Eastman Chemical - Diversification And Growth Potential

| About: Eastman Chemical (EMN)

Summary

Surprisingly, in an expensive market, some of the big chemical companies are still selling at attractive valuations.

This $12.39 billion chemical company still has plenty of room to grow keeping in mind that Dow Chemical has a market cap of $78.69 billion.

Given the growth expectations along with the current P/E of 14.28, there is still room to go in the stock price.

Surprisingly, in an expensive market, some of the big chemical companies are still selling at attractive valuations. Investors that take a close look at Eastman Chemical (NYSE:EMN) will find an attractively priced company poised to provide an acceptable rate of return at fairly low risk. This $12.39 billion chemical company still has plenty of room to grow keeping in mind that Dow Chemical (NYSE:DOW) has a market cap of $78.69 billion. We believe the company actually has the potential to grow earnings at over 8% annually for the next five years per the average analyst estimates currently provided. The stock has already moved up over 20% over the last 12 months. However, given the growth expectations along with the current P/E of 14.28, there is still room to go.

Diversification

Similar to Dow Chemical, with Eastman you get diversification. Consider that its four segments: Additives and Functional Products, Advanced Materials, Chemical Intermediates, and Fibers, produce chemicals for a wide array of industries. The major end markets include transportation, building and construction, tobacco, consumer durables, industrials, agriculture, and health and wellness. The table below highlights the makeup of the 2016 sales.

2016 Sales Revenue by End-Use Market

Transportation

20%

Consumables

16%

Building & Construction

14%

Tobacco

11%

Industrial Chemicals & Processing

10%

Personal Care Health & Wellness

7%

Consumer Durables

7%

Food, Feed & Agriculture

6%

Energy, Fuels & Water

4%

Electronics

3%

Other

2%

Source: EMN 2016 Annual Report

Eastman guides that its Additives and Functional Products segment sales growth will be similar to global domestic product growth due to the segment’s sales to diversified markets. This segment manufactures chemicals for products in the coatings, tires, consumables, construction, crop protection, energy and industrial applications to name a few. The Advanced Material segment had sales revenue of $2.5 billion in 2016 which was 28% of total sales. The AM segment produces polymers, films, and plastics used in transportation, consumables, and construction among other industries. The Chemical Intermediates segment is the most cyclical due to periods of supply and demand imbalance in the olefin and acetyl-based businesses. For the Fibers segment, management expects continued strong cash flow despite lower capacity utilization rates. Of course, the broad product mix means that Eastman has a wide range of customers making them less dependent on a single customer. The company seeks to grow through innovation and improving the product mix but has also completed several acquisitions in the last few years. For example in 2014 the company made four notable acquisitions.

  • December 5, 2014 – Global specialty chemical company Taminco - $2.8 billion
  • December 11,2014 – Commonwealth Laminating & Coating - $436 million
  • June 2, 2014 – BP plc’s global aviation turbine engine oil business - $283 million
  • August 6, 2014 – Knowlton Technologies (microfiber technology) - $42 million

Valuation

Performing discounted cash flow analysis indicates that Eastman is not extremely undervalued but is at least fairly valued. Let’s consider the following the following inputs:

EPS (TTM)

$5.95

Analysts' annual growth estimate for the next five years

8.8%

Dividend

$2.04

Discount rate (desired annual return)

10%

P/E

14.35

Buy below

$90.70

Current price

$85.40

Percent of target buy price

94%

Using the mean analyst annual growth estimate provided by Finviz results in a target buy price of $90.70. The current price is slightly below this indicating that this may be a good entry point. Notice that a desired annual return of 10% was used in the valuation, which most investors would be very happy with. This annual EPS growth estimate seems fairly optimistic. While not unachievable, it does not leave much room for error. In the past five years, the company grew earnings by 6.30% annually. Therefore, it makes sense to see how the stock would be valued under a range of growth scenarios. For example, we can compare the table above to an identical calculation where we only vary the annual long-term EPS growth estimate to 6%, slightly below the rate achieved over the last five years. In this case, we get a target buy price of $76.55, which is 10% below the current price. However, we should note that these calculations assume that the outstanding share count will remain unchanged. We think this is a reasonable assumption given that while the outstanding share count was reduced over the past 10 years, the number actually increased from 2012 to 2014. The company stated in its latest annual report that the priorities for cash after funding operations include payment of quarterly dividends, debt repayment, inorganic growth opportunities, and from time to time repurchasing shares. Of course, if shares are repurchased, then this will help increase the EPS growth rate.

Chart EMN Average Basic Shares Outstanding (Annual) data by YCharts

Another way to gain more insight into how the company is valued is to compare some of the financial metrics to the industry averages. The table below also includes a comparison to the metrics of Dow Chemical Company.

EMN

Industry Avg.

DOW

Quote

$ 85.40

$66.24

P/E

14.35

21.01

17.17

Div Yield

2.39%

2.02%

2.78%

Price to Book

2.68

4.85

2.99

Price to Sales

1.37

2.94

1.6

Price to Cash Flow

8.5

16.48

10.35

Net Profit Margin

9.77

15.08

9.95

Net Profit Margin - 5-Yr. Avg.

8.95

3.66

8.16

Return on Assets (TTM)

5.65

15.23

6.76

Return on Assets - 5-Yr. Avg.

6.18

3.79

6.27

Return on Investment (TTM)

6.4

19.67

8.25

Return on Investment - 5-Yr. Avg.

7.13

5.23

7.69

Return on Equity (TTM)

19.9

28.59

19.2

Return on Equity - 5-Yr. Avg.

23.3

7.27

19.56

Source: Reuters

Eastman seems slightly undervalued to its peers when looking at some of the key valuation metrics such as price to sales and price to cash flow. Also when observing that Eastman has a lower P/E ratio than Dow Chemical, one also needs to keep in mind that this is despite the higher EPS growth estimates given to Eastman. As far as the profitability ratios such as net profit margin and return on equity, while the industry average may be higher than Eastman's in the last year, the Eastman numbers all look superior when considering the five-year averages which provide a better picture compared to looking at the performance for a single year.

Risks

Something to keep in mind when assessing the risk associated with an investment in Eastman is that the stock is up 13.55% year to date and 19.11% for the last 12 months. The stock is 36.20% above its 52-week low and is basically at its 52-week high. Of course, none of this by itself means the company is overvalued, but the stock is definitely not as cheap as it was a year ago or even six months ago. When it comes to earnings reliability, Eastman has had positive earnings in the last 10 years per the table provided below. The last time the company had negative earning was 2003.

EPS Basic Total Ops

Dec-16

5.80

Dec-15

5.71

Dec-14

5.03

Dec-13

7.57

Dec-12

3.00

Dec-11

4.63

Dec-10

2.95

Dec-09

0.94

Dec-08

2.30

Dec-07

1.82

Source: Barchart

However, from the table above we do see volatility in the earnings numbers as Eastman was impacted by the cyclical nature of some of its segments and the recession in 2009.

Another risk to consider becomes evident when looking at the cash flow numbers of Eastman. Cash flow looks strong when comparing cash flow from operations to investments in property, plant and equipment. Throwing acquisitions into the mix highlights the need for Eastman to successfully integrate the acquired companies which it has so far been able to do.

Dec-16

Dec-15

Dec-14

Dec-13

Dec-12

OPERATING CASH FLOW

$1,385,000

$1,624,000

$1,433,000

$1,297,000

$1,128,000

Ppe Investments

-585,000

-648,000

-580,000

-483,000

-470,000

Sum

$800,000

$976,000

$853,000

$814,000

$658,000

Net Acquisitions

-26,000

-45,000

-3,509,000

0

-2,669,000

Sum

$774,000

$931,000

($2,656,000)

$814,000

($2,011,000)

Final Thoughts

We think that now is a good time to initiate a position in Eastman Chemical despite the rise in the stock price. We want to invest in a chemical company that while already very diversified with a broad customer base still has room to grow. We should note the company will be announcing earnings shortly on July 27th. Based on the discounted cash flow analysis discussed above, while not extremely undervalued, the company appears to be fairly valued at current levels and should provide long-term investors with a satisfactory rate of return on their investment. For investors interested in using options to initiate a position in Eastman, we think there are some interesting put options that could be sold. Of course, there are many put options available, but one possibility is selling the put option with an expiration date of September 15th and strike price of $85. The current bid is $2.90, which means the investor would receive $290 in premium providing for about a 3.3% return in two months or an annualized return of about 19.5% if the option expires worthless. A seller of this put option would save about 3.9% on the purchase of 100 shares at $85 per share compared to purchasing the shares at the current price of $85.40. Overall, regardless of whether or not an investor chooses to use options or purchase the shares outright, we think the current price offers a reasonable entry point and we have a positive long-term outlook on Eastman Chemical.

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.

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