Rising Costs Tarnish Outlook for DuPont
02/23/2012 2:00 pm EST
A big spike in raw materials costs that the world’s leading chemical producer won’t be able to pass on to customers is a compelling reason to sell the shares.
Not so long ago—in my long, long February 21 post—I said that for the first half of 2012, earnings growth would come under pressure as companies found demand strong enough to push up the cost of raw materials, but not so strong that they would be able to pass all those increases through to customers. Keep an eye out for companies facing that problem, I advised, and when you find one in your portfolio, sell it.
That is why I’m selling DuPont (DD) out of my 12-18 month Jubak’s Picks portfolio today. (I still like the longer-term picture for DuPont, so I’m keeping it in my Jubak Picks 50 portfolio—especially since the rules of that portfolio only allow selling once a year in January.)
There are lots and lots of reasons to like DuPont for the long term—its seed business and its enzyme business to name just two sources of long-term growth. And with natural gas, a major feedstock for many chemicals, stuck in a very long-lasting slump, DuPont doesn’t face rising raw materials costs for many of its products.
Except for titanium dioxide. And that’s a huge problem.
DuPont is the world’s biggest producer of titanium dioxide, the white pigment crucial to making paint in all colors. DuPont’s performance chemicals segment makes up 20% of the company’s sales, and titanium dioxide accounts for 44% of that.
The long-term prospects for sales of titanium dioxide are great since as incomes rise in developing economies, those countries use more paint. Currently, for example, China uses less than one kilogram of titanium dioxide per capita compared to four kilograms in developed economies.
The problem is that the world is experiencing a bit of a titanium dioxide squeeze because the supply of mineral sands with high concentrations of titanium dioxide such as rutile and ilmenite hasn’t kept up with supply. In 2011, the cost of rutile climbed 77% while the price of titanium dioxide climbed just 38%.
Can you say margin squeeze?
In its long-term guidance for Wall Street analysts in December, DuPont said that margins for the performance chemical unit would come in at 24% for 2011 as a whole, but projected a drop to 18%-20% in 2012 and after.
That didn’t trouble me greatly when DuPont gave that guidance in December because the stock was still relatively cheap then. But DuPont’s shares have climbed 13.6% in 2012 (through February 21), and that means the margin squeeze in titanium dioxide matters more.
What else has changed since I last updated this stock on January 30?
I’ve learned more about the mineral sands mining industry. Not only is there a current lack of rutile and other mineral sands with big concentrations of titanium dioxide ore, but also there aren’t many mining companies with plans far enough along to add to supply soon.
For example, Rio Tinto (RIO), which mines about 25% of the world’s ilmenite, will spend $60 million to study expanding mines in South Africa, Canada, Madagascar, and Mozambique. If the study plays out, the company would be able to add new supply in 2017.
Just about the only mineral sands miner with new capacity coming on line now is Kenmare, an Irish company that trades in London (KMR.LN). As you might imagine under this kind of tight supply scenario, shares of Kenmare have been the subject of endless acquisition rumors.
The most recent is a rumor of what looks like an unlikely acquisition by Rio Tinto. The combination would put together so much of the world’s supply of titanium dioxide minerals that, the skeptics say, the deal wouldn’t pass anti-trust muster. That skepticism hasn’t stopped shares of Kenmare from climbing 87.5% from November 22 through February 22.
With the tight supply and rising cost of titanium dioxide raw materials likely to persist for quite some time, and with DuPont customers pushing back on titanium dioxide prices, I’d like more than the 13% potential gain I forecast for DuPont’s share price in 2012. (DuPont also makes auto paint, but that business is much smaller—12% of sales versus 20% for performance chemicals—and much, much less profitable—5% of pretax operating income versus 22%. Titanium dioxide is the big dog here.)
The risk/reward ratio just isn’t all that attractive right now (even with the stock’s 3.2% dividend yield—by the way the record date for the next dividend payment was February 15), so I’d take profits here from this rally. I’m selling today with a 7.8% gain since I added the stock to Jubak’s Picks on November 2, 2011.