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Wolf’s Corona Discounts: Eastman Chemical Company (NYSE:EMN)

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Via SeekingAlpha.com

My Corona discounts go on – we’re far from done yet. While the market seems to be moving up to higher levels step by step, at least over the past two weeks, all I do is adjust my investment targets. Over the past two weeks, I went from investing in quality dividend kings in staples to investing majorly in some of the other sectors – such as pharma, IT and basic materials.

As we continue upward, I already know well the companies I will be targeting for my weekly and monthly buys – all step by step, and all calmly continuing to collect dividends.

Today’s presentation, dear reader, is about Eastman Chemical Company (EMN). Take a seat and see if this interests you.

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Eastman Chemical Company – What does the company do?

Eastman Chemical Company is a 100-year-old basic materials company, around since 1920, headquartered in Tennessee, which produces Chemicals, Fibers, and Plastics. The company was spun off from parent company Eastman Kodak (NYSE:KODK) back in 1994 and recorded almost 15,000 employees serving a worldwide market in 2019.

The company quite literally manufactures hundreds of various chemical, fiber, and plastic products in a vast variety of markets. Some examples include adhesives, agriculture, coatings, electronics, housewares, energy, food/beverage ingredients, furniture graphics art, hygiene, medical devices and equipment, ophthalmics, packaging, transportation, signs, and pharma.

(Source: Company FY19 Report)

The company has divided its active businesses essentially into 4 segments, which also serve as reportable and operating segments in the company’s financials. These are:

  • Additives & Functional Products (AFP), manufacturing adhesive resins and chemicals for transportation, coatings, animal nutrition, tires, construction, health/wellness, and the consumer market. Key products include polymers, insoluble sulfur, hydrocarbon resins, propylene derivatives, and alkylamine derivatives.
  • Advanced Materials (AM), serving markets in need of cellulose esters, copolyesters, interlayers, window film for transportation, consumables, and electronics. Key products/technologies include cellulose esters, copolyesters, polyvinyl butyral, and others. The company markets Tritan™, Saflex™, and others.
  • Chemical Intermediates (CI) serves the market with acetyl, olefins, alkylamine streams and manufacturing for specialty fluids, such as industrial chemicals, construction, medicine, water, fuels, agriculture, and consumables. The output from the segment is also used as input by Eastman’s other segments. Key products include acetyls, oxos, plasticizers, polyesters, and alkylamines. This segment has a high degree of cyclicality.
  • Fibers services the market with proprietary Eastman fibers such as Estron and Estrobond, Chromspun and other things which are used in cigarette filters, acetate yarns for the clothing industry, furnishings, and industrial fabrics. Eastman is the world’s largest producer of acetate yarn and has been active for over 85 years in the segment.

(Source: 2Q18 Presentation)

In short, Eastman supplies our world with key components for what it needs to drive the current society we’ve constructed – from ingredients in our foods to coatings for our cars, to things for the medical devices and pharmaceuticals which prolong and save our lives. The company is a key player in all of these markets, and I spent over an hour perusing the various chemicals and “things” that the company produces to get a picture of the scope of company operations.

Needless to say, they are large and far-reaching. Out of the above-mentioned segment, AFP is the largest, constituting around 33% of sales, with AM and CI being close to equal at 24-28% each. Fibers is the company’s smallest segment at below 10% of FY19 sales.

Geographically speaking, the company is more diverse than you might expect.

(Source: FY19 Annual Report)

While the majority, on a per-geography basis, of the company’s business is found in the US, international business as a whole is larger in total than the US business, making Eastman more dependent on international sales than domestic.

So – that is what the company does and how it earns money. It serves the global market with access to chemicals, fibers, materials, and intermediates for key areas. The company has done so for nearly 100 years, though it spun off from Kodak only back in 1994. Kodak meanwhile, as we know, has gone nowhere but down and currently trades at 2.14/share. The Eastman chemical company meanwhile, is alive and thriving.

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Let’s see how this company looks when you take a look at their financial results.

Eastman Chemical Company – How has the company been doing?

There’s good and bad here. First of all, the overall long-term earnings trend and the generation of cash flow is quite strong. The company has an excellent FCF generation history over the past 10 years, and it isn’t until the past few years that earnings growth has started lagging a bit.

Some parts of 2019 were excellent…

(Source: FY19 Presentation)

… while some financial results on a YoY basis were comparatively lower, and this is true not only for EMN but for nearly all chemical companies.

(Source: FY19 Presentation)

Specific performance highlights on a comparative basis were found primarily in the Advanced materials segment, which dropped only 2% due to volume/mix and FX, coming from slightly lower sales volume and bad exchange rates. However, EBIT was up on an annual basis due to the lower raw material cost and a good, high-cost product mix.

Other segments weren’t so lucky. The worst performer was, as expected, the cyclicality-exposed Chemical Intermediates, which recorded a 14% sales drop due to lower volumes, lower raw material prices and increased competition. Wet weather impacted agricultural markets and EBIT decreased due to volume/mix and lower spreads. We see similar things in other companies providing olefins and polyolefins, so this wasn’t all that surprising to see in Eastman either. 2019 wasn’t the best year, but the comparison year was incredibly strong (2018), and this needs to be taken into account. The overall trend, this notwithstanding, is solid over the long term.

(Source: SimplySafeDividends)

Other metrics I like looking at concern company cash management and debt, as well as overall returns. The fact is that due to recent margin pressure, return and margins are pressured somewhat, currently at lows with a 13% RoE. Again, this isn’t unique, but it looks bad when EMN is typically over 20%. Operating margins remain at the very least solid, hovering between 13-15%, though the company sometimes reaches 15-17%.

The company has been acquiring businesses, as we can see in the presentation, and the combination of this and the current geopolitical and socioeconomic situation is of course unfavorable. Company net debt to EBITDA stood at 3.09X at FY19 and is currently at 3.17X based on lower EBITDA expectations for 2020. This is somewhat above what I like to see, which is below 2.5X.

That being said, EMN doesn’t suffer from maturities in 2020, and only some in 2021…

(Source: FY19 Presentation)

… and the company has plenty of access to cheap capital thanks to an investment-grade, BBB credit-rating. The company has $1.5B on a revolver, and like any business can use SCM factoring for both payables and receivable when needed. Its current assets are laden with both inventory, trade receivable and over $200M worth of cash and equivalents, totaling nearly $3.3B in current assets. Eastman has also a good track record of allocating capital conservatively…

(Source: FY19 Presentation)

… and while Corona will likely take a bite out of these expectations, it’s nothing that will break the company’s back.

In the end, 2019 is a year that for Eastman will be remembered for trade conflicts, weakness in key markets and a challenging overall environment which Eastman nonetheless managed with grace. Despite all these headwinds, the company increased EBIT in key segments, increased new business revenue to $400M for the year, generated over $1B in FCF for the full year, paid down debt, increased the dividend and M&A’ed two companies.

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Corona is as bad to Eastman as to other chemical companies, and this needs to be considered, but it’s also part of the reason this excellent company is currently on sale.

Overall, I’m not worried about how Eastman has been doing for the past few years, as they’ve been presenting a very strong front with excellent fundamentals – nor am I worried how things will go going forward, once Corona is over and countries fully go back to work.

Let’s look at key risks.

Eastman Chemical Company – What are the risks?

Risks in this company are similar to risks we see in other companies of the same sector, meaning:

  • Inherent cyclicality in key areas, such as intermediate chemicals. While some of the company’s areas are more resilient towards the supply/demand cycle, many are just the same as with peers. When the demand turned poor, Eastman suffered along with everyone else, though less than companies strictly exposed to the specific sectors.
  • Above-preferable debt at 3.17X. The company’s targeted downpayment of debt may, or will likely be affected by Corona impacts. I have my doubts that the figures given in FY19 will be able to be executed under current circumstances, and slower repayment or even requiring to take on more debt could put into danger the company’s BBB rating.
  • FX risk due to the company’s international exposure, which is higher than some peers.

Overall, Eastman’s diverse operations gives the company a higher defensive tact than its competitor LyondellBasell (LYB), which primarily engages in cyclicality-sensitive business, but this doesn’t mean the company is immune from these risks.

Let’s look at the company valuation!

Eastman Chemical Company – what’s the valuation?

Valuation, as expected, is excellent.

(Source: F.A.S.T Graphs)

I give EMN a valuation target of $74/share, which represents a midpoint between current FY20/FY21 EPS estimates. This means that the current upside to the company is 34%. With a BBB credit rating, an uncut dividend of 25 years, a narrow moat, 12% 5-Y average DGR, and an LTM P/O south of 40%, this gives EMN a 3-Y forward PEG ratio of 1.19 and classifies it as a “Class 1” stock with a “Very Safe” dividend.

I do want to point out, however, that Eastman may be in danger of being downgraded to BBB-, which consequently would force me to lower it to a 2nd class stock, regardless of what happens to the SSD dividend safety. This wouldn’t mean the stock would be a bad buy, but as it was BBB after a bad year going into 2020 with a 3X+ net debt/EBITDA, it’s not unthinkable that the market will communicate a downgrade here.

With this sort of upside based on a 10X P/E ratio, however…

(Source: F.A.S.T Graphs)

… that’s not something I really worry about. Combined with the company’s ample liquidity, it’s only a matter of time until things turn around and once again start looking more favorable. Even at current expectations, the payout has risen only to slightly above 40%, making the company’s dividend not something in danger of cutting – and I’d argue that the company may want to preserve its 10-year growth streak at this time.

(Source: F.A.S.T Graphs)

Forecast accuracy suffers a bit from the aforementioned cyclicality, and we must consider that the forecasts, as seen above, may be either too low or too high. However, at nearly 5% yield, I would argue that we’re paid a very good risk premium for a comparatively small risk in a fundamentally conservative and appealing company.

The bottom line is that while peers/competitors like LyondellBasell, Cabot (CBT) and Celanese (CE) can be argued to be more favorably valued – at least in part – few of them offer the breadth of operations that this company does. LyondellBasell may be more appealing from a pure yield perspective, yielding currently 8%+ while still sporting a BBB+ ratio (but being a Class 3 stock due to its dividend streak and safety), but as a whole, I believe EMN to be the better long-term investment at this time.

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It is, at the time of writing this article, a class 1 quality stock, with a quality score of 21 (LYB 17) and only 2 points lower in terms of opportunity score (due to a lower yield). EMN also has the higher dividend growth.

Due to this, I consider a 35% upside to Eastman at a conservative valuation from today’s price given the company’s prospective growth.

Thesis

I’ve presented the Eastman Chemical company before, in one of my undervaluation articles – and I add this article to give a more comprehensive view both of the company and my current stance upon it. I consider it an excellent investment at today’s corona-induced panic on the market.

While we may indeed see a credit rating downgrade, which would, in turn, make the company a class 2 stock regardless of the SimplySafeDividend safety rating (I have class 4 stocks that are considered “Very safe”), this certainly does not mean that it’s a bad investment. In fact, some 5% portfolio allocation positions that I currently have are class 4 companies. This highlights, I hope, my desired message, that a class 4 stock isn’t a bad stock. If I consider a stock uninvestable, I don’t even present it in my list/articles. A good example of this is energy companies, which I don’t currently want to consider investable at all given the current oil war uncertainty. Another example is certainly real estate companies which while I own, I don’t follow or endorse in my list.

Class 1-4 stocks are merely a way of weeding the “absolute best” in terms of conservative overall safety, from the “less than absolute best.” A class 1 stock, in my way of viewing things, needs to combine such an array of positive factors that currently, in my list, only 19% of the stocks I follow are Class 1 – and while this may sound like much, the list is the result of weeks of meticulous picking of companies and stocks which I want to, or could consider owning. If a company has characteristics that are sub-par, it’s usually not even on the list.

A. O. Smith (AOS), one of the world’s most conservative companies in the area of water heating and treatment is actually, due to its nonexistent credit rating, a class 4 stock. It has, despite this, a 99/100 Very Safe dividend rating. I hope that illustrates that class 4 does not in any way mean “bad.”

As such, regardless if Eastman turns out to stay a Class 1 or goes down into Class 2 stock, the thesis in this article currently stands.

This quality is undervalued, and it’s worth a “BUY” from me, and I hope a look from you.

Thank you for reading.

Stance

Due to a 35% undervaluation from what I would consider conservative fair value, I rate Eastman Chemical Company a “BUY.”

Disclosure: I am/we are long EMN, CBT, LYB, CE. 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.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.




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