Eastman Chemical Company — Q3 2012 Form 10-Q
Reporting period: Quarter ended September 30, 2012; financial statements are unaudited. Eastman acquired Solutia on July 2, 2012, so reported results include Solutia only from the acquisition date. Unless stated otherwise, amounts are in millions of dollars.
Financial performance
| Metric | Q3 2012 | Q3 2011 | First nine months 2012 | First nine months 2011 |
|---|---|---|---|---|
| Sales | $2,259 | $1,812 | $5,933 | $5,455 |
| Gross profit | $525 | $433 | $1,437 | $1,365 |
| Operating earnings | $263 | $271 | $844 | $918 |
| Earnings from continuing operations | $154 | $174 | $490 | $594 |
| Net earnings | $154 | $174 | $491 | $634 |
| Diluted EPS | $0.99 | $1.22 | $3.35 | $4.40 |
Reported sales rose 25% in Q3 and 9% year to date, principally reflecting Solutia volumes. On a pro forma combined basis, sales were approximately flat year over year for both periods. Reported gross margin was approximately 23.2% in Q3 versus 23.9%, and 24.2% for the first nine months versus 25.0%. Reported operating margin was approximately 11.6% versus 15.0% in Q3 and 14.2% versus 16.8% year to date. Margins and earnings comparisons include acquisition-related items described below.
Management’s adjusted figures excluded specified acquisition, inventory, impairment, restructuring, and pension items. Operating earnings excluding those items were $397 million in Q3 versus $278 million, and $993 million for the first nine months versus $895 million. Pro forma combined operating earnings excluding items were $397 million versus $359 million in Q3, and $1,163 million versus $1,173 million year to date. These are non-GAAP measures and should be considered alongside reported GAAP results.
Cash flow, debt, and liquidity
- First-nine-month operating cash flow was $688 million, compared with $273 million. Management attributed the increase to lower working-capital requirements, approximately $130 million less in federal tax payments, and cash generated by Solutia after acquisition.
- Investing cash outflow was $2,795 million, including the acquisition; financing cash inflow was $1,765 million. Capital expenditures were $297 million. Cash declined from $577 million at year-end 2011 to $237 million at September 30, 2012.
- Total borrowings were $4,985 million, up from $1,598 million at December 31, 2011; long-term borrowings were $4,865 million. The increase primarily funded the Solutia acquisition and repayment of Solutia debt. Net interest expense was $48 million in Q3 and $95 million year to date, versus $20 million and $57 million.
- Current assets were $2,673 million and current liabilities $1,464 million at quarter-end. Eastman reported no outstanding borrowings under its $750 million revolving credit facility or $250 million accounts-receivable facility at September 30. It stated that it was in compliance with applicable debt-facility covenants.
- Management expected 2012 capital expenditures of approximately $450 million and U.S. defined-benefit pension contributions of approximately $120 million.
Material changes and notable items
- Solutia acquisition: Completed July 2 for approximately $4.8 billion of total consideration, including $2.6 billion cash net of acquired cash, approximately $700 million in Eastman shares, and assumed and repaid Solutia debt valued at approximately $1.5 billion. The preliminary allocation included $1,965 million of goodwill and $1,807 million of intangible assets; acquisition accounting was expected to be finalized in Q4.
- One-time inventory charge: Purchase accounting added $75 million to Q3 and year-to-date cost of sales as acquired Solutia inventory was sold. Transaction, integration, and Solutia-related severance costs were also recognized; Q3 amounts were $15 million, $7 million, and $28 million, respectively.
- Segment performance: The company adopted five reportable segments, applied retrospectively. In Q3, Advanced Materials sales more than doubled as reported due largely to acquired businesses, but segment earnings declined, including a $39 million acquired-inventory charge. Fibers earnings were flat; Adhesives & Plasticizers and Specialty Fluids & Intermediates earnings increased.
- Environmental reserves: The environmental contingency reserve rose to $399 million from $39 million at year-end, primarily from $366 million of Solutia-assumed remediation reserves. Estimated remediation costs ranged from a best estimate of $370 million to a reasonably possible maximum of $625 million. Management did not expect the liability to be material to consolidated financial position or cash flows, while acknowledging possible material effects on results in the period recognized.
- Accounting change: Eastman retrospectively changed pension and other postretirement accounting to recognize actuarial gains and losses in the year incurred. The change reallocated $676 million from retained earnings to accumulated other comprehensive income at December 31, 2011, with no change to total equity at that date.
Outlook, risks, and contingencies
Eastman forecast full-year 2012 diluted EPS from continuing operations of $5.30–$5.40, excluding acquisition-related costs and charges, asset impairments and restructuring charges, and mark-to-market pension and OPEB adjustments. Management cited expected contributions from legacy Eastman operations, second-half Solutia earnings, and integration of prior acquisitions, while noting persistent economic uncertainty and a seasonally slower fourth quarter. It expected less volatile raw-material and energy prices overall, but higher costs through the rest of 2012; the expected full-year tax rate on reported continuing-operations pretax earnings was approximately 33%.
Key disclosed risks include global economic weakness, especially in Europe; raw-material and energy price or supply volatility; manufacturing or infrastructure disruptions; customer losses; and the possibility that growth initiatives or Solutia integration fail to deliver expected benefits or require more resources. The filing also describes environmental and legal exposures. Management did not expect pending legal matters to materially affect overall financial condition, results, or cash flows; a DOJ appeal concerning Medicare reimbursements was awaiting a decision, and an EPA administrative matter involved potential civil penalties of at least $100,000.
Important facts for investors to verify
- Whether Solutia integration delivers expected operating benefits and synergies, particularly in Advanced Materials.
- How much reported performance reflects acquired businesses versus underlying pro forma trends, and the sustainability of management’s adjusted earnings.
- Debt repayment progress, interest burden, covenant headroom, and liquidity following the acquisition financing.
- Final Solutia purchase accounting and the adequacy and timing of environmental remediation estimates, including shared-site obligations.
- Progress against the $5.30–$5.40 adjusted EPS outlook and assumptions for demand, pricing, raw-material costs, and fourth-quarter seasonality.