Eastman – Should You Try For 2nd Base?

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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

February 22nd, 2016

Eastman – Should You Try For 2nd Base?

  • Eastman’s internal view of its portfolio as largely specialty in nature appears warranted by segment analysis that shows its businesses have enjoyed above average margins and below average volatility over the last three years relative to Chemical sector peers
    • Action by management to unlock value and improve messaging could drive upside
    • Inaction will likely drive outside help – which also suggests upside from here
  • However, the external investor view remains highly skeptical for a variety of reasons:
    • Company is hard pressed to keep earnings flat in ’16, and consensus currently sits below ’14 EPS
    • The capital base has meanwhile grown significantly – Exhibit 1 – the reverse of the situation last decade when EMN grew earnings more than two times in excess of its assets
  • The large debt component of EMN’s enterprise value also appears to be a weight on valuation
    • Stock looks very cheap on earnings but is more than fairly valued on an EV/EBITDA basis relative to its historical discount/premium to Chemical sector peers
  • All of this is wrapped up in a portfolio so complex, that many investors don’t make it to first base!
    • One clear concern is that specialty chemicals are only “special” for a while before competition turns them into commodities
    • EMN’s re-segmentation suggests that this phenomenon is alive and well – several companies have tried to cover up commoditization in their portfolios in the past by regrouping and renaming segments, but it never works
  • EMN cannot do much to prevent commoditization, but it can actively manage the portfolio and it can improve the messaging
    • Divesting businesses that fit better in a more commoditized portfolio can work (the attempt to sell excess ethylene capacity will be challenging but could help); harder where processes are integrated with businesses which remain specialty – this is likely the case at the Kingsport facility
  • Our thoughts on how EMN could improve its messaging:
    • If the company can quantify its exposure to various end markets to highlight its diversification (as it has), it should be able to track its volumes within these markets to better illustrate where strengths and weaknesses are and what is driving the businesses
    • Anecdotes about individual products that represent minute percentages of sales are interesting more than informative and generally do not help investors build robust models

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Eastman appears to be one of the cheapest stocks in the chemical sector on earnings (both normal and forward), particularly if you exclude those that have serious balance sheet issues and reflect the possible risk of insolvency. This low valuation is particularly surprising when you reflect on the data in Exhibit 2. EMN’s segments not only have margins which place them firmly in the “specialty” chemical bucket, but they also have shown quite limited volatility.

EMN may trade a discount to its own history and the chemical sector as a whole, but it trades at a substantial discount to what appear to be its peers, as measured in Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

The problem is largely self-inflicted in our view, as the acquisition strategy which has created the current Eastman and driven top and bottom line growth for the past several years, has made the portfolio quite complex to understand and the company has done a poor job of explaining what it is and how to think about its growth and profitability drivers. We believe that the re-segmentation of the business, as outlined in the Q4 earnings release, further clouds the issue as it will be taken as a sign that some specialty segments are deteriorating and becoming commodities, debunking the message that has been delivered to investors.

Companies that have a history of changing reporting segments – including Eastman pre-2000 – have a habit of underperforming – Exhibit 3. In part this is because the re-segmentation troubles investors as it adds uncertainty to financial models – EMN can ill-afford for this to happen as the story is already complicated enough and an impairment when it comes to getting investor opinion. The other driver of underperformance is that a change in reporting structure is often an indication that something is wrong – earnings disappoint and the stock underperforms.

Exhibit 3

Source: Capital IQ and SSR Analysis

A Self-Inflicted Fall From Grace

Eastman management took a perfectly good story and broke it – the announcement of the Solutia acquisition in January 2012 coincided with the beginning of a long move downward in the stock’s relative multiple and is illustrative of the problems that have since plagued the company. Acquisitions fueled EMN’s growth throughout the 2000s, but this was perhaps a step too far, too soon. Investors, at any rate, began to lose interest in the story, uncertainty contributed to multiple contraction – Exhibit 4 – and an already complicated portfolio was further clouded with the subsequent Taminco deal.

Exhibit 4

Source: Capital IQ and SSR Analysis

As well as scaring investors with the large cash based deals, EMN has compounded the problem by under-delivering – failing to get the returns on the investment needed to get back on its trajectory of the 2000’s – despite what looks like good EPS growth. In Exhibit 5, the jump in the “net income based on return on capital” line is a function of the increase to the capital base as a result of the acquisitions. The failure to meet that implied earnings level – regardless of any extenuating circumstances, such as the propane hedge – simply adds fuel to the investor sentiment fire and helps drive the relative P/E trend seen above. Eastman is not earning significantly below trend – Exhibit 6 – and there are plenty of companies in worse shape today, but none is being penalized the way EMN is because in EMN’s case the changes in the portfolio make it hard to determine whether what we see today is a normal cyclical issue or something else.

Changing segment reporting structure will, in our view, only add to the uncertainty.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Once EMN made the acquisitions it is possible that its course was set and that no matter what the company had done following the moves we would be where we are today. However, we do not believe that. The propane hedge in itself was probably forgivable – it was made at a time when crude oil was above $100 per barrel and the overwhelming consensus was that it would stay there. Rolling the hedge for 2 years and then being very selective with disclosure was the problem as it only made the confidence issue worse.

At the end of December 2011 (the month before the Solutia announcement), EMN’s relative multiple (based on normal earnings) was 0.77; today it is 0.4 – the lowest in the sector (excluding the TiO2 group). At the December 2011 multiple, the stock would be above $100 per share, the equity value would be $15 billion and debt would be a third of the overall enterprise value. With the loss of confidence and the declining relative multiple, the equity is much lower and debt becomes a problem!

Debt a Key Valuation Overhang

Relative to peers in the Chemical sector, EMN is at an extreme valuation discount on a P/E basis, but is more or less in line with (actually slightly above) historical averages on an EV/EBITDA basis – Exhibit 7. While the stock looks cheap on earnings alone, the high debt component of EMN’s enterprise value – Exhibit 8 – is limiting upside.

Exhibit 7

Source: Bloomberg and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Here is what EMN should do:

  1. Tell the whole truth!
    1. Don’t skirt around the potential earnings hit from the propane hedge – put a framework around it so that investors have a best and worst case model and understand what drives that model
    2. Be definitive about the strategy with regard to further acquisitions
    3. Either stick with the original segmentation or give investors enough detail in future reporting such that the old segments can be recreated – or give years of history on the new basis
  2. Buy back stock
    1. At this price the cheapest acquisition out there for the company is EMN stock and assuming that debt maturing in 2016 and 2017 can be refinanced attractively, the company should refinance and buy the shares
    2. The recent dividend increase could help, but if management really believes in the growth opportunity and margin opportunity within the portfolio then a buyback is better
  3. Divest businesses that are worth far more to others than to EMN at current values – buy back stock or pay down maturing debt
    1. Is there a high multiple piece of the portfolio that could be carved out in a tax efficient RMT, allowing EMN to retire a disproportionate number of shares relative to the earnings that are sold:
      1. Advanced materials?
      2. Additives and Functional Materials?
      3. Yes, these are core businesses for EMN, but if they are worth substantially more to someone else the per-share impact of a sale with the right structure could have a huge positive TSR impact for EMN shareholders – more so that the “steady as it goes” approach
    2. Other possible smaller high value sales
    3. Recent announcements that the company is looking to sell some of its ethylene capacity and intermediates operations is good and bad news
      1. Good because the company is at least thinking about portfolio management
      2. Bad because the timing is probably not great – selling a business at a low in the cycle generally does not generate a good return
      3. The ideal time to sell would have been two years ago and while EMN wanted to sell at this time it was hampered by a pipeline dispute stemming from its earlier sale of assets to Westlake – and then hampered by the propane hedge.
        1. Ethylene margins are now low, and the cycle timing is wrong
        2. The plant is landlocked and relies on Westlake for pipeline access
        3. The plants are old
        4. EMN is adding more assets to the deal to try and make it more attractive
        5. Unlikely that this will be an accretive sale.
  4. More (or more helpful) disclosure
    1. Drivers of top line for each major business segment and some sort of consistent metrics to measure those drivers
    2. Risks to each business – key demand risks, raw material risks, substitution risks
    3. Competitive strengths within each major business line – what sets Eastman apart?
  5. Costs
    1. All acquisition strategies tend to result in a buildup of structural costs – acquisition synergies can be a distraction in this regard as the corporate focus is on the synergies and not on whether the overall cost structure is appropriate
    2. We think that EMN could probably find another $200 million of costs with the right focus

Failure to address the messaging and data part of what we suggest will likely keep the stock under pressure. If this is then combined with a lack of any of strategic and cost related moves – either as suggested or other – then someone else is going to fix this story, either through a successful bid and then possible break-up at a value that is well below potential, or through activism.

We continue to see the value in Eastman and would own the stock. We are not sure what the catalyst will be; activist, acquisition, management change, messaging change, but we are confident that there will be one.

©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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