EMN - Eastman Chemical: Not Out Of The Woods

2023-07-05 11:26:55 ET

Summary

• Eastman Chemical's revenues are still under pressure due to weak demand and customer de-stocking.
• Despite a decline in sales, the company has seen growth in the automotive sector.
• Investors should demand a minimum of 4% dividend yield before investing.

Eastman Chemical's ( EMN ) stock has stayed flat since I rated it hold in December 2022. An investor who purchased at the then-recommended price of at or below $79 would have earned a good dividend and be sitting on small gains. The company and materials sector may not yet be out of the woods. Demand may not return until 2024, assuming the U.S. and the world economy avoid a recession due to high-interest rates. I retain a hold rating on the stock with a suggestion to buy it at $79 when the stock would yield 4%. The stock offered multiple buying opportunities below $80 during the past six months and may present more opportunities in the near future.

Revenues are still under pressure, although customer de-stocking may be nearing its end

In Q1 2023 , the company saw its sales fall by 11%, mainly due to lower sales volumes and unfavorable product mix. The company mentioned that volume was weak across most product lines due to weak demand and customer de-stocking across consumer durables, building and construction, personal care, and water treatment. One bright spot was the automotive sector, where the company experienced volume growth.

Surprisingly, the auto sector continues to do well in the face of relentless high prices of new cars. The company has reported over 11% y/y revenue declines in back-to-back quarters (Exhibit 1) . Gross and operating margins have recovered sequentially in the March quarter, but the operating margins of 12.1% remain below its quarterly average of 13.6%. The company used cash in its operations in the March quarter, which may be partially due to seasonality in its business.

Exhibit 1:

This is the least affordable car market in recent times, and yet, in May, the U.S. recorded vehicle sales at a 15.6 million seasonally adjusted annual rate. At the same time, the number of car buyers paying $1000 or more per month is at an all-time high . The high prices of new vehicles and borrowers stretching themselves to these cars can only spell trouble. The high borrowing costs have added to these troubles. The reckoning for the auto market, which I have been predicting for a while, is yet to come.

Typically, bubbles last longer than any investor's patience, and when they do burst, they do so suddenly and cause a lot of damage at once. Take the great 2007-09 recession caused by the housing bubble. The bubble persisted for many years until it burst and caused a lot of damage when it did. The auto market is not as large as the housing market, and the pain should be limited to the automakers, their suppliers, a few banks, and borrowers.

The company also pointed to de-stocking efforts by its customers as another cause for its loss of revenue. The question remains whether demand will return after the de-stocking efforts of its customers. WSJ recently reported that high-income earners are disproportionately affected by layoffs over the past year and may be taking jobs that pay lower than their previous jobs. Walmart reported that they are seeing more high-income earners shop at their stores.

About 40% of the top earners account for 60% of the spending, so any reduction in spending by this segment can disproportionately impact the economy. In short, the U.S. economy and the materials sector, which is very much dependent on economic growth, can take a leg down in the coming quarters. Although the recent GDP revisions were positive , the pressure is continuing to build on the consumer. BofA recently downgraded several chemicals producers, citing that recovery has been elusive.

Wait for the stock to yield a minimum of 4%

Investors have an opportunity to gain a 4% yield in Eastman Chemical, but they need to acquire the stock when it dips below $80 patiently. At $79, the stock would yield 4%. Investors should expect lower growth rates from the U.S. economy as the aging population curbs consumption. Lower growth rates could also curb stock price appreciation, so a higher yield becomes essential to generate income and build wealth. The stock is trading at $85, but there have been multiple instances over the past year when it has tumbled below $80 - the stock's 52-week low is $69.91. The RSI and MFI technical indicators suggest that the stock may be approaching overbought levels and may be due for a pullback (Exhibit 2) .

Exhibit 2:

The payout ratio is a manageable 40%, and the company has grown its dividend at a CAGR of 7.4% over the past five years. The company also repurchases its stock when it has the cash flows to do so. It has repurchased $2 billion of its shares since September 2020 (Exhibit 3) . Since the company did not generate any cash in the March quarter, it did not make any new repurchases. The stock count has been reduced from 136.3 million in September 2020 to 119.7 million in 2022, a 12% reduction in share count.

Exhibit 3:

Since the company's EBITDA has dropped over the past year, the total debt-to-EBITDA ratio is 3.3x, and the net debt-to-EBITDA ratio (after cash) is 3x. Given the industry's cyclical nature, the company's debt load is a bit on the high side. A debt-to-EBITDA ratio closer to 2x would put the company in a solid fiscal position.

Eastman Chemical holds promise for reducing energy use, promoting recycling, and reducing greenhouse gas emissions.

I am on the lookout for companies offering products and technologies that add value to the consumer by lowering costs or increasing the user experience. More importantly, the products need to stand on their own merits in the economy without support from government subsidies. Today, too many companies rely on the Federal Government for tax credits and subsidies, from Intel (INTC), Micron (MU), and Tesla (TSLA) to Darling Ingredients (DAR), a producer of renewable diesel. Governments provide subsidies to spur innovation, increase scale, and reduce the costs of the subsidized end products.

Companies dependent on subsidies should look for ways to reduce the cost of their end products. Governments can and will reduce or eliminate subsidies at some point. By this time, if the company has not created a cost-competitive product that can compete against non-subsidized products, demand will drop and resulting in steep losses and even bankruptcy.

Recycling will continue growing to reduce waste from piling up in landfills and plastics from polluting our land and ocean. Eastman Chemical's focus on creating recycling technologies and reducing energy use holds long-term promise. Investors should be on the lookout for more information on the economic, consumer, and environmental effects of the various technologies rolled out by Eastman Chemical.

Market performance

The NASDAQ Composite Index has had its best first half of the year, rising 32%. The S&P 500 Index has done exceptionally well, rising 16%. Both these indexes have benefitted from the performance of the so-called Magnificent Seven , a group of seven high-tech stocks, many benefitting from the AI hype. The other sectors of the economy have notably lagged behind the NASDAQ and the S&P 500 Index.

Many worried that the market's rally lacked breadth. But things may have changed in June. For example, the Vanguard Materials Index Fund ETF ( VAW ) has gained 10.7% over the past month. This fund is composed of 114 stocks, and 103 or 90% of those stocks had a positive return over the past month. Just 11 stocks in the Vanguard Materials ETF ((VAW)) lost money. The Vanguard Industrials ETF ( VIS ) had a similar story, with 134 of the 150 stocks having a positive return over the past month. Eastman Chemical has gained 3.5% over the past month and is still down 6% over the past year. Much may depend on the strength of the U.S. and world economy for this rally to continue.

Valuation

The company is fully valued compared to the materials sector. It trades at a forward EV to EBITDA multiple of 8.3x compared to the sector median of 7.6x. But some other players are trading at a higher valuation than Eastman Chemical. For example, Dupont trades at 12x and RPM International at 14x EV to EBITDA multiple. A discounted cash flow model estimates the per-share equity value at $80 (Exhibit 4) .

Exhibit 4:

This model makes optimistic assumptions about the company's growth and discount rate. The model assumes a 5% growth rate and a 7% discount rate. This model uses its long-run average free cash flow margin of 8.84%. But this free cash flow margin comes with a high standard deviation, given the company's fate is tied to the economy. I am looking to add to my position in the stock at or below $79. The stock would yield 4% at that price, a good income generator.

Given the cyclical nature of their business, Eastman Chemical should be bought at an attractive valuation and dividend yield to provide investors with a margin of safety and good income. The company is not out of the woods yet, and demand recovery could take some time. Investors should wait for a minimum of 4% yield before buying the stock.

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