Eastman Chemical – A Good Story, But At Risk Of A Complexity “Own Goal”

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629 / 203.989.0412

gcopley@/nlipinski@ssrllc.com

November 11th, 2014

Eastman Chemical – A Good Story, But At Risk Of A Complexity Own Goal

  • Eastman is an undervalued stock on many metrics, and in our view continues to be penalized in part because of the sins of its now distant past. As the company builds a better business, with potentially more reliable earnings growth and consistency, it needs to consider the possible risk associated with the increasing complexity of its new portfolio
  • EMN has an industry low relative multiple (Exhibit 1), despite years of improving earnings and much reduced earnings volatility. The discount in this multiple to companies like DOW and DD is very hard to justify and suggests that the stock has meaningful upside.
  • The stock is possibly being held back by the increasingly complex nature of its portfolio, which now encompasses several relatively unique chemistries which are not well understood and for which there are few publicly traded proxies. Investors are showing less and less willingness to take on hard to understand/model stories, opting instead for simpler business mixes.
  • Complexity will likely limit the upside for EMN, but despite that we think the story is interesting and the stock attractive. The company has talked about closing the valuation gap with S&P500 peers with similar earnings consistency. The company should be able to close half of that gap. We see as much as 20% upside without a multiple re-rating and as much as 40% with one.
  • The gap will not close if the company makes it hard for investors to understand what they are buying. The company has changed its reporting segment structure 4 times since it became public and will likely do so again when the Taminco business is added. Eastman needs to go out of its way to make useful and consistent disclosures if it wants investors to fully value its story.

Exhibit 1 – SSR Chemical Coverage Group

Source: Capital IQ and SSR Analysis

Overview

Eastman is one of the very few real transformation driven success stories in the Chemical industry. The company has spent the best part of 12 years repositioning its portfolio away from commodity polyesters and into a portfolio of differentiated specialty chemical and plastics products. We use Eastman in this analysis to tie together the success of a transformation in strategy and the possible failure when taking a good thing one step too far; and also because, despite this, it still has significant upside in our view.

The Positive: Eastman’s focus on transforming its portfolio from one which was rapidly commoditizing into one that was more differentiated and required more manageable levels of capital spending drove the changes evident in Exhibit 2. This type analysis was covered in more detail in
research published last week
– where we used the analysis to attempt to identify companies that might be interesting activist targets.

Exhibit 2


Source: Capital IQ, SSR Analysis

Even conceding that 2008 was a false low – created by the sector’s massive underperformance in the wake of the GFC – the progress over the last 6 years has been impressive. In the work last week, we highlighted PPG as a transformative story and Eastman and PPG do have something in common, in that neither company really got the shareholder attention they deserved until the last real commodity divestment was completed.

However, if we added 2014 YTD to the chart above we would not see much further progress as Eastman has underperformed the market and is about to meaningfully increase it’s spending with the acquisition of Taminco, suggesting a major TSR hurdle in 2015 to stay positive. So why the more muted interest in the stock over the last couple of years?

The Negative: We have demonstrated in
prior research
that investors are increasingly leery of complicated stories. As shown in Exhibit 3, the relative multiple paid for the more complex Industrials and Materials stocks has fallen steadily since 2000, while the multiple for less complex companies has risen. We chose a simple metric for determining complexity in that we divided the number of reported segments by the percentage of revenues in the US. The more reporting sectors and the more offshore business – the more complex.

Exhibit 3

Source: Capital IQ, SSR Analysis

We conclude that complexity is all about the ability to model a company. The harder a company is to model, the fewer investors there are willing to make the effort to understand the company, with others choosing companies that are less complex.

With its acquisitions of Solutia and now Taminco, Eastman has added several new technologies and product sets to an already complex mix of specialty chemicals with diverse end markets. In its analyst day last week, Eastman talked about a large number of diverse end markets and different geographies, encompassing a broad set of chemistries. These include less well known chemistries, and in many cases Eastman is the only publicly traded company with significant positions in these chemistries. In short this is now a complex company to understand and to model and it is even harder to verify the assertions around growth made by the company given the lack of proxies.
An Own Goal?

Has Eastman scored an “own goal” here, by taking the acquisition strategy too far off-piste? Possibly, as we did not see the stock move meaningfully following what was a very well-crafted analyst day. The days of “I’ve got a great business here – trust me” died with Jack Welch, Enron and others. Eastman is doing everything right – improving returns, growing earnings consistently and adapting to changing markets – we have highlighted the stock as interesting on more than one occasion and it sits in our bucket of preferred chemical names. The company has underperformed since the end of 2011, despite improving returns – Exhibits 4 and 5. There are not many Chemical companies that can show the same level of business progress.

Exhibit 4


Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

CEO Mark Costa ended his presentation last week with a look at how Eastman compared with other S&P 500 constituents from an earnings growth perspective. He pointed out that the 50 S&P 500 companies which, like Eastman, had shown 8 years of earnings growth on average traded at a 7x earnings multiple premium to Eastman. This is a wide discrepancy and we would concur that a company with Eastman’s trajectory of earnings and returns on capital should not be trading at such a low earnings multiple.

However, looking through the list of the other companies in the group of 50 you find plenty that are much simpler to model – or at least much simpler in terms of defining a few key drivers and assumptions around success or failure.

In Technology: Apple, Comcast, Direct TV, Google, Oracle, Citrix, IBM, CA Technologies, American Tower, Intuit, Alliance Data, Cognizant, Harris: Energy/Utilities: Wisconsin Energy, Xcel, Nextera, AON: Healthcare: Medtronic, LabCorp, Amgen, CVS Health, Medtronic, Biogen Idec, Baxter, Express Scripts, Celgene, Stericycle, Stryker, Allergan, Cerner, Healthcare, Edwards Life science, AmerisourceBergen: Consumer/Retail: Johnson & Johnson, Petsmart, Fossil, Ross, Family Dollar, Walmart, MacDonald’s, AutoZone, Kellogg’s, DaVita, Yum Brands, Colgate Palmolive, Nike, McCormick: Financials/Services: Dunn and Bradstreet, MasterCard, Aflac, Fiserv, Torchmark: Industrials: Ball, Ecolab, CH Robinson, Sigma Aldrich

A first observation is that there are not many Industrial and Material companies on this list. Including Eastman, Industrials and Materials makes up only 10% of the group, with the biggest weightings in Tech, Consumer/Retail and Healthcare.

We calculated a “complexity index” for each of the companies in this list using our simple methodology – number of reporting segments divided by the percentage of revenues derived from the US. The findings are summarized in Exhibit 6. In this we are assuming that Taminco will add a reporting segment for Eastman, but even without that assumption, Eastman sits well to the left on the chart and a has an index value that would place it within the “most complex” grouping in Exhibit 3. The group average – ex Eastman – is only 4 which puts it firmly in the least complex grouping in Exhibit 3. This difference alone accounts for 45% of the multiple difference – all things being equal, if the group is at an 18x forward PE, the best EMN can hope for is just over a 14.75x multiple. A long way from where it is today (11x), but still a meaningful discount.

Exhibit 6

Source: Capital IQ, SSR Analysis

Options for Eastman: Consistent Performance and Consistent Disclosure

Eastman will need to lead investors through its story and make more disclosures than many other companies. It will need to give enough information to investors to allow them to create a believable model and then provide the data to allow for the model to be updated. There will always be a handful of analysts who take the time to understand every nuance of the portfolio and create a model that may be better even than the company’s, but if this group of believers only holds 40-50% of the stock, Eastman will continue to lag. The trick is to get enough believers to cover 120-150% of the stock – then the price goes up!

Certainly the stock will respond to better earnings and better returns, as we have seen broadly since 2008, but stock performance will lag results, rather than anticipate them, if the story is unclear.

In the late 1990’s Eastman came under a great deal of criticism for changing its reporting segments twice once over a three year period. The company was underperforming badly and investors took the view that the reporting structure changes were no more than ‘smoke and mirrors’, aimed at hiding just how badly some businesses were doing. As Eastman adds Taminco, some significant thought needs to be given to how the company will report its business going forward, and how much supporting data it will provide to investors.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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