Description

BZ

My write-ups to date have been credit focused, so I figure it is time to show an interesting equity idea. This is a little briefer than I would like, but earnings are coming out this week, and I wanted to get something posted before earnings. I don’t think that this Q will be the catalyst, but wanted to give other people the ability to make that decision for themselves. The trade is long BZ equity.

The company has reached a level in its net debt that we anticipate should lead to either an acquisition of new packaging assets (which will help to re-rate the shares higher), a large share buy-back, or potentially a special dividend. The company is announcing earnings this week so the timing may be soon, however, due to macro uncertainties I would not be surprised to see management wait until sometime in the late third quarter/early fourth quarter. First I will give a brief overview of the business followed by thoughts on capital structure/trading levels.

Description

Boise Inc. is a leading packaging and paper company in North America and Europe.  The company manufactures packaging products and papers, including corrugated containers, newsprint, market pulp and uncoated free sheet (“UFS”). 

The company currently is the third largest North American producer of UFS with capacity of 1.3mm short tons. Its packaging business is made up of a food focused corrugated box business in the northwest as well as its acquisition of Tharco and Hexacomb which also have a more customized protective angle to them. The company also has a small newsprint presence however, packaging and UFS make the bulk of the story.

While one might argue the entire space trades cheap, BZ trades at levels more in line with its legacy newsprint/UFS businesses than the more stable packaging side. Further, the market seems to give little benefit for what we would consider one of the top management teams at deploying FCF for shareholder value creation (something we believe should be the main focus of a commodity priced businesses). The management team members are significant holders of common stock with insiders owning over 10% of the equity (including the CEO and CFO who own just over 1mm shares each).

Capital Structure/Valuation

Market Cap- $750mm

Debt - $797.5 mm (consists of a credit facility and two bonds trading at yields of 4% or less, which is amazing).

Cash $54mm

Enterprise value = $1.493bb

 Note: excludes pension which we take out the payments out of FCF calculation

 EBITDA Assumed $340mm

 EV/EBITDA = 4.39x

FCF Per share (including growth capex of $130 and cash  pension payments of $20mm)

Fully taxed -$90mm or $.89 cents a share

 Assuming zero taxes due to current NOLs - $134, $1.32 a share (Note: The company anticipates being a cash tax payer by the end of 2013).

Why it trades at a discount

The company’s EBITDA is split with 47% coming from its packaging division and the rest coming from its paper division (newsprint, UFS, pulp). Newsprint/UFS are obvious secularly declining story.  Although many had hoped that capacity closures would help lead to higher pricing, this is proving to be a difficult story as illustrated by the recent re-opening of White Birch. The BZ management team, however, is properly harvesting the cash from these operations in order to reposition the company toward packaging and containerboard.  

Traditional containerboard businesses trade at significantly higher multiples. In fact, a private company in this space called Longview Fibre is levered over 5.0x and has bonds that trade at a 6.0% yield (levered nearly 2.0x higher than where BZ is trading). BZ is a bit of a stock without a home: it is not the lowest cost producer, and does not allow an investor to take a pure play bet on any of the underlying industries, so it seems like the classic value trap.  However, by looking at management’s historical actions I feel there will be several catalysts to help re-rate the stock higher, or at the very least pay investors handsomely should those catalyst take longer than expected to materialize. 

First, management has repeatedly said that its target leverage is 2.5x-3.0x, and BZ is currently is levered at approximately 2.3x (leverage continues to fall due to robust free cash flow). In fact by the end of this year, using analyst consensus estimates net leverage will fall to just under 2.0x. We anticipate management will act through a combination of acquisitions and special dividends.

“As part of those strategies as a matter of policy, we've stated that we want to maintain a target EBITDA to debt ratio of 2.5 to 3 times. For the right opportunity, we feel that we'd be willing to go above that with the opportunity todeleverage quickly. At the end of our most recent quarter, which ended on March 31, 2012, our net debt to EBITDAratio was 2.2 times, clearly well within our targets. And additionally, we also want to opportunistically return cash to shareholders, and I'll touch on that in the later slide” Sam Cotterell,  DB conference 6.14.12

The company was created through a SPAC, so it did receive a large cash influx from warrant dilution, however management was quick to use those proceeds to return capital to shareholders, something management is proud about:

“And in 2011, we received proceeds from the exercise of warrants of $285 million going back to – coming into existence as a special purpose acquisition company. We've been disciplined in the deployment of this capital. We've returned $249 million to shareholders through payment of special dividends of $128 million, or $1.28 per share based on a to-date share count and the repurchase of $121 million of our common stock at an average price of $5.74 per share. During this period, we've decreased our net debt by $365 million and we've spent $341 million on capital expenditures and just over $325 million on the acquisition of Tharco and Hexacomb, representing very well the balance and discipline that we're looking at in our capital allocation.” Sam Cotterell  DB conference 6.14.12

The company has stated on multiple occasions they have three potential uses of FCF:

1)      Acquire more packaging assets (First priority)

2)      Issue special dividends

3)      Buy back shares

The company has done all three over the past few years, including frankly one solid impressive buy back in the summer of 2011  (one thing of note: management has in the past sold puts on the company’s stock to collect premium and allow them a cheap entry to buy back their own stock, whether you agree or disagree that this is a smart idea it does show a capital market savvy management team who understands how to harvest the natural volatility in its shares).

In the most likely scenario, I think it is most likely that the management team will do a combination of acquisitions and special dividends. Assuming the management team is willing to go slightly above their target range to 3.25x EBITDA, and using only current cash on the balance sheet of  ~$54  (i.e. no benefit for FCF for rest of the year) and rolling in EBITDA from an acquired asset by the end of the year (assuming an 7.0x EBITDA purchase price), the company can acquire over $107mm of containerboard EBITDA, leaving the company with over 60% of their EBITDA from packaging.  This is substantial enough in our opinion to begin to lead to a re-rating of the company by public markets.  If not, the company should still continue to generate tremendous amounts of FCF with an additional 27 cents of free cash generated post the deal (assumes additional capex =  $35mm; 5% cost of debt= $35mm; less 30% for taxes), which will enable them to quickly delever and revisit either (i) additional  packaging asset acquisitions, (ii) special dividends, or (iii) initiating additional share buybacks.

In an alternate scenario in which management does not find an appropriate deal, we think a special dividend of $150mm can also be issued by year end which would still leave the company toward the lower end of its target range.  While I think it is more likely to see a special dividend of closer to $55-$60mm, with management owning 10% of the company, and tax rates set to potentially jump next year, they have some personal incentive to scale up before the end of the year.

Ultimately, I think the management team will most likely focus on acquisitions and shareholder distributions. I think it is quite possible for the company to easily do 50 cents a year in distributions per share plus continue to acquire more packaging EBITDA annually @ 7.0x. Further as the company is going to be a cash tax-payer by the end of 2013, there is more incentive to do a debt financed transaction.

In summary, BZ is a high free cash flow business operated by a capital structure savvy management team that is in the process of transforming itself.  This high FCF business has the potential to pay you with compelling special distributions while you wait for the company to continue gain scale and equity market re-rating through additional packaging asset acquisition. The current expiration of lower dividend tax rates plus the company being levered below its target range should lead to a catalyst before the end of the calendar year.

Company-Specific Risks

The obvious pricing issue -The company has a large sensitivity to paper/packaging prices and nat gas prices. A major part of this thesis is that containerboard -  while obviously cyclical - should have secular winds at its back due to continued trade, industry consolidation, as well as purchases from the internet continuing to take share from traditional brick and mortar retail.  This topic is not a major part of the write-up (as it could be a write-up unto itself, and again want to get this out before earnings), however one should be comfortable with the general belief as the multiple arbitrage between packaging and paper companies is an important part of the thesis.

BZ investor presentations also do a great job showing sensitivities to various input prices. While I am taking a longer term view on price stability in my BZ recommendation, if you are concerned about a particular sector, you can short out a multitude of public comps. 

Officemax concentration – OMX sales are a very large component of the company’s total sales at north of 20% (they have an agreement to sell uncoated free sheet to OMX). OMX clearly has been struggling and a loss of this contract could have a material effect on the shares. Being that it is a commodity product, the main benefit for BZ is that it can run its mills for longer periods allowing them to be more efficient. While OMX is clearly struggling, a filing does not appear imminent, allowing BZ to reposition itself/the catalysts to be realized over the next 12 months+.

The Dumb deal risk -  A major part of this thesis is based on management’s intentions and capabilities. If the management team starts allocating capital poorly or retraces its stance on leverage levels, it may be time to move on to a lower cost/better producer.

Catalyst