EMN - Eastman Chemical: Automotive Concerns Create Value; Recycling PET Creates Growth

2023-09-19 11:02:32 ET

Summary

• Eastman Chemical is a specialty chemical manufacturer with a significant portion of its revenue generated outside the US.
• The company operates in four segments and has a sizeable automotive business.
• Eastman Chemical is investing in molecular recycling of plastics, which presents a new business opportunity for the company.

Eastman Chemical ( EMN ) is an important contributor to the global recycling effort, battling the overabundance of plastics in the environment. EMN is a specialty chemical manufacturer with 58% of 2022's $10.5 billion revenue generated outside the US. EMN operates in four segments: Additives and Functional Products (AFP, 30% of total 2022 sales), Advanced Materials (AM, 30%), Chemical Intermediates (CI, 29%), and Fibers (F, 11%). Two important considerations for investors are EMN's sizeable automotive business and the company's push into molecular recycling of plastics - the first is creating some momentary stock weakness and the other providing an interesting new business opportunity.

As described in Eastman's 2nd qtr. Investor Presentation , important end markets include transportation at 15% of 2022 revenue, building and construction at 12%, and consumables and electronics at 12% of revenue. Eastman is the world's largest manufacturer of window tint and safety glass materials used in both the automotive and construction industries. The newest glass-interlayer technology for heads-up display on windshields is an expanding component of EMN's automotive product line. EMN also produces an automotive paint protection film to increase the longevity of OEM auto-body finishes. EMN is a manufacturer of industrial chemical additives, such as polymers and solvents, along with producing intermediate chemicals, such as olefins and acetates, used to produce other specialty plastics. Lastly, EMN produces acetate tow, the primary fiber material used to manufacture cigarette filters. An excellent breakdown of EMN products and markets is in their Company Databook offered on their website .

At the end of July, Eastman announced quarterly earnings. While quarterly earnings of $1.99 per share were in line with EMN's previously announced reduced guidance and above lowered consensus of $1.93, 2nd qtr. and 6-month results were below those of 2022. The theme of the earnings contraction was "customer de-stocking" from bloated inventories caused by supply uncertainties of the past few years, with slacking customer demand reducing EMN volumes and profits. Management sees this trend as persistent but diminishing during the second half of 2023 and into 2024.

Eastman Chemical forecasts 2023 EPS in the $6.50-$7.00 range, a slight increase over 2022 reported earnings of $6.35. Based on improving volumes and the start-up of EMN's molecular plastics recycling facilities in the US and France, profits are expected to increase to the $8.25 to $8.96 range in 2024, $9.00 to $9.31 in 2025, and to expand at an 8% rate going forward. Management has forecast operating profit margins over the next five years will average ~20% for its most important operating groups - AM and AFP segments - and is in line with current operating margins. Operating cash flow is projected to exceed $1.4 billion annually.

Eastman is investing over $1.8 billion in new technology to recycle PET plastic at the molecular level. One of the most expensive plastics to recycle is polyethylene terephthalate, PET. PET is also one of the most common thermoplastics and is used for water, soda, and beer bottles, fibers for fabrics, carpeting, and clothing, and, in combination with glass fibers, used in engineered resins. With the explosion of "disposable and recyclable" water and beverage bottles over the past decade, the use of PET has skyrocketed. Due to its physical properties, such as absorbing bacteria, PET recycling has not been popular and has not kept up with the astronomical growth of its use in consumer packaging. The difficulty of recycling PET is succinctly described by the Atlantic Magazine in an article from May 2022, concerning the various formulations of PET:

They all include different chemical additives and colorants that cannot be recycled together, making it impossible to sort the trillions of pieces of plastics into separate types for processing. For example, polyethylene terephthalate (PET#1) bottles cannot be recycled with PET#1 clamshells, which are a different PET#1 material, and green PET#1 bottles cannot be recycled with clear PET#1 bottles, which is why South Korea has outlawed colored PET#1 bottles. Yet another problem is that plastic recycling is simply not economical. Recycled plastic costs more than new plastic because collecting, sorting, transporting, and reprocessing plastic waste is exorbitantly expensive. The petrochemical industry is rapidly expanding, which will further lower the cost of new, virgin plastic. PET is formed from two notable intermediates derived from crude oil or natural gas, terephthalic acid (TPA) and ethylene glycol ((EG)). Virgin PET is manufactured and marketed by various companies.

As part of the societal demand to recycle plastics, governments are responding by pressuring companies to step up their use of recycled materials in their plastic products. For example, California is requiring consumer plastics to comprise 25% recycled materials by 2025 and 50% by 2030. The inability to mechanically recycle PET in meaningful amounts, in addition to the explosive prevalence of PET consumer bottles, lends itself to molecular recycling of PET. Eastman Chemical is a leader in developing the technology to recycle PET at the molecular level. EMN is in the process of completing the construction of two of the world's largest PET molecular recycling facilities in Normandy, France, and Kingsport, TN. Management has indicated a third plant, most likely in the US, is on the drawing boards.

To push individual company ESG agendas, organizations are beginning to appreciate the desirability of molecular recycling of PET in consumer packaging, even at higher costs. Government regulations are beginning to require a minimum of 25% of consumer packaging to utilize recycled materials, with many targets upping the levels to 50% within 7 years. While a bit slower than anticipated, US and European consumer products companies are starting to make commitments to use consumer plastic packaging made from EMN's recycled PET raw materials. Many of these firms, including Pepsi ( PEP ), have signed a Memorandum of Understanding, or letters of interest, to use EMN recycled PET as a raw material. Several French luxury consumer products companies, including LVMH Beauty (LVMHF), Estée Lauder ( EL ), Clarins, Procter & Gamble ( PG ), L'Oréal, and Danone (DANOY), have signed MoU with EMN to utilize recycled molecular materials in their packaging.

Acknowledging the transition from MoU to actual bankable production orders is a large and important process, management is very confident current corporate interest will transform into orders. In a recent interview with industry trade publication Plastics Recycling in August, EMN CEO Mark Costa offered this insight:

'Eastman is targeting applications where mechanical recycling doesn't really work, including 100% recycled-content products. So, while regulatory requirements may be only 25% in 2025, a lot of brands have set targets for some key applications to be 100% recycled content. And to maintain quality, they're not going to be able to do that with mechanical recycling.' Costa said the company remains confident the contracts will be signed, noting, 'the engagement is high, and the regulatory requirements, especially in Europe, are going to require people to have recycled content. Mechanical PET reclaimers simply can't double their capacity between now and 2025 to meet the government minimum-recycled-content mandates for 25% recycled-PET content in bottles.'

'So, we feel like we're in a good position, and working really productively with our customers and we're aiming to have those contracts done by the end of the year.'

Eastman Chemical's share price has been weak recently, mainly on flattish 2023 earnings and the uncertainty of the UAW walkout impacting its business. Share prices have declined from the mid-to-high-$80s to the high-$70s, and currently offer a 4.0% dividend yield. EMN has a 5-yr average dividend increase rate of 7.1% and has raised its distribution annually since 2010. With a projected 8% earnings growth rate, DGI investors should expect more of the same.

Last July, I recommended pairing investments in Dow Inc. ( DOW ) with Eastman, buying EMN on anticipated dips. The strategy is to pair a basic material company for its commodity exposure and income ( DOW ) with a specialty materials company ( EMN ) for above-industry growth. With the recent decline to just under $78, my good-until-canceled EMN buy order was triggered. I have owned DOW since its corporate restructuring and separation in 2019.

Investors looking for growth in the basic materials business should review Eastman Chemical. With price targets around $90 to $100, total returns should easily surpass 12% annually over the next several years, especially as EMN builds multiple molecular PET recycling facilities.

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