Description

Eastman Chemical (EMN) is a US-based global chemical company which manufactures a number of commodity and specialty chemicals, fibers, and plastics. Today, the company is organized into four segments: Coatings, Adhesives, Specialty Polymers & Inks (CASPI); Performance Chemicals and Intermediates; Fibers; and, Specialty Plastics. With the pending acquisition of Solutia (SOA), and in light of the recent stock price weakness as EMN gets sold along with most other chemical and cyclical companies, investors are being presented with an opportunity to acquire a very cheap asset in the midst of a transformative step which will see the company shift from a mostly commodity producer to one that is mostly a specialty manufacturer. This should, over time, lead to a higher earnings multiple than what EMN has historically achieved, but in the short term, even if the earnings multiple does not expand from the current 2012 number, there will be a material step-up in EPS in light of synergy capture and deal accretion. I estimate the company should earn greater than $5 in EPS in 2012 (pro forma) and over $6.50 in 2013. At a reasonable 10x, EMN should be worth $65, for ~40% upside.

The other leg to the thesis is the positive secular backdrop relating to raw material inputs on the commodity side of EMN’s business. In particular, EMN is a key beneficiary of the “shale revolution” which has unlocked extensive reserves of natural gas in North America. That has pushed down the price of natural gas, and will likely keep the price of natural gas in the US globally competitive for some years (< $4.50?). More importantly for EMN, certain components of the natural gas stream, namely natural gas liquids, and most importantly for them, propane, which had historically been linked to crude oil prices are now also moving into over-supply, furthering EMN’s cost advantage. Indeed, part of the recent stock move downwards likely stems from investors assuming that weakness in propane driven by weakness in propylene (a plastic pre-cursor) is a negative for EMN, when in fact, because much of the weakness appears to be coming from slack demand from polypropylene (a very common commodity plastic representing ~2/3 of all propylene demand), EMN may actually see higher profitability as it sells other, more valuable derivatives.

What Does Eastman Do?

CASPI: Polymers, resins, and solvents for paints and coatings used in architectural, transportation, industrial, and original equipment manufacturing ("OEM"); inks used in packaging; adhesives ingredients used in tapes, labels, personal care products and building and construction uses; and other formulated products

PCI: Intermediate chemicals for agriculture, transportation, beverages, nutrition, building and construction, pharmaceuticals, coatings, medical devices, toys, adhesives, household products, polymers, textiles, consumer and industrial products, and health and wellness uses

Fibers: Acetate fibers for filter products (esp cigarette filters – approximately 80% of segment revenue) and textiles     

Specialty Plastics: Copolyesters and cellulosics for appliances, store fixtures and displays, building and construction, electronic packaging, medical devices and packaging, graphic arts, general purpose packaging, personal care and cosmetics, food and beverage packaging, performance films, tape and labels, fibers/nonwovens, photographic and optical films, and liquid crystal displays

EMN presents itself as a global chemical company leveraging three different chemistry streams: acetyls, olefins, and polyester. Acetyl, in which the company begins with high-sulfur coal which is then gasified, is the source for products across all four segments. Olefins, in which the company begins with propane and ethane, cracked into propylene and ethylene, is the source for products across all the segments except Fibers. Finally, polyester, in which the company begins with purchased paraxylene, is the source for products in PCI and Specialty Plastics.

As noted above, the company has benefited greatly from cheap propane, and it is especially focused on the spread between propane and propylene (and in the recent downtrend in prices, propane declines have outpaced propylene declines, increasing the spread). Propylene, which is generated in greater proportion from propane and naphtha (a crude oil product) as compared to ethane (from which little is produced), appears to be in structural shortage because of the shift to ethane in producing ethylene, away from those heavier feedstocks (which produce both ethylene, the main manufacturing goal, and propylene as a co-product). Because it is more integrated into propylene production than competitors, and because EMN produces more durably-priced propylene derivatives (so-called oxo products, as opposed to commodity plastic, polypropylene), the company is able to earn more of the spread as downstream prices are supported by propylene prices while its costs are linked to propane. Thus, as propane prices weaken, as long as propylene prices do not weaken to a greater extent and as long as their products retain their historical price premium, EMN should earn more money. The company is currently pursuing options to further its integration in propylene (currently 2/3), with the likely choice being an agreement to take the output of a third-party built propane dehydration unit, driving an estimated $30mm+ EBIT improvement without any capital committed.

As of last week, propylene contracts were down 17% m/m, but propane prices were down more at -27%. While EMN would prefer to de-emphasize how important the propane-propylene spread is, they did disclose in Q3 2011 that it represented $70mm of direct EBIT benefit (on a base of $891mm), and for 2011, the figure was $140mm (on a base of $1,013mm). EMN also benefits from weaker ethane prices.

The Solutia Deal

In a surprise announcement this January, EMN announced that it was acquiring SOA in a cash and stock deal. SOA stockholders are to receive $22 in cash and 0.12 shares of EMN ($27.65 per SOA share, a 42% premium at announcement), for a total transaction value of $4.7bn. While not an obvious combination, the SOA deal moves EMN further along in its transformation from a predominantly commodity chemical company into one more balanced though slightly more skewed towards specialty chemicals. In recent periods, EMN sold or exited under-performing product lines in CASPI and divested its PET business, and so adding specialty capabilities is part of a longer-term strategy to “high-grade” its product portfolio. In addition, SOA bolsters EMN’s presence in emerging markets, especially Asia.

The company has pointed to complementary end markets in auto and architectural, but apart from the specialty films business, there is not a material overlap. What SOA does bring, though, is industry-leading EBITDA margins (23.5%-24.3% in 2009-11) at a reasonable valuation: at the deal price of $27.65, EMN is paying 12.5x 2012E EPS. The accretion guidance becomes even more obviously achievable when you consider the guidance for $100mm of synergies and the financing EMN was able to obtain: $1bn 2.4% notes due 2017, $900mm 3.6% notes due 2022, and $500mm 4.8% notes due 2042. All-in, the debt for the transaction has a pre-tax cost of 2.7% (EMN also has a $1.2bn term loan at LIBOR + 1.5%). Importantly, this does not count the tax benefit of the SOA NOLs (an NPV approaching $400mm) which will mostly be utilized over the next three years – this will be another driver in FCF generation which will mostly be directed to deleveraging over this period. The company has suggested that it will generate $1bn in FCF through the end of 2013, once the deal is closed.

Solutia in recent years has similarly divested less attractive business lines to focus on its core specialty businesses, namely Advanced Interlayers, Performance Films, and Technical Specialties. The company’s 2011 investor day presentation does a good job of summarizing the businesses (http://investors.solutia.com/Cache/1500038298.PDF?D=&O=PDF&IID=4281075&Y=&T=&FID=1500038298) so I will not go through it in great detail, but there are a couple of points worth noting. Firstly, 2011 EBITDA margins of 24.3% are amongst the highest in the chemical sector, slightly below a highly-specialized manufacturer like MON, comparable to companies such as ALB, FMC and ROC, and above other specialty players such as GRA, HXL, and IFF. (As a side note, ALB trades at 12.1x 2012 EPS, FMC at 14.8x, and ROC at 10.1x; GRA/HXL/IFF average 14x 2012 EPS.) These strong margins are supported by a couple of market-leading products with sustainable earnings profiles, specifically Saflex in the Advanced Interlayers segment (used in a number of applications including car windshields, in which it helps making the glass lighter with better UV protection and acoustic properties), and Crystex in the Technical Specialties segment (an insoluble sulfur product which is the leading vulcanizing agent for tires, a key component improving durability, flexibility and appearance).

Financials

Risks

Global industrial production

A change in natural gas extraction regulations, hindering the shale revolution

A severe decline in crude oil (making propylene from other sources more readily available / cheaper)

Catalyst