The recent plunge in the price of oil has capped off quite a tumultuous year in the commodity space. The chemical sector hasn't been spared as many fear a slowdown in worldwide economic growth will stymie their profits. The article below will highlight Eastman Chemical (NYSE:EMN) a recent addition to my portfolio.
EMN can best be described as a diversified chemical producer that has transformed its product mix to rely on specialty chemicals a less competitive space. Specialty chemicals carry a far higher margin and are less prone to commodity like price shocks, which in my view help stabilize margins and prevent sudden drops in profit and revenue. The business has been transformed over the past few years with the purchase of Solutia and the expected deal for Taminco (NYSE:TAM). EMN currently has less than 20% exposure to olefin chain commodity exposure which would continue to drag down profits due to the low price of oil.
After studying the company extensively over the past few days, I have come away impressed with the transformation of the company. I would like to begin by highlighting the TAM acquisition as it will quicken EMN move towards a specialty chemical provider and reduce its reliance on commodity based products. TAM amines and crop protection business will be incorporated into EMN Additives and Functional Products division which carried 31% gross margins in 2013. TAM amine business will be incorporated into the Specialty Fluid Division which carried 21% gross margins in 2013. These two divisions will make up more than 50% of EMN sales going forward with higher than normal gross margins. The third division I would like to highlight is the highest margin division of all, the fibers division which carried a 36% gross margin in 2013.
If we look objectively at the gross margins of the divisions above, they tend to cast a new light on EMN. EMN has painstakingly transformed itself into a higher margin specialty chemical player which will drive profits higher for shareholders as long as economic growth continues. Management expects the combination to be accretive to earnings from day 1 and add approximately $0.35 cents per share.
EMN uses a variety of feedstock to produce their end products. A sudden spike in the price of the raw materials they use could hamper profits so naturally the company would employ hedges to limit the impact on commodity moves. In the case of EMN, they locked in some of their commodity exposure most notably propane at a price higher than where the market is currently trading at. I anticipate over the course of next year, EMN will look to hedge its 2016 commodity exposure at much lower rates which will provide a boon for future profits.
Impact of Lower Oil
Management offered some guidance on the impact of lower oil on the share price. They expect a 25 cent headwind if Brent averages roughly $85 per barrel next year. In my estimates, I expect the benefit of the TAM deal to roughly offset the decline due to lower crude oil. Naturally, one would ask why invest in such an opportunity. The reason is the shareholder friendliness of management as evidenced by the share reduction plan.
EMN currently has roughly $750 million remaining under its share reduction plan. The beauty of EMN is its ability to generate a large amount of free cash flow which can be used to make acquisitions or repurchase shares. With the TAM purchase, EMN has further strengthened the company. I anticipate management will deploy the bulk of the repurchase authorization over the next couple of quarters to offset any weakness in the share price. The share repurchase authorization is worth approximately 6.5% of all shares outstanding.
Levered Returns Model
As we can see from the model above, EMN generates a substantial amount of free cash flow which can be used to fund further acquisitions or repurchase shares. To account for the impact of lower oil, an additional risk of 1.5% to 2.5% was added to the equity risk premium to model for this. Over time, I anticipate the price of oil will rebound yet not before EMN can adjust their commodity hedges lower thus ensuring a more profitable 2016. Naturally, the company is directly tied to economic growth and if a recession were to begin, it would suffer.
EMN offers an excellent way to profit from the increase in worldwide GDP over the course of 2015. I suspect the various stimulus measures enacted overseas along with the virtual "tax cut" provided by low energy prices to help foster a more constructive economic backdrop. Assuming Continental Europe along with Japan begins to print positive GDP numbers over the course of the next six months, I expect EMN to close the valuation gap and trade at fair value. There is a bit more risk involved here than my normal plays, yet I believe the tradeoff is justified and have added shares of EMN to my portfolio. I will continue to monitor the situation and will update when warranted. Thank you for reading and I look forward to your comments.
Disclosure: The author is long EMN.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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