Description

Sometime the best new idea, is actually an old one...Here we present an idea both old and new. While both Fortress Paper equity and debt have been presented before, we will outline a new piece of the capital structure which has not been pitched before and present a novel way to think about the enterprise as a whole (namely Fortress as an operating and capital investment driven ROI holding company).

Last year vic contributor mpk391, presented the Fortress 2016 debentures which have so far worked out very well (trading 90 currently). We believe that this year you can “repeat” this trade by buying the 2019 converts. However, with this piece of the capital structure 1.) the YTM is higher (27% vs. 21%) and the IRR will be significantly higher as to the gross dollar discount to par is much higher and should re-rate quickly, 2.) the issue is about 80% larger and more liquid, 3.) the enterprise is more stable today, and 4.) with this security the conversion feature actually may hold some interesting upside optionality.

To review the business very briefly:

Price (3/4/16): $4.50 Shares outstanding: 14.7mm Mcap: $66mm
Net debt : $195mm EV: $261mm BV: $219mm
BV/Share $14.90 2017E EBITDA : $50mm – 100mm
P/B: 0.30x EV/EBITDA: 2.6x – 5.2x

Fortress Paper was established in 2006 by Executive Chairman Chad Wasilenkoff (17% owner of the Company), a successful Canadian entrepreneur with a penchant for making contrarian commodity investments, creating low-cost production assets, and then growing them into improving markets.
In 2010, Fortress became the first new entrant to the dissolving pulp market in 30 years by purchasing a bankrupt paper mill in Thurso, Quebec for $3.2MM (less than scrap cost). The company invested approximately $300MM, nearly half of which was provided by the Quebec Government/union pension at extremely advantageous terms, to convert the plant to a dissolving pulp facility with 200k tons/year of capacity and a 24MW cogeneration facility. The conversion was only recently fully completed in 1Q’15 . Additionally, Fortress owns a banknote manufacturing plant in Landqart, Switzerland producing paper for a broad base of international currencies, including an exclusive contract for Swiss Franc banknotes . Recently, the Landqart plant began printing the first new Swiss Franc series in 16 years, which will offer best-in-class security features and significant gross margin expansion relative to current book of business
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Having just recently completed a very large ($400mm) CAPEX cycle we believe the Company has just begun a significant CF generation cycle. We examine this possibility by briefly reviewing the track record of investments (both business and capital) to date. Our conclusion is that there is a unique opportunity to get equity-like returns but remain higher up in the capital structure with the purchase of the 2019 convertible debentures.

Currently the Company has approximately $70mm of cash. There is a $40mm 2016 debenture (the one previously pitched), a $25mm 2017 private debenture held by the union pension, a $69mm 2019 debenture (the one we recommend), and a $105mm non-hold co (secured by Thurso plant) loan funded by the Quebec government. Currently generating operating cash (at an increasing rate the last several quarters), we estimate that this year (2016) will end with $50mm+ in cash, the $40mm debenture fully paid off and the other three pieces of debt outstanding. At this point, while second in line from a timing perspective to be repaid, it is important to note that the other two lenders have a large vested interest in seeing the operations continue to operate.

The Fortress Track Record:
Fortress is set up as a holding company structure and, while only on its fourth major investment, there already is a strong track record that demonstrates considerable ability to:

1. Find value (in some cases, deep value) investments that sell products into growing end markets globally
2. Find top quality managers to run operating businesses
3. Invest in transformative growth CAPEX, which is creatively financed and consistently leads to material growth
4. Focus on value creation, while remaining agnostic to how value is created 
5. Design favorable tax strategies

Fortress follows a simple, though far from simplistic, strategy, which results in a powerful ROI through buying and building businesses. There is no financial engineering involved. Rather, this is a good, old-fashioned investment strategy of modernizing capital equipment to feed growing end markets. 

With the Company having recently completed a multi-year, nearly $400mm CAPEX cycle, the Fortress operating assets are poised to show large growth in cash flows, while feeding uncorrelated and expanding markets. Unfortunately, investor discontent over operational and conversion delays at its dissolving pulp facility in Thurso, Canada moved the Fortress equity into the discarded bin. Now that these delays have been addressed and cash flow is beginning to accelerate, this discontent is our opportunity.

Before we demonstrate why, even with the time and cost overruns, Fortress’ investment in the Thurso conversion was sound and can generate a very strong ROI, we will first review the rest of the Fortress track record. For the purposes of this analysis, we are taking the most conservative approach possible when examining the return: all CAPEX is included in the investment even though nearly all of it was funded through internal cash generation, which is not given credit on the return side.

Dresden (2006): $7.5mm paid for a dry strip wall paper business in Germany; Invested $41.7mm to expand capacity. Grew mill capacity from 20K tons to 60k tons and global market share from 26% to 48%. Annual revenues were grown organically from $63.2mm to a $173mm runrate at time of sale; Sold for $213mm in 2013 to Glatfelter (a $2BN in sales specialty paper manufacturer)
Paid no taxes on transaction; +330% ROI

Landqart (2006): $7.5mm paid for bank note business in Switzerland; Invested $94.8mm to date in modernization of existing banknote line and construction of a second state of the art bank note line
$24.8mm was financed through non-core land and water right sales. Increased capacity from 2.5k tons of banknotes to 10k tons. Increased sales from $60mm to $137mm
Funded and completed research for a new patented currency technology called Durasafe which is now being rolled out as the highest security (and margin) product in the banknote industry. This business remains within the Fortress portfolio. New efficiencies in the manufacturing process combined with the rollout of the first new Swiss Franc series in 16 years provide a strong visibility into doubling EBITDA over the next 2-3 years with what should be a similar growth in value; +89% ROI and counting (based on public comp multiples)

Optical Thread (2011): $0.75mm paid for a discarded bank note security feature from Bank of Canada. Moved equipment to already owned land in Quebec; Invested $4.2mm to build facility and operations From zero to $2.5mm in annualized high margin revenue in two years; Sold for $17.5mm in 2014 to Nanotech Security Corp an established manufacturer of anti-counterfeiting products; +254% ROI

It is worth re-emphasizing two key takeaways:

1. Fortress is not just a passive investment holding company. Fortress invests in and grows businesses organically.
2. Fortress is no stranger to investing large sums of money into complicated capital projects

Is Thurso as good an idea as the other three? To answer this question, we must examine the investment and the potential return scenarios.

Thurso (2010): $3.0mm paid for a paper pulp mill from a bankruptcy proceeding; Invested $243mm in CAPEX to convert the mill to a dissolving pulp mill and build a 24MW cogen facility
Invested an incremental $56mm to fund operating losses during the completion of the conversion. From zero sales to $137mm (FY’14) and on a much higher revenue runrate in 2015
Signed long term power contract with Hydro Quebec that generates $20mm of annual EBITDA. This is a core asset that is just beginning a large cash flow generation cycle; +?? ROI

The most conservative way to think about the size of the investment requiring a return is to include all operating losses, which results in a total investment of $302mm. Currently, dissolving pulp prices are just 30% of all-time highs and only 10% off all-time lows. The FTP manufacturing capacity utilization is still only 75% (it will slowly ramp to 85%+), while its cost structure remains more than $100/ton above the final target. Even with such draconian inputs, this scenario still produces $15mm of EBITDA less CAPEX, a 5% annual return on the $302mm investment. 

US$1,200/ton is the price required to bring on any significant new capacity and likely a low mid-cycle estimate, since at this price the bottom quartile of the global manufacturing industry finally will be break even. Under this price scenario and with no improvement in cost structure or capacity utilization, Thurso would make approximately $90mm of EBITDA less CAPEX or a 30% annual ROI. If prices return to the mean of the last decade with no improvement in cost structure or change capacity utilization, Thurso will produce approximately $150mm of EBITDA less CAPEX or a 50% annual ROI.

Much more conservatively, if the price of DP never increases (i.e., 1/3-1/2 of global supply produces dissolving pulp indefinitely at a loss) and all Fortress does is finish the optimization process to get to design cost structure and 85% capacity utilization (items firmly within the Company’s control ), Thurso still will produce $40mm of EBITDA less CAPEX for a 13% annual ROI.

As we now know, optimization of the plant to produce high quality product takes time and money. This comes in the form of funding operational losses before, during, and after the conversion process. The upside of this is twofold: First, Fortress gets a tax shield from the operating losses. Second, and more importantly, as supply gets tight, it will take much longer for others to bring on additional capacity and the cost may itself serve as an obstacle to a conversion. This dynamic will ensure a long window of tight inventory; elevated market prices; and, of course, profits for Fortress.

The final tally on the magnitude of the return is still unknown. However, the conversion at Thurso has fully demonstrated the mettle of management. The nearly perfect storm that so severely challenged Fortress during the Thurso investment cycle would shake any management team to its core. Yet this group guided the company through a difficult period and now is set to thrive, once again. Therefore, we strongly feel that the success completing this very difficult plant conversion stands alongside the Fortress track record of investment/growth at the other units. While this appears lost for the moment on the market, investors should take great comfort in knowing that Fortress was able to operate during the most difficult of circumstances. Now, imagine what it will do when times are good.

How we think about the debt: 

The Fortress model uses, in part, creative debt financing for its CAPEX projects.

We observe:
1. Fortress has just under $200mm in net debt
2. There are two public issues trading at discounts to par (90 for the 2016s and 55 for the 2019s )
3. Fortress produced $7.0mm of EBITDA in YTD’15 (through 3Q)

These three easily observable facts may lead an investor to the conclusion that Fortress has deployed too much debt. However, we look at this very differently:

Over half of the net debt is a loan from the Quebec government, which is highly motivated to help create jobs in the pulp industry, if they feed growth end markets . This debt accrues no interest or principal payments until January 2017, at which point the interest rate is 5% and the principal amortizes over a ten year period ending in 2027. This debt is plant specific and has no recourse to Landqart or the parent. The Quebec government is an excellent and very friendly lending partner.

The final conversion and stabilization of Thurso was completed just recently in 1Q 2015. Because the plant is beginning to generate significant cash flow, it is much more meaningful to calculate what the capital structure will look like at the end of this year and the next. At the end of 2015, net debt will be approximately $190mm and trailing EBITDA will be approximately $10-15mm, still a high multiple. However, in only one more year, the picture will be entirely different. 

At year-end 2016, even if we assume absolutely zero improvement in dissolving pulp prices, Thurso’s cost structure and capacity utilization , Fortress will have approximately $170mm of net debt and $35-40mm in trailing EBITDA. At this point Net Debt/EBITDA will be under 5x and prospectively investors will look out a year and understand the business is under-levered.

Perhaps more prosaically, we believe in asking whether the asset value supports the debt. If it does, then the debt/EBITDA numbers will, as well. This equation does not work, however, in reverse order. Just because Debt/EBITDA looks fine does not mean the company is not over-levered (i.e., a business in decline). 


$200mm of debt is:

1. Only 2/3 of the value of the Thurso conversion CAPEX, which may very well be the best Fortress investment to date
2. Approximately the value (perhaps a bit more) of Landqart
3. Only $1,000/ton of dissolving pulp capacity (or <1.5x mid-cycle EBITDA/ton)
4. Only 1/5 of the replacement value of assets (building, machinery and equipment) as determined by insurance value
5. Under 10x EBITDA of just the cogen EBITDA with contracted government take rates out 10-25 years 

Our conclusion is the return on the Thurso and Landqart investments will be substantial and without taking equity risk you can double your money by purchasing the 2019 debentures. Interestingly, no one remembers or speaks anymore about the fact that these are actually converts.
The conversion feature kicks in at $31. While the 2016s also have a similar feature, the duration left leaves this option nearly worthless. Not true for the 2019s where we have over three years left. In fact at the upper end of our EBITDA range for 2017 the SOTP for the two businesses is well over the strike and into 2018 the possibilities get even larger.

Catalyst

1. Continued cost improvement at Thurso from CAD$850/ton to CAD$725/ton
2. Price increases in DP. With supply/demand getting tight, viscose customers have no inventory and prices have already moved well ahead of price increases in DP, a very strong leading indicator
3. The rollout of the new, higher security, high margin Swiss Franc will double Landqart EBITDA over the next several years and should further establish the Landqart mill as a premier supplier of banknote paper.
4. Potential for balance sheet enhancing activities, including bond repurchases (already announced 1/16) or sales of non-strategic assets (management has spoken about two either of which would be a game changer a.) sale of shuttered LSQ mill and b.) sale leaseback of Landqart)