Eastman Chemical Co: Stock Price Still has Room to Grow

Overview

Eastman Chemical Company (EMN, Financial) is a global specialty chemical company. Its products range from base and high precision plastics, chemicals, and fibers, most of which are integrated into the products and processes of other firms in virtually all industries everywhere, including food and beverage packaging, toys, medical equipment, computer hardware components, construction materials, and electronic devices. The company was spun-off from Eastman Kodak in 1993 and, fortunately, is no longer tied to the photography business. Some of its key products include yarns, chemical solutions for water treatments, adhesives, inks, paints, wood preservatives, polymers, resins, and apparel fibers. EMN's full product line is enormous, and to fully understand each item would require a degree in chemistry. That being said, EMN faces perpetual market demand for its products and has a strong repeat revenue business model.

The company's products and operations are managed and reported in five reporting segments:

• Additives & Functional Products (18% of revenues) include chemicals for products in the coatings and tires industries in transportation, building and construction, durable goods, and consumables markets.
• Adhesives & Plasticizers (14% of revenues) include resins and plasticizers used in the manufacture of packaging materials, construction adhesives, interior flooring, glove applications, and medical devices.
• Advanced Materials (25% of revenues) include polymers, films, and plastics for cosmetic packaging, housewares, appliances, and window films.
• Fibers (16% of revenues) include plasticizers for use in cigarette filters, yarns for use in apparel, home furnishings, and industrial fabrics.
• Specialty Fluids & Intermediates (27% of revenues) include paint/coating applications, construction chemicals, and other chemicals for building materials and cleaning solutions.

EMN's products represent vital inputs into the production processes of many other firms and, as such, it is not dependent on any particular buyer or sector for revenues. Basically, when the overall global economy grows, EMN's revenues grow. As such, last year was particularly good for EMN with earnings leaping ahead of pre-recessionary levels.

Solutia (a specialty chemicals maker) proved to be a fantastic acquisition for EMN and will continue to support growth. EMN has also recently sold off underperforming plastic facilities and management appears well focused on higher margin activities (i.e. feedstock production). Stability in petroleum prices (EMN's key production input) will also provide gross margin support moving forward. We like that management is expanding the firm's global manufacturing presence, establishing production facilities in Korea and China. Serving these market and maintaining cost parity with international competitors is absolutely critical to EMN's future success.

What's most concerning about EMN is its close ties to manufacturing and commodity price cycles, which can quickly take their toll on revenues. While petroleum prices have been accommodating recently, quick spikes in prices can devastate margins. Competition is also fierce along many of its product lines. There is a lot of uncertainty surrounding environmental regulations and the cost of remediation and chemical capture laws.

Historical Financial Performance

About $9,350M in revenue moved through EMN's door in 2013. EMN’s revenues are closely tied to the business cycle, and for the Dec 2004 to Dec 2013 period, clocked in at an average annual rate of growth of 4%. Revenues grew at an annual rate of 17% over the last 3 years and 7% annually over the last 5 years. This has been driven by acquisition activities, an improvement in the economy, and improved levels of international manufacturing production. Year-over-year, EMN continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $2,776M in 2014. Gross profits have grown by 12% per year over the last 10 years and 20% per year over the last 5 years.

EMN's production costs appear well under control, with COGS rising by 2% per year over the last 10 years against revenue growth of 4%. EMN does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have expanded from 15% in 2004 to 30% in 2013. In addition to being on an upward trend, EMN's gross margins are reasonably strong (averaging 21%). As a general rule, we want to see consistent gross profit margins above 30% for firms in the sector. While EMN has not been able to meet this requirement in any of the last 10 years, gross profits margins consistently between 15% and 20% for firms in the sector is, in our opinion, indicative of a firm with a reasonably strong competitive advantage and moderate pricing power.

EMN spends about 25% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending 25% of gross profits on SG&A a very good result. Cost of SG&A, however, have been increasing, rising by 4% per year over the last 10 years and 14% per year over the last 3 years. That being said, we consider this an acceptable result when viewed against annual revenue growth of approximately 4% and 17% over the same periods respectively.

EMN has shown continued strength and reasonable stability in its operating earnings picture, rising by 30% per year over the last 10 years and by 29% per year over the last 5 years. The long-term trend in operating income has been upward, rising from $175M in 2004 to $1,862M in 2013. EMN has earned on average about 10% in operating earnings on total revenues over the last 10 years -- an acceptable result. EMN carries a substantial amount of debt on its books and pays out about 10% of operating income on interest payments annually. This is a poor result, though consistent with much of the competition.

Bottom line results show a strong upward long-term trend in earnings, with definite cyclical volatility, growing at an average annual rate of 24% over the last 10 years. Earnings are expected to tick upwards in 2014 and 2015 as the global economy continues to improve. EMN’s reasonably strong competitive position has allowed it to maintain net margins of about 6% over the last 10 years. We do not expect to see much margin expansion from this company over the short- to medium-term.

Diluted EPS grew from $1.09 per share in 2004 to $7.44 in 2013. Since 2004, earnings growth has outpaced revenue growth by 20% per year. To us, this is a sign of earnings quality strength. We dislike, however, that the firm's share-base has not fallen over the last 10 years and remains at about 156M. EMN's ROE performance has been exceptional, averaging 24% over the last 10 years. Its ROA performance has been moderate averaging 7%.

Table 1: Key Financials

Free Cash-Flow to Equity Estimation

A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.

Here we estimate fair value in 5 steps:

(1) We forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;

(2) We discount those cash-flows to the present;

(3) Calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;

(4) Add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and

(5) Divide the present value of all cash-flows by the number of shares outstanding.

Free cash-flow estimates are presented in Table 2. Table 3 presents valuation results and Table 4 presents a valuation matrix.

Table 2: Free Cash-Flow to Equity Estimation

Table 3: Valuation Results

Table 4: Valuation Matrix

Conclusion

EMN’s per share earnings in 2013 were $7.44. Historical earnings per share grew at an annual rate of approximately 24% per year since 2004. EMN’s sales per share in 2013 were $59.74. We project that sales will grow at a rate of about 3.4% per year between 2014 and 2023. We expect stable gross margins but compressing net margins. Interest expenses and capital expenditures will remain at recent historical levels in the amounts of approximately 2% and 6% of sales respectively. Our fair value estimate of EMN equals $85.73, suggestig that EMN is underpriced by about 14%.