Eastman – Time to Focus on the Shareholders – Stop Acquiring and Settle Down

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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

May 6th, 2015

Eastman Time to Focus on the Shareholders – Stop Acquiring and Settle Down

  • Eastman has the third highest return on capital growth in the Chemical sector and the second lowest relative multiple in the group. If the relative multiple is right, things are about to go horribly wrong at EMN – more likely, however, is that the stock has meaningful upside.
  • The complexity of the portfolio can make or break the story. If EMN can continue to deliver earnings growth and improvements in return on capital, the stock will do well and could be another “PPG” story. If the portfolio becomes too difficult to manage, we have another 1990s and 2000s Dow Chemical or DuPont in the making and disappointments will follow.
  • Eastman’s recent fall from grace began with the acquisition of Solutia and the subsequent acquisition of Taminco, both of which have resulted in a collapse in EMN’s relative multiple. The stock would be trading at $120 today if the market valued EMN’s earnings as much as it did in 2011. Capital management is at the heart of the story.
  • EMN has a better return on capital trend than all but MON and POL in our chemical universe over the last five years. While current estimates show 2015 below the return on capital trend, without the expected losses from the propane hedge they would be on or above trend.
  • Upside will come over time from better and consistent earnings growth, assuming that the portfolio can do what the company thinks it can. Outlook for volume growth is strong in Advanced Materials, Tires and Specialty Amines.
  • EMN can afford to raise its dividend meaningfully (as much as 50%) while still meeting its debt reduction goals. Not returning more cash to shareholders simply fuels the belief that the company has another complicating (risk) deal up its sleeve. More acquisitions will likely dent confidence.
  • EMN is a “relatively” efficient company and so this is is less about cost cutting (as it is at DuPont and Dow) but improving return on capital through consistent earnings growth. Exhibit 1 shows the recent disconnect between return on capital and relative multiple.

Exhibit 1

Source: Capital IQ, Company reports and SSR Analysis

Overview

Eastman presents a compelling yet concerning story at the same time. The stock remains inexpensive, despite its recent run, but only if you believe that the company can continue to grow earnings. The company believes that it can continue at the rate seen in recent years (with the propane hedging loss limiting 2015 and 2016 to a lesser extent), but the market clearly does not share that belief or the stock would be much higher than it is today. Eastman has the third highest return on capital growth in the Chemical sector and the second lowest relative multiple in the group – an extreme disconnect –

Exhibit 2

Eastman is now a very difficult company to understand and to model – the story is very complex, involving many end markets, many geographies and many chemistries. The acquisition spree of the last few years may offer the company growth and cost cutting opportunities, but it creates an IR problem. Whether investors will take the time to understand the story depends on a couple of things – how easy the company makes it, and how reliable results are going forward. What EMN now comprises is summarized in Exhibit 3. The good thing is that the company provides a lot of detail. The bad thing is that, despite that detail, there are still too many moving parts which are hard to measure and hard to forecast in an industry which has taught investors to be skeptical. In Exhibit 3 we color code what we like – the more green the better the more yellow or red the less we like it or the less we understand it.

Earnings consistency and a lack of volatility will go a long way to improve investor confidence and should lead to a rebound in the multiple – as long as the company can deliver the numbers. The Q1 upside surprise was good, but when you hear that “prices did not fall as fast as raw materials” there is concern that part of the Q1 gain may go away in Q2 or Q3, and given lack of clarity around what might drive product pricing going forward the complexity issue re-emerges.

In our work we have shown that there is a degree of correlation between complexity and optimism. Complex companies overestimate growth, returns etc. more frequently that those with simpler portfolios – DOW and DD are the two best examples in chemicals – Exhibit 4. Historically, EMN has shown no signs of being an optimist (at least not since 2000), but if it is the complexity that is driving the optimism at DOW and DD then complexity could be the leading indicator. Optimists are huge destroyers of value and EMN wants to stay away from this group.

Exhibit 3

Source: Company reports, SSR Analysis

Exhibit 4


Source: Capital IQ, SSR Analysis

The other positive move that EMN could make is one that we have suggested already – a reallocation of cash. The current mode appears to be pay down debt, buy something, pay down debt, and buy something else. The investment community does not like that strategy – at least not yet. EMN saw an improving relative PE (to the S&P 500) from the late 1990s right through the end of 2011. As soon as the Solutia acquisition was announced, the relative PE started to fall and today it is back where it was in the old PET days of the late 1990s – Exhibit 5. There is a great deal of lost confidence or lack of understanding implied in this chart as EMN is not falling short on the earnings front and earnings are becoming less volatile. As shown in Exhibit 6, EMN’s earnings are very close to what we would call normal – growing as the capital base grows and following an improving return on capital trend.

Exhibit 5


Source: Capital IQ, SSR Analysis

Eastman’s average relative PE since its spin out of Kodak has been 0.70. This compares with Dow at 0.76, DuPont at 0.89, and PPG at 0.79. Using the EMN historic average (0.7) we generate a “normal” value for EMN today of $104 per share. If EMN could gain enough investor confidence to move to a 0.8 relative multiple the revised value would be close to $120 per share. The average of our “most complex” company group today is a relative multiple of 0.85. Since divesting its commodity chemical business, PPG has seen its relative multiple move above 1.00 and as shown later in the report its return on capital profile is not materially different than for EMN, but EMN’s trend growth since 2000 is higher.

Exhibit 6


Source: Capital IQ, SSR Analysis

Complexity – Perhaps Necessary But Needing Careful Management and Messaging

The wide range of Eastman’s businesses, illustrated in Exhibit 3, have some logic in combination where they share common end markets, channels to market, chemistries, and integration. We see plenty of companies struggling because they do not have critical mass, or because they are not integrated into feedstocks, when competitors are, or because they are too narrowly focused.

The market, however, tends not to see the benefits, and the chart in Exhibit 7 has been included in work on EMN in the past. Not only does the market not like it, but it likes it less today than it did 10 years ago. Developing/growing into a more complex business is not a popular move and we could not ask for a more explicit example than the relative chart in Exhibit 4. At the other end of the scale, the market does not really like one product companies either.

Exhibit 7


Source: Capital IQ, Company reports, SSR Analysis

The only way that EMN can reap the benefit of its complex and integrated portfolio is if it delivers the earnings growth and the cash that management suggests is possible and this will only happen if the company maintains a sharp focus on what each business can achieve and what the real synergies are. The optimists tend to lose their grip on what the real competitive strengths of the portfolio are and the necessary focus to ensure that those strengths are maintained. Dow and DuPont have both been focused almost exclusively on the growth piece of the story in each case and have largely ignored the cost side – DuPont more so than Dow in our view – while competitors have caught up and in some cases passed them. The erosion of the industry’s cost structure, which neither company has led, or in some cases even taken part, has undermined base margins such that any “upgrading” victory that either company has had has been drowned out by what has gone on at the other end of the chain. Their optimism has stemmed from their hopes of innovation, and while both companies are now addressing cost, they have some serious ground to make up.

The big risk for EMN is that the company gets sucked into a strategy which focuses on too many end-use application opportunities – resulting in more and more R&D, technical sales and general SG&A costs and loses the cost focus as others have done. Investors don’t care how many new products you brought to market this quarter if you miss or meet an estimate that has been revised down 25-35% over the prior 18 months.

Capital Allocation – An Opportunity to Restore Confidence

Eastman’s current focus of debt repayment above all else is more of a concern to us than it is perhaps to others. Yes, the company has a high debt level, resulting from the recent Taminco acquisition, and this should be addressed. However, the debt market is attractive, interest rates are low, and the interest expense is in no way constraining the company’s ability to operate. Skeptics would associate the desire to pay down debt quickly with a desire to buy something else big as soon as is practical; a strategy consistent with general guidance provided by the company. This is clearly not what shareholders want – or the stock would be trading at a premium to history in support of the strategy.

EMN has around $7.5bn of debt, but is generating cash of roughly $1bn after capex and consequently has the ability to pay down debt quickly, which will be important given the need to address significant maturities in 2017 – Exhibit 8. However, with surplus cash at close to 5x the current dividend cost, EMN could materially increase its dividend and continue to address its debt repayment needs. In a recent
piece we wrote on companies likely to gain the most from a change in dividend policy,
EMN was on the short list. Not only would the improved payout likely help the stock price, but the change in allocation might give investors more comfort around what happens to the cash going forward.

Exhibit 8

Source: Capital IQ, SSR Analysis

There is also the possibility of returning to stock buy-backs but to do so in a meaningful way would involve raising more debt, which, given the schedule highlighted above, might not make much sense, even at today’s very low interest rates.

Valuation – Is EMN the Next PPG or the Next Dow?

Eastman has destroyed quite a bit of shareholder value recently – Exhibit 9 – but it has really been felt in 2014, with the company spending to buy Taminco and getting a negative reaction in the stock price as a result of the spend and despite robust earnings.

Exhibit 9

Source: Capital IQ, SSR Analysis

It all comes down to execution and then market confidence. In the series of charts which follow we look at net income versus our return on capital based trend net income, return on capital itself and then relative PE. We compare PPG, DOW and EMN (the EMN relative PE chart was shown earlier as Exhibit 4).

If we start with earnings, then in each case the companies cycle around what would be generated by their trend as you would expect and in all cases the trend appears predictive. However, the return on capital charts look very different with recent (post 2000) EMN resembling PPG (but growing more quickly) and old EMN resembling DOW (but falling more quickly). If EMN can continue on its current trend then perhaps it should be thought of like PPG, but looking at the PPG relative PE chart, the cyclicality of earnings at PPG, prior to the chlorine divestment resulted in a very low relative PE and the recovery has only happened since that sale.

 

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Exhibit 17

Source: Capital IQ, SSR Analysis

©2015, 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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