Undervalued Dividend Growth Stock of the Week: Eastman Chemical (EMN)

The stock market has been awfully volatile lately.

The US-China trade war has escalated.

This comes on top of a weakening global economy.

What’s an investor to do? 

I think we should focus on what isn’t volatile.

That’s right.

Stock prices go up and go down every day.

But what doesn’t go up and down too much are dividends.

Dividends aren’t volatile.

In fact, dividends from high-quality dividend growth stocks tend to move in only one direction: up!

This gives an investor a sense of calm in especially choppy waters.

This is one reason why I’ve stuck to investing in many of the high-quality dividend growth stocks you can find on the Dividend Champions, Contenders, and Challengers list.

I’ve built my FIRE Fund in the process of doing that.

This is my real-money dividend growth stock portfolio.

And the five-figure passive dividend income it generates for me is enough to cover my essential expenses in life.

I’m in my 30s.

And I’m retired.

Jason Fieber's Dividend Growth PortfolioI used dividend growth investing to put myself in this position.

And I lay out exactly how I did that in my Early Retirement Blueprint.

A big part of the Blueprint is living below your means.

But you then have to convert that capital from savings into equity.

This is something that must be approached intelligently.

Well, it’s highly intelligent to focus on high-quality businesses that are undervalued at the time of investment.

It’s that latter aspect that can be really critical.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.

That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.

This higher yield leads to greater long-term total return potential.

Total return is, after all, the sum of investment income and capital gain.

Boosting yield gives you more potential investment income.

Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.

These favorable dynamics also reduce risk.

Undervaluation introduces a margin of safety.

That’s a “buffer” that protects the investors downside against unforeseen issues.

An undervalued high-quality dividend growth stock can be a tremendous long-term investment.

Fortunately, spotting undervaluation isn’t as difficult as it might seem.

Fellow contributor Dave Van Knapp put together an excellent valuation tool for dividend growth stocks.

Check out Lesson 11: Valuation, which is part of an overarching series on dividend growth investing.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Eastman Chemical Company (EMN) is a global specialty chemical company that manufactures and markets a wide range of advanced materials, chemicals, and fibers which are used in various consumer and industrial products.

The company operates across four segments: Additives & Functional Products, 36% of FY 2018 sales; Chemical Intermediates, 28%; Advanced Materials, 27%; and Fibers, 9%.

Sales by customer location broke down for FY 2018 as follows: United States and Canada, 42%; Europe, Middle East, and Africa, 27%; Asia Pacific, 25%; and Latin America, 6%.

Major end-use markets include Transportation, Consumables, and Building & Construction.

Originally founded in 1920, and later spun off from parent company Eastman Kodak Company (KODK) in 1994, the company now operates as one of the world’s largest specialty chemical companies.

What’s interesting about Eastman Chemical is, they’re exposed to just about every industry and geography out there.

It’s incredibly diversified.

And its specialty chemicals are often a necessary, yet low-cost, element of the manufacturing process for numerous products.

This bodes well for their ability to continue profiting for many years to come.

It also bodes well for their ability to continue paying their shareholders a growing dividend.

As I mentioned at the outset of this article, it’s important to focus on what isn’t volatile.

Well, Eastman Chemical’s dividend is far less volatile than its stock.

In fact, the dividend has for years been moving in only one direction: up!

The company has increased its dividend for nine consecutive years.

Their dividend raises have been incredibly consistent in nature, again speaking to the lack of volatility.

The ten-year dividend growth rate stands at 9.8%.

And the most recent increase came in at over 10%, which is right in line with that long-term DGR.

With a payout ratio of 38.1%, the dividend has plenty of room for more growth.

On top of all of this, the stock yields a hefty 3.89% right now.

That’s not only well in excess of the broader market, it’s also almost 140 basis points higher than the stock’s own five-year average.

That dividend pretty much checks all the boxes a dividend growth investor wants to see.

High yield. Low payout ratio. High dividend growth rate. Strong commitment to dividend raises.

It’s all there.

Of course, we invest in where a company is going, not where it’s been.

In order to estimate where the company might be going, which will have a lot to say about the dividend, we’ll build out a trajectory.

I’ll first show you what Eastman Chemical has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional forecast for profit growth.

Combining the known past with that future forecast should give us plenty to work with in terms of approximating the company’s future growth path.

Eastman Chemical increased its revenue from $5.047 billion in FY 2009 to $10.151 billion in FY 2018.

That’s a compound annual growth rate of 8.07%.

I love this top-line growth.

The Great Recession had a major impact on the business, as was the case for pretty much all businesses, but Eastman Chemical came really came out of that period largely unscathed and in growth mode.

Moreover, the company was still producing positive free cash flow even during FY 2009.

It’s quite impressive.

Meanwhile, earnings per share advanced from $0.93 to $7.56 over this period, which is a CAGR of 26.22%.

Again, it’s quite spectacular stuff.

However, I wouldn’t draw too many conclusions from this massive EPS growth rate.

FY 2009 was a highly unusual year from which to start this kind of comparison, as that was the trough of the company’s earnings through the Great Recession.

That said, even more recent growth – say, just over the last five fiscal years – has also been strong.

Looking forward, CFRA is predicting that Eastman Chemical will compound its EPS at an annual rate of 7% over the next three years.

CFRA believes product innovation, strong positioning in emerging markets, higher prices, and higher volumes all add up to a strong near-term growth outlook.

Offsetting some of that is a slowing global economy, the cyclical nature of the chemicals industry, and volatile raw material costs.

I would say uncertainty seems a bit elevated right now, especially in the geopolitical sense.

But it’s also not like this forecast is overly aggressive.

It’s less than 1/3 of the growth rate Eastman Chemical posted over the last decade. And it’s roughly in line with more recent trends.

Yet this would still put the company in a good position to hand out big dividend raises.

With the payout ratio being as low as it is, a 7% EPS growth rate could allow for at least high-single-digit dividend raises for the foreseeable future. Low-double-digit dividend raises, like the most recent one, aren’t out of the question.

However, if some kind of global recession enters the picture, that could sharply lower expectations.

Moving over to the balance sheet, the company’s financial position is good. Not great. Just good.

The long-term debt/equity ratio is 1.0, while the interest coverage ratio comes in at 6.5.

Total cash is immaterial.

The good news about the balance sheet is, the company has been steadily improving it.

Both the long-term debt/equity ratio and interest coverage ratio looked worse just a few years ago.

Whereas a lot of companies out there have been loading up on debt and deteriorating their financial positions in recent years, Eastman Chemical Company has reduced its debt and put itself in a better position.

Profitability is in a similar spot, whereby the company has improved itself from even just 2-3 years ago.

Key profitability metrics are now very strong.

Over the last five years, the company has averaged annual net margin of 10.26% and annual return on equity of 22.12%.

Awfully nice for a commodity business.

The averages were helped a bit by a spike in FY 2017 metrics after the company took a one-time gain related to US tax reform. However, the last five years exceeds the preceding five years, in any case.

I think Eastman Chemical offers a lot to like as a long-term investment.

They provide a number of key chemicals and materials that go into numerous everyday products that make up everyday life.

And these chemicals and materials are protected by patents, which offers a competitive advantage.

Even if a major recession hits, everyday life must go on.

Their diversification across chemicals, products, end-markets, and geographies is impressive.

I think this insulates them somewhat from a sudden and major drop in profit.

Fundamentally, the company is in very good condition. And the dividend metrics are great.

Of course, there are always risks to consider.

Competition, litigation, and regulation are omnipresent risks in every industry.

As a commodity player, Eastman Chemical can be more of a price taker than a price maker.

Raw material and other input costs can be volatile.

And with the cyclical nature of chemicals, they are exposed to a global recession.

Overall, though, this looks like a high-quality dividend growth stock.

And the valuation appears to be compelling right now…

The stock trades hands for a P/E ratio of just 9.82.

That’s about half of the broader market’s earnings multiple.

And it’s markedly below the stock’s own five-year average P/E ratio of 12.5.

This isn’t some kind of high-flying tech stock by any means, but there does appear to be a valuation disconnect.

The current P/CF ratio, at 5.8, is well off of its three-year average of 8.2.

And the yield, as noted earlier, is significantly higher than its recent historical average.

So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a 7% long-term dividend growth rate.

That DGR is substantially lower than the company’s proven long-term dividend growth rate thus far.

And it’s actually right in line with the EPS growth forecast discussed earlier. That means I’m assuming no excess dividend growth above and beyond that level.

It’s a rather cautious model.

But I always like to err on the side of caution.

With global uncertainty seemingly rising right now, I think it’s particularly wise to be conservative here.

The DDM analysis gives me a fair value of $88.45.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even with what I believe is a careful valuation model, the stock still looks cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates EMN as a 4-star stock, with a fair value estimate of $93.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates EMN as a 4-star “BUY”, with a 12-month target price of $87.00.

Averaging out these three numbers gives us a final valuation of $89.48. That would indicate the stock is possibly 41% undervalued.

Bottom line: Eastman Chemical Company (EMN) is a high-quality company with great fundamentals. Recent improvements in key metrics and incredible diversification across its businesses makes the company even more attractive right now. With a 3.9% yield, a very low payout ratio, almost a decade of dividend raises, double-digit dividend growth, and the potential that shares are 41% undervalued, this stock should be on every dividend growth investor’s radar.

-Jason Fieber

Note from DTA: How safe is EMN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 85. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, EMN’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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