Eastman Chemical’s (NYSE:EMN) recent adjusted EPS and revenue beat has been one of the pleasant surprises the chemical industry has delivered this earnings season. Thankfully, my cautious hypothesis that I made in the recent note on Celanese Corporation (NYSE:CE), one of EMN’s competitors, that “some other earnings surprises in the sector are perhaps due in the coming weeks of the season” appeared to be correct, as the pace of the economic recovery in the third quarter was faster than Wall Street expected.
After carefully reading EMN’s Q3 report and especially attentively analyzing its cash flow data, I am glad to conclude that the dividend thesis I presented in January is fully valid. Now let’s delve deeper into the data.
The top line
Eastman’s revenues have been falling steadily since 2018 due to a slew of reasons that my dear readers are likely perfectly aware of. First, it was the trade war, which spawned uncertainty and hammered supply chains, thus depressing demand for EMN’s products. Second, the pandemic has proved to be a calamity with no doubt, precisely like for most chemical companies, which had not fully recovered from the repercussions of the trade-war-induced softness when the lockdowns began to restrain the economic activity.
The second quarter was the gloomiest period of the year, as total revenues virtually cratered, falling 18.6% year over year. In Q3, the trend continued as total revenues were down by 8.7%. But if we delve a bit deeper, we will notice that not all the segments were equally exposed to the detrimental effects of the counter-Covid-19 measures that have precipitated the economic downswing this year. While Advanced Materials and Fibers fared relatively well, reporting only mid-single-digit contraction in sales, Chemical Intermediates, and Additives & Functional Products were down in the low teens. Let us elaborate on why.
- The Additives & Functional Products segment reported an 11% reduction in sales YoY together with an 8% sequential improvement. Lower revenues compared to 3Q19 were mostly the consequence of weaker volumes that fell 8%, while 4% pricing headwinds (partly offset by a 1% positive contribution from FX) also took a toll on the top line. But what exactly precipitated the decline in volumes? In the press release, commenting on the segment’s results, EMN briefly mentioned that the demand from the transportation end-markets was especially soft. The company also highlighted that “aviation fluids and certain coatings additives” were particularly weak. In fact, it was barely coincidental, as the aerospace industry has been bearing the brunt of the global economic crisis. I have already touched upon that matter in my articles on Carlisle (NYSE:CSL), PPG (NYSE:PPG), and Sherwin-Williams (NYSE:SHW). EMN’s comment was short, it did not share any details on what liquids, in particular, suffered from lackluster demand. Anyway, I should shortly remark that the company produces Skydrol™ fire-resistant aviation hydraulic fluids, and the segmental top line likely reflected the lower demand for them. Considering that aviation is recovering exceptionally slowly, I reckon this will definitely remain a headwind to the company in Q4. However, I also do not expect this issue to fully offset the recovery in the other end-markets including automotive. Also, it is worth noting that trying to minimize the toll the conundrum in the aerospace had taken on the company, its team worked hard to find new applications for the fluids “beyond … legacy applications” and ultimately succeeded. In the prepared remarks (page 8), the Senior VP and CFO Mr. McLain mentioned that Eastman “won a very significant project that will start impacting revenue in fourth quarter 2020.”
- Advanced Materials was down only 4% vs. 3Q19 thanks to the robust recovery in the automotive end-market, as reopening of the economies and massive fiscal stimuli revived the optimistic sentiment in the industry. Its sequential improvement on the back of surged volumes was even more impressive, reached 18%.
- Chemical Intermediates delivered the weakest result, as its sales declined by 13% and were up only 10% sequentially. The principal culprit was maintenance, not only on Eastman’s side but also in the cases of unnamed customers (page 8). Unfortunately, the firm did not mention what product lines, in particular, were especially weak, so it is not clear was it intermediates like, for example, glycol ethers or esters, plasticizers, or alkylamines.
- Finally, the Fibers segment’s sales dipped 5% YoY to $206 million, as acetate tow prices disappointed despite higher volumes. Another headwind was related to lower sales of textile products. On a side note, Fibers was the only segment that failed to deliver sequential revenue improvement.
Overall, all the segments managed to deliver an operating profit (page 6), even though the results were weaker than in 3Q19 due to lower sales. The Q3 diluted EPS did dip to $1.18 vs. $1.93 in 3Q19, but it is of only limited importance for the dividend thesis. Let us focus on cash flows, the very foundation of intrinsic value of a stock and shareholder rewards.
Scrutinizing cash flows: EMN did a great job securing liquidity amid the economic storm
The pandemic has been a stress test for businesses across the globe in many senses. Obviously, it has been especially tough to rapidly optimize the cost structure and recalibrate capital allocation patterns in order not to outspend cash flows and protect the balance sheet amid the economic doldrums. And the Q3 and 9M data illustrated that Eastman succeeded in opex optimization and working capital management, as it delivered a 26% increase in 9M net operating cash flow. Its capital expenditures were scaled down, while the acquisition activity was frozen. As a result, FCF of $771 million was delivered, while shareholder rewards required only $329 million.
While revenues and profit dropped to a five-year nadir, the net CFFO touched a five-year high.
And, according to my calculations, Eastman reached an over 14% Cash Return on Total Capital, thanks to higher cash flow and reduced debt (the end-September total capital was down to $12.02 billion vs. $12.3 billion in 3Q19). So, it will not be an exaggeration to say that EMN did a truly great job keeping its costs and working capital at bay.
Speaking on the dividend, the company did not shed light if it was considering the DPS increase this year. However, answering an analyst’s question, Mr. McLain made a quick remark on shareholder rewards:
On the capital allocation front, our priorities have not changed. We’ve increased our dividend for 10 consecutive years. And that’s an important mechanism for us returning cash to stockholders.
Meanwhile, in the prepared remarks (page 10), he said that the company remains “on track for greater than $1 billion of free cash flow.” All in all, considering the company has ample liquidity, I reckon there is still a high possibility it will increase the DPS this year. But as the recession is not over yet, the increase, if materialized, will likely be in the low-single-digit range.
Eastman is expecting Q4 volumes to approach Q4 ’19’s, thanks to the “solid recovery” in a few end-market including the automotive (slide 12).
However, since the Q3 earnings presentation, a few events have already clouded the outlook for the global economy, casting a shadow on the prospects of the recovery and subsequent growth. In short, the coronavirus-related restrictions are returning. For example, after a massive surge in daily revealed coronavirus cases, Britain and France re-imposed lockdowns. The Bank of England has already signaled there will be additional stimuli, but it is not clear yet if it will be enough.
So, the risk that the recovery will ultimately be a patchy one with a W-shape is becoming more evident.
The third-quarter results of Eastman Chemical Company made an overall positive impression, especially the cash flow data. As the firm is on track to deliver over $1 billion in annual FCF, the dividend thesis and the ~3.05% yield are not in jeopardy. But as EV/EBITDA is in the low teens (10.7x at the moment, well above the five-year average), I prefer to remain neutral this time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.