Eastman – A Bad Business, A Bad Strategy or a Bargain?

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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

August 1st, 2016

Eastman – A Bad Business, A Bad Strategy or a Bargain?

  • EMN is a bargain only with a radical shift in strategy. In an M&A driven market where we are currently routinely seeing good quality asset sales at values in the range 13-15 EV/EBITDA, a company trading at less than 7.5x should be for sale!
    • If EMN is worth 11x EV/EBITDA in pieces and if we haircut expected 2017 EBITDA from $2.3bn to $2.0bn there is 50% upside to the equity value.
  • The current strategy is not working as the portfolio does not appear as robust as described, losing pricing in all segments and only seeing volume growth in one. This is in a slow but positive growth global economy.
    • Pricing is falling in the “cash cow” fibers business and we do not believe that EMN can gain any further relative cost benefit versus competitors, unless we see a sharp uptick in global oil or LNG pricing.
    • We think there is further risk to 2H 2016 guidance and clearly 2017 numbers need to come down as they are well above guidance.
    • Others are also seeing price pressure, but not as broadly as EMN and are finding offsets with cost initiatives and portfolio moves – EMN has one of the worst EPS trends.
  • It is very hard to get investor attention when you have a story that is as complex as Eastman’s and it is even harder when the numbers are not there and the portfolio is not performing as intended.
    • This creates a valuation opportunity – not for equity investors, but for others who believe that businesses might be worth more on their own, or combined with other portfolios, or more aggressively, that the company is simply a better break-up story.
  • This appears to be a very inexpensive stock, but there are likely further headwinds – some sort of leadership/strategy change is needed to address the following:
    • Disappointing earnings and further headwinds – hard to get comfortable with guidance.
    • Complexity that few can get their heads around and corporate business descriptions that do not align with results.
    • A sum of the parts that is clearly more valuable than the whole today.

Exhibit 1

Source: Capital IQ, Company Presentations, SSR Analysis

Specialty/Diversified Group: ASH, CBT, FUL, HUN, NEU, POL

Overview

We do not believe that the challenges facing Eastman are materially different from those facing other chemical companies: price pressure (made worse by slow growth), like for like competition, unlike for like competition, commoditization, volatile feedstocks costs, etc. Where EMN appears to falter is either in its understanding of these pressures and how they impact strategic decisions, or if it does understand the issues but cannot manage them effectively.

Dow Chemical has now given us three years of clear proof that everything mentioned above can be managed in a way that generates growth, through a combination of focus, portfolio management, the appropriate use of innovation where it can result in better pricing, and cost management. So it can be done.

Eastman continually faces questions about what parts of its portfolio are specialty and what parts are commodity. We think this discussion is a red herring and that the appropriate way to manage any company in the chemical space is to assume that commoditization pressures exist in every business segment and that it should be a continual focus to either maintain sufficient differentiation to stay ahead or manage the cost base to deal with declining pricing power. Alternatively, if a company wants to maintain a specialty multiple, it needs to actively manage the commoditizing businesses out of its portfolio. EMN is faced with some interesting choices as the market is giving the company zero credit for its “more diverse” portfolio today, instead focusing either on the challenging complexity or simply on the businesses which seem to be in most trouble – Intermediates this quarter and possibly Fibers going forward.

The market pays for earnings growth and certainty and right now EMN is providing neither. Eastman is losing pricing in every sector and is only seeing volume in Advanced Materials. Pricing for the most part is declining because costs are falling, but this is not the case in Chemical Intermediates where margins have collapsed – Exhibit 2. While margins remain high in Fibers, the volume and pricing trends are poor (Exhibit 3) and the margins are robust because coal prices have collapsed. While coal demand is weak, coal pricing is unlikely to go much lower with transport costs now a meaningful proportion of the price. If volume and pricing trends continue in fibers, margins will come under pressure going forward. Eastman needs global energy pricing to rise (relative to coal) to protect its margin, and this does not look like it will happen in Q3.

Exhibit 2

Source: Compnay Presentations, SSR Analysis

Exhibit 3

Source: Compnay Presentations, SSR Analysis

In summary, there is very little in the data provided by Eastman to give any confidence that earnings should grow in 2017, or even hit revised expectations for 2016. The rhetoric is positive but the trends are not. The company will see some gains from the rolling off of its propane hedge in 2017, but this will not be material if the company sells its ethylene business, as it has suggested is likely by year-end.

We still believe that there is value in Eastman, either from a refocus of the strategy to either embrace the changing nature of the portfolio or to manage the portfolio more aggressively. We remain unconvinced that the management team understands what they have and how to get the most value from it and until there is a change (management turnover, activist entry) the stock will continue to drift.

Losing Price Everywhere – Volume Only Working In Advanced Materials

If you look at the two exhibits above and the then Exhibits 4, 5 and 6, it is hard to think about EMN as a “Specialty Chemical” business. Specialty businesses are expected to show some resilience to economic swings. Through 2015 and 2016, while we have not had great economic growth we have had growth around the world, with only Latin America in recession (which is small for EMN).

Exhibit 4

Source: Compnay Presentations, SSR Analysis

Exhibit 5

Source: Compnay Presentations, SSR Analysis

Exhibit 6

Source: Compnay Presentations, SSR Analysis

The risk with fibers is that EMN has seen input costs come down as coal prices have fallen over the last 24 months – Exhibit 7 – but Brent has fallen further and global competitors are either using feedstocks that link to international oil prices or cheap coal as well. While we think that pricing competition is likely to keep going in this segment we do not see much scope for lower costs for EMN and the very high margins and high cash flows in this business are at risk in our view – through the balance of 2016 and in 2017.

Exhibit 7

Source: Capital IQ, SSR Analysis

Unclear That The Company Knows What To Do – Hope If Someone Else Does

Reading the corporate press release and listening to the response to questions, the company appears very reactive – lots of discussion about what is happening to EMN and not much discussion about what the company plans to do about it. EMN is not alone in this situation as there are others who are claiming that they are victims of the energy and macro environment with few options. We don’t really buy this argument as we see others acting proactively to try and fix things – with aggressive cost initiatives – portfolio management and more meaningful M&A. EMN is looking to sell its ethylene business but will likely do so in what we think will be a relatively short dip in the market and probably get a cyclical low price for the assets. They are not worth much as they are old, small and logistically challenged, but the company itself is admitting to pressures in ethylene margins in the same breath that it is talking about divesting assets. EMN’s relative PE has collapsed as investors have lost confidence in the story and as earnings have faltered – Exhibit 8.

Exhibit 8

Source: Capital IQ, SSR Analysis

EMN is trading at 8.6x what are clearly inflated consensus expectations for 2016. It is trading at an EV/EBITDA ratio of 7.3 when looking at 2017 estimates EBITDA, which are also likely to be too high. In its conference call, EMN talked about steering clear of acquisitions in the current market because of high premiums paid for businesses – 15x EV/EBITDA was mentioned. If this is the case EMN should be selling assets or itself. Even if the company is worth 11x EV/EBITDA in pieces and if 2017 EBITDA is only $2bn, you get an enterprise value of $22bn, versus a current EV of $17bn – the incremental $5bn would fall to equity, suggesting more than 50% upside from current levels. Clearly this is simplistic, as there would be all sorts of possible tax issues which might lower the value, but we have been conservative on the multiple and the EBITDA to account for this. Further, EMN has a very high asset value because of the acquisitions and consequently breaking the company up may not be that tax inefficient.

Earnings are below our normalized trend, but despite the recent misses are actually recovering from the dilution of the acquisitions – Exhibit 9.

Exhibit 9

Source: Capital IQ, SSR Analysis

Eastman is close to an all-time valuation low on our “normal value” metric (Exhibit 10) and looks very much like it did in 2000. At that time a management and radical strategic refresh yielded some stunning results and a couple of years of stunning outperformance – helped by a commodity recovery in what was a much larger commodity component of the portfolio at the time.

Exhibit 10

Source: Capital IQ, SSR Analysis

When compared with the rest of the group, EMN is a stand out on the low side today looking at value versus return on tangible capital – a chart we have used several times in recent research – Exhibit 11. It sits in the company of commodity pure plays such as WLK, CF and MOS despite having much higher returns. Exhibits 8, 9 and 10 clearly show the loss of confidence in the company.

Exhibit 11

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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