers and less costs. The chemical industry is a highly competitive, low margin business. Highly leveraged firms can expose themselves to loss of market share if debt were to grow to problematic proportions. What beta did Bloomberg use to calculate the cost of equity? Does this beta equal the beta you calculated in Question 4 part a? If not, why might that be the case? 1.07 No, the betas do not equal each other. Bloomberg calculates their beta for this Cost of Equity using the S&P 500 Index based on a 2 year date range between the current date of access and the equivalent date two years back. This beta is based on a much shorter time span than the one calculated using the variance decomposition and does not take into account the returns, or lack-of return, realized during the most recent financial crisis. By revising the beta upwards to the one calculated in the variance decomposition, the Equity Risk Premium and overall Cost of Equity increase as one might expect. Bloomberg also uses a different market proxy in its beta calculation. What we called in class the market risk-premium or the excess return of the market, Bloomberg calls the Country Premium. What is the Country Premium for your firm? 7.01% Where did Bloomberg get the risk-free rate that it used to calculate the cost of equity? What was the risk-free rate? Is this a reasonable proxy for the risk-free rate? Bloomberg uses the US Generic Government 10 Year Bond index as its risk-free rate. 2.75% is the risk-free rate. Bloombergs use of the USGG10YR as a proxy for the risk-free rate follows a conventional approach to using domestically-held government bonds to determine the rate. Theoretically, a government bond should have no risk given that the government can always print more money to cover bond payments. This would make the USGG10YR an appropriate proxy for the risk-free rate. What is the cost of equity for your firm? 10.21% What tax rate did Bloomberg use in the cost of debt calculation? Exactly how was this rate calculated? 19.46% Bax 10

 It is calculated as a trailing 12 month income tax expense divided by trailing 12 month pretax income, multiplied by 100. What is the cost of debt for the short-term debt of the firm? What is the cost of debt for the longterm debt of the firm? What is the overall cost of debt for the firm? Please include the screen capture for where you got this information and any necessary calculations. Figure 5. Breakdown of DuPonts Cost of Debt

0.31% short-term cost 2.75% long-term 2.06% is total Pre-Tax Cost of Debt What proportion of the debt is short-term? What proportion of the debt is long-term? What implications does this have for the firm in the short and long-term? 0.28 is the proportion of short-term debt 0.72 is the proportion of long-term debt DuPonts quick ration is 1.25, which indicates an ability to cover its short-term financing. Regarding long-term debt, DuPont has substantial and growing net worth in terms of

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stockholders equity that should prevent the company from encountering financial difficulties in the foreseeable future. Even if the firm does not have any preferred stock, how does Bloomberg calculate the cost of preferred stock? Does this methodology make sense? It calculates preferred equity by dividing preferred dividends into preferred equity. Bloombergs methodology does make sense. Companies who issue preferred stock are essentially paying for the lump-sum income they derive from issuing then selling the stock. What the company pays for that income is the dividend paid to the stockholders divided by the price at which the company issues the stock. One may liken the cost of preferred stock to an interest rate a company would have to pay on money it borrows from a bank. VI. Appendix Table 3. Summary Output of Variance Decomposition
SUMMARY OUTPUT Regression Statistics Multiple R 0.824046908 R Square 0.679053306 Adjusted R Square 0.67781413 Standard Error 0.02595907 Observations 261 ANOVA df Regression Residual Total 1 259 260 SS MS F Significance F 0.369274228 0.369274228 547.9875938 7.26436E-66 0.174533194 0.000673873 0.543807422

Intercept RAY Total Ret

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.000917275 0.001607357 0.570672722 0.568716285 -0.002247877 0.004082426 -0.002247877 0.004082426 1.131605914 0.048340356 23.40913484 7.26436E-66 1.03641575 1.226796078 1.03641575 1.226796078

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