Eastman – The Silver Lining of the Propane Cloud

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Placing the wrong bet on propane prices may have been the best thing that could have happened to Eastman! Eastman is a roll up story and the thesis is that as the company adds complimentary and sometimes overlapping product/technology platforms there are growth and, perhaps more importantly, cost opportunities.

Eastman is delivering on the costs and the improvement in overall operating margin drove a big earnings beat in a weak sales quarter, negatively impacted by price, volumes and currency. Perhaps the company would have been less focused on the cost opportunity had it not been staring in the face of a major hedging headwind – nothing focuses the mind like having to overcome a major error/hurdle.

The portfolio remains confusing and complex, but the company is delivering. EMN’s well received Q2 results were highlighted by significant margin expansion in the Advanced Materials segment (9 percentage points). This improvement was notable for its magnitude but also in its demonstration that the company is beginning to derive value from its acquisitions, a condition we have previously noted would be necessary to realize the (still material) upside in the name. 50% of the Advanced Materials segment is comprised of legacy Solutia businesses (Performance Films and Interlayers), and the demand outlook here remains strong, though margins are expected to normalize at the blended 1H rate of ~17%.

That this run rate would represent just the fourth highest margin of EMN’s segments speaks to the company’s cash generative capability, and cash flow in Q2 indeed came in well above estimates. The company encouragingly offered a very shareholder-friendly view of capital allocation moving forward, favoring increased dividends and share repurchases with “large acquisitions” on hold “through 2017”, meaning investors will be paid as they wait for the still-considerable upside in the share price ($100 mid-cycle value on our model implies 23% from current levels). This change in strategy with regard to use of cash is exactly what investors have been asking for and was highlighted in our initial work on the name.

Eastman’s ability to put up very strong earnings in the face of a major hedging headwind should significantly increase confidence in the stock, with the (re)allocation cash a further positive. Note that EMN has a very low historic average relative multiple (to the S&P500), in absolute terms and relative to other chemical names. Restored/improved confidence could drive the relative multiple higher and our $100 per share fair value would then only be a starting point.

EMN remains one of the most attractively valued names in the Chemical space in our view.

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