|Shares Out. (in M):||10||P/E||23.2||13.24|
|Market Cap (in $M):||308||P/FCF||236.9||7.8|
|Net Debt (in $M):||130||EBIT||25||38|
|Borrow Cost:||Available 0-15% cost|
Orchids Paper Products Company ("TIS") is based in Pryor, Oklahoma and manufactures private label tissue for the discount retail and grocery channel. In mid 2015, Orchids decided to expand its operations in Barnwell, South Carolina to access the east coast. The $150M project, which is barely generating any revenue, has been financed primarily with debt and comes amidst the greatest industry-wide tissue capacity expansion in the past decade. This leverage has placed undue pressure on the balance sheet and has brought the business to near insolvency, requiring Orchids to amend its credit agreement after breaching a covenant on December 31, 2016. With heightened levels of capex ($40-50M), principal payments on its debt ($8M), tripling of interest expense following a covenant breach (~$6M in 2017 vs $2M in 2016), and highly uncertain incremental volume from the new Barnwell facility, Orchids will not be able to generate enough cash flow in 2017 to sustain its dividend policy. As a result, we believe Orchids will have to cut its dividend and/or issue equity in the next 6-12 months.
TIS just had its Q4 2016 earnings call, with results far below consensus expectations: actual sales/EBIT/EBITDA/EPS came in at $37.7M, $3.0M, $6.3M, and $0.25 versus $41.4M, $4.3M, $8.1M, and $0.26 for consensus. Q4 results contained a convenient tax benefit, which is why EPS came in line while sales, EBIT, and EBITDA did not.
Orchids' weak results confirm our view that the company faces continued competitive pressures (promotions from branded competitors and added capacity from private label competitors) and has overleveraged its balance sheet with the Barnwell expansion.
1. Orchids breached its leverage covenant of 4.0x. As a result, Orchids amended its credit agreement on 1/19/2017 relaxing its covenant to 5.0x. The leverage situation is expected to worsen, with covenants further relaxing to 5.75x in Q1 2017 and 5.50x in Q2 2017. While CEO Jeffrey Schoen construed the covenant relief as the creditors' faith in Orchids' future earnings, he failed to address the fact that the consequence of relaxed covenants is a much higher interest rate (at >5.0x leverage, 2.75% interest rate under prior credit agreement vs 5.75% under amended credit agreement). This will result in a near tripling of interest expense in 2017 to ~$6M vs. $2M in 2016.
2. Orchids essentially cut its dividend. By pushing out its dividend payment to April 3, 2017, Orchids will forego paying a quarterly dividend in Q1. While Schoen commented that the dividend is "part of its long-term strategy to maximize shareholder value" he admitted there were "no guarantees" and that the board is evaluating the dividend on a quarterly basis. We still maintain the view that the dividend is unsustainable and will either be cut or sustained via an equity raise, which would dilute existing shareholders. With $40-50M in capex and $8M in principal payments in 2017 alone--on top of $4M in incremental interest expense--Orchids will not be able to generate enough cash flow to sustain its ongoing dividend policy.
3. 35% increase in case volume is NOT guaranteed. Management's comments on a 35% increase in volumes are highly misleading to investors. On January 23, 2017 Orchids issued a press release citing "bid awards," whereby customers may place purchase orders which may "ultimately present approximately a 35% in annualized sales volumes of converted-product cases, based on customer forecasts and relative to third quarter 2016" beginning in Q3 2017. These bid awards are not binding and carry no contracted volumes; they merely indicate potential volume increases based on conversations with customers. This press release was purposely issued in conjunction with the amended credit agreement to mislead investors into believing that--despite just having breached its leverage covenant--Orchids may be able generate enough EBITDA in 2H 2017 to remain compliant. Management’s use of the term “award” is extremely loose and misleading, as it simply refers to potential business that may be won. This is no different than a politician asserting that he or she has the potential to win 100% of the votes—while factually correct, it is highly unlikely. No other player in the tissue space has—or likely ever will—issue such a misleading and promotional press release.
Even if a 35% increase in volumes materializes and Orchids successfully generates an incremental $15-20M in EBITDA by 2018, Orchids’ potential earnings power is still far below consensus expectations. Annualizing the Q3 2016 baseline EBITDA of $6.8M give us $27M. Adding $15-20M on top of this is $42-47M, but even this optimistic calculation is far below 2018 consensus of $53.6M. At the high end of $47M ’18 EBITDA, Orchids stock is worth $20/share at best using 7x ’18 peer EV/EBITDA multiples, representing 30%+ downside.
Here are some other red flags:
1. Manipulated Earnings: Orchids’ Q4 2016 earnings results included an unusual tax benefit (as opposed to a tax expense), which had the miraculous effect of manufacturing results that came in-line with analysts’ expectations. Moreover, Orchids’ departed from its practice of reporting non-GAAP adjusted earnings, which would have normalized for this unusual tax benefit resulting in earnings that were 50% below that of analysts’ expectations. Given lofty consensus estimates are in part set by one of Orchids’ largest shareholders, Taglich Brothers, this would provide cause for management to overstate earnings.
This is just one of numerous questionable practices around its earnings disclosures. For example, Q2 2016 earnings conveniently omitted $1.1M in insurance proceeds. Additional, TIS stopped disclosing key volume metrics in its 10-Q to mask declining order volumes.
2. CFO Resignation Not Addressed: Keith Schroeder, who was CFO for 15 years abruptly announced his resignation on June 14. He is now the CFO of XCaliber International, a Oklahoma based tobacco manufacturer (https://www.linkedin.com/in/keith-schroeder-73527b11). If Barnwell was on track to meet its intital targets and TIS will succeed in generating ~$60M ($280M in sales @ 20-22% EBITDA margin) in EBITDA by 2018, I can't imagine why the CFO would leave for a cigarette maker that does less than that in sales (we don't have financials for XCaliber but here's one unverified resource: http://xcaliber-international-llc.pryor.ok.amfibi.directory/us/c/3960584-xcaliber-international-llc).
3. Relocation of Headquarters to Nashville Never Disclosed: This is a material event that not yet been disclosed to investors. The company’s primary operations are based out of Pryor, Oklahoma where the company had been based for decades. The move to Nashville was likely driven by the CEO’s personal desire (the CEO is based in Nashville) and not for business reasons, which is why management is reluctant to disclose this information.
4. Promotional Insider on Earnings Call: Taglich Brothers, Orchids’ sixth largest shareholder which has an ongoing investment banking relationship with Orchids and maintains a “buy” rating on the stock, has monopolized earnings call with their promotional line of questioning. On the Feburary 15, 2017 earnings call, Taglich was offered two of the five slots during the Q&A, leaving less room for analyst who have questions that are more critical of management’s practices. Taglich’s very promotional line of questioning appears to have been intended to manipulate the stock price by creating short squeeze, with the goal of keeping the stock price elevated.
Here is Michael Taglich discrediting shortsellers: “there's a 1.6 million share short position in the stock. Have you talked to these [shorts]?”; “do you have any insight on where their head's at?”
Here is Michael Taglich validating management’s new facility which is causing a drain on much needed free cash flow: “from a cash flow standpoint, this basically is, once you turn on that mill, things turn around, obviously.”
Taglich’s line of questioning clearly is intended to manipulate the stock. Failure to elevate Orchids’ stock amid deteriorating fundamentals would have diminished Orchids’ prospects of a much needed equity raise, which would have resulted in Taglich forfeiting substantial investment banking fees.