Description

Providencia manufactures nonwoven materials in an oligopolistic market in Latin America, and possesses a cost and technology advantage in both the US and Latin American markets.  The company currently trades at a 30% long term FCF yield.  We believe that the company is worth conservatively BRL $14.00, representing greater than 175% upside based on a 12% FCF yield.

The industry is currently experiencing a seismic shift in the demand for higher technology products which PRVI3 has the capacity to make.  A shuddering of competitor capacity in the industry due to cost and ageing machines will cause a steady pressure on supply, allowing PRIV3 to command pricing power in the medium term. 

The company has recently spent money consolidating competitors, improving operations, and planning new projects.  With all commitments determined and further sales of non-core assets on the horizon the free cash generation of the company was revealed in the second quarter and will continue to improve going forward. 

Why the Stock is Cheap

There stock has suffered with the Brazilian markets, the work through of one-off issues associated with acquisitions, SAP, the recent IPO and increases in oil prices.  As is further explored below, the business was undermanaged for years, and until now under earning a corresponding amount.  The tremendous cash flow has been obscured in messy quarters and timing issues associated with maximizing capacity utilization. 

With clean quarters being reported (starting with Q2 printed in August) and expected going forward much of the earnings power will be revealed.  Input prices continue to rationalize, and operations continue to improve.  It is worthwhile to note that the company listed in early 2007 at BRL 15.00 raising greater than BRL 450MM, a greater amount than the current maket cap.  For easy reference and further historical perspective, note that nantembo629 wrote up the same company on 10/16/07. 

Operational Drivers:

·         Oligopolistic supplier in 15%+ growth Latin American market protected by law from imports of the same material

·         Low cost producer with installed or planned capacity having a 30% cost advantage

·         Competition shuddering capacity due to increased costs, expended useful lives of machinery, and changes in demand relating to product specifications that cannot be met

·         PG US and KMB US are driving technological change, PRVI3 has the proper capacity and equipment to meet new product specs

·         Competition is materially undercapitalized and cannot add capacity in new technology

·         Company is expanding rationally capacity addition having 20%+ ROIC

·         New capacity committed in US to allow current capacity in BZ to be allocated to higher growth Latin American market, putting new product into a high growth market with no additional capex.

Value Drivers:

·         The company is an active repurchaser, even through the recent capital expenditure cycle, authorizing 3.1MMshares, or 10% of outstanding in Dec 07 (law in BZ no greater than 10% per authorization) buying back 92% of authorization through July 08 at an average price of BRL 7.60

·         Company will likely look to divest a small (10% of operating profits) PVC business with limited competitive advantage in the near term

·         New capital being deployed with 20%+ ROIC based on predetermined off-take agreements

·         Dividend in conjunction with additional repurchases highly likely after divestiture and capital spending plan wrap up, most likely Q408

·         Management priority is to return value to shareholders having shown no interest in “empire building”

Key Business Information & Operational History

Providencia was historically a family owned operating business that was run inefficiently with little consideration for competitive forces or pricing. 

·         The key business for the company is the nonwoven textiles, which account for 80% of revenues and 90% of operating profits. 

·         The business produces fabrics for disposable products such as diapers and sanitary pads, with the ability to produce sophisticated high value add bi-component nonwovens for medical products. 

·         The key input is polypropylene, a direct derivative of oil, which is then converted to nonwovens with specialized machines.

·         Forward volume for PRVI3 will be approximately 30% US and 70% Brazil

·         Major customers include KMB US and PG US

The market had, and still has weak and unsophisticated competition in the local markets; however it is dominated by only two players.  In the nonwoven market, customer relationships and political relationships relevant to the import ban to Brazil are closely held by the two sophisticated players.  Due to the potential to dominate an unsophisticated market, the company was targeted by AIG Private Equity, and was acquired in the early 2007. 

Oligopoly in Latin America

Latin American nonwoven supply is dominated by PRVI3 and PGI, a private firm operating out of Argentina.  Fiberweb is a participant, but does not have operations further south than Northern Mexico.  The market is currently rationally supplied for the coming year as Providencia just brought on an additional line during the first part of 2008, KAMI9.  More discussion of supply and demand issues can be found below.  Pricing remains rational as both Providencia and PGI recognize their position of power as they negotiate pricing and develop further capacity.  As mentioned above, there are strict import restrictions on this material in Latin America adding to their solid footing in the market and eliminating the risk of low cost imports. 

Stability of the Oligopoly

The oligopolistic nature of their position was tested in 2004 when Clopay, a US firm funded the expansion of Isofilm to produce thermal bonded nonwovens.  They failed to gain efficiency or customer base, and were acquired by Providencia in late 2007.  Isofolm was well capitalized, had modern facilities, and should have had the opportunity to take market share as both the majors were rationalizing their business at the time.  

New Management & Operations

The company has made some admirable changes in a short period of time since AIG took over the business including:

·         Divesting non-fundamental assets including a flexible packaging business and using the funds to buy an underperforming competitor in nonwovens

·         Focusing almost manically on capacity utilization

·         Adding an SAP system from which the company is now reaping planning benefits

·         Renegotiating both input and output pricing

·         Proactively managing currency volatility affecting their export business

Many of the benefits of these changes have only just begun show.  The massive improvement in operational efficiency is demonstrated by flat operating margins in the face of a 32% increase in input costs.  With oil prices normalizing and the ability to pass through 5-8% price increases going forward, the improvements will fall directly to the bottom line. 

Growth Trajectory

With approximately 70% of their end market volume consumed in Latin America, mostly Brazil, there is much growth ahead.  The company is benefiting from enormous secular tailwinds with the use of its products growing at greater than 12% in Latin America.  The current penetration of diaper products in Brazil is 40% with 95% penetration in developed nations.  Looking historically, in the 1990s, it took Poland/Eastern Europe 10-12 years to go from 40% to full penetration as in Western Europe, this implies an 8% + secular growth rate on top of GDP plus several percentage points from further acceptance of hygienic solutions.  Adding in medical use growth and hard good consumption the anticipated growth rate for the segment is conservatively 15%. 

Approximately 30% of their forward volume is in the US, a much more stable consumer of nonwovens.  Growth drivers for PRIV3 include general consumption drivers at a rate of GDP, plus incremental usage in the adult diaper segment, this adds marginal demand on already taxed production infrastructure.  This market for adult diapers is small; however it grows at 6-7% in the US due to the aging population.  The last driver for growth is the closing of capacity among competitors.  Assuming a flat to slightly negative demand growth, highly unlikely due to PG US and KMB US driving market development and medical product usage, the company has the opportunity to steal 5% market share per year due to closing factories ensuring growth in the near term and full capacity utilization in the long term.

US Expansion

The company has committed to a expenditure of USD 120MM to build two state of the art lines with 40k tons of production in North Carolina.  The company has stated that they expect a greater than 20% ROIC on the project.  PRVI3 has been selling into the NA market for some time, and has strong relationships both of the major converters.  It is highly likely that they have off take agreements with the converters allowing them to achieve this return.  

The rational for this spending and positioning in the US market will become more apparent in the below supply and demand discussion, however it is relevant at this point to note the prowess of management as they chose to strategically enter the US.  By building a plant in the US, they will shift the volume they export from Brazil back to the faster growing Latin American market.  They are essentially able to grow production in a market with pricing power and a 25%+ incremental EBITDA margin, capture that return, and at the same time be confident in greater than 20% ROIC on the capital they deploy in the in the US.

Funding for the project will be in the form of bank debt that the company has recently announced.  The debt will be funded at 3ML+70 bps allowing for a large spread between cost of capital and anticipated returns.  We are pleased to see the company using inexpensive US debt to fund this project as it helps to rationalize the balance sheet and increases the likelihood of a dividend in the near term.

Seismic Demand Shift

The nonwoven industry has historically been a fragmented industry with many small suppliers, and several dominant converters consuming the supply.  The result has been, especially in Europe, an overcapacity and limited pricing power.  The US market is much less fragmented, with only a handful of large producers sending incremental supply to the converters KMB US and PR US. 

Both major converters are constantly looking to rationalize pricing and efficiency.  They are slowly but methodically changing the product they use in their conversion machines to a thinner product.  The conversion machines they use have recently been changed from those that produce to units at 300 per minute to 1,000 or 1,200 per minute.  The direct result is that they need wider, stronger, absolutely consistent product to be able to run through their machines with highly specific elongation and tenacity in the fibers.  PRIV3 has the 4th generation machines capable of running these fibers both in Latin America, but also in the US. 

The second shift in demand is the use of nonwovens in specific medical application from dressing wounds to surgical gowns.  Many of these applications require super specific nonwovens that have the characteristics of multiple single component nonwovens.  The new technologies can be strong and absorbent rather than strong and hydrophobic or hydrophilic but without tensile strength.  PRVI3’s KAMI9 production line is which makes it unique and capable of making specialty products for the medical and hygiene applications.  There is only one competitor in US, with limited capabilities and the rest of the supply is imported from Europe at very high cost.  Specifically, the new lines will be able to produce lower basis weight and higher quality products than the other competitors can produce with the machines they have, this lowers end cost for the converters, and entrenches PRIV3 as a key supplier. 

The above changes in demand profile for the larger converters is important as KMB US and PG US are willing to pay higher margin for quality product.  Their entire pricing model is driven by end use costs, and this puts the consistent manufacturers in a position to hold margin.  If PRIV3 is producing product, at a 25% EBITDA margin but delivering consistent product with less than 1% waste, the end cost is the same as a small single line producer running 6% waste and lower volume, as a result KMB US and PG US are highly supportive of the larger sophisticated manufacturers. 

Simply put, a converter can buy the whole package, simple and complex nonwovens, from PRVI3 at a lower end cost due to volume shipped, quality and loss stats, delivery timing, and shipping savings than they can from smaller single line producers, or other large firms without the modern technology to provide the highly developed product.  The converters will pay a higher price as they model based on end use costs and PRIV3 gets to keep the difference generated by their production efficiency and cost advantage.

Cost Advantage

There are several contributing elements to the company’s cost advantage.  The machines they have are the latest technology and have a 20% cost advantage over older spunbonded and a 40% advantage over the even older carded capacity.  This advantage will not disappear in the medium term as PRIV3 has commitments on machines from the major global manufacturer where others do not.  A two year lead time upon approval of financing is necessary to get a machine manufactured and installed. 

The global market is a mix of older spunbonded and carded capacity ~40% and ~60% respectively, over time there will be replacement of older machinery, as mentioned above, there is a long lead time, adding to the longer term advantage is the condition of the competitors as discussed below. 

Competition

Competition is in very bad shape in the industry which prevents them from making the capital investment needed to either add capacity. 

Key production competitors are highlighted below:

·         FWEB LN - Fiberweb

o   Having some financial difficulties, skated by their debt covenants in recent half

§  Net Debt to EBITDA came in at 2.61x with a covenant of 3.25x

§  EBITDA to Interest 5.47x with covenant of 4.75x

o   Limited capital outlay anticipated

o   Difficulty in product development and R&D have turned away customers for value add products

·         PGI

o   They have older lines, but have recently implemented an effective cost savings plan

o   Currently maintain relationship with and volumes with P&G as they own Swiffer patent

§  Competition moving swiftly to make a substitute that does not break patent, currently several in testing

o   Reluctant to deploy capital due to patent cashflow stability issues

·         First Quality Nonwovens

o   Hiring retired engineers to build out R&D in an effort to boost value add production, currently limited

o   Have new generation machine online out of approximately 5 lines

o   Limited capital allocation as they are a private operator, and the nonwoven business feeds much of their lower margin private label product at their other companies

·         AVGL IT - Avgol

o   Estimated that they are over levered as recent attempt to acquire FWEB LN was scuttled due to bank financing issues

o   Approximate leverage based on 6 month results is 2x EBITDA, however they have committed capex plans that could over lever the company

o   Have several lines running in the US

o   Recent addition of 1 4th generation machine, several other orders for machines cancelled

·         KMB US

o   290 thousand tons per year internally produced

o   Older custom machines unfit for new conversion machines

o   Shutting capacity t ~5% per year creating 15k ton supply vacuum in market on top of growth

Supply & Demand

The US market is not currently oversupplied for the high quality products that PRIV3 produces on their KAMI9 or on the future lines destined for the US that is used of the high end hygienic and medical segments.  There is currently high demand and undersupply for lighter weight products in the region as many machines currently supplying the market have technical limitations as touched on above.  About 70 thousand tons of older capacity is non specialized machines, 50 thousand tons are the older generation of the machines PRIV3 operates in their new lines, and 290 thousand tons are self supplied by KMB US on custom lines. 

KMB US has not added capacity in three years, but rather outsourced to FWEB LN, First Quality and AVGL IT.  It is anticipated the KMB US will close capacity at a rate of 5% a year as they continue to upgrade conversion machines and can no longer operate efficiently with their current lines that are in some cases 30 years old.  As noted above First Quality and AVGL IT have added some newer machines recently, but are will likely take some of their older capacity offline as costs of operations are too high. 

There is effect a vacuum of approximately 15 thousand tons per year of capacity that will have to be filled, and few competitors with the balance sheet to spend the capital.  PRVI3 has the ability to seize the opportunity in the market and is doing so conservatively with their US project.

Valuation

Several key elements need to be considered when looking at the balance sheet

·         The company will deploy BRL 200MM (120MM USD) for the US facility

o   This transaction will be funded with debt

·         There will likely be a monetization of a large portion of the tax asset on the balance sheet

o   Brazilian law allows companies to sell VAT tax credits that have been built up through exports of goods

·         The PVC business will likely be sold, we estimate for approximately BRL 75MM

 

We anticipate 2009 reoccurring cash flow of BRL 115MM in 2009 building to greater than BRL 140MM in 2010.  Please note that the company has accelerated certain depreciation to gain tax protection this will fall off over the next several years.  The resulting valuation is based on an anticipated reoccurring cash flow of 115MM BRL in 2009 resulting in an approximately 30% FCF yield to equity. 

Conclusion

·         Secular and systematic changes in demand shifting towards PRVI3 and its installed technology

·         Highly favorable supply demand dynamic with limited ability of competitors to invest in the new projects

·         Management driving value creation with a focus on shareholder returns

·         Completion of capital expenditure cycle showing cash generation power of the company

·         Opportunity to purchase an asset with a high yield due to near term market volatility

Catalyst

Q3 earnings with operations at full capacity, and margins benefiting from operational efficiency and flattening raw material costs as well as statutory price increases for customers
Allocation of capital to 20%+ ROIC US project
Divestment of small PVC business and resolution of tax assets, adding cash to balance sheet and providing for special one time dividend
Declaration of a dividend policy giving equity a cash yield and proving commitment of management to return shareholder dollars