Eastman Chemical: Free Cash Flow Champion With A 3.5% Dividend Yield – Eastman Chemical Company (NYSE:EMN)

In my opinion, shares of Eastman Chemical Company (EMN), a global advanced materials and specialty additives firm, might be worth considering for long-term-oriented dividend investors who prefer undervalued companies with moderate growth prospects and shun stocks with inflated multiples.

At the moment, EMN yields ~3.5% (forward yield is estimated to be ~3.59%); the yield is not spectacular but is close to the top 25% of dividend-paying stocks in the U.S. market. Besides, EMN has been consistently repurchasing shares since at least 2010. The dividend is fully covered both by accounting profits and free cash flow. Though I do consider its 102% Debt/Equity as high, the company is not financially distressed as interest coverage by EBIT and operating cash flow is not a concern. Besides, in the last five years, it successfully narrowed the spread between debt and shareholder equity, that widened after the 2014 acquisition financed primarily by borrowings, and considerably reduced the share of debt in the capital structure. It also has a high quality of earnings supported by positive free cash flow to equity, which is of principal importance when we are assessing a company from a dividend investing standpoint.

Now let’s delve a bit deeper.

Bumpy 2019 amid trade confrontation

Last year, circulating recession fears and ripple effects of the trade war hammered Eastman’s fundamentals and pummeled valuation, pushing EV/EBITDA to the extremely low level. The market disliked its inability to deliver revenue and EPS in line or above the expectations of Wall Street. After each quarterly earnings presentation, bearish traders dragged the share price down. The silver lining is that as dividend yield and share price are antithetical, bearish market sentiment bolstered the yield, which edged close to a 10-year high.

Data by YCharts

The company has been tackling headwinds since the fourth quarter of 2018 when it failed to live up to analysts’ EPS estimations for the first time since 2016; since then, EMN had been missing on both revenue and EPS during most of 2019.

Eastman Chemical, a manufacturer of a plethora of materials and additives, has four divisions:

  1. Additives & Functional Products (e.g., adhesives resins, tire additives, crop protection, etc.)
  2. Advanced Materials (e.g., polymers, films, and plastics)
  3. Chemical Intermediates (e.g., oxo alcohols & derivatives, acetic acid & derivatives, acetic anhydride, ethylene, glycol ethers, etc.)
  4. Fibers (e.g., Estron, Estrobond, etc.)

As its customers operate in industries that are cyclical (e.g., building and construction, automotive), all the divisions were affected by the macroeconomic headwinds in 2019. As the CEO clarified in the press release:

“… global economic conditions worsened as uncertainty related to trade issues escalated and impacted consumer discretionary markets such as transportation and consumer durables …”

Changes in volume/mix, selling prices, and foreign exchange led to a 9% drop in 3Q19 sales, while EBIT slipped 18.2%.

Though revenue decline weighed on gross profit, operating income, and EPS, Eastman did an excellent job optimizing opex and controlling working capital to secure cash flow, protect shareholder rewards (dividends and buyback), and alleviate the debt burden. Its efforts resulted in significant operating and free cash flow growth both compared to 3Q18 and 9M18. While EBIT was under pressure, 3Q19 FCF (computed as net operating cash flow minus net capital expenditures) rose 18.6% and amounted to $306 million. Moreover, according to the company’s guidance (see page nine), FY 2019 FCF might touch $1.1 billion; that transforms into a prodigious estimated FCF yield of around 11% (assuming the current market cap of $10 billion).

In order to generate as much cash surplus as possible, it scaled back capital expenditures. In 9M19, the company invested $308 million in PP&E, while in 9M18, capex was $381 million. Combined with acquisitions, 9M19 capital investments equaled to $356 million (in 2018, Eastman made no acquisition). Some readers might question this approach, highlighting that capex reduction jeopardizes future growth. I partly agree; however, I believe that amid an unfavorable environment, debt reduction and dividend protection are of higher importance. At the same time, in the previous years, Eastman amassed a considerable asset base (both through acquisitions and organic investments), which secures medium-term low-to-high-single-digit sales growth.

Dividend & buyback coverage

Now let’s assess the shareholder rewards coverage.

Since 2012, Eastman’s organic free cash flow to equity (net CFFO less capex) has always been positive after covering both dividend and buybacks except for 2010 and 2011; inorganic FCFE, which includes acquisitions, turned negative in 2012 and 2014, but excluding these years, it also was positive. So, shareholder rewards coverage was exemplary.

Eastman ChemicalOrganic/inorganic FCF computed by the author. Raw data from Seeking Alpha

All of the above emphasizes Eastman Chemical is a free cash flow champion; its FCF gives it flexibility not only to cover stockholder rewards but also to consider possible dividend hikes in the future.

Medium-term growth prospects

By now, analysts anticipate Eastman’s 2019 revenue to slide to only $9.27 billion, while in the early 2020s, the top line, according to their assumptions, might recuperate and increase at a low-to-high single-digit rate and ultimately surpass 2018 record by FY 2022. 2019 profit outlook remains somber, as a 16% drop is on the cards. However, continuous cost optimization can help it to deliver double-digit earnings growth in the coming years.

Cash Return on Total Capital

To uncover more in-depth insights, I have also taken a look at the efficiency of Eastman’s investments in the last ten years. While Return on Equity is a popular and widely used metric, I doubt it is apt in the company’s case, as debt and equity are nearly equally weighted in its capital structure, and thus ROE is distorted. EBIT-based ROTC or Cash Return on Total Capital, Organic & Inorganic FCF ROTC can be used as substitutions.

In the 2010s, EMN made a few acquisitions that have taken a toll on inorganic free cash flow, and consequently, Inorganic FCF ROTC, while total debt crept higher. For instance, in July 2012, Eastman concluded the acquisition of Solutia, which back then was a leading global company in specialty chemicals and various performance materials; in 2014, it acquired Commonwealth Laminating & Coating and Taminco.

Eastman Cash Return on Total Capital

All the figures computed by the author. Raw data from Seeking Alpha

As you can see, in the 2010s, EMN had been consistently generating double-digit CROTC, while its Organic/Inorganic FCF Return on Total Capital was in high single digits (except for 2012 and 2014). In my opinion, it’s a solid result.

Brief remarks on valuation

At the moment, Eastman Chemical has a ‘B’ Value Grade and is likely underpriced; it trades at a 14.5% discount to the Materials sector according to LTM EV/EBITDA multiple; its EV/EBIT ratio is lower by a fifth than the sector median.

Final thoughts

While Eastman Chemical had not delivered startling revenue growth or substantial improvement of accounting profit in 9M 2019, it had been generating surfeit operating cash flow robust enough to cover capital investments and show a surplus. Most of this excessive amount was returned to shareholders. So, thanks to healthy FCF generation, it might be apt for dividend growth investors.

Improved U.S.-China trade relations and the Phase one deal, as well as a few stimuli (e.g., a parade of rate cuts) across the globe, instill confidence the global economy made a step back from the brink of a precipice and a recession had been (temporarily) staved off. But risks remain. It is worth bearing in mind that it is not guaranteed a global crisis will not strike this year; in the case of steep growth deceleration, the valuation of EMN and other chemical stocks will be depressed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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