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Gene Shtark

EMN AT A GLANCE

P/E ► 24.4 LOW EV/EBITDA ► 12.4 AVG ROA ► 3.7% AVG ROE ► 9.6% AVG Debt to Equity ► 2.38 AVG Current Ratio ► 1.91 AVG Interest Coverage Ratio ► 7.66 HIGH

 

 

 

 

 

 

Eastman Chemical (NYSE: EMN) converts basic chemicals into useful compounds and materials. With $6.8 billion in sales in 2007, the company is at least five times smaller than its two nearest rivals, Dow Chemical Company (DOW) and DuPont (DD).^[1]

Since FY03, Eastman’s net sales grew at a stable average of 6% per year to reach $6.8 billion in FY07. These revenues were spread fairly equally among the Company’s five operating divisions throughout this period. The Company’s earnings, on the other hand, fluctuated much during this same time period, ranging from a $270 million loss in FY03 to $300 million in net earnings in FY07. ^[2] Throughout FY03-FY08, the most important factors that influenced the Company’s earnings included the volatility of its input costs (including energy) and the depression of the chemical industry’s product prices due to excess market supply. Although the global economic slowdown in 2008 lowered demand for the Company’s products and increased the volatility of its input costs, management has maintained Eastman’s profitability by raising product prices. In Q3 of FY08, Eastman’s earnings increased by 500% from $20 million to $100 million while revenues increased by 8% to $1.8 billion compared to Q3 of FY07. ^[3]

As of Q3-FY08, several of Eastman’s competitors have laid off large numbers of staff, cut on capital expenditures, and closed down factories. Among Eastman’s largest competitors, Dow Chemical Company (DOW) has laid off 11% of its employees and cut production at 30% of its plants, BASF SE (BASFY) has idled 80 plants and cut production at 100 others, and DuPont (DD) has announced that it would lay off 5% of its workforce and significantly cut production at 110 of its plants. ^{[4] [5] [6]}

Eastman, on the other hand, has announced that it would cut fewer than 100 positions while limiting wage increases for its entire workforce. It has been able to sustain its operations through the 2008 recession because of its strong liquidity and solvency (2.0 quick ratio, 65% debt to asset ratio). ^{[7] [8]}

Overview

Eastman sells its products to the food, pharmaceutical, and construction industries.^[9] From FY03 to FY07, the Company has shifted its product mix by cutting production in low margin segments and expanding in high margin ones. Most notably, it has cut approximately 50% of its Performance Polymers production capacity from FY06 to FY07 while increasing capacity in its Fibers segment by 5% per year. ^{[10] [11]} The company’s biggest challenge from FY03 to FY07 has been to bolster its profit margins, which have been volatile due to rising input costs and falling product prices.

Financial Discussion

Five-year data on sales, earnings, and profit margins^[12]

From FY03 to FY07, Eastman Chemical’s net sales have grown at a steady average of 6% per year. ^[13] This growth reflected continued capacity expansion in core operations such as in the Fibers and CASPI (Coatings, Adhesives, Specialty Polymers, and Inks) divisions as a result of strong capital expenditures. ^[14] From 2005 to 2007, for example, Eastman’s total capital expenditures increased by 51% from $343 million to $518 million. ^[15] Such expenditures have increased production capacity across divisions and locations, especially in the Fibers Division and in Europe, respectively.

Unlike its sales, Eastman’s earnings have fluctuated from FY03 to FY07. Beginning with a loss of ($270 million) in 2003, Eastman’s net income grew to $557 million in 2005, and then fell back down to $300 million in 2007. ^[16] As with Eastman’s sales, volatility in input costs and product prices have driven the fluctuations in net earnings. In the first nine months of 2008, for example, Eastman’s cost of goods sold rose by approximately 9% compared to the same period last year while its global price increase led to a 14% increase in net sales. ^{[17] [18]} Given these two changes, it can be calculated that the Company’s global price increase averted a ($123.4 million) loss in Q3-FY08, and instead gave rise to earnings of $100 million.

Eastman’s third quarter earnings in 2008 increased from $20 million to $100 million while net sales increased from $1.69 billion to $1.82 billion compared to Q3FY07. ^[19] Keeping product prices constant, the fall in sales volume would have lowered net sales by 8%.^[20] The effect of the price increase, however, was to increase net sales by 14% while controlling for sales volume, thus more than compensating for the slump in demand.^[20] Due to this positive short-term performance, Eastman has not had to halt any long term projects unlike its competitors. ^[4]

Operating Segments

Eastman’s production is divided into five segments: Coatings, Adhesives, Specialty Polymers, and Inks (CASPI); Fibers; Performance Chemicals and Intermediates (PCI); Performance Polymers; and Specialty Plastics (SP). The CASPI division is more cyclical than Eastman’s other segments since it sells to the construction, automotive, and heavy manufacturing industries. During market downturns, less cyclical divisions such as Fibers or Specialty Plastics stabilize Eastman’s net sales.

Percent of Eastman’s sales that originates from each operating segment (from FY05 to FY07) ^[21]

Percent of Eastman’s sales that originates from each operating segment (in FY07)^[22]

Operating margin of each division of Eastman chemical (from FY05 to FY07)^[23]

Coatings, Adhesives, Specialty Polymers, and Inks (CASPI) (21% of sales, 42.6% of earnings)

In its CASPI division, Eastman manufactures chemicals for use in paints, coatings, inks, and adhesives.^[24] Eastman makes these products using proprietary chemical processes that lets it maintain 15-20% profit margins. This segment caters largely to the construction, automotive, and heavy manufacturing industries, so its performance is more cyclical than Eastman’s other divisions’. Because of growth in these client markets until 2007, Eastman has built several new CASPI factories outside of the United States.^[25]As the construction and automotive industries are demanding less raw materials from CASPI due to their stagnation since October, 2008, this segment’s growth is threatened. ^[26]

Fibers (15% of sales, 43.2% of earnings)

Eastman Chemical’s Fibers segment caters mostly to the tobacco, clothing, and furniture industries. Eastman is the world’s second largest manufacturer of acetate tow fiber, which is used as an additive in cigarette filters. Since the tobacco industry’s approximate 2% annual growth in Asia and Eastern Europe is generating demand for cigarette filters, Eastman’s management expects this segment to grow as well in the foreseeable future.^{[27] [28]} In order to keep up with the approximate 3% annual growth rate in acetate tow demand, Eastman expanded its acetate tow production capacity by 5% in October via factory expansion in England. ^[29] It is planning similar expansions over the next two years. The Fibers segment is arguably Eastman’s most stable and promising, and its relatively high 24% operating margin encourages Eastman to continue investing in it. ^[30]

Performance Chemicals and Intermediates – PCI (31% of sales, 39.9% of earnings)

The PCI segment produces commonplace and unique chemicals for the pharmaceutical, foods, and agricultural industries. It has a low 10.5% operating margin despite Eastman’s efforts to optimize its processes, and its price level depends on a volatile market equilibrium. ^[30] Revenues in Eastman’s PCI division have risen lately due to price increases.

Performance Polymers (21% of sales, loss is -37% of earnings)

The Performance Polymers division produces Polyethylene Terephthalate (PET) for use in packages, bottles, and other liquid containers. Profit margins in this division have declined rapidly and culminated in a $207 million loss in FY07. ^[31]This decline is due to oversupply of PET in the world market as well as Eastman’s one-time costs stemming from factory closures. To combat declining margins in PET production, Eastman has divested approximately 55% of its PET capacity since 2006, and it is also optimizing its remaining PET production using proprietary IntegRex technology.^[32] Eastman is scaling back its Performance Polymer production in order to boost its companywide profit margin and rid itself of the line’s volatility.

Specialty Plastics (SP) (13% of sales, 11.8% of earnings)

The SP segment produces copolyesters, cellulose derivatives, and plastics for packaging, LCDs, durable plastic goods, and tapes. This division has had stable sales and price levels over the past five years, and Eastman plans to marginally increase SP production as the segment grows on par with the general economy.^[33]

Global Operations

Volume of Eastman’s sales that originated in each of its operating locations (in Q3FY07 and Q3FY08^[34]

Although Eastman carries out approximately 60% of its sales in North America, it also maintains sizeable operations in Latin America, Asia, Europe, and Africa. ^[34] Revenues rose for all geographical segments because of Eastman’s global increase of its product prices. By itself, the decline in demand across all these regions decreased revenues most significantly in Latin America (-32% effect on sales) and North America (-9% effect) while controlling for product pricing. ^[34] In Europe, the Middle East, and Africa, Eastman’s price increase was bolstered by a favorable change in exchange rates, which accounted increased net sales by 4% while controlling for volume and prices The sharp sales decrease in Latin America is due to Eastman’s divestment of local PET and Performance Polymers operations. This divestment is part of Eastman’s long term strategy of switching its production to higher margin products.

Trends and Forces

Increasing Cost of Raw Materials Limits Profit Margin

70% of Eastman’s total costs in 2007 were allocated to purchasing raw materials, which mostly include small organic molecules such as ethylene glycol or paraxylene. ^[35] Since the Company purchases approximately 80% of its inputs from outside sources, its profitability depends on the market price of those raw materials. ^[36] In the event of a relatively frequent 1% market price increase of Eastman’s raw materials, the Company’s total costs increase in an approximate 7:10 ratio to the mentioned price change, and its profit margin decreases at a similar 7:10 ratio as well. In order to protect itself from price fluctuations, Eastman purchases most of its inputs through 3-5 year contracts and occasionally engages in derivative hedging. ^[37] As a result of such long term contracts, Eastman insulates itself from most month to month and even single year price fluctuations, and can afford to worry only about long term price changes.

As of Q3-FY08, Rising Energy Costs Directly Decreased Eastman’s Earnings

Energy costs have posed significant threats to Eastman’s operations, especially during FY06-FY08. ^[38] In late FY07 and early FY08, Eastman countered the rapid appreciation of oil by increasing its own products’ prices. Such a tactic, however, runs the risk of disrupting client relationships. One long term solution that Eastman has adopted is to convert its current manufacturing of basic chemicals from oil to a coal-based process. This conversion decreases the Company’s reliance on expensive and volatile oil and natural gas.

In order to raise its margins in the long run, Eastman is expanding its capacity in industrial gasification – a process that produces raw materials from coal coke instead of oil and natural gas. Coal coke is a cheap and accessible raw material since not many manufacturers have the ability to use it. So, by switching its manufacturing to coke-based processes, Eastman will be able to stabilize its cost of goods sold. The Company plans to open a $1.8 billion gasification plant in Texas in 2010.^[39] This plant will generate basic chemicals for all of Eastman’s divisions, and its excess gasification capacity will be sold to other companies in the chemical industry.

Eastman is Subject to Competitive Market Prices

As a maker of commoditized chemical products, Eastman conforms its price levels to its industry’s low market equilibrium. ^{[40] [41]} In response to permanent price depressions for specific products, Eastman normally drastically lowers its production of the depreciating product and converts the unused factories’ capacity to produce higher margin goods. ^[42] During FY07-FY08, global overproduction of PET lowered product prices in Eastman’s Performance Polymers division to unprofitable levels, thereby encouraging Eastman to convert Performance Polymers factories into more profitable Fibers operations.^[43] As a result of this price depression, Eastman has cut its PET production capacity by 55% and and expanded its profitable Fibers capacity by 5% (as of Q3-FY08).^[44]

Competition & Market Share

Market share by sales of companies in the chemical industry (as of FY07) ^[45]

Eastman Chemical competes with much larger firms across its five business segments. Eastman’s profit margin is on the low end of the single-digit average of the chemical industry. This competitive disadvantage is encouraging Eastman to switch to coal-based production technology and convert its existing operations to higher-margin processes. While Eastman is lagging behind its competitors in terms of margins and sales, it is outperforming them in the wake of the 2008 recession. While companies like du Pont and Dow are cutting deep in their capital expenditures and investments, Eastman is proceeding with its long term growth plans. The Company’s strong liquidity and solvency (2.0 quick ratio, 65% debt to asset ratio) are helping it make strategic moves to surpass its competitors.^[46]

• E.I. du Pont de Nemours & Company (DD): Beyond competing with Eastman in all its operating segments, EI du Pont also makes bioengineered seeds for agricultural uses. It has a very large global presence, with 60% of its net sales originating outside of the United States. ^[47]
• Dow Chemical Company (DOW): Dow has pursued a high volume, low margin strategy in its operations by making products in its Hydrocarbon and Silicon Rubber segments. It also has entirely nonchemical operations such as its insurance wing.
• BASF SE (BASFY): Based in Germany, this company operates on a much larger scale than Eastman in all of its five divisions. It is also involved in the oil exploration and nutrition industries.
• Huntsman (HUN): With sales only ~50% larger than Eastman’s, Huntsman specializes in the production of polyurethanes, which are used extensively in the construction industry. ^[48]It has had problems with excessive leverage and profitability from FY03 to FY07. ^[45]
• Akzo Nobel N.V. (AKZOY): Both buying and selling several divisions through M&A during FY06 and FY07, Akzo Nobel competes with Eastman mostly in its production of coatings, inks, paints.

References

1. ↑ EMN 2007 10-K, Item 7: Management’s Discussion and Analysis, page 38
2. ↑ EMN 2007 10-K, Item 7: Management’s Discussion and Analysis, page 30
3. ↑ MarketWatch, “Eastman Chemical Profit Jumps,” 23 Oct. 2008
4. ↑ ^{4.0 4.1} “Coming Dow Layoffs Lead to Uncertainty Along Coast,” 12/8/2008
5. ↑ “DuPont will lay off 6,500 people and reduce the production,” 12/8/2008
6. ↑ “BAST cutbacks follow massive US price drops,” 11/19/2008
7. ↑ “Eastman slashes labor costs in 2009,” 12/8/2008
8. ↑ EMN 2007 10-K, Item 8: Financial Statements and Supplements, page 81
9. ↑ EMN 2007 10-K, Item 2:Business, page 7
10. ↑ Yahoo Finance, “Eastman Completes Acetate Tow Expansion at Workingston Site,” 10/30/2008
11. ↑ EMN 2007 10-K, Item 2: Business, page 14
12. ↑ EMN 2007 10-K, Item 6: Selected Financial Data, page 30
13. ↑ EMN 2007 10-K, Item 6: Selected Financial Data, page 30
14. ↑ EMN 2007 10-K, Item 7: Management Discussion & Analysis, page 72
15. ↑ EMN 2007 10-K, Item 8: Consolidated Financial Statements and Supplements, page 124
16. ↑ EMN 2007 10-K, Item 6: Selected Financial Data, page 30
17. ↑ EMN 2008 10-Q, Item 2: Management Discussion and Analysis, page 25
18. ↑ EMN 2008 10-Q, Item 2: Management Discussion and Analysis, page 24
19. ↑ EMN 2008 10-Q, Item 1: Financial Information, page 3
20. ↑ ^{20.0 20.1} EMN 2008 10-Q, Item 2: Management Discussion and Analysis, page 24
21. ↑ [http://www.sec.gov/Archives/edgar/data/915389/000091538908000017/emn200710k.htmEMN 2007 10-K, Item 7: Management’s Discussion and Analysis, page 43}
22. ↑ 2007 10-K, Item 7: Management’s Discussion and Analysis, page 43
23. ↑ 2007 10-K, Item 7: Management’s Discussion and Analysis, page 43
24. ↑ EMN 2007 10-K, Item 1: Business, page 5
25. ↑ EMN 2007 10-K, Item 1: Business, page 9
26. ↑ “Construction industry drying up, and not just in the desert,” 12/11/2008
27. ↑ [http://www.alternet.org/healthwellness/64222/, “The World’s Growing Number of Smokers,” 10/4/2007
28. ↑ Tobacco.org, “Asia-Pacific has fastest rise in women, children smoking,” 9/13/2007
29. ↑ Bnet.com, “Eastman to Expand Acetate Tow Production,” 9/11/2006
30. ↑ ^{30.0 30.1} EMN 2007 10-K, Item 7: Management Discussion and Analysis, page 5
31. ↑ EMN 2007 10-K, Item 7: Management Discussion and Analysis, page 47
32. ↑ EMN 2007 10-K, Item 1: Business, page 15
33. ↑ EMN 2007 10-K, Item 1: Business, page 17
34. ↑ ^{34.0 34.1 34.2} EMN Q3FY08 10-Q, Item 2: Management’s Discussion and Analysis, page 36
35. ↑ EMN 2007 10-K, Item 1: Business, page 19
36. ↑ EMN 2007 10-K, Item 7: Management Discussion & Analysis, page 71
37. ↑ EMN 2007 10-K, Item 1: Business, page 19
38. ↑ Cosmeticsdesign-Europe, “Oil costs continue to pressurise speciality chemical prices,” 10/11/2005
39. ↑ EMN 2007 10-K, Item 1: Business, page 18
40. ↑ EMN 2007 10-K, Item 7: Management Discussion & Analysis, page 72
41. ↑ EMN 2007 10-K, Item 1: Business, page 14
42. ↑ Yahoo Finance, “Eastman Completes Acetate Tow Expansion at Workingston Site,” 10/30/2008
43. ↑ Foodproductiondaily.com, “DAK plans construction of PET unit,” 6/7/2002
44. ↑ EMN 2007 10-K, Item 1: Business, page 15
45. ↑ ^{45.0 45.1 45.2 45.3 45.4 45.5 45.6 45.7 45.8} “Chemical Industry Financial Information,” 12/20/2008
46. ↑ EMN 2007 10-K, Item 8: Financial Statements and Supplements, page 81
47. ↑ E.I. du Pont de Nemours & Company (DD)
48. ↑ Huntsman (HUN)