Eastman's Growing Specialty Chemical Portfolio Should Generate Long-Term Profit Growth

Seth Goldstein
Equity Analyst

Eastman's third-quarter results were negatively affected by continued weak demand in its automotive and electronics end markets. Consolidated operating earnings were down over 18% year on year, leading management to lower 2019 EPS guidance to a midpoint of $7.10 from $7.75. After updating our model to incorporate the lower near-term results, we have slightly reduced our Eastman fair value estimate to $91 per share from $93. However, our long-term outlook remains intact that Eastman's portfolio of specialty chemicals will translate to pricing power and lead to profit growth. As such, we are maintaining our narrow moat rating.

The advanced materials, or AM, segment was the lone bright spot. Segment operating earnings grew 8% year on year due to growth in the segment's premium products, including Saflex window interlayers, despite a decline in auto builds from Eastman's auto customers. We think Eastman is well positioned for growth of its Saflex products as adoption of electric vehicles increases, because window interlayers will be needed to make auto cabins more energy-efficient, which increases an EV's range.

At current prices, we view Eastman shares as undervalued, on a risk-adjusted basis, with shares trading in 4-star territory. Many of Eastman's customers are Chinese consumer goods manufacturers that have been negatively affected by the U.S.-China trade dispute. As a result, we think it is unlikely that Eastman will see a full rebound in customer demand until a trade agreement is finalized. That said, in our view, Eastman's results are approaching a cyclical bottom. We think the company could return to earnings growth in 2020 even without a trade agreement in place, as we think the AM segment will continue to generate profit growth, while we forecast the remaining three segments to show stable results versus 2019. As such, we point to a return to companywide profit growth in 2020 as a near-term catalyst that could boost Eastman's share price.

Business Strategy and Outlook 25/10/2019

Through acquisition and internal development, Eastman owns a solid portfolio of specialty chemicals. Looking to beef up its specialty chemical and materials offerings, Eastman acquired Solutia in 2012. Solutia's portfolio is weighted toward the automotive and construction markets, with components used in safety glass, window tinting, and tires, among other products. In 2014, Eastman completed the $2.8 billion acquisition of Taminco, which manufactures alkylamines and offers a solid growth profile. To invest in future patent-protected specialty products, the firm plows back roughly 4%-5% of sales from its additives and functional products and advanced materials segments into research and development. As a result, Eastman is well positioned to meet growing demand for auto window interlayers, including heads-up displays, and low-rolling-resistance tires, which will benefit from stricter tire regulations.

Eastman also holds a solid position in acetate tow, which is primarily used to make cigarette filters. The acetate tow industry has experienced falling prices due to overcapacity in China over the past several years. However, a handful of players dominates the industry, a factor that led to disciplined capacity shutdowns by all of the major companies during the industry downturn. While the number of U.S. smokers has continued to decline, global acetate tow sales should decline at a slower pace. About three fourths of the company's acetate tow revenue comes from outside North America. Eastman achieves high margins in acetate tow production by using coal as a feedstock, which provides a favorable cost profile versus marginal producers who use crude oil.

Eastman uses multiple feedstocks, including nautral gas, coal, and wood pulp, to make other chemicals and plastics. Eastman's coatings, adhesives, specialty polymers, and inks businesses generate solid operating margins. Along with the fiber segment, these businesses provide a relatively stable earnings base to offset swings in other areas. As with other chemical companies, Eastman's business model is subject to a high degree of operating leverage.


We award Eastman a narrow moat rating based on the intangible assets stemming from its patent-protected specialty chemicals portfolio. Eastman's patent-protected specialty chemicals compose roughly 50% of its specialty portfolio and have an average patented commercial life of 10 years. While Eastman sells a diverse portfolio of chemicals that have a wide range of end uses, we see a couple of trends that should benefit its competitive advantage over the next several years. Eastman's best-in-class portfolio of tire additives should benefit from more stringent tire regulations that take effect in 2021. These regulations require tire manufacturers to reduce rolling resistance in order to increase fuel efficiency. They also require a minimum amount of wet grip and maximum level of external rolling noise. Eastman's continual innovation of its Crystex and Impera brands allow the company to charge a premium as its newest patented products allow tire manufacturers to meet the pending regulations in all three areas. Additionally, the company's automotive glass interlayers, which are among the best in the industry, should benefit from greater demand as increased electric vehicle sales will require energy-efficient windows to extend battery range. The interlayer products should also benefit from the heads-up display feature being installed in a greater proportion of vehicles.

Although some of Eastman's products are low-cost, we don't think the cost advantage moat source is strong enough on its own to support a moat for the company. Eastman's ethylene and propylene production uses low-cost U.S. natural gas, which gives the firm’s olefin stream a low-cost base. While Eastman's coal-based production of methanol, acetic acid, and other chemicals gives the company a low-cost base for some of its products, the coal-based feedstock makes other products more expensive. On a consolidated basis, we think Eastman's cost position is on the lower half of the cost curve, but not low enough for us to award the firm a cost advantage. We award Eastman a narrow economic moat rating as its patented-protected specialty chemicals combined with its solid cost position give us confidence that the firm will outearn its cost of capital over the next 10 years.

Fair Value and Profit Drivers 25/10/2019

Our fair value estimate is $91 per share. We use an 8.1% cost of capital and a terminal 9.0 times enterprise value/EBITDA multiple to value future cash flows after our five-year explicit forecast. Eastman will continue to develop new products that will allow it to increase profits above GDP. We forecast that operating margins will average roughly 19%-20% in these segments over our five-year explicit forecast. In order to develop new products, we expect Eastman to reinvest roughly 5% of these segments' sales in research and development, which is slightly higher than the mid-4% range of the past five years. We expect operating margins in Eastman's chemical intermediates business to slightly decline over the next five years from around 10% in 2018 to between 8% and 9% as the spread between oil and natural gas declines. Eastman’s intermediate products are made from both coal and natural gas, while many of its competitors use higher-cost oil-based naphtha, which sets global marginal cost.

Risk and Uncertainty 25/10/2019

As with most chemical manufacturers, Eastman's profits are tied to the health of end-market customers, and, while the company has a fairly diverse customer base, it has significant exposure to the volatile automotive and construction industries. The cost of raw materials also affects the company's fortunes. If Eastman is not able to pass on higher costs to customers, its profitability will suffer. To boost margins, Eastman has focused on the development of patent-protected formulations that have an average commercial life of around 10 years. The company often works with the end users of its products, such as automotive original-equipment manufacturers. However, if Eastman is unable to develop new products to replace formulas that roll off patent, or if its new products fail to generate the same incremental demand growth from its end users, its ability to command a premium price for its specialty products would deteriorate. In addition, Eastman's high operating leverage means production disruptions, whether caused by internal or external factors, can severely affect cash flows.

Eastman is also subject to environmental, health, and safety regulations. Because the company produces chemicals from high-sulfur coal, it is exposed to potential emissions regulations that could disproportionately affect Eastman over other chemicals producers that use only natural gas. Along those lines, as a maker of cigarette filters, the company could face a decline in acetate tow profits if governments increase tobacco taxes or global cigarette consumption declines more rapidly. The acquisition of Solutia brought potential litigation and environmental remediation liabilities from the legacy Monsanto chemical business.

Stewardship 26/04/2019

We assign Eastman a Standard stewardship rating. Mark Costa became CEO in early 2014. He joined Eastman in 2006 as a senior vice president of marketing, strategy, and business development. He has held various positions of increasing responsibility at the company and served as Eastman's president before being appointed to the CEO position. Costa is also the chairman of Eastman.

In our opinion, management's acquisition of Solutia was value-accretive. The purchase added a high-margin specialty business at a reasonable price (after adding cost synergies and tax benefits). Further, the Taminco acquisition moves the company's chemical mix more toward the specialty end of the industry spectrum. We think management is smart to focus on the development of patented specialty products as they give the company some pricing power until the patent expires. However, management's record of capital allocation is not spotless, as exemplified by the discontinuation of the company's Beaumont industrial gasification project in 2009. Overall, we think management has a solid but not spectacular record when it comes to capital allocation. The company has consistently returned a portion of capital to shareholders in the form of dividends and share repurchases.

Management's long-term compensation is based on return on capital and total return to stockholders. We are in favor of the return on capital metric as we think this encourages management to invest in more valued-added areas of the business, such as continuing to develop new patented specialty chemicals that command pricing power.

Established in 1920 to produce chemicals for Eastman Kodak, Eastman Chemical has grown into a global producer of chemicals, plastics, and fibers with manufacturing sites in seven countries. The company generates the majority of its sales outside of the United States, with a strong presence in Asian markets. During the past several years, Eastman has sold noncore businesses, choosing to focus on higher-margin specialty product offerings.