Description

The overall chemical sector has experienced significant earnings revisions, potentially signaling that we are closer to a bottom for valuations, particularly if there is an improvement in negative sentiment surrounding the macro environment and manufacturing. I believe that Eastman is positioned to perform well over the long term as the molecular recycling assets begin to come online and show a new productive source of revenue. The improved balance sheet and continued evolution toward a specialty chemical company leads me to beleive that it is appropriate to begin building a position in this company despite the potential for an negative macro environment on the horizon. 

Background

• Eastman was founded in 1920 for the purpose of producing chemicals for Eastman Kodak’s photo business. They became a public company in 1993. Today they have 41 manufacturing facilities in 12 countries. They are headquartered in Kingsport, TN.
• Mark Costa is the chairman and CEO of Eastman. He worked in strategy consulting prior to joining Eastman in 2006 and was the chief marketing officer prior to stepping into this current role in 2014. William McLain is the CFO. McLain, a Kingsport native, worked at PWC before joining Eastman in 2000 where he worked his way up to CFO in 2020.
• Executive incentive compensation plan is ~81% of total potential salary. Annual awards are based on 75% of adjusted EBIT and 25% on operating cash flow. Long term stock based compensation is based on a 3 year ROIC target, and stock and dividend performance relative to peers.
• Management ownership is 0.52% with the CEO accounting for more than half of that amount.  

How do they make money?

Eastman is a vertically integrated chemical producer focused on specialty applications. Eastman uses their chemical intermediates segment to produce basic materials for use in their specialty segments and sell excess supply into the broader market. They also produce some basic fiber materials for use in cigarette filters, as well as consumer and industrial fabric. Eastman sells to customers through either a master sales agreement or standalone purchase orders.

The specialty products produced find their way into end products used for consumer and industrial applications such as automobiles and “plastic” consumer goods. They work closely with end customers and other downstream users to create reoccurring purchases and improve the development of their products. They look to target attractive niche markets and take advantage of disruptive macro trends such as sustainability trends.

Beginning in 2004, the company began to focus more on specialty chemicals which to led restructuring, including the divestment and discontinuation of under-performing assets in that year (resins, inks, and monomers), then divestment of the polyethylene business in 2006, divestment of PET assets from 2007-2010, acquisition of Solutia in 2012, and acquisition of Taminco in 2014. Most recently, Eastman divested 2 businesses in the Additives and Functional products segment for a total of ~$1.8 B. The divestments closed in 11/2021 and 4/2022. The proceeds from the sale of these two businesses have primarily funded share repurchases which decreased share count by 16 million or 11.5%. No major acquisitions have occurred in the past 6 years.

With a much higher number of recent divestments than acquisitions, Eastman has focused on organic growth through R&D and expansion of facilities. They have maintained a R&D to sales above 2% for a number of years and believe that their scale is an advantage for their R&D relative to competitors. The 2% R&D is impacted by the Intermediates segment, whereas R&D is closer to 4% of sales for their specialty segments. Their most recently developed growth engine is their PRT molecular recycling business, which will create a circular market for their products and others.

More than half of Eastman’s sales are to customers outside of North America. Many of these sales are derived from manufacturing capacity outside of the U.S. as they try to reduce geographical distance between the manufacturing plant and the customer’s location. The most significant foreign currency exposure is the Euro.  

Eastman has two joint ventures, both in China. One with a 45% ownership joint venture with China National Tobacco Corp. to manufacture acetate tow (cigarette filters) in China. The other is a 50% ownership interest for the manufacture of compounded cellulose diacetate (used in injection molds). The combination of these two business is on the balance sheet at a value less than $100 M or ~2% of equity.

Recent Performance and Cyclicality

In 2021, higher volume and prices along with favorable mix in Advanced Materials (AM) and Additives & Functional Products (AFP) more than offset increases in commodity (raw material and energy) prices for their products. In 2022, volume was generally flat prior to Q4 when destocking and reduced demand for durables led to a significant decline in volume during the quarter. However, higher prices led to increased total revenue during 2022, but operating income fell due to lower volume in Q4 and the impact of divestments, as lost income was not fully offset by share repurchases.

So far, Eastman has done a good job of passing along higher commodity input costs to their customers.

The Chemical Intermediaries (CI) segment is likely the most cyclical and commoditized of their segments. However, 50% of that segment is driven by 3 products that have fewer cyclical attributes. This segment sells functional amines into the agriculture sector, which is majority cost plus. They sell acetic anhydride into the pharmaceutical and food end markets, which tend to be more stable, and specialty plasticizers that have been stable historically. Despite these products, it is likely that the overall segment performance is worse in 2023 as  spreads for olefin products normalize.

With the changes that Eastman has undertaken during the last decade, it is tougher to contextualize how the business will hold up during a recession. However, it seems that they are more favorably positioned than in the past. Also, some end markets like autos have only recovered to 80% of 2019 levels, potentially lessening the impact of an economic downturn on a relative basis.

Customers

Eastman customers are primarily in the construction, consumer goods, automotive, and general chemical end markets.

Competition

Eastman faces competition from a broad number of companies directly and indirectly. 2/3rds of revenue comes from products where Eastman has leading share and 25% of revenue is more sensitive to cyclical pressure, with more commodity-like competition.

Protection from competition comes in the form of patent protection for 50% of their specialty chemical business. These patents have an average life of 10 years. Their engagement and integration with customers also provide another less tangible moat source.  

For chemical intermediates, sources suggest that they may be toward the lower end of the cost curve, which should provide some protection from new capacity coming online. Their feedstock for creating base chemicals are natural gas for olefins and coal for a range of other chemicals.

Growth and Business Changes

The highlight of Eastman’s growth potential is their molecular/ polyester recycling facilities. The first of these plants (Kingport) is set to open in 2023. The second facility will be opened in France and serve the European market. The third will be another facility in the US, which will service a signed agreement with Pepsi for baseload volumes. These facilities will be able to recycle materials that cannot be recycled by traditional mechanical recycling operations.

There should be a secular tailwind for these facilities as regulation and commitments by consumer packaged good makers should increase demand for recycled content. For example, legislation in Europe that is currently being implemented will require packages to include 30% recycled content. The mechanical recycling operations do not seem to have enough capacity to meet this new demand, particularly looking at food grade product.

Here is a link of some of the commitments made by large companies: https://consumerbrandsassociation.org/wp-content/uploads/2020/06/Top-25_Sustainability-Commitments.pdf

The 3 announced projects will require ~$2.3 B of CAPEX and are expected to produce greater than $450 M of EBITDA in 2027 when they should be at full production.

Eastman has ~15% revenue exposure to automobiles, which is primarily in the Advanced Materials segment. While this portion of the business is cyclical, there is an underlying secular growth trend in that Eastman generates 2.5-3x more from the manufacturing of electric vehicles versus traditional combustion engine vehicles. This is due to the increased amount of glass/specialty glass used for EVs. 

In the Fibers segment, acetate tow (cigarette filters) are generally in decline. However, their newer product, Naia (sustainable fiber) has begun to more than offset the decline, which is aided by a less than expected decline in tow revenue. More than 25 different clothing brands such as H&M and GAP have adopted the use of the Naia fiber into their clothing. This fiber is generally replacing that of traditional polyester (PET) which is an oil based product. Naia is made from wood pulp and recycled content.

On margins, Eastman has focused on integration across products which has led to higher margins. Said another way, their multi technology products have about two times the margin as single technology platforms. This benefit should continue as the new molecular recycling facility will help to provide feedstock for their Tritan copolyester facility to yield a polymer with recycled content.  

Financial Strength

Eastman completed their debt repayment program from 2019-2021, which has led to improved financial strength. This is evidenced by their credit rating upgrade from Baa3 to Baa2 with a stable outlook by Moody’s in April of 2022. Management now plans to focus their capital allocation towards shareholder returns and growth projects. Management believes that maintaining an investment grade credit rating is important to their long term strategy and financial flexibility. 

Excluding potential additional borrowings on their revolver,  commercial paper or receivables facility, Eastman’s variable rate debt exposure is a modest ~14% of total debt. However, they do have additional interest rate risk in the form of refinancing risk due to near term maturities.

Eastman has a pension plan that applies to employees hired prior to 2007. The funded status for the U.S. and non -US is greater than 97%. They settled ~5% of the pension with an insurer in 2020.

• Eastman has debt of $5.1 B and leases of $0.2 B.
• Additional obligations:
  • $3.1 B of purchase obligations over a period of ~30 years. Each year’s purchase obligation is ~$150 M
  • Estimated future environmental expenditure for undiscounted remediation costs ranging from $253-473 M, which is based on their best estimate at the current time.

Valuation

It seems reasonable to assume Eastman can earn $8 during 2023 as cost headwinds fade. With a 10 year average PE of ~11.5x that would result in a price of $92 or 11% upside from today. However, I think the value here is more long term as they begin production at their molecular recycling facilities. Using a ROE based DCF, I arrive at a valuation of $95. For this model, I use a constant 15% ROE, 41% payout ratio run rate and conservative 9.5% discount rate.

Using a free cash flow model, I arrive at an equity value of $96. In this model, I use an average sales growth of 6% for 5 years, a terminal growth rate of 3%, a year 5 FCF margin of 9%, and discount rate of 9.5%.

The average of these three models leads me to a fair value of $94.3, suggesting ~14% upside.

I believe it is appropriate to begin building a position in this company today, while taking advantage of potential declines in stock price brought on by macro weakness. The value in this company is more long term as Eastman buildings out the next phase of their continually improving company.

Catalyst

Bottoming sell side estimates. China reopening. Improved financial strength allowing for growth opportunities. The start-up of the molecular recycling projects will show progress toward a new productive revenue source.