Description

Those held in honor will one day fall, and those fallen will one day be held in honor.

AFT-U shareholder

At risk of building a name as “That guy that always posts income trust ideas”, I will present VIC readers with another income trust idea from the great white north. I believe Advanced Fiber Income Trust (AFT) is compelling investment offering buyers the opportunity to buy a high margin/low capex business with industry leading market share at a bargain basement price. Management is honest and competent and multiple catalysts exist in the form of an operational improvements and a potential takeout.

AFT is one of the oldest producers of pulp screen components, having been in operation for approximately 100 years. The company was formerly a part of the Canadian conglomerate CAE, but was IPO’d as an income trust in Mach 2002. As is typical in such cases, CAE, which had overleveraged itself and after run into trouble, sold the crown jewels when it came time to come up with some quick cash.

As the world's leading producer of customized screening solutions to the pulp and paper industry, AFT has approximately 30% market share of the worldwide cylinder market (global market is approximately $200m in size). Pulp screen cylinders, which account for approximately 70% of AFT’s sales, are devices used to remove contaminants from pulp during the paper making process. Screens are critical in ensuring the quality of the pulp, which in turn impacts the quality of the resulting paper products. Screens are commonly used in all pulp and paper mills around the world. Mills will typically have several stages of pulp screens to ensure both a high degree of contaminant removal and minimal loss of useful fiber. For pictures please visit www.aft-global.com.

The attractive element of AFT’s business is that screen cylinders are consumable items that are typically replaced every two years. Approximately 85-90% of the screen cylinder market is comprised of maintenance and replacement purchases for existing equipment, with the remainder coming from new equipment sales. With an average price of $10,000-15,000 the product accounts for a relatively low portion of a mill’s costs, yet is of the utmost importance to production. While maintenance capex can be deferred during tough times, the replacement cycle is driven by volume as opposed to the actual commodity price. Quite simply, as long as paper is being made, screen cylinders are undergoing wear and tear.

There are 4,000 mills worldwide, of which approximately 1,000 are AFT customers. Customers tend to be very sticky, which obviously makes it easier to hold market share, but conversely difficult to grow as well. The customer stickiness is driven by several factors, with inertia being the foremost. Due to the fact that screens are a technically sophisticated product, there is potential for a plant shutdown if a changeover in suppliers does not go smoothly (either upon implementation or in procuring replacement orders). To put it in perspective, a plant shutdown of 1-2 days for an average size plant would cost the equivalent to 100x the savings of a 10% reduction in screen prices.

With respect to the technical characteristics of a screen, changes of less than four hundredths of an inch to screen apertures can have a significant impact on performance. As such, each sale to a new customer requires an applications engineer to carefully consider the sizing, selection and detailed specifications of the component. Being able to judiciously determine the appropriate rotor type, screen cylinder, aperture size, aperture spacing, contour depth, surface finish and other defining parameters is an integral portion of the sales process. Therefore, although the industry tends to move at a rather glacial pace when it comes to introducing new technologies, the products are very sophisticated from an engineering perspective, making it difficult for new entrants to break in.

Similarly, because there are so many different types of mill machinery in use, a potential entrant to the industry would have to invest a meaningful amount of time and money to develop a unique screen to fit each piece of equipment. Thus, it would not make sense for you or I to go into the business from scratch, as the diversified needs of our customers would likely prevent us from ever reaching economies of scale. As a data point, AFT current provides screens to over 200 models of pulp and paper equipment.

For the reasons in the prior two paragraphs, all of the OEMs actually purchase one product or another from AFT, as opposed to engineering and producing a part in house. If you actually look back 10 years to 1994, you will see that 73% of AFTs sales were actually made to OEMs rather than mills. However, over the past decade the OEMs have consolidated the independent screen cylinder suppliers such that in the latest quarter AFT sold 70% of its output directly to endusers.

Prior to AFT’s IPO, Andritz, the world’s largest pulp and paper equipment supplier, actually pursued AFT offering the equivalent of $6 share. Subsequently Andritz purchased Fiedler, one of the last remaining independent screen cylinder manufacturers. Unfortunately the details of the OEMs screen acquisitions during their consolidation spree are not publicly available, so I cannot provide readers with the takeout multiples for Fiedler or any of the other independents.

It is worth mentioning that despite this consolidation by the OEMs, AFT’s global market share has actually increased from 25% to 30% during the past three or so years. If you ask AFT, they will tell you that they have grown market share by developing a superiour knowledge of their customer’s specific solution needs and offering innovative products in response. As a result of this customer intimate and product innovation focus, AFT helps customers by reducing their total costs via products that offer differentiated attributes. As an example, AFT has developed a proprietary software package (SimAudit) which can analyze a mill’s production processes and highlight areas where the mill can reduce energy usage, reduce wear and tear, increase contaminant removal, reduce fiber loss, etc. Another advantage to customers is that as a result of having manufacturing facilities in Asia, North American, and Europe, AFT can supply customers with parts in 4 weeks versus an industry average of 12 weeks.

Similarly, by identifying opportunities for process enhancements and customer savings, the applications engineering team lays the basis for future sales of other complementary products. AFT's sales force is thus able to present its customers not only with a broad line of advanced screening components, but also to provide cost-effective solutions for complementary products which the company has recently begun to emphasize.

As to whether this is a good business, AFT has historically generated EBITDA margins in the low 30% / high 20% range. Capex has historically been quite modest at $1.5-2.0m per year on a business that does $20-25m in EBITDA. So what you historically had is a slow growing cash cow with leading market share and a strong competitive position as the industry specialist.

As I said in the paragraph above, I was talking about historicals. In a manner of a short few months earlier this year, AFT went from being a fat and happy high low 30% / high 20% EBITDA margin business to a high teens EBITDA margin business. What happened you ask, well this is where the story gets interesting and investment opportunities are created.

As mentioned previously, after being spurred by CAE, Andritz went off and bought Fielder. In an effort to capitalize on the distribution synergies with existing replacement products, Andrtiz tried to gain market share by supposedly putting through a double digit price cut. Thus, in addition to losing some screen cylinder business from Andritz (who had previously been AFT’s largest customer) AFT saw margins erode as it cut prices to maintain market share.

To compound the problem, AFT had to endure an increase in steel prices and a significant appreciation in the CAD/USD exchange rate. As a result of this perfect storm, EBITDA will decline from $21.6m last year to my forecast of a little over $16m for 2004 (December year-end). Not surprisingly as a result of the decline in profitability the company announced in September that annual distributions were going to be cut from $1.20/share to $.60/share. Needless to say the company was taken out back behind the woodshed and hit repeatedly with a 2x4 until the share price was cut by more than half.

Fast forward to the most recent release of results last week and the story seems to have changed a little. AFT previously organized its sales force with one worldwide VP of sales to whom the various sales agents and direct sales employees reported. This VP was apparently hearing from the sales force that Andritz was cutting prices and AFT had to match to protect market share. In an effort to improve the effectiveness of the sales force and gather better market information, AFT recently reorganized the sales force with Regional Sales Directors to whom local employees and agents would report. Low and behold, the word from these Regional Sales Director’s is that while Andrtiz did get aggressive on some items, it appears that the sales force was overstating the competitive threat in an effort to get AFT to lower prices and make their jobs a little easier.

Thus, it would appear that AFT’s large price decrease earlier this year was based in part on poor information from the field. For skeptical investors, a data point worth noting is that AFT actually put through a price increase last month, which was accepted by customers with no pushback. Not a single client has left thus far (granted it has been a short time period), but several customers even commented “We were wondering what was taking you so long to put through an increase”. Furthermore, AFT stated on their last conference call that competitors followed their lead and raised prices as well.

In fact, despite the fact that maintenance revenue only accounts for about 20-25% or total revenue, the big 3 OEM competitors all make about half their profits from maintenance related sales. With maintenance margin 2-3x that of capital equipment sales, none of the OEM competitors have any interest is seeing their cash cows killed. Given that the pulp and paper equipment industry is relatively oligopolistic (Voith, Andritz, Metso) there is no reason for anyone to act stupid. In my conversations with Metso and Andtiz, both told me that price competition is on par with what one would expect from an oligopolistic industry.

Moreover, Andritz is a very rationally run firm, with ROE targets, compensation based on EVA, etc. As such while I cannot guarantee they won’t act stupid, it would appear that the first price cut was not as wide as AFT originally believed, and it is unlikely Andritz will cut prices again after seeing zero market share pickup.

Lastly, it is worth noting that Andritz had tried a similar price cut before in another segment of the industry. After suffering for a couple of years and seeing no pickup in market share, the company reverted back to higher pricing as opposed to shrinking the pie for everyone. This would suggest while things may not improve for AFT in the near-term, they probably will not get worse and could get better (note my forecast does not include a rebound in pricing to historical levels).

So where are we today and why do I think the story is interesting. Let’s start with the current valuation (all figures in CAD):

S/O 13.8
Price $5.50
Mkt Cap $76m
Debt $49m
EV $118m

Even if the CAD/USD fx rate remains where it is today, I forecast the company will do $16.2m in EBITDA going forward with a 1.20 CAD/USD fx rate. Run rate FCF to the equity holder at this EBITDA would be as follows:

EBITDA $16.2m
Interest Exp ($3.4m) - fixed at 6.9%
Cap Ex ($1.8m) - mgmnt forecast and in line with historicals
Taxes ($.2m) - pay a small amount of tax on Korean operations
W/C ($.1m) - assume 18% of any increase in sales
FCF $10.7m
FCF yield implies a 14.0% FCF yield ($10.7 FCF / $76m Mkt Cap).

As for how I get to the $16.2m EBITDA, I actually think I am being conservative in most respects. In contrast management and analysts are coming in at $17-19m EBITDA for next year, but let me provide some details of my forecast below.

On the revenue line I assume 2005 is pretty much flat with 2004 at about $81.5m. Management is guiding to $85-88m so I am well below consensus. Looking forward I have sales coming in at about $83m and $84m in 2006 and 2007, respectively, which is well below street/mgnt numbers.

Management thinks the company will see sales growth in 2005 from Optimum, an acquisition closed earlier this year that still has not been well integrated on the sales side. Optimum currently does about $5m in annual sales with margins slightly higher than the rest of the business. Management believes it can grow this product at a double digit pace as a result of focusing an individual on assisting the sales force in educating customers about the products unique attributes. As a result of owning the subsidiary for the full year instead of 3 quarters, AFT should see at minimum $1m in incremental Optimum sales in 2005.

Overall the industry grows at about 2-3% a year, although the underlying commodity exposure does mean that some years may be slightly better than others. As for the price cut and subsequent increase, 2004 had pre price cut ASP’s in Q1 2004, followed by post-price cut ASP’s for most of the remaining calendar year (price increase announced in October won’t affect orders in the backlog and will take a few months to filter through the system). My back of the envelope math suggests that overall ASP’s for 2005 should be roughly unchanged from the 2004 average.

As for EBITDA, I assume a core margin of about 19.2% in 2005 which gets you to $15.7m. I then deduct $2.5m for the fx impact of the CAD/USD at present rates, add back $3.0m for cost savings from various initiatives that have been publicly disclosed.

The fx impact is a topic that merits some explanation. For every $.01 change in the fax rate costs AFT about $100k of EBITDA off of 2003 figures. The company is 89% hedged for 2005 at 1.35 and the 2003 avg fx rate for the company was $1.58. Based on the percentage of sales exposed to the USD, and incorporating the hedged portion, I shakeout at a negative variance of $2.5m for 2005 using 2003 as your base year. I assume the CAD and Euro move together which eliminates any fx impact from Euro sales. Management is obviously looking for ways to reduce exposure to the USD (Eg. Source more raw material or parts from the US), but my forecast has not not given them any credit for this plan.

With respect to the cost savings, the company has a cost reduction plan and a product development plan. The cost reduction plan was running at $2.0m in annualized run-rate savings during Q3 2003 (disclosed in Q3 report). Targeted run-rate annual savings are $3.0m, which should be reached by second quarter of 2005. I believe these savings are in the bag as the remaining $1m will come from introducing new capital equipment to the Canadian facility that already being used at the company’s Finnish facility.

The above noted capital equipment will eliminate waste from raw materials and allow the company to order raw materials in a cheaper format (Eg. One machine is a wire maker/cutter that will allow the company to order rolled product rather than pre-cut wire. This will eliminate waste wire, and the rolled product is cheaper to purchase than the pre-cut). Management says they expect a 1 year payback based on the capital equipment they will be installing in Q1 2005 and they have full confidence the $3m target will be reached. Nonetheless I model in $2.5m in savings from this program for 2005 and an eventual run-rate of $2.8m thereafter.

The product development plan revolves around redesigning products to reduce costs. In its prior life the company was a fat and happy 30% margin business producing the absolute best products possible (often better than customers require). The company is now looking at cross-sharing components, taking some of the engineering out of products where it is not needed, and sourcing alternate parts to reduce costs. The company target is to generate $3-4m in savings from this program, although this will not be achieved on an annualized basis for 2-3 years. I assume from the low hanging fruit that seems to be available the company will generate $0.5m in savings in 2005.

An added kicker is the company has an option to purchase a Finebar, a manufacturer of complementary refiner plates that expires within two years. AFT is currently selling Finebar products on a profit neutral basis. In the event AFT believes there is significant market potential, they will exercise the Finebar purchase option, but only if the impact will be accretive to current unitholders. As for the upside of Finebar, look at is a free call option. The size of the market is $150m versus $200m for the screen cylinder market. Longer term, management’s plan is to have a Finebar business with similar market share and margins to the existing business, implying incremental annual sales and EBITDA of $45m and $10m, respectively.

Looking out beyond 2005, without getting into excruciating detail, the cost reductions from the product development plan as well as the cost reduction plan should be sufficient to offset the additional fx losses as the USD hedges roll off. Combined with modest revenue growth my model shows EBITDA increasing from $16.0m in 2005, to $16.9m in 2006 and $17.3 in 2007.

Looking forward, my model suggests that the distribution will increase from its current rate of $.60/year to $.80 for 2007. The $.60 gives unitholders an attractive current yield and should cap the downside. Assuming I am right and the distribution is $.80 in 2007, unitholders should benefit from an improvement in distributions as well as the capital appreciation that would likely result (right now AFT is the highest yielding legitimate income trust I know of).

On the M&A front, AFT is now a somewhat different organization than when Andritz first offered the equivalent of $6/share for the company. AFT now owns Optimum ($5m revenue, $1m EBITDA), 100% of their Korean subsidiary (formerly 35%) and has an option to purchase Finebar. Realizing that the company may be even more attractive to a strategic enquirer such as Andritz, AFT recently adopted a shareholder rights plan to ensure that all unitholders have sufficient time to consider any bids that appear. At current prices one can only assume that strategic and financial buyers are likely going to kick the tires (private equity guys and stategics were lined up to buy this thing prior to CAE announcing the IPO).

By the way, I believe because AFT in incorporated in Quebec it is a limited liability vehicle, but please consult your personal legal advisors for verification of this opinion.

In full disclosure I own this name personally and through my fund, and readers should expect that I will add more or sell some or all at anytime without updating this website.

Catalyst

- Cost saving initiatives
- Future increase in the distribution rate
- Potential M&A activity
- 11% cash distribution yield while you wait