Dan Loeb of Third Point Q3 letter to investors below
Also see The Value Interviews Part One: Finding Value – The Process
Equity Investment: Dover Corporation
During the third quarter, we invested in Dover, an industrial conglomerate with a $15 billion market capitalization. Dover has leading share in several highly consolidated end markets, including retail fueling, industrial printing, retail refrigeration equipment, and artificial lift for U.S. onshore energy production.
Dover shares have materially underperformed the industrial peer group over the three-year period preceding our investment. A significant earnings decline in Dover’s energy business and the substantial fall in global crude oil prices were the primary drivers behind the underperformance. By this summer, energy commodity prices had stabilized and short cycle industrial end markets began to accelerate. We have been engaged in a constructive dialogue with management regarding several compelling value creation opportunities which are outlined below:
1. Separate the Energy Segment – Through several acquisitions, Dover has built a leading artificial lift franchise. We believe the strong cash flow generation, recurring parts and service revenue, and margin profile of the Dover energy segment will make it an attractive strategic target to many buyers. At the same time, removing the energy cyclicality from Dover will greatly reduce earnings volatility, allowing investors to focus on a high quality industrial portfolio with strong growth drivers and supporting a re-rating of Dover shares.
2. Address Underearning in Core Industrial Portfolio – Over half of Dover’s industrial EBIT is generated in consolidated markets where it has a #1 or #2 market share - primarily printing and identification and retail fueling. Despite these attractive end market dynamics, Dover industrial segment margins are well below peers in these businesses. Earlier this summer, Dover took the first step to address this material underearning and issued a plan that calls for 300bps of margin improvement by 2019. While the market has largely ignored these targets given the company’s mixed execution track record, management has confidently reassured us of their commitment to these targets and is taking full accountability for their ability to meet them.
3. Optimize Capital Allocation – In today’s market, Dover’s industrial peers with strong capital deployment frameworks receive credit for forward cash generation. Dover has a similar opportunity – we believe the company needs to communicate a strategic vision, continue to optimize its portfolio around that vision, and set stringent M&A criteria. With a disciplined approach to capital allocation, we believe the market will begin to discount the >$4 billion of cash generation at Dover industrial over the next five years. Since the summer, Dover has announced it is exploring strategic alternatives for its energy business. The company has also announced a plan to switch to “adjusted EPS” reporting to better highlight its strong free cash flow generation. We plan to closely monitor the company’s progress toward its 2019 margin targets and will stay engaged to promote a thoughtful capital allocation process. While Dover shares have started to appreciate since these announcements, we still see significant upside with shares trading at 14x 2019 estimated free cash flow versus the broader multi-industrial peer group that trades at 18x 2019 consensus free cash flow.
Joel Greenblatt’s How to be a Stock Market Genius is required reading for all new Third Point employees. On the topic of spin-offs, Greenblatt writes: “When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course.” While a significant portion of the public debate regarding spin-off structure for DowDuPont was devoted to the “multiples” the various companies would trade for, what most excites us about our DowDupont investment is the dynamic that Greenblatt describes.
Few in the corporate world understand this dynamic better than DowDuPont CEO, Ed Breen. He is renowned for executing a similar blueprint at Tyco, and we have confidence he will provide the leadership that these two storied companies need to fulfill their potential. Along with these favorable conditions, DowDuPont carries an unlevered balance sheet and retains significant M&A optionality. Yet, DowDuPont trades at just 8.6x consensus EBITDA in 2019, a substantial discount to its sum-of-the-parts when we look at the multiples of the likely comparables for the three (or more) Spin-Cos. As a result, we continue to see significant upside to our investment in DowDuPont.