Understanding Transformational Change – The Eastman Example

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 5th, 2013

Understanding Transformational Change – The Eastman Example

  • We use an analysis of Eastman Chemical to frame the possibilities for Dow and DuPont, both of whom are discussing meaningful portfolio changes to focus on areas where they have a distinct competitive edge. The analysis leaves us far more positively disposed to EMN itself, despite its very strong run.
  • EMN has succeeded where DOW and DD are now focused, in creating a portfolio of differentiated products, mostly sold based on value in use. This has resulted in higher returns on capital and much lower earnings volatility. The first move was divesting pieces that did not fit and at the same time provided internal and external distraction.
  • DuPont has an opportunity to create a portfolio with much greater earnings stability, the question is how quickly can it grow? Here the company is betting on an R&D engine that looks very promising, but in some areas still has a lot to prove.
  • Dow’s portfolio will likely remain cyclical, but by focusing in products with significant technology driven added value, and lowest costs feedstock the company should see higher cyclical lows. The trade off may be lower cyclical highs, but if this comes to the benefit of much better returns on overall investment investors will approve.
  • EMN should no longer be thought of as a diversified company as it has fundamentals and a product suite that belong in the Specialty sub-group. The stock has more upside from an improving relative multiple – we see fair value above $100 per share.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In the last two week we have had a couple of high profile companies in our coverage universe talking about reshaping their portfolios – DuPont and Dow Chemical. Rather than simply refining strategy, reorganizing operating segments and changing graphics in their presentation decks (a more traditional approach to “change” in the Chemical sector), both companies are talking about divesting businesses that do not fit with what have been, for some time, fairly consistent strategic visions. This suggests that both believe in what they are doing and believe strongly enough to see those unaligned businesses as either distractions or anchors.

The most important question is “can this work?” and the second is “how much is it worth?” Eastman is a smaller company but perhaps the best example of what can be done and what it is worth or could be worth. Eastman was a company heading towards a pit of despair in the late 1990s, having made a very big bet on PET and being squeezed on the price side by oversupply and irrational competitors and on the cost side because of limited integration. The company saw its return on capital fall from a peak of 16% in 2004 to -1.6% in 2000 as the margins structure around PET collapsed (Exhibit 2) and the company took charges and write downs at it divested the poor businesses. The company shed these businesses and focused on building up its specialty portfolio through more focused management and through smaller and larger acquisitions – the most significant being Solutia last year. Return on capital is now less volatile and oscillating around 10% with the likelihood of further increases. The stock is up 700% from its low in 2009 and 400% from its 2001 low, and we can make an argument that it is still undervalued today.

Exhibit 2

Source: Capital IQ and SSR Analysis

Can DuPont and Dow do the same thing? The portfolio reshaping issue is a little clearer to see for DuPont than for Dow – Dow may have to divest more than it is suggesting in order to get the focus it needs. DuPont is betting on a science and technology angle that is partly unproven. Dow is betting on a cost and integration strategy that will still leave the company exposed to commodity cycles and requires significant capital spending. So, not quite the same; both have risks (different risks) and arguably DuPont has more stable upside (Dow could have a greater peak valuation if the stars align).

Eastman has been a great example of transformation of a portfolio, business practice and results. There are other examples (Praxair comes to mind), but these two and others have generally resulted from what we would term “regime changes”. DuPont and Dow have been more evolutionary than revolutionary over the last ten years.

Interestingly, the more work we have done on Eastman, as a window into the possibility for others, the more undervalued we see the company and could easily argue for a value over $100 per share given the overall market strength. In recent work we suggested an upside value for DuPont around $90 per share looking at the multiple strength at both EMN and PPG. The Dow story is less clear and would depend on how much the restructuring could improve returns. While all three stories could be very interesting, we would rank them in the following order; DD, EMN, DOW.

Eastman – A Lesson In Focus and Business Management

When we started covering the chemical sector in the 1990s Eastman, quite frankly, was a bit of a joke. It had spun out of Eastman Kodak with a very strong acetate tow business, some legacy Kodak driven film and specialty businesses and a growing presence in PET, then as an adjunct to the polyester film business that was key to the Kodak film business, but was declining. Eastman had no real competitive advantage in PET, but pursued the business aggressively, while others with greater scale and feedstock integration and a lower regard for near-term returns on capital built also. The return on capital and earnings debacle that followed at Eastman was even worse than the chart in Exhibit 2 suggests, as through it all the company had a very profitable acetate tow business based on unique technology and advantaged raw materials at Kingsport TN as well as a reasonable specialty business.

Realization of the problem came towards the end of first CEO’s tenure, but it took the leadership change of Brian Ferguson, followed by current CEO Jim Rodgers to really get things moving. They recognized quite quickly that Eastman actually did have some very differentiated businesses with strong potential underlying growth, around which they could build a good company. The commodity pieces were divested – not easy given their limited profitability – and EMN has been a much better business ever since. The company has bought and sold a number of businesses over the last 12 years (Exhibit 3), with the 2012 acquisition of Solutia the most significant strategic move to date. The company has achieved the following:

  • Much greater stability (less volatility of earnings and returns)
  • Faster growth
  • Higher return on capital, despite a significant increase in the capital base
  • Significant outperformance from a TSR perspective (Exhibit 4)

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

The stock has done well, but if we take a fresh view of our valuation framework and give the company so benefit of the doubt for its behavior over the last 10 years, we can argue that it could do much better.

Return on Capital – What is the Real Trend

The 2012 Solutia acquisition more than doubled EMN’s reported capital employed. In the previous 18 years, the capital base increased at a compound annual growth rate of 1.5%. If we look to the more immediate past, the 3 year CAGR was 4.5%. A third, intermediate, calculation of 10 years shows a yearly capital decline of 0.1%.

In our framework, from 2006 to the end of 2012, EMN’s return on capital grew at a CAGR of 1.1%. We assume that the company can achieve this same growth with Solutia integrated (it could well do better). With the higher capital base, assumed to grow at the 3 year average, estimated end 2013 ROC implies forward 2014 net earnings of $1148M; estimated end 2014 ROC implies forward 2015 net earnings of $1219M. Current consensus estimates show EMN earning $1126 net in 2014 and $1233 net in 2015 – in other words we can get quite comfortable with the consensus view if we assume that the advances and focus shown over the period since the financial crisis can be continued. Taking this view we generate a current “normal earnings” for EMN of $6.10 per share, while our historic model would have generated $4.40 per share.

We represent the analysis graphically below, including the two alternate scenarios of capital growth.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Dow & DuPont

The opportunity for DuPont is to continue on its current underlying return on capital path without the distraction of the volatility caused by the chemicals business. We do not need to assume that current returns on capital have to become the new normal – which is good, because we think that current returns will take a reasonable hair cut as the chemicals business is divested. To get to our target, we do have to assume that returns continue to grow and quickly exceed double digits.

For Dow if we were to assume that the company could get back to its historic average return on capital we could generate a fair value in excess of $60 per share.

For both, we are assuming tax advantaged divestments.

What Is The Right Peer Group – And The Right Multiple

Let’s start with the thesis that EMN should be valued as a Specialty Chemical company and then try and tear that idea apart. The reason to do this is because our Specialty universe trades at a multiple parity with the market, while the diversified and commodity groups trade at a discount and an historic average for EMN is only 0.79 (Exhibit 8).

Exhibit 8

Source: Capital IQ and SSR Analysis

If we put a market multiple (of normal earnings), which today is around 17.5, on our revised view of EMN normal earnings, we get a current normal value of $106 per share, some 30% higher than current value. Now this is very much an upside argument, but running through how to think about the multiple we get the following results – all of which support significant multiple appreciation for the company from the current level. We are assuming no relative multiple improvements for DOW, and we are assuming the multiple improvements outlined in recent research for DD.

Five Year Growth Analysis

Eastman lags the specialty group on a revenue growth basis but is well above the diversified group, Exhibit 9.

Eastman does far better than the specialty group and the diversified group on an EPS growth basis, Exhibit 10.

On a 5 year return on capital growth, EMN lags the diversified group, but is well above the specialty group (albeit a specialty group penalized by ECLs acquisition spree) – Exhibit 11

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

If we look at the companies, EMN is certainly holding its own within the specialty pool – Exhibits 12, 13, and 14.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

©2013, 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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