Company Overview
Eastman Chemical Company (EMN) is a U.S.-based industrial company that manufactures a wide range of commodity and specialty plastics, chemicals and fibers. It was spun off from Eastman Kodak in 1994. As a company which sells most of its products to manufacturers of end user-related products, EMN is a highly cyclical company. The company generates its sales all over the world, with a slight emphasis on the U.S. and Canada:
The company operations are managed and reported in four segments (pp. 9, 2020 annual report):
Additives & Functional Products manufactures materials for products related to the energy, transportation, consumables, building & construction, animal nutrition, crop protection and home care markets. Main end products are resins, preservatives, water treatments (e.g., flocculants and surfactants), aviation fuels and tire additives. The segment’s focus lies on high-value additives that provide critical functionality while only comprising a small percentage of total customer product cost. Main competitors include Dow, Exxon Mobil, BASF, Celanese, Kolon Industries, Evonik, Perstorp, Huntsman, Corteva and Bayer.
The Advanced Materials segment is the company’s business unit responsible for the production of polymers, films, and plastics for value-added end-uses in, e.g., transportation, consumables, building and construction. As an example, the segment produces copolyesters that are used as BPA-free container surfaces. Also, the segment produces high performance coatings for solar heat rejection that maintain excellent optical properties. Through the segment’s vertical integration, scale in manufacturing and long-term customer relationships, the company exhibits a competitive advantage. Main competitors include 3M, Saint-Gobain, Covestro, Evonik, Mitsubishi Chemical, Daicel Chemical Industries, Sekisui Chemical, Kuraray, Chang Chun and XPEL.
EMN’s Chemical Intermediates segment includes cellulose and acetyl, olefins, and alkylamines manufacturing facilities that are also vertically integrated. The segment sells excess intermediates beyond the company’s internal specialty needs and benefits from its competitive cost positions primarily resulting from the access to lower cost raw materials. Management expects the segment to continue to benefit from the growth in relative use of non-phthalate plasticizers in the western world. Main competitors include the aforementioned companies but also LyondellBasell, Lonza, US Amines and LG Chem.
The Fibers segment manufactures acetate tow and triacetin plasticizers. Of note, EMN is one of the world’s two largest suppliers of acetate tow and has been a market leader in its manufacture and sale since the early 1950s. Also, it is the world’s largest producer of acetate yarn. Due to its market leading position and its long-standing experience, EMN has a competitive advantage in this field as well.
Performance of the Business
Since 2015, EMN grew its top-line at a compound annual growth rate (CAGR) of 1.4%. The cyclical nature of the business is underscored by a decline in sales of 9% in 2020. The company’s exposure to commodity-related products results in a rather low overall gross margin, which is nonetheless very respectable by industry standards. Between 2015 and 2020, gross margin declined from 26.7% to 23.3% but rebounded in fiscal 2021 to 23.9% (see below), at times when other companies operating further down the value chain are having troubles passing on price increases to their customers. Sales rebounded nicely from the pandemic-induced low, underscoring the economic recovery. Nevertheless, the company remains highly cyclical and is partially dependent on the automotive industry, where it is currently feeling the effects of the shortage of OEM components (see Q4 2021 earnings presentation). Likewise, the performance of its construction-related businesses is impacted by continuing supply chain disruptions and labor shortages. EMN’s operating profitability also rebounded nicely from the 2020 dip but remains below its longer-term average profitability (see below). Overall, Eastman’s operating margin is pretty strong for a chemicals company. In comparison, Dow Inc. (DOW) is more dependent on commoditized products as is suggested by its five-year average operating margin of less than 10%. The same holds true for German competitor BASF (OTCQX:BASFY, BFFAF), with an average operating margin of 8%.
Eastman’s focus on adding value to otherwise commoditized products is also underlined by its – relatively speaking – strong return on invested capital (ROIC) and cash return on invested capital (CROIC), which is largely a function of the company’s typically robust free cash flow conversion (see below). Nevertheless, the company cannot necessarily be considered a net creator of shareholder value, as its profitability metrics hover around or are at times weaker than the estimated weighted average cost of capital ((OTCPK:WACC)) of 9.5%.
Understandably, profitability took a hit in 2020, in line with peers, but is already back to normal levels. Please note that my estimate for Eastman’s 2021 CROIC is likely higher than the values published elsewhere. This is attributed to the fact that the company booked significant (one-time) additions to working capital in 2021 that impacted operating cash flow and consequently also free cash flow, as it is typically computed. However, as my calculations rely on normalized free cash flow (see below), I accounted for this one-off and instead looked at the long-term average contribution of working capital accounts.
The cyclicality of EMN’s business is further underlined by fluctuating capital expenditures and movements in working capital accounts, which give rise to a rather volatile but nevertheless robust normalized free cash flow (nFCF). Comprehensibly, the company’s nFCF margin has been similarly volatile at 6.3% to 14.4% over the last seven years. Eastman’s nFCF conversion ratio, which is a measure of the company’s ability to convert net earnings into free cash flow, is typically very robust (i.e., at or above 100%) but was pretty low in 2017 (68%). This is attributed to a non-cash benefit related to a reversed tax provision ($394 million) which boosted net earnings. Besides Eastman’s historic nFCF, its reconciliation is shown below as well. Changes in working capital typically amount to less than 1% of sales but were more pronounced in fiscal 2020 (a decrease in working capital of 2% of sales) due a material decrease in inventories ($ 291 million). Considering the various adjustments, a normalized FCF of $870 million appears appropriate for the purpose of valuation, as is outlined in the respective section of this article.
Balance Sheet Assessment
For cyclical companies, I prefer balance sheets with conservative debt and leverage ratios. Eastman’s debt-to-equity ratio was pretty high in 2015, at 2.9. However, the company deleveraged significantly and its debt-to-equity ratio is now as low as 1.6 (based on the 10-Q3 2021 balance sheet). Note that EMN carries a significant amount of goodwill on its balance sheet (i.e., $4.0 billion as of September 30, 2021), which translates to 65% of shareholder equity.
EMN’s net debt to EBITDA, as well as its net debt to nFCF have spiked in 2020 due to the pandemic-related decline in earnings and operating cash flow but have already reached very acceptable levels in fiscal 2021 (see below). Overall, debt appears to be well managed at Eastman Chemical.
The company’s interest coverage ratio in terms of pre-interest nFCF is somewhat weaker than I would like to see in a highly cyclical business. Historically, EMN has covered its interest expenses with nFCF by a factor of 4 but the ratio has increased to almost 6 in 2021, largely due to the strong OCF, the still quite modest capital expenditures but notably also due to the ongoing deleveraging. EMN’s total debt declined from $7.0 billion in 2015 to $5.5 billion in 2021. As a side note, the deleveraging is not attributable to sale-and-lease back transactions as is confirmed by the similarly declining operating lease liabilities ($273 million in 2015, $193 million in 2021). The company’s maturity profile suggests that EMN will likely need to refinance most of its upcoming maturities at the less favorable interest rates currently anticipated.
Pension-related liabilities are material but certainly manageable at 6% of total assets. Even though such liabilities are interest-rate sensitive and subject to stock market gyrations, they have remained rather stable in absolute terms but have nevertheless decreased relative to total assets.
Overall, it can be concluded that Eastman’s balance sheet is reasonably robust for a cyclical company. Its interest coverage ratio is not particularly strong but I do not consider this overly concerning due to the ongoing deleveraging thanks to the company’s relatively stable free cash flow. Nevertheless, due to the material upcoming maturities and potentially increasing interest rates, Eastman is expected to spend an increasing portion of its operating profit on interest payments, which could lead to less generous dividend increases in the future.
Shareholder Returns
Eastman pays a quarterly dividend of currently $0.76, which translates to a yield of 2.5% based on the current share price of $120. The company has increased its dividend since 2011 and notably also in 2020, underscoring management’s shareholder-friendly attitude. The long-term dividend growth rate is very strong at a CAGR of 12%. Over the last seven years, EMN has increased its dividend at a CAGR of 9.3%. The payout ratio is very modest at typically around 30% to 40% of nFCF. In addition to the dividend, the company also repurchases its own shares. The dilutive effect of share-based compensations is obviously more than offset by share repurchases, as is shown by the reduction in diluted shares outstanding from 150 million in 2015 to 135 million in 2021.
It can be concluded that thanks to the robust free cash flow, Eastman’s dividend appears very safe and is expected to continue to grow at a healthy rate, as also the payout ratio is still far from concerning. However, if interest rates rise materially, dividend growth is expected to slow down or stop altogether, as the company’s interest coverage ratio is not particularly robust (see previous section).
Risks
EMN is highly sensitive to the overall economy and as a consequence, the main risk is an upcoming recession and the associated decline in demand for products that contain Eastman’s materials, such as cars, beddings and building materials. As a materials/industrial company, EMN’s margins are not the strongest and are likely to drop significantly in a recession. However, it should be reiterated that the company adds significant value to a large number of otherwise commoditized products and is hence in a better position than, e.g., Dow or BASF.
The company has weathered the recent recessions very well, which is also underscored by the company’s decision to increase its dividend even in an extraordinary year like 2020.
Other risks include the already discussed refinancing at potentially unfavorable rates. Eastman appears to be exposed to this risk due to upcoming maturities of $1.9 billion between 2022 and 2024.
Personally, I see the main risk in buying shares of this cyclical company at or near the top of an industrial cycle. Of course, this risk can easily be avoided by simply refraining from buying cyclical stocks at historically above-average valuations.
Valuation
As taught by Peter Lynch, cyclical companies like Eastman should be avoided during economic expansions and bought during recessions, i.e., when the price-to-earnings ratio of such companies increases due to weak earnings. Today, EMN trades at a moderate premium to its six-year average valuations:
An equity value-based discounted cash flow analysis for Eastman, based on an average nFCF of $870 million, a terminal growth rate of 2% and a cost of equity of 10% suggests that the company is significantly overvalued (i.e., a fair value estimate of $82). Put differently, at a share price of $120, the market expects Eastman to grow its nFCF by 4.5% ad infinitum, which appears unrealistically optimistic in my opinion. Certainly, a reduction of the cost of equity would also result in a higher fair value estimate but I argue that the cash flows of a cyclical company should be discounted by an annual rate of at least 10%.
Eastman also trades at a modest premium to its historical average dividend yield, as is illustrated on Seeking Alpha’s dividend yield tab. In my opinion, a dividend yield of at least 3.3% to 3.5% should be targeted by a prudent investor with a preference for income-oriented investments. At a current yield of only 2.5%, it takes a considerable amount of time to arrive at a meaningful yield on cost, even considering the strong growth rate of Eastman’s dividend.
Conclusion
Eastman is certainly a strong company, as is emphasized by the industry-leading margins, the robust return on invested capital and rapidly growing dividend. Investors seeking exposure to the chemicals sector are likely to be well served with Eastman, which is strongly focused on value-added products and is a market leader in several segments. Nevertheless, the fact that the company’s profitability is at times below its WACC is a point of criticism.
At a share price of $120, the stock appears slightly overvalued from the perspective of historically observed multiples and severely overvalued from the perspective of a discounted cash flow analysis. Income-oriented investors may also be looking elsewhere at the moment, as the current dividend yield is anything but enticing for a cyclical business, even though the dividend growth rate is phenomenal.
Personally, I consider Eastman a potential addition to a well-diversified portfolio but would only consider opening a position at a share price of less than $90, i.e., a dividend yield of at least 3.4%.
Thank you for taking the time to read through my article. If you have any comments or criticism to share, I am happy to read from you in the comments section below or via private messaging. Also, if you have any questions regarding the calculation of any of the presented metrics, I am happy to answer these as well.