[Netherlands] Over time companies can change significantly and Koninklijke DSM (OTCQX:RDSMY) is a prime example of transformation throughout a company’s history. This Dutch science-driven chemicals and biotech multinational was founded as a state-owned company in 1902 for the exploitation of the coal mines in Limburg, the southernmost province of the Netherlands.
Those days are long gone, over the decades the firm diversified into fertilizers and other chemicals and by the time the last coal mines closed (because imported coal was much cheaper) the company had transformed into a bulk (petro)chemical company.
The company name still refers to its old mining past, the name DSM was adopted in 1973 and is an abbreviation for Dutch State Mines. An IPO followed in 1989 and seven years later the Dutch state sold its last stake in the company.
A second and ongoing transformation started in the 1990s, DSM sold most of its commodity chemical operations and became a “Life Sciences & Materials Science” company to escape from the harsh competition in the bulk chemicals market. In a way this sounds similar to the remarkable transformation of Belgian company Umicore, which started its life as mining company Union Minière du Haut Katanga but eventually specialized itself in high-tech materials, catalysis and recycling.
While the business descriptions of Umicore (OTCPK:UMICY) and DSM share the materials science part, the company operations are nothing alike. DSM has a strong focus on biotech and its Nutrition division is one of world’s largest suppliers of nutritional ingredients for humans and animals. Nutrition sells vitamins, omega-3, enzymes, organic pigments, supplements, and other fine chemicals for the feed, food and personal care industries. Major clients of Nutrition include animal feed companies and food/drinks companies like Coca-Cola, Danone, Nestle and Unilever.
This as well as Performance Materials, which focuses on engineering plastics, Dyneema fibers and resins for the automotive, construction and textiles markets now make up the bulk of DSM’s sales. One smaller segment of DSM is its Innovation Center, this is sort of an incubator for future growth, it includes biomedical, biofuel and solar panel coating related projects.
The last two decades DSM moved away from the cyclical bulk chemical business with the goal of reshaping its portfolio to a more defensive, higher-margin and trend-driven mix of products. Key areas of focus for future growth include megatrends like population growth, urbanization, emerging markets, healthcare, the environment and renewable energy.
DSM is a typical B2B (business-to-business) company, as a consumer you may not be familiar with its products so let me give you one high-profile example. Everybody knows that salmon flesh is pink, but what is less common knowledge is that farmed salmon flesh is gray. This is because salmon flesh turns pink as the wild fish eats large numbers of crustaceans, such as tiny shrimp and krill, which contain lots of reddish-orange astaxanthin pigments.
As farmed salmon are fed a cheap, totally different diet than what the wild fish eats its flesh never reaches the recognizable pink color. Consumers will not buy this weird-looking salmon so companies invented food additives that turn the farmed salmon’s flesh pink.
These days DSM is one of the biggest providers of astaxanthin and even has its own color card (SalmoFan) for salmonids. The company claims dark-colored salmon flesh consistently commands a premium so it’s no surprise salmon farmers spend a lot of money on this additive. Pigment supplements reportedly make up 20 percent of the feed cost of farmed salmon.
If you eat salmon chances are high you regularly consume one of DSM’s products. It is just one of the many food supplements manufactured by DSM, which is one of world’s largest manufacturers of nutrition ingredients. With revenue of 4.33 billion EUR ($4.79 billion) in 2014 the nutrition unit accounted for just over 47 percent of sales from continuing operations but the higher margins of this division means DSM’s earnings are very dependent on this unit. Nutrition brought in EBITDA of 850 million EUR ($940.99 million) last year, representing almost 73 percent of DSM’s total EBITDA.
EBITDA to net sales shows Nutrition brings in net margin of 19.6 percent, while Performance Materials has a net margin of 12.3 percent. Over the last couple of years DSM invested billions into its Nutrition unit to bolster future growth but the company’s financial results show more work is needed to successfully integrate these parts in the company as profit has been slumping in recent years.
Potential takeover or spin-off candidate?
Activist investor Daniel Loeb from hedge fund Third Point is calling for splitting the company into two companies: one centered around Nutrition and one focused on the Performance Materials division. DSM CEO Feike Sijbesma dismisses calls to separate the company but did sell off some of its weaker performing units.
On a related note, since 2014 there have been on-and-off rumors about a potential takeover by German rival Evonik but so far nothing has materialized and the rumor seems a bit unlikely. With a market cap of 9.24 billion EUR ($10.29 billion), DSM could be a potential takeover target for some of the larger players in the chemicals industry but this shouldn’t be a large part of your investment thesis in this company. Management has shown no interest in a deal and a hostile takeover is unlikely due to DSM’s poison pill takeover defense.
On its website, DSM mentions it aims to provide a stable, and preferably rising dividend. The company adopted this policy in 2008, previously DSM’s dividend was determined as a percentage of its free cash flow. While most US companies pay quarterly dividends, DSM employs a more European-style dividend policy with an interim and a year-end dividend.
Like most European dividend payers, the dividend growth from DSM is far from stable but fortunately the dividend itself appears stable. It is hard to find reliable long-term data beyond the ten-year period published on DSM’s website but from what I can find there hasn’t been a dividend cut in the firm’s recent history.
Unfortunately, this specialty chemical firm does have a history of keeping the dividend at the same level for several years in a row. In its home currency, DSM paid 1.65EUR in 2013 and 1.65EUR in 2014. So far the company has paid an interim dividend of 0.55EUR for 2015, but the interim dividend is always one-third of last year’s total dividend and provides no indication for the full-year dividend, so we won’t know if there’s a dividend increase until the dividend announcement in April 2016.
For US investors four ADRs represent the value of one ordinary share. Due to the strong rise of the dollar, the 2014 dividend was $0.4855, a big decline versus 2013’s $0.5629. The interim dividend for 2015 was $0.1499.
And while there don’t seem to have been any cuts to the total, full-year dividend in the recent past, the company does sometimes cut the final dividend to keep the total dividend at the same level as the year before so it’s far less straight-forward than typical US dividend growth stocks.
The five-year dividend growth rate in DSM’s home currency is 6.58%, the ten-year dividend growth rate is 6.55% but the 15-year dividend growth rate is only 5.3%.
DSM’s dividend yield is 3.24% and the Dutch dividend withholding tax is 15%. DSM also offers a share dividend, if you opt for shares that portion of your dividend is not subject to the 15% Dutch withholding tax.
Google Finance shows a P/E of 105.95 but when I calculate the trailing P/E based on DSM’s core EPS* from the past four quarters I reach a more reasonable P/E of 18.79. DSM’s investor section reveals 2014’s dividend payout ratio was 71%, this is up from 41% in 2010. Since 2012 the dividend has not been covered by free cash flow, for 2014 DSM was on the hook for 296 million EUR ($327.69 million) in dividends, of which it paid out 175 million EUR ($193.73million) in cash. The company’s free cash flow in 2014 was 155 million EUR ($171.59 million). Given the company’s cashflow, a large dividend increase seems unlikely until the company is back on track.
* Core net EPS is the EPS from continuing operations before exceptional items and before acquisition related (intangible) asset amortization
DSM recently concluded a share buyback program of 2.3 million shares to cover existing option plans. Unfortunately, the share count increased from 164.05 million shares at the start of 2010 to 173.53 million shares on December 31, 2014. One of the reasons for this is the scrip dividend, it allows the company to conserve cash in the short-term but dilutes shareholders in the long run.
The low-growth economic environment, heavy competition in the vitamin market and low demand for Omega-3 fatty acids are among the factors hurting DSM at the moment, but at the same time it’s also enjoying currency tailwinds due to the strong dollar.
Nutrition is heavily impacted by low pricing for Vitamin E, at current spot pricing DSM expects a negative impact to EBITDA of 80 to 90 million EUR ($88.56 million to $99.63 million) compared to 2014. Low Vitamin E pricing has been impacting DSM for several quarters as the company is battling with Chinese rivals over marketshare and even boosted its production to turn up the pressure. While DSM is still making a profit on its Vitamin E sales, management believes its main Chinese rivals are running at a substantial loss and will eventually have to step out of the market.
Earlier this year currency was still a concern as the Swiss unpegged the franc because most of Nutrition’s production capacity is in Switzerland, a result of the takeover of Roche’s nutritional products business in 2003. Now the pendulum has swung the other way as the positive impact of the strong dollar is outweighing the negative impact of the Swiss franc. DSM’s second quarter earnings saw a 12 percent increase in revenue versus the same period a year earlier, but on a currency-neutral basis the increase was a mere 3 percent.
In its recent earnings report, DSM promises to boost future earnings via efficiency and cost reduction programs, with a prime focus on the high-margin Nutrition business. In recent years DSM focused on acquisition and divestment, now the time has come to focus on increasing operational performance. More details about new efficiency measures for DSM-wide support functions will be announced later this month while the cost-cutting program for Nutrition will be revealed in November.
DSM maintained the outlook for 2015, the company expects to deliver EBITDA in 2015 ahead of 2014, but this will mainly be driven by currency tailwinds.
Despite the disappointing financial figures from the last couple of years and a recent downgrade by S&P, I think DSM holds good dividend growth promise for the future as the underlying fundamentals remain strong if the company’s focus on megatrends plays out as expected. If DSM can cut costs to improve efficiency and deliver higher margins the share price will reward investors who buy today.
DSM is a well-respected player with a good safety record, it offers an attractive portfolio and there’s potential for the unlocking of value in the company’s joint venture activities, such as the upcoming IPO of Patheon, a joint venture with private equity firm JLL Partners in which DSM has a 49% share.
One concern, however, is that DSM may not have sustainable pricing power. Morningstar, for example, thinks DSM does not possess an economic moat as the global chemicals industry is highly competitive and there’s an industry-wide push towards higher-margin specialty chemicals, which may reduce margins in the future.
As such, DSM needs to stay ahead of the innovation curve but fortunately reinventing itself is in DSM’s DNA, and while you wait for share price increases, the company rewards you with a handsome yield of 3.24%.
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