Description
Fraser Papers is a specialty paper company with insider buying currently trading at between 2.7x and 5.8x “trend” after-tax-free cash flow, under 25% of 2005 sales and 47% of tangible book value with a clean balance sheet, pro-forma for asset sales and a likely acquisition.
Spun off from forest products company Nexfor in 2004, Fraser Papers is an integrated specialty paper company with approximately US $1 billion in annual sales, which produces a wide variety of technical printing and writing papers and lumber products. Although Fraser Papers is headquartered in Toronto, Ontario, over 90% of sales and 56% of company-owned assets are in the US. The 1.1 mm tons of different paper and pulp grades produced by Fraser Papers are uncoated freesheet, uncoated groundwood, coated groundwood, and bleached hardwood kraft pulp. Approximately 75% of the paper production is uncoated free-sheet paper—comprised of printing and writing papers used to produce reading materials including prospectuses, reference and religious books, and trade advertisements. Only 30% of Fraser Papers’ paper is commodity-grade. Fraser Papers is the sixth largest producer of uncoated free-sheet paper in North America—trailing International Paper, Weyerhauser, Domtar, Boise Cascade, and Georgia Pacific.
This report will argue that the low valuation is due to a few major reasons: 1) Weak industry conditions from 2000-2003 caused by a recession, producer overcapacity, and declining paper demand relative to GDP; at the same time burgeoning energy and fiber costs coupled with a weak US dollar have overcome price increases that started at the beginning of 2004. These factors have depressed results for the North American paper and forest products industry, which is now arguably one of the most out-of-favor and worst performing industry groups in North America. It is down approximately 25% YTD. 2) Investors lack of patience for and misunderstanding about Fraser Papers’ margin improvement program and asset repositioning activities. 3) Low investor interest due to a lack of an independent operating history, weak liquidity caused by a small market cap and the minority shareholder Brascan Corporation owning 45% of the shares outstanding.
Fraser Papers has approximately 29.5 mm shares outstanding and trades on the Toronto Stock Exchange. Fraser Papers reports in USD. For this reason, all dollar amounts in this report are USD unless stated otherwise.
What Went Wrong
In 2003, Dominic Gamiero, the CEO of Nexfor, realized that his Company was undervalued. Nexfor was comprised of Norbord—an industry-leading company that produced oriented strand board and wood-panels and was posting record profits at the top of the cycle. Investors were paying little attention to Fraser Papers, which was supposedly at the bottom of the cycle. In addition, it had a woefully inefficient cost structure and a confusing mix of underperforming and undervalued assets. Brascan, a very savvy publicly-traded investment firm based in Canada, owned approximately 42% of Nexfor and was extremely supportive of a plan to separate the two businesses. Brascan is no stranger to spin-offs—see zzz007’s 2003 write-up of Brookfield Homes (NYSE: BHS).
When it appeared as if the paper cycle would begin its typical recovery as a “late cyclical,” Gamiero became the CEO of Fraser Papers and formulated a comprehensive 12 - 18 month restructuring plan. Management believed that there was a lot of low-hanging fruit to cut costs, reposition the product mix, shut down or sell unprofitable mills, and divest valuable timberland assets. Management indicated that paper prices were approximately 90% of trend and had the potential to increase substantially in the next 12 to 18 months. From Nov. 2003 to June 2004, the S&P TSX Paper and Forest Index appreciated around 25% in anticipation of a long-awaited recovery.
Just a few days after Fraser Paper began trading in late June of 2004, energy and fiber costs began their meteoric rise—the magnitude of which caught most by surprise and simply has been a disaster for the industry. Even worse, the Canadian dollar continued to strengthen and chemical costs increased—hurting profitability for not only Fraser Papers, but all Canadian paper producers including industry-leader Domtar. Despite improving paper prices that appear to be at mid-cycle levels, the global paper and forest industry has not generated returns anywhere near its cost of capital over the past five to six years. Most companies are generating negative free cash flow. At the same time, few paper industry executives expect cost pressures to improve any time in the near future.
Fraser Papers has struggled since the spin-off and has had its cost improvements and top-line growth offset by rising input costs.
As a result, Fraser Papers has declined from an August 2004 high of $14.05 a share to a low of $7.42 a share after disappointing Q2 2005 earnings results that did not meet analyst expectations.
At this point with most paper companies at 52-week lows, many institutional investors have thrown in the towel. Many believe there has been a secular change in the paper industry that will never be reversed and that these stocks are value traps—see aidan819’s Neenah Paper writeup that received a poor rating back in December 2004.
Specifically, investors are even more bearish on Fraser Papers. Many perceive it to be a marginal company, an illiquid stock and a high-cost provider. Out of the six analysts in Canada who cover Fraser Papers, every single one has either a hold or sell rating on the stock. Nobody has ever made money owning this stock. Not surprisingly, investors are scrambling to sell shares at these low prices.
Why Does Fraser Have a Chance?
Despite seemingly bleak prospects, Fraser Papers has substantial upside over the long-term due to the reasons below.
Balance Sheet
Fraser Papers has the most pristine balance sheet in the entire North American forest and paper products industry with only 8% net debt to equity before asset sales. After the sale of timber assets described below, Fraser Papers will have significant net cash. The average US pulp and paper company has a net debt to EV of 55%, while the average Canadian pulp and paper company has a net debt to EV ratio of 45%.
As many of you know that follow cyclical businesses, it is a huge competitive advantage to have a clean balance sheet during an industry downturn. For example, when the steel business had a downturn during 2001-2003, over 35 companies filed for Chapter 11 bankruptcy and could not survive long enough to benefit from strong industry conditions that led to record profits only 12 months later.
Share Repurchase Plan, Brascan Insider Buying, Private Equity Deals
Despite challenging industry conditions and negative investor sentiment, Fraser Papers has had substantial insider buying at current and higher price levels. During the open window, Fraser Papers, Brascan, and the CEO purchased a total of 770,000 shares in the market (4.5% of the float)—which unbelievably was over 45% of the total volume during that time period.
More importantly, Brascan has aggressively added to its position and purchased 154,000 shares from May 2005 to early June 2005. When material corporate news surfaced and Fraser Papers entered a blackout period in advance of the end of the second quarter, Brascan was forced to postpone any plans to purchase shares. However, Brascan just filed a notice with the Toronto Stock Exchange that indicates a 45% ownership in Fraser Papers after purchasing another 200,000 shares in the open market over the past week, which represented around 40% of the total volume traded after the weak quarter.
Brascan has a fantastic track record of allocating capital and investing counter-cyclically in many different industries. For example, Brascan purchased a sizable 7% of Nexfor’s shares ending November 2001, which turned out to be a bottom for Nexfor’s stock. Given that the SVP of Finance and 50% of Board Members are affiliated with Brascan, we believe Brascan’s open market purchases are a strong signal that Fraser Papers could be undervalued by the market.
Moreover, Fraser Papers purchased 600,000 shares or 2% of the shares outstanding back in June. The Company has an additional 900,000 shares under a normal course issuer bid. We believe Fraser Papers is likely continuing the buyback at the current moment since the blackout period has ended. If you speak to the management team, you will be convinced as we were that they believe large share buybacks at today’s price levels will be very beneficial to shareholders.
On May 12, 2005, the CEO purchased 20,000 open shares in the market for $9.65 per share. In addition, two directors have purchased shares in the open market during the past year at higher prices.
Despite the bleak picture, private equity firms have committed billions of dollars to the paper industry. For example in 2004, Cerberus Capital Management purchased MeadWestvaco’s paper business for $2.3 billion and Madison Dearborn Partners purchased Boise Cascade’s paper business for $3.9 billion. One potential short-term downside of Brascan’s significant interest in Fraser Papers is that it may deter lowball bids from private equity firms and/or strategic acquirers. In addition, Brascan is known to be a long-term investor that is sometimes very early from a macro perspective.
Margin Improvement Program, Norbord Lease Agreements
In 2004, management followed through on their promise at the time of the spin off to reduce costs excluding non-controllable currency and commodity costs. Fraser Papers generated impressive margin improvements of $42 mm on a revenue base of almost a billion dollars in only 12 months by leveraging fixed costs, selling non-core assets, reducing headcount, and closing unprofitable mills. At the same time, Fraser Papers was hurt by approximately $57 mm because of higher fiber costs ($27 mm) and a strong Canadian dollar ($30 mm).
Before the year started, Fraser Papers announced an additional $50 mm margin improvement program and a $69 mm purchase of operating leases from Norbord. The margin improvements were to be achieved through headcount reductions, closure of unprofitable machines, and a superior product mix.
Fraser Papers was successful at executing the lease purchases. However, in the first half of 2005, Fraser Papers achieved only $5 mm of the $50 mm target and reduced its target to $40 mm for the year, which disappointed investors. The lower margin improvement was due to management’s decision to take downtime at four different pulp and paper mills. This downtime was necessary to perform maintenance and will not be occurring in the second half of 2005 or 2006.
Despite the lowered guidance, we believe that the incremental $10 mm of cost savings can be achieved in the first half of 2006. This will be achieved by management eliminating 10% of its lowest margin, commodity grades and continuing its shift towards higher-grade, specialty paper products. In 2007 and 2008, management targets reduction of the remaining 20% of commodity-grade paper products which are non-competitive on a cost basis relative to the larger producers and earning negative EBITDA. This is a very important fact because Fraser Papers’ specialty paper products are higher-margin and generally cannot be mass produced by IP and Domtar’s state-of-the-art un-coated freesheet machines.
Asset Sales
In Q1 2005, Fraser Papers monetized approximately 240,000 acres of timber assets in Maine for $335 per acre, yielding proceeds of $80.5 mm and exceeding expectations. The Maine timber assets had $5 mm in annual EBITDA—implying an EBITDA cap rate of 6%. Timber assets are valued as low risk investments because of their stable cash flows, land values, and perceived hedge against inflation. As a result, comparable transactions in the past couple of years have occurred at EBITDA cap rates with a small premium to Treasuries.
At this point, Fraser Papers currently owns 765,000 acres of timberland in New Brunswick, Canada. Management has publicly stated that they perceive this asset to be non-core. We believe it will be sold by the end of 2005. Fraser Papers agreed to a 20-year fiber supply agreement with the purchaser of the Maine timber asset and we predict that they will enter into a similar agreement with the purchaser of the Canadian assets. Although the Canadian timber assets are carried on the books at only $19 mm, they earn annual EBITDA of $9 mm - $10mm; they are unlikely to have the same value as the Maine timber assets because of various reasons I will explain if needed. We believe that a 6.25% to 7.00% EBITDA cap rate (a 200 bps to 300 bps premium to Canadian government bonds) equating to a $129 mm to $153 mm valuation is very reasonable and conservative.
This valuation implies a per acre valuation of $170 to $200 per acre—a 40% to 50% discount below the Maine timberland valuation. Fraser Papers should receive after-tax proceeds of $89 mm to $109 mm ($3.00 to $3.70 per share) using a 33% tax rate.
Acquisition of Katahdin Paper
Fraser Papers has a call option to purchase Katahdin Paper by October 2005 for an undisclosed price. Katahdin Paper is owned by Brascan and was purchased out of bankruptcy in April 2003 at a fire-sale price, according to management. Fraser Papers has managed the mills for Brascan for two years and we believe Katahdin Paper was purchased by Brascan with the clear intention of selling the asset to Fraser Papers after the spin-off.
Katahdin produces directory paper and super-calendared (SC-A and SC-A+) paper used for trade and magazine advertisements. Katahdin Paper has capacity to produce 465,000 tons. It is an excellent strategic fit for Fraser Papers. The directory paper mill is attractive because it has secured long-term contracts with the key players (Yellow Book, Verizon, RH Donnelley, etc) and has less cyclicality. Fraser Papers will have a 30% market share in this business if Katahdin Paper is acquired. The SC-A paper grade is a substitute for light-weight coated paper due to its cheaper cost.
Our conversations with management and sell-side analysts indicate that the likely price is between $100 mm and $125 mm. Management has indicated to us that the Katahdin asset has a complex formula to value the business, which unfortunately is not publicly disclosed. With that in mind, management has indicated that Katahdin will be sold at a discount to private market valuation that must come with a fairness opinion.
The Katahdin Paper mills are in a turnaround situation as well. According to Moody’s, Katahdin Paper generated -$18 mm of EBITDA in 2004. The Katahdin mills are currently running at 85% of capacity and EBITDA negative as well in the first half of 2005. According to management, Katahdin will be at 100% of capacity at the end of Q3 and will be significantly EBITDA positive. There is no publicly disclosed information about Katahdin and thus it is difficult to analyze. That being said, we believe that Katahdin revenues can reach approximately $400 mm to $450 mm when the paper machines are running at 100% capacity compared to $350 mm today, according to our estimates and field checks. We estimate that Katahdin will earn a normalized $25 mm - $30 mm in EBITDA or a 5% to 6% EBITDA margin. Management believes this estimate is reasonable and also offers upside potential.
Industry Rationalization
The paper industry is suffering from overcapacity, low prices, high input costs, and weak demand. Fortunately, the large producers Domtar and IP are struggling with high debt loads and weak free cash flow generation even though the industry is supposedly at trend pricing levels. Domtar, the largest uncoated free-sheet producer in Canada, was downgraded to junk by Moody’s in June 2005; IP recently announced a restructuring plan to divest approximately $8 billion to $10 billion in non-core assets to focus on core paper assets and avoid a ratings downgrade to junk status.
By the end of 2005, IP, Domtar, and Badger Paper Mills will have removed another 4% of capacity out of the uncoated free-sheet market. From 2001 to 2004, Fraser Papers management estimates that approximately 10% of industry capacity was removed. For these reasons, we believe that the paper industry is rational. It is taking the right steps to ensure a proper supply / demand balance that will permit some acceptable return on capital. After inventory de-stocking weakened 1H 2005 results, our field checks suggest the industry is likely to raise prices in the second half of the year.
Furthermore, few investors are giving the paper industry any optionality for an increase in demand from emerging countries.
2003 1995 Q2 2005 2004 1999-2005
Average
Uncoated Free-sheet $628 $1,150 $740 $676 $700
50 lb offset (Trough) (Peak)
IP EBITDA Margins 15% 25% 12% 14% 14%
Domtar EBITDA Margins 15% 32% 8% 9% 19%
Boise Cascade 9.1% 28% 8% 9% 13%
EBITDA Margins
Fraser Papers -1.5% 13% -1% 1% 6%
EBITDA Margins
USD / CAD Average 72c 73p 82c 77c 71c
Commodity grade products that can be easily tracked from industry publications and sell-side analysts account for only 30% of total paper production. This makes it difficult to track industry trends such as capacity, pricing, demand, and input costs on an apples-to-apples basis relative to IP or Domtar.
In the past, Fraser Papers has achieved EBITDA margins over a full cycle of over 5% without the benefit of a motivated management team with a clear plan to rationalize the cost structure. As of the second quarter of 2005, Fraser Papers is on pace (based on Q2’05 run-rate) to lose over $50 mm of incremental EBITDA from rising energy ($8 million), fiber costs ($22 million) and a strong Canadian dollar ($20 million)
That impact combined with the $57 mm Y/Y setback in from 2003 to 2004 indicates that Fraser Papers has lost a whopping $107 mm in EBITDA due to uncontrollable factors. On an after-tax basis, that is $2.40 per share from 2003 to 2005.
Our conservative normalized EBITDA of $54 mm assumes that Fraser Papers has suffered a permanent impact and will be unable to pass on these costs to its customers.
In our upside scenario, we assume one of two potentials: a) input costs will return to historical levels or b) Fraser Papers and the rest of the industry will raise prices to a higher “trend” level than the past 10 years to account for a structural change in input costs. As one can see below, the weak Canadian dollar cost Fraser Papers $20 mm in EBITDA. Because of the USD / CAD revenue-cost mismatch, each 1 cent change is worth $5 mm in EBITDA. Furthermore, fiber costs are soaring in the Northeast because of the strong housing market and are 40% above trend, according to management.
One can argue that the Canadian dollar puts Fraser Papers at a competitive disadvantage compared to US paper producers and thus Fraser Papers should not have the ability to raise prices. We are receptive to this argument and think this is a distinct possibility. However, at the same time we believe high energy, chemical, and fiber costs are hurting the entire industry without discriminating against any one producer and thus have a decent chance of being passed onto customers.
Nonetheless, our conservative normalized EBITDA does not give Fraser Papers any relief from high commodity prices and a strong loonie. Our upside normalized EBITDA assumes paper prices at trend levels and 2004 input costs. If these three cost pressures reverted to 2003 levels, a seemingly unlikely but yet somewhat plausible scenario, Fraser Papers could earn an incremental $57 mm of EBITDA or $1.30 per share on top of our $2.90 to $3.00 upside estimate. In this extremely unlikely scenario, Fraser Papers would be earning after-tax free cash flow of $4.25 per share.
Fraser Papers Financials
Enterprise Value
Shares Outstanding: 29.5 mm
Stock Price: $7.55
Equity Market Capitalization: $223 mm
Add 10 Year Debt at 8.75%: $150 mm
Add Underfunded Pension Liability: $49 mm
Add Katahdin Paper $112.5 mm
Less After-Tax Proceeds of New Brunswick Timber Assets: $100 mm
Less Q2 2005 Cash: $108 mm
Enterprise Value: 327 mm
($ in millions)
Conservative Upside
Normalized Normalized
EBITDA EBITDA
Legacy Sales $1,000 $1,000
Katahdin Paper 425 450
Pro-Forma Sales 1,425 1,450
Q2 2005 Run-rate -8 -8
EBITDA Reported by
Fraser Papers
Mgmt Cost-savings 35 45
Pulp / Paper Downtime 12 12
Norbord Lease 11 11
Agreements
Canadian Dollar No Change 20
Fiber Costs No Change 22
Energy Costs No Change 6
Legacy EBITDA 50 108
Legacy EBITDA Margin 5.0% 10.8%
Add Katahdin
Normalized EBITDA 25 30
Katahdin EBITDA
Margin 6% 7%
Adjusted EBITDA 75 138
Adjusted EBITDA 5.3% 9.5%
Margin
Legacy D&A 35 35
Katahdin D&A 15 15
EBIT 25 88
Interest Expense 13 13
($150 mm at 8.75%)
Pretax Income 12 75
Taxes (33% Tax Rate) 4 25
Net Income 8 50
Add D&A 45 45
Less MCAPEX 15 15
(1% of pro-forma sales)
FCF to Equity Holders 38 80
Pro-Forma Shares Out 29.5 29.5
FCF Per Share ~ $1.30 ~ $2.75
Implied FCF Valuation 5.8x 2.7x
Fraser Papers management targets a 12% return on reported tangible equity ($473 mm or $16 per share) over a full economic cycle. This implies $1.90 per share of “trend” after-tax free cash flow.
Price Target
We believe a multiple of 8x to 10x normalized free cash flow is not unreasonable for a low-growth, cyclical mundane business that can generate respectable free cash flow.
It is worth noting that many forest and paper companies have historically traded for above-market multiples of normalized earnings and EBITDA.
Our two year price target for Fraser Papers is $10.40 to $27.50—representing upside of approximately 38% to 264% from current price levels.
Conservative Upside
Normalized EBITDA Normalized EBITDA
(no relief from inputs) (relief from inputs to 2004 levels)
Price / FCF to Equity
8 $10.40 $22.00
9 $11.70 $24.75
10 $13.00 $27.50
11 $14.30 $30.25
EV / EBITDA
4.5x $7.90 $17.50
5x $9.20 $20.00
5.5x $10.50 $22.20
6x $11.75 $24.60
Risks
1) Higher input prices, decreased demand, and irrational pricing structurally reduce returns of the paper industry.
2) Management cannot cut costs to improve halfway to industry normalized margins.
3) Strong loonie makes entire paper industry uncompetitive.
4) Interest rates increase substantially and thus timber assets cannot be sold at targeted price levels.
5) Paper cycle turns dramatically before Fraser Papers has time to cut costs and integrate Katahdin Paper.
We believe Fraser Papers has enough scale to charge competitive prices and earn margins that are several hundred basis points lower in the process. They have been doing this since the late 1800s. We realize these types of businesses are not worth high multiples or even market multiples, but we believe the dirt-cheap valuation and clean balance sheet makes this opportunity attractive.
That being said, this is an extremely speculative investment since Fraser Papers is not generating free cash flow today. Much has to happen for this stock to work out, but we believe the upside is massive if Fraser can execute its business plan.
Disclaimer: We are currently long Fraser Papers. We may buy more and/or sell stock at any time for any reason without notifying anyone. This is not an offer to buy or sell securities—so please do your own work and reach your own conclusion.
Catalyst
1) Fraser Papers continues to buy back stock and create value for shareholders. Brascan continues open market purchases and potentially bids for the entire company.
2) The paper industry raises prices and continues to remove capacity.
3) Management is successful with their cost cutting / asset repositioning program.
4) Industry consolidation.