CE vs. EMN – Similar Current Valuations but EMN has the Potential

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 14th, 2016

CE vs. EMN – Similar Current Valuations but EMN has the Potential

  • Traditional valuation metrics are similar for Celanese (CE) and Eastman (EMN) but valuation based on a normal return on capital supports opportunity for EMN as it proves the value of its acquisitions
  • On normal earnings CE looks about as expensive as EMN looks cheap, driven by:
    • EPS estimates
      • Rising for CE, falling for EMN (EMN falling partly because of increasing cost of propane hedge – this could reverse if energy strengthens)
      • Expected EPS growth (2015-2019 CAGR) nearly identical (10%)
      • More linear for CE, with 2016 for EMN driven by propane losses
    • Balance sheet
      • Much less debt for CE and far more cash – if CE goes down a path of aggressive returns to shareholders it may well outperform an acquisitive and cash poor EMN
      • This strategy of buy-back and dividends has worked well for LYB
    • Geography
      • EMN has greater domestic exposure (42% of sales in the US) – equivalent figure is 26% for CE, which generates 31% of revenues in Germany alone – legacy Hoechst
      • EMN gains least as dollar weakens
    • Efficiency
      • CE has more sales and EBITDA per employee than EMN (3 year average) – this could mean too much cost at EMN and an opportunity to improve
      • Return on total capital much higher for CE – return on tangible capital similar (more goodwill/intangibles at EMN because of acquisitions)
  • Strong cash flows and balance sheet flexibility are favorable for CE but valuation appears to be factoring those in
  • EMN has considerably greater upside – on normal earnings, fair value is well over $100
    • We still believe EMN needs a messaging refresh and possibly a strategy rethink also – some portfolio management may be needed to get investors back on board
    • EMN benefits more than CE from rising energy

Exhibit 1


Source: Capital IQ, SSR Analysis

Overview

Eastman and Celanese are obvious companies to talk about in the same sentence. They are similar enough in terms of business mix and sufficiently different from everyone else that they almost belong in a chemical subset of their own. They are producers and consumers of a wide range of chemical intermediates and more downstream specialty derivatives. As such, they boast greater stability of income, but growth has been a challenge and both have had to spend to get growth – EMN mainly through acquisitions and CE through capital spending – Exhibit 2. Eastman’s spending looks far less efficient and this is clearly shown in the return on capital charts in Exhibits 3 and 4. Eastman’s returns on capital have been hurt by the large amounts of goodwill that the company has taken on through acquisitions. In theory, the company should only have made these moves and paid the goodwill if it felt that it could get an adequate return on the total investment. We can look at Exhibit 4 in two ways – did EMN make a mistake, or is this the opportunity at EMN. Could returns recover to the historic average? If so the upside is far greater for EMN than for CE.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Despite similar current traditional valuation metrics, EMN and CE differ dramatically in our “normalized” framework because of this return on capital issue. Our valuation work is based on a reversion to mean (or trend) return on absolute (rather than tangible) capital. We assume that companies acquiring businesses can drive synergies to offset the cost of the goodwill and over time get back on an historic track (we see this time and again with successful acquirers). With that assumption, EMN looks very cheap while CE looks a bit expensive – Exhibit 5.

Exhibit 5


Source: Capital IQ, SSR Analysis

Analysts and investors feel very differently about these two companies – the sell side has become incrementally more interested in EMN than CE over time – Exhibit 6 – while investors have preferred CE – Exhibit 7.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

But the companies are complex – Exhibit 8 – EMN more so than CE; and complex companies only work if earnings are predictable, and have become increasingly unpopular with investors – see prior research.

Exhibit 8

Source: Company Reports

Investment Conclusion

CE is not cheap but has the cash flows and the balance sheet to continue to outperform if dividends rise and share buy-back continues. EMN is not expensive if it can deliver the returns anticipated when it made the large acquisitions and if it can regain investor interest lost through the hedging mistakes. This is not going to be easy given the complexity of the company and what we think is a tired IR message in need of a refresh and a different approach to help investors better understand what they are buying.

Potential catalysts:

  • In an acquisitive world both could be targets – perhaps for a company like BASF or for Dow Material Science (eventually) or in some clever combination with each other (there would be regulatory hurdles)
    • Both have the undesirable filter tow business – which comes under attack every time there is a groundswell of negative sentiment on cigarettes – for both companies this is a great source of free cash even with increasing Chinese competition
  • We have always felt that EMN is vulnerable to an activist, but we suspect the complexity is off-putting – an activist wants to know exactly what to do before taking a position, and while EMN is cheap and looks people heavy it may be a step to far
    • CE was acquired and restructured by private equity (Blackstone). EMN is likely a bit too expensive unless one could find an immediate cash buyer for a large piece of the business
  • Rising energy will help EMN more than CE. Rising energy improves EMN’s cost position at Kingsport relative to the rest of the world and reduces the propane hedging loss. Rising natural gas will increase methanol costs and prices which are much more of a negative for CE than EMN.
  • A major reorganization or strategy refresh at EMN – focused on business streamlining, cost cutting and possible some portfolio management
    • The company needs this in our view

Different Approaches to Capital Allocation Have Benefitted CE Shareholders So Far

CE has not been as active an acquirer as EMN – the focus has been proportionately more toward capital expenditures. Share appreciation has been significantly greater than EMN despite less dividend support.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

EPS Estimates – EMN Hurt by a Propane Hedge – Relatively Disadvantaged If the Dollar Weakens

EPS estimates are summarized in Exhibits 11 through 12. The forward estimates are consensus and it is worth noting that estimates for EMN would be $1.50-1.60 per share higher if EMN could get back to trend return on capital. CE is already earning above trend.

Exhibit 11


Source: Capital IQ, SSR Analysis

Exhibit 12


Source: Capital IQ, SSR Analysis

When looking at estimates we tend to favor forward numbers for companies that do not have a history of optimism in their guidance – as can be seen in Exhibit 13. EMN and CE are too close together to distinguish on this basis.

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14


Source: Capital IQ, SSR Analysis

Balance Sheet

EMN has greater leverage than CE resulting from its focus on acquisitions. Debt is a significant portion of EMN’s enterprise value – Exhibit 15. Debt/EBITDA ratios favor CE, as EMN is towards the higher end of the Chemical universe here. The other side of that argument of course is that any improvement in the EV/EBITDA multiple for the pair has a greater proportional impact at EMN than at CE.

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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