Description

I am recommending a long position in the NewPage 2nd lien (10% coupon, $806MM face, matures May 2012, currently trading in the 67.5 context) and Floating Rate Notes (L + 625, $225MM face pari passu to 2nd Lien, matures May 2012, currently trading in the 64 - 65 context), which presents a compelling risk-reward proposition with a total return potential of >35% over the next 3 - 6 months (based on probability tree matrix further below). Very similar to the previous VIC write-ups on PLYGEM and ACAS, I'd lump NewPage into the same general bucket: (i) unloved (coated paper industry is generally hated but the reality is that advertising will cyclically "normalize" / show incremental improvements in the near-term given it lags GDP and is heavily reliant on auto / housing / employment turnover which have arguably started to show incremental improvements and moreover, the industry construct is relatively rational and has the potential to show more consolidation w/ the top-4 players currently controlling >70% of supply), (ii) mis-perceived (i.e. everyone is hyper-focused on NewPage's balance sheet and liquidity situation extrapolating Q1 - Q2 2009 results - which included significant downtime / and the industry end-markets were witnessing fierce / unprecedented inventory de-stocking - into 2H 09E - 10E and assuming a n-term liquidity crunch BUT my view is that the business will have more-than-adequate liquidity for the next 2 - 3 years which provides an ample run-way for the business to grow into its normalized earnings power) and (iii) mis-understood (i.e. generic Street view is that NewPage will generate $10 - $20MM of EBITDA in Q3 period which I think is a VERY low hurdle - I have them at around $70 - $90MM for the quarter - moreover, most analysts gloss over the significant cost savings implemented by the company over the past couple years post the SENA acquisition which I think will provide them with significant operating leverage on further volume improvements in 2H 09E and potential pricing improvements into early 2010E).

While I'd fully admit that there are many uncertainties in / around coated paper, what attracts me most to this investment opportunity is the already overly-punitive / low expectations creating many n-term catalysts for upside surprise (more pragmatically, getting a ~15% CY to wait while allowing these n-term / m-term catalysts to unfold seems like an attractive risk-reward opportunity to me). Moreover, its worth noting that NewPage's Secured Notes are currently trading around 101% (~11% YTM) which compares to the 2nd Lien / FRNs at 65 - 67.5% (~28 - 30% YTM) which is 2x additional turns of leverage based on "normalized EBITDA" (while we may not be back in a relative value world, I'd argue this spread differential is too large). In addition, its worth noting that the Verso Paper (ticker VRS) equivalently leveraged / 2nd lien security trades at a sub-14% YTM and the more highly leveraged / sub note security trades at less than a 21% YTM (once agin, not sure if relative value holds any weight, but the 800 - 1500 bps differential is notable).

SUMMARY THESIS:

Several key factors should enable NewPage to outperform even in this difficult environment: (i) best-in-class management as reaffirmed via multiple channel checks and evidenced by cost savings / acquisition synergies (my sense is that the $265MM target that they highlighted at the time of the SENA acquisition in late-2007 has / will result in >$450MM of savings based on channel check conversations as well as company presentations), (ii) decent exposure to some of the more attractive parts of coated (~56% / ~44% split btwn freesheet and groundwood which comprise ~3.2MM tons of their coated exposure - notably, NewPage presence in super-calendar paper is very attractive given its niche positioning and >1.2MM tons of uncoated groundwood which is not a bad counterbalance and seeing incremental improvements), (iii) relatively rational industry market structure on the whole with the top 4 players comprising >70% of supply (NewPage w/ 36%, Verso 14%, Sappi 11% and UPM 8%) should help mitigate any further pricing erosion and could result in legitimizing price increases in early 2010.

There are four primary reasons why I think NewPage's securities are timely / actionable including: (i) N-TERM RESULTS: Q3 - Q4 2009 results should surprise to the upside given the very low hurdle by Street estimates (JPM credit desk expects $9MM for Q3 EBITDA vs my view of $70 - $90MM driven largely by volume improvements from a pick-up in Holiday advertising as well as decelerating inventory de-stocking trends and further cost cutting initiatives) and should ultimately inflect the Street's 2010 - 2011E perspective to a $350 - $450MM EBITDA range (assuming further recovery in the economy); (ii) COVENANT-LIGHT: NewPage 2nd Lien trades at recovery values BUT the reality is that NewPage has a covenant-light capital structure and adequate near-term liquidity to weather the next 2-3 years w/ no covenant issues, (iii) LIQUIDITY: liquidity will be enhanced by (a.) working capital improvements (inventory improvements in 2H 09E should yield >$75 - $150MM in 2H 09E - my sense is that Street is NOT factoring in much if any benefits from working capital), (b.) potential asset sale of remaining hydroelectric generation capacity could yield $50 - $100MM (my sense is that Street is NOT factoring in any benefit from this), (c.) black liquor benefits running through YE should result in $140 - $160MM of 2H 09E benefits (my sense is that Street is factoring in $100 - $120MM so an incremental $20 - $60MM above Street); and (iv) SUPPORTIVE INDUSTRY DATA PTS: tangential data points should be supportive including the following: (a.) advertising "normalizing", (b.) ruling on China / Indonesia duties expected on Nov 6 / 9th and could result in a favorable ruling - both perception and reality - and (c.) US Postal Service could announce another discounting program in the next couple months to catalyze further volume improvement. Another notable (I'm viewing as pure upside to the trade BUT I don't think its unreasonable to expect more clarity on this front over the next couple months) catalyst could be equity sponsor support from both Cerberus (~80% owner) and Stora Enso (~20% owner) in the more junior parts of the capital structure (notable that Cerberus has approached the 2nd lien holders in the past to proactively buy back securities so I think this is NOT out of the question (especially as we think about how Cerberus can "create" the equity at an attractive / lower absolute $ price.

NewPage 2nd Lien / FRNs currently trade in the ~65 - 67.5 range (leveraged from 3.4x - 4.6x at market price based on "normalized EBITDA") and provide a CY of ~15% and 1-year yield-to-90 of ~50%. Over the longer-term, I don't think its unreasonable to assume a valuation multiple of 6 - 6.5x for this asset based on "normalized" EBITDA. The graph below highlights my views on peak ($1Bln) vs trough ($250MM) vs normalized ($550MM) EBITDA - my view is that this business should be valued at around $3.25 - $3.75Bln on normalized EBITDA (which compares to the current $ creation value of ~$2.55Bln based on current market pricing). Given NewPage's covenant-light capital structure and decent liquidity ($288MM currently BUT I think this has a high likelihood of being >$400MM by YE 09), this is effectively a 2-3-yr cycle bet on the underlying demand drivers for coated paper industry (i.e. margin of safety to the trade is taking the view that only 25 - 50% of the 100% coated paper volume fall-off comes back again / is cyclical in nature - which I think is a very conservative assumption ... which should result in "normalized EBITDA of $550MM). Over the next 3 - 6 months, I expect the 2nd Lien to appreciate significantly (providing >40% returns) and view this as a very attractive risk-reward. Moreover, while the Sub Notes (trading in the high 40s) are fairly illiquid, I also think this provides significant upside optionality as the margin of safety on earnings power improvement is attractive.

(1) Excludes black liquor
(2) SENA acquired in late 2007
(3) Estimate driven by quarterly presentations of productivity improvements and 3rd party channel checks

SUMMARY CAP TABLE (JUNE 2009 updated for Secured deal in Sep):

NewPage's capital structure consists of a $500 million ABL facility due December 2012 ($74MM currently drawn and $69MM w/ LOCs), ~$1.7Bln Secured Notes due 2014 (note they recently completed this deal in September which effectively removes all covenants), ~1Bln of 2nd lien / senior notes and ~$630MM of junior securities (including Sub Notes / Holdco / Super-Holdco notes). The Secured Notes on a book basis currently finances down to 7.5x 2009E trough cash EBITDA and based on "normalized EBITDA" of $550MM the Secured Notes finance to ~3.4x EBITDA. The 2nd lien / FRNs finance down to ~10.2x 09E trough EBITDA and based on "normalized EBITDA finance down to ~4.6x.

MARGIN OF SAFETY:
From a 2nd Lien perspective, anything above $400MM in "normalized" 2 - 3 years out EBITDA should result in the 2nd Lien trading back to par (assuming a ~7.0x multiple). Given my views that earnings power should be >$550 million in 2 - 3 years, I would anticipate the 2nd Lien trading up well in advance of any pricing improvements in coated paper.

UPSIDE / DOWNSIDE ANALSYIS (prob tree further below):
HOMERUN CASE (5% prob): assuming 1-yr exit at 95 - 100 cents driven by continued upside improvements in coated paper volume and pricing trends which results in 2010E EBITDA of >$400MM and Street gets more comfortable w/ a "normalized" EBITDA of >$600MM. Moreover, the home-run case encompasses the possibility of Cerberus re-approaching the debt and public equity markets to (i) refinance out its Secured Notes at a more reasonable bank loan pricing grid and (ii) take the business public (notable as we consider various recent S-1 filings in which sponsors are considering monetizing a % of their stake as a deleveraging event - witness the Generac S-1 filed by CCMP on Oct 20th for a >7x LTM EBITDA biz w/ the intent to take it below 5x). housing bottoming and 2H 09E - performance that surprises to the upside given cost savings / market share gains (~15% CY and 30 pts of capital appreciation = ~60% upside)
UPSIDE (30% prob): assuming 1-yr exit at 90 cents driven by further / incremental improvements in 2H 09E - 1H 10E (~15% CY and 22.5 pts of capital appreciation = ~45 - 50% upside)
BASE (~45% prob): assuming 2-yr exit at 85 cents driven by which the industry continues to move sideways (~15% CY per annum and 17.5 pts of upside over 2-years = ~25% - 30% upside)
DOWNSIDE (less than 17.5% prob): assuming the coated paper market relapses and goes through a restructuring process beginning in late 2010 - early 2011E. In this case, Street will likely use a 2012E for the basis of their analysis and let's assume "normalized" EBITDA surprises to the downside and is ~$325 - $375MM. Assuming a $350MM normalized EBITDA (or approx 35% of 2006 / peak EBITDA), and using a 6.5 - 7.5x multiple (given the inherent operating leverage / robust footprint and very low earnings power assumption in this case, I think a higher multiple is fair) gets to an implied ~60% price on the 2nd lien / FRN (~15% CY per annum offset by 5 - 7.5 pts of downside over 2-years = 10% upside)
SUPER-DOWNSIDE (less than 2.5% prob): assuming I'm completely wrong on the underlying trends in coated paper and Street is right on Q3 - Q4 09E and 10E EBITDA is sub-$100MM, a restructuring kicks off in mid-2010E in which case there is probably 20 - 25 pts of n-term downside (given the inherent cyclicality of this industry / fixed cost nature of the biz). This case probably entails significant concerns around where the fulcrum security resides (~15% CY and 20 - 25 pts of n-term downside = -10 to -15% downside)

CATALYSTS:

N-Term - Q3 performance (reports November 10th): there is a tremendous amount of pent-up-negativity in coated paper given weakness in its end-mkts. Any less-than-expected-disasters could result in significant short covering (my sense is that there is a fair amt of shorts in the 2nds liens as a pair trade w/ the Sub Notes + marginal buyers)

N-Term - Improvements in liquidity: Currently w/ ~$288MM of cash + ABL availability; my latest estimate is that they'll finish the year >$400MM and could see further upside surprises driven by hydro asset sales (potential in early 2010)

N-Term - Clarity around duty legislation: clarity around China / Indonesia duties should be out on Nov 9th (per RISI) and I'm cautiously optimistic that this will be a very positive headline for NewPage

N-Term - Clarity around US Postal Service: chatter that their might be a 2nd discounting program which could be an incremental positive for insert volume improvements

M-Term - Cost cutting / best-in-class mgmt: strong operators w/ proven history of cost cutting extraction; given the significant outperformance on this front (>$450MM of improvements by my math versus the $265MM guidance at the time of the SENA deal), I'd anticipate even more significant operating leverage as volumes (and pricing further down the road) improve

M-Term - Sponsor / strategic support: Cerberus owns ~80% and Stora Enso ~20%; Cerberus has explicitly approached 2nd lien lenders on a couple occasions to purchase the 2nds and while I'm not sure how much they own, I wouldn't be surprised to see them "create" the equity in / around the Sub Notes or 2nd Lien

M-Term - clarity around black liquor part 2 and biomass credit: on the first pt, the big n-term offset is that NewPage is NOT a tax-payer currently, would neuter the n-term liquidity upside potential, BUT it would enhance the strategic value as well as longer-term liquidity potential - also would arguably shift equity sponsors' view on deleveraging the business and "creating" the equity at a lower price to extract the tax benefits; on the 2nd pt, continue to do work and I think this could potentially be a significant input benefit to the paper industry w/ a couple players higher up on this list who qualify

L-Term - Covenant-Light capital structure: This is a cycle play (2 - 3 years) in which you're paid to wait (~15% CY and ~28 - 30% YTM)

RISKS:

Longer / deeper coated paper downturn: risk is if you view coated paper as 100% structurally impaired

Over-leveraged and inadequate liquidity: risk is if you think NewPage will do less than $100MM of cash EBITDA in 2010E in which case the business will burn >$250 - $300MM and put it in a very difficult position

Disclosure: I own various securities in the NewPage capital structure and may buy or sell at any time, without notice. We have no obligation to inform you of any changes in our views of NewPage

Catalyst

N-Term - Q3 performance (reports November 10th): there is a tremendous amount of pent-up-negativity in coated paper given weakness in its end-mkts.  Any less-than-expected-disasters could result in significant short covering (my sense is that there is a fair amt of shorts in the 2nds liens as a pair trade w/ the Sub Notes + marginal buyers)

N-Term - Improvements in liquidity: Currently w/ ~$288MM of cash + ABL availability; my latest estimate is that they'll finish the year >$400MM and could see further upside surprises driven by hydro asset sales (potential in early 2010)

N-Term - Clarity around duty legislation: clarity around China / Indonesia duties should be out on Nov 9^th (per RISI) and I'm cautiously optimistic that this will be a very positive headline for NewPage

N-Term - Clarity around US Postal Service: chatter that their might be a 2^nd discounting program which could be an incremental positive for insert volume improvements

M-Term - Cost cutting / best-in-class mgmt: strong operators w/ proven history of cost cutting extraction; given the significant outperformance on this front (>$450MM of improvements by my math versus the $265MM guidance at the time of the SENA deal), I'd anticipate even more significant operating leverage as volumes (and pricing further down the road) improve

M-Term - Sponsor / strategic support: Cerberus owns ~80% and Stora Enso ~20%; Cerberus has explicitly approached 2^nd lien lenders on a couple occasions to purchase the 2nds and while I'm not sure how much they own, I wouldn't be surprised to see them "create" the equity in / around the Sub Notes or 2^nd Lien

M-Term - clarity around black liquor part 2 and biomass credit: on the first pt, the big n-term offset is that NewPage is NOT a tax-payer currently, would neuter the n-term liquidity upside potential, BUT it would enhance the strategic value as well as longer-term liquidity potential - also would arguably shift equity sponsors' view on deleveraging the business and "creating" the equity at a lower price to extract the tax benefits; on the 2^nd pt, continue to do work and I think this could potentially be a significant input benefit to the paper industry w/ a couple players higher up on this list who qualify

L-Term - Covenant-Light capital structure: This is a cycle play (2 - 3 years) in which you're paid to wait (~15% CY and ~28 - 30% YTM)