Own Goal Investing – EMN Presents Another Opportunity

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Graham Copley / Nick Lipinski
203.901.1629 / 203.989.0412
gcopley@ /nlipinski@ssrllc.com

January 13th, 2015

Own Goal Investing – EMN Presents Another Opportunity

  • As we have noted in prior research, Eastman is particularly cheap and is one of our top picks for 2015. The stock has traded down meaningfully as oil prices have tumbled. In part, we believe that the selloff is driven by concern around the negative impact of a feedstock hedge in 2015 and 2016. The company locked in pricing for propane before the big oil decline.
  • So far the sell-side has missed this in that estimates for 2015 have not moved since oil and propane prices declined and it may be 2015 guidance associated with the Q4 earnings call that becomes the trigger. The stock, however, in our view, does discount the downside and, like other “Own Goal” scorers, we expect this to be a good story for the next year.
  • Other famous own goals in the chemical space have been fantastic buying opportunities and we believe this will be also as it is a recent first offence – as the APD data in Exhibit 1 shows, it may not work on a second or third offence. We probably need the mea-culpa to mark the bottom and get all the bad news out.
  • We have tried to estimate a likely EPS impact of the 2015 hedge, taking a worst case on the volume side – we come out at an earnings cut of around $1.12 per share. If propane pricing falls to zero (an unlikely downside!) the maximum impact for EMN would be $2.10 per share in 2015 and a bit less than this in 2016, assuming the hedge is smaller.
  • Even with the worst case earnings revision the stock is attractively valued in our view and any further weakness only makes the story more compelling. We have mid-cycle earnings for EMN of around $7.40 per share – so below current 2015 consensus but above what is likely. The stock is trading at less than 10x consensus today.
  • The earnings power of the company – ex the hedge – is growing quickly and could surprise on the upside if EMN does a good job of integrating the Taminco acquisition (the company appears to have done a good job with Solutia). The last 5-10 years of performance from EMN deserve a much higher multiple than the market has given the company and there could be upside here also. With a more reasonable relative multiple, we quickly get to a relative valuation 50% higher than today’s price.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

For those of you unfamiliar with the phrase “Own Goal”, it suggests that you only watch American Football or Baseball, as it means putting the ball in the back of your own net in many other sports. In our research we define an own goal as making a significant error of business judgment that either costs you money or reputation. It generally results in significant stock underperformance and often results in a great buying opportunity if you can get past the obvious emotion of feeling let down by the company or questioning management’s ability to manage. Sometimes own goals are the result of making the wrong bet on a market and sometimes they are simply mistakes.

The chemical sector is full of historic own goals and we list a few here; note that in the bullets below we discuss absolute stock price movements in general terms – in the charts which follow we discuss relative performance to the S&P500

  • Air Products making a bid for BOC 2000. APD hedged the pound exposure, lost the deal and took a $650 million hedging loss. The stock dipped and gained 42% in the 6 months that followed.
  • Lyondell – Cash purchase of Arco Chemicals in 1999. LYO was subsequently unable to raise equity to finance the deal and the debt burden crippled company for years. The stock hit a low in February 2000 – following 2000 guidance and an admission that the company could not raise equity and would be stuck with the expensive debt – the stock almost doubled from that point in 12 months – but more than doubled in 6 months from the earnings call.
  • Dow – Cash bid for Rohm and Haas – July 2008 – following the market collapse Dow was unable to extract itself from the deal – took on dilutive financing to close the deal in April of 2009. The stock dipped as it became clear that Dow could not get out of the deal and had to take on very expensive debt – hit a low in March of 2009 – tripled within 6 months.
  • Air Products (again!) – hostile bid for Airgas 2010. Bid was unsuccessful and APD withdrew bid February in 2011 – stock did not react following the cancelled bid but underperformed the market for the next 2 years.
  • DuPont – 2012Failure to recognize and publicly acknowledge a collapse in the margin structure in TiO2, while other competitors were discussing the problem. This resulted in a major earnings miss and signal to investors that management oversight/understanding was lacking. Stock sold off as earnings missed and negative revisions continued and the stock bottomed in November 2012 – stock was up 12% in 6 months and more than 40% within 12 months.
  • Eastman – 2015 – poorly placed hedges on ethylene feedstock??

Of the list above, only the second APD “own goal” did not present a buying opportunity. The huge upside following the DOW dip was caused by real concern on the way down that DOW could not afford ROH and would perhaps be forced to seek protection through chapter 11. It was an unlikely possibility but enough to shake investor confidence and cause the stock to reach $6.20 per share.

EMN is sitting on the wrong side of a propane feedstock hedge for 2015 and 2016 based on today’s price for propane and assuming that propylene and propylene derivative prices fall in tandem with propane. At current prices for propane and assuming every penny is given away in lower product prices, EMN stands to lose around $260 million of EBITDA in 2015 – or around 11% of expected consensus estimates. This equates to around an EPS hit of around $1.12 per share, and consensus has not moved since propane prices have fallen. If propane fell to “zero” EMN would be looking at an EPS hit of $2.10 in 2015 against an estimate of $7.70 per share.

The stock is a different story – it has fallen by 15% from a high in November and from its summer (pre-oil price fall) highs. Shareholders appear to have accounted for the hedging risk much more than the sell-side and our view is that the downside in earnings is very much priced in already. EMN is trading at a significant discount to normal value, and a normal value that is based on a very low historic and current relative multiple to the S&P. Once we get past this “own goal,” the earnings based upside and a possible multiple re-rating could result in meaningful upside.

This is likely to be a self-inflicted valuation low, from which investors will get good returns. It is possible that we will get more weakness as the story/guidance unfolds, but we would see that as an entry point.
Own Goal Examples
Note that all returns expressed in this section are relative to the S&P 500. We have taken some liberties in defining the trough points. For Lyondell, we take the trough from the point the company came clean and admitted that it could not raise equity and set expectations accordingly. In the case of Dow, the stock low occurred before the ROH deal closed, once investors realized that DOW could close the deal without the risk of chapter 11. However, on the chart we show the performance from the deal close.

Like Lyondell, Air Products, the first time around, was caught in a period of equity declines, which exacerbated the level of hedging losses as they became a larger part of overall enterprise value. Based on the way the stock traded, investors assumed the deal was going to fail long before the company announced the cancellation.

The second APD own goal was one too many, as it also came on the heels of some other strategic missteps. The result was investor disinterest rather than a buying opportunity.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Eastman – How Bad Can It Be

Eastman operates 635,000 tons of ethylene capacity at Longview, Texas – which is equivalent to 1.4 billion pounds. The units can run ethane or propane feed and while ethane was the most attractive feed in the US for the most part of 2014, let’s assume that EMN has run on 100% propane to maximize propylene output and has hedged on that basis. (Eastman needs the propylene but is a seller of ethylene). Let’s also assume that the plant runs at 95% of capacity and that EMN has hedged 90% of its propane at 90 cents per gallon.

It takes around 0.54 gallons of propane to make a pound of ethylene – leading to an estimated EMN hedge on 650 million gallons of propane. If we assume propane in 2015 averages 50 cents a gallon (the current price is closer to 45 cents per gallon), then EMN will lose roughly $260 million of EBITDA on the hedge alone. This is versus a current 2015 consensus EBITDA estimate of $2.45 billion – a cut of roughly 11%.

If the $260million falls to the bottom line with no positive product pricing offsets and is taxed at 35%, it represents a cut to EPS of $1.12 for 2015. Our understanding is that hedging for 2016 is for a slightly smaller volume and at s slightly lower price – so maybe a cut of $1.00. These cuts would take consensus for 2015 to around $6.60 per share and 2016 to around $7.50 per share.

Clearly if propane falls further, things get worse and if it rises they get better: every 10 cent per gallon move in propane – all things being equal – is around 23 cents per share up or down to EMN if we have the assumptions right above. We have deliberately taken the most negative volume impact that we think is reasonable to adequately bracket the risk. However, this 23 cent estimate is consistent with guidance given in October based on propane pricing that was around 10 cents below the 2015 hedge.

So this is bad. But the important question is whether it is already priced in. Certainly it is not reflected in consensus estimates which are largely unchanged since oil began its slide. Accordingly, we are likely to face a round of negative revisions/guidance. In our view the stock expects this if we use our Skepticism analysis as a guide – Exhibit 7. Skepticism has increased suggesting that the stock price discounts negative revisions already.

Exhibit 7

Source: Capital IQ and SSR Analysis

Valuation & Risk
EMN is cheap – Exhibit 8 – and, while this analysis is driven by an improving ROC trend the company has delivered the results to support this – Exhibit 9. This ROC chart will see a negative correction if estimates come down, but if this is for a self-inflicted wound it should not change the trend.

This is where additional other valuation upside comes from – companies with return on capital trends like EMN do not have relative multiple charts that look like Exhibit 10. Part of the reason for the discount is probably the very poor performance of the company in the 1990s (Exhibit 9), but this was a long time ago and EMN today does not look anything like it did then. Compared with other chemical companies, EMN should have at least a 0.8 relative multiple to the S&P. If we plug that and our “normal” earnings number into our model we arrive at a fair value close to $110 per share. Given the possible propane “own goal” it is unlikely that we will see than value soon, but it is a reasonable 2 year target and it is more than 50% higher than the current price. While other companies with EMN’s earnings profile have higher relative multiples than 0.8, we do think that EMN will get some penalty for its increased complexity and we have
written about this recently.

The upside will come sooner if the company beats expectations in terms if acquisition synergies or if oil prices starts recovering (reducing the penalty of the hedge). Equally, we could see more downside if crude/propane weakens further,

The upside will not come at all if the company becomes a serial offender with regards to strategic mistakes. Here the other risk is investor long memories; while today’s EMN does not resemble its 1990s predecessor from a business mix and leadership perspective, investors in the 90s often felt that EMN was playing against itself!

Downside in the stock is limited in our view as if we look through the hedging losses we still have a company expected to make well in excess of $8.00 per share in 2017. Something else would need to go wrong with the business in addition to the hedging for there to be more downside.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

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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