In a little over a decade Eastman Chemical (EMN) has transformed itself from a producer of commodity chemicals into a producer of specialty chemicals. Despite Eastman's transformation the stock still trades at the valuation of a commodity chemical company. After paying down debt in 2013 Eastman will be able to use its strong free cash flow in 2014 for repurchases or accretive acquisitions that should lead to a rerating of the stock.
Eastman has achieved its transformation into a specialty chemical maker through a series of divestitures and acquisitions that began in 2001. $3 billion in divestitures and numerous acquisitions later Eastman has become a more profitable company with less earnings volatility. Since 2002 Eastman has increased its gross margins from 15% to 27%, while earnings per share have increased more than six fold.
Over the years Eastman's shareholders have been rewarded as the stock has risen with its earnings growth. Even after this rise Eastman still trades at one of the lowest valuations in the chemical sector despite having one of the best margin profiles. Eastman Chemical has one of the highest EBITDA margins in the chemical sector yet trades close to the bottom of the group in terms of valuation. The charts below illustrate this.
Eastman has a lower valuation than all its peers except for Huntsman (HUN)
Eastman trades at roughly 11 times its $7 2014 earnings estimates and less than 10 times the $8 earnings goal that Eastman's management has set for itself in 2015. Eastman's free cash flow should exceed earnings for the next few years as Eastman utilizes its NOLs. I would note that analysts estimates for 2014 do not include Eastman utilizing its over $7 in free cash flow for share repurchases or accretive acquisitions. Eastman management has indicated that they intend to aggressively utilize their free cash flow in order to reach their $8 earnings goal.
If Eastman were assigned the same price to earnings ratio as Dupont (DD), Eastman would trade at over $100. Eastman has higher margins than Dupont and has had far superior earnings growth over the years yet trades a deeply discounted valuation.
Nearly every sell side analyst that has a neutral rating on Eastman Chemical gives the same explanation for their rating. They acknowledge that Eastman trades cheap relative to its peers but claim that there is not an immediate catalyst for a rerating of the stock. I disagree with this assertion as there are numerous levers management can and will likely pull that should lead to a rerating.
Eastman will be done paying down its term loan in 2013 and will have as much as $8 of free cash flow in 2014 to repurchase shares and/or do accretive acquisitions. Management has indicated that they plan to use their free cash flow in 2014 for precisely these purposes. Management has also indicated that prices for acquisition targets are high and that they will continue to be disciplined. This leads me to believe that most likely outcome will be an aggressive share repurchase in 2014 or a combination of share repurchase and some small bolt on acquisitions.
Over the past three months Eastman has been one of the worst performing stocks in the chemical sector. This underperformance started roughly when propane prices began to take off in July as propane is one of Eastman's major input costs (propane went from under 90 cents in June to 1.15 in October).
There has been much hand wringing and spilled ink regarding Eastman's propane costs over the past few months. This culminated in Eastman lowering its 2013 earnings estimate from a range of 6.40-6.50 to a range of 6.30-6.40. Over time Eastman should be able to push these higher propane costs to customers but Wall Street is more focused on the short term "beat/miss the number" game.
On Eastman's most recent conference call management guided to double digit earnings growth in 2014 before the effects of any share repurchases or acquisitions. Eastman management has a strong record of achieving their goals. I do not hold this most recent disappointment against them as a surge in a commodity price is beyond their control and this issue is transitory in nature.
Eastman is yet another case where investors are missing the forest for the trees. Investors are obsessing over short term issues while ignoring the fact that Eastman is one of the highest quality companies in its sector trading at a deeply discounted price to its peers. Aggressive management use of free cash flow should lead to a rerating of the stock by the end of 2014.
Additional disclosure: I am short ALB, CE, DD, DOW, FMC as hedges to my long position in Eastman Chemical