Description

Paperlinx Step-up Preference Shares (PXUPA)

Please note that PXUPA units are highly illiquid and the issue size is small, so the idea is only actionable for PA/small funds.

Executive Summary

I view an investment in PXUPA preference shares as having attractive risk-reward characteristics with upside of anywhere between 10-150% (possibly higher), depending on how value is apportioned between preference and common shareholders. I believe the complexity and unique features of the security, combined with the revulsion towards the company and its volatile corporate history have contributed to the opportunity being made available.

Company background

·      Spicers Limited (SRS.AU and formerly named Paperlinx Limited) is an Australasian paper merchant headquartered in Australia and listed on the ASX. The company has had a volatile corporate history, which I think is worthwhile briefly recounting to see how this has lead to the current state of affairs.

·      The company (called Paperlinx on inception and until a name change to Spicers Limited in 2015) was initially conceived through the demerger of packing giant Amcor’s paper merchanting and manufacturing operations in 2000. From there the company went on an acquisition spree in the first half of the decade (most notably 2004 acquisition of Buhrmann’s paper merchanting division – renamed Paperlinx Europe), with the goal of being the world’s first global paper merchant – an industry that is typically regionally fragmented.

·      At one point, the company was the largest global paper merchant in the world, with revenues over $6bn and a market cap in excess of A$1bn, however a combination of poor management, structural and cyclical headwinds hit the company hard, with the company being perpetually loss-making since 2009. First, the company sold its paper manufacturing operations in 2010 at a large loss to become a pure paper merchant. It is also worth noting that until recently, the company was a global paper merchant and generated the majority of its revenues from the European market.

·      The European operations were loss-making for a number of years and burned cash, whilst the company was in breach of its debt covenants, given the weak operating results and large debt burden associated with acquisitions. In 2015, Spicer’s various European legal entities were either sold for fire sale prices or declared insolvent. However, as there was no cross-default language in each region’s bank facilities, the default on the European debt had no bearing on the Australasian and Canadian assets/debts, which both generated positive EBIT and had low debt levels.

·      In 2015, the company sold its North American assets for C$64mn and renamed itself from Paperlinx Limited to Spicers Limited. Prior to the insolvency of the European operations/North American sale, the company had a geographic mix of revenues as follows – 70% European, 15% Canada, 15% Australasia

·      Following these events, the company now has a radically different earnings profile and balance sheet. Now the company generates all of its revenues/EBIT in the Australasian region, whilst the company has a net cash position of over A$30mn, mainly due to the sale of the Canadian business.

·       

Security features

Paperlinx issued face value of A$276.5mn (A$100 per unit) of Step Up Preference Shares (PXUPA AU – also listed on ASX) in 2007 in order to de-lever debt used to acquire in the earlier part of the decade. The main features of the security are as follows:

·      Initial margin of 2.4% over Australian 180-day BBSW (currently 1.93%) and stepped-up by a further 2.25% on remarketing date of 30th June 2012 as Paperlinx did not have the capacity to retire the shares at par value.

·      Security is perpetual (no scheduled maturity date – last re-marketing date was 30th  June 2012),

·      Distributions are non-cumulative in nature and completely at management discretion. PXUPA holders are only protected by dividend/buyback stopper, whereby Spicers has to pay PXUPA distribution for at least 12 months before it is allowed to pay a dividend to common shareholders. PXUPA hasn’t paid a distribution to unit-holders since 2011.

·      Following a poorly received tender offer in 2013 (mentioned in greater detail below), there remain 2.63mn units trading at a market price of A$10 per unit (1/10^th face value).

History for hybrid holders

·      The preference shares have traded at a fraction of face value since the company stopped paying distributions since 2011. Initially the hybrid owners had the twin concerns of potential default risk as well as how to divide remaining value between themselves and common equity holders.

·      As a result of this, there has been a long history of conflict between hybrid owners and management/common shareholders. There was a grass-roots activism campaign started by disgruntled PXUPA holder and retiree, Graham Critchley (who passed away). Following his efforts, a more formalized group was put in place, called PIGS  (PXUPA Investor Support Group) < https://paperlinxpigs.wordpress.com/>, comprising a number of hybrid owners, that have highlighted concerns to management and proposed solutions to resolve the capital structure. 

·      In late 2011, an unnamed private equity firm purported to offer a ‘whole of company offer’ to acquire Paperlinx. The offer was for $117mn total, offering A$55mn (or 9c per share) to common equity and A$62mn (or $21.85mn per hybrid unit) to PXUPA holders, and requiring approval of both classes of security holders. The offer never proceeded, likely a result of acceptance that hybrid holders would never agree to the deal (PIGS was actually established in response to this private equity offer, as the division of proceeds between hybrid holders and common equity was far less favourable to hybrid holders than what was stipulated in ‘change of control’ event as per the product disclosure statement.) This highlighted a further issue - it was unlikely that the company could be a valid takeover target until the capital structure issue was resolved, given the difficulty in getting two separate classes of shareholders to accept an offer.

·      In 2013, then-CEO Andrew John Price (who deposed the previous CEO via shareholder activism and was also a top 10 owner of the common equity at the time) talked tough with Paperlinx hybrid holders and attempted an off-market tender offer, proposing an exchange ratio of 250 common shares for each hybrid, which would result in hybrid holders owning 52% of the company, assuming full take-up. The offer represented a very modest premium to PXUPA’s price at the time (~$9) and had a dismal take-up rate of less than 8%.

·      In August 2015, Blue Pacific Partners, A New-York value-oriented hedge fund and PXUPA holder run by former Greenlight Capital analyst Christopher Sommers, sent the Paperlinx Board a letter proposing a hybrid-common exchange at a ratio of 1000-1, giving hybrid owners 80% of the common equity if the proposed transaction were to take place. One month later, Blue Pacific sent a letter to the Responsible Entity of the SPS Trust, stating that Paperlinx had breached an undertaking of the issue, as it had bought back a nominal number of common shares in 2013 and 2014, associated with equity compensation for management. If the breach is valid, this would effectively wipe out the common equity and given hybrid owners virtually full ownership of the business. The issue remains unresolved, with Blue Pacific having sought legal recourse.

Valuation

·      I propose valuing Spicers using a whole of company method, before dividing value between PXUPA holders and common shareholders. I will use two methods– an earnings based approach and a balance sheet based approach

·      Earnings approach: In trying to determine what normalized earnings look like for Spicers Limited, there are some challenges given that historical financials are heavily weighted towards the previously dominant European operations.

·      Looking at geographical segment earnings numbers, I note the following – ANZA (Australia, NZ and Asia, which is essentially the entire company now) has recorded  -4% CAGR in revenue and +7% CAGR EBIT between 2012 and 2016. The declining revenues reflect the slow secular decline in commercial print operations, whilst the rising EBIT is a result of the company diversifying operations into higher margin sign and display businesses.

·      In 2016, Group EBIT was A$4.5mn and up 42% YoY largely as a result of lower corporate costs due to their much simpler operation. Nevertheless, 2016 results were impacted by poor results from the Australian operation, which saw 40% YoY decline as a result of FX and pressures in commercial print.

·      Applying a conservative multiple of 6x EBIT gives a valuation of A$27mn for the company’s operation. Whilst the economics of the business are not great, I see the business of paper merchanting as having a low risk/reward profile and low operating leverage. I feel current earnings levels should be sustainable given the business already operates at razor thin margins, with potential upside should the company continue in its successful efforts to diversify to higher margin sign & display businesses.

·      The company also has A$30.7mn net cash on its balance sheet, following the sale of the Canadian business. Adding the net cash to our business valuation, gives whole of company valuation of A$57.7mn.

·      Balance sheet approach: Spicers has a highly liquid balance sheet largely comprised of working capital assets and cash. I propose a very simplistic and conservative approach of subtracting total liabilities from hair-cutted current assets (and assigning zero value to all non-current assets). Using a 10% haircut on FY2016 current assets, gives us a net asset value of A$81.7mn.

·      In determining how to apportion value between hybrid holders and common equity holders, I propose 50% and 80% split to hybrid holders as the lower and upper bounds. The rationale behind using 50% as the lower bound, is that this was broadly the level proposed to hybrid holders in the previously mentioned 2013 off-market tender offer. Given the weak take-up rate and effective failure of that offer, it seems reasonable to use that hybrid holders would definitely accept no less than 50% at a minimum. Whilst in theory, common equity should be worthless until hybrid holders are made whole, even hybrid holders understand the commercial reality that common equity needs to be thrown a bone for any resolution to take place. Blue Pacific proposed 80% in its letter to the board, whilst PIGS had previously proposed 75%, so 80% seems a reasonable upper bound.

·      Using the above valuations and equity split, gives the following valuation range to the hybrid holders. Based on the current hybrid price of $10 per unit and 2.63mn units, the current market value of the hybrid stake is A$26.3mn. The current market capitalization of common equity is A$19mn.

·      Even in the most conservative scenario  (earnings based approach assuming a 50/50 split), I still derive a current valuation to hybrid holders above the current market price, whilst most scenarios provide a healthy premium to the current traded price for PXUPA holders. Furthermore, if the capital structure issue does get resolved, then Spicers Limited may become an acquisition target to better-managed paper merchants.

·      For PXUPA holders to lose from here, earnings would have to go lower from what is already a low run-rate and/or a deal that is highly unfavourable to hybrid holders is negotiated with common equity. When also taking into account the remote possibility that current equity holders could potentially get wiped out, if proven that management breached terms of the SPS, I view the current risk-reward for PXUPA holders as very favourable.

Why does the opportunity exist?

·      Along with the small size of the issue and lack of analyst coverage for both common shares and hybrid holders, there is also a very small universe of corporate hybrid issues in Australia, with few market participants scouring this corner of the market for opportunities. Furthermore, the majority of investors who typically look at these issues are retail investors looking for yield.

·      As demonstrated by the volatile corporate history of Spicers/Paperlinx, there is substantial investor revulsion to the name. This is further compounded when examining the weak protection afforded to PXUPA holders, based on the current structure, which allows distributions to be withheld indefinitely.

·      The effective Mexican stand-off between the common and preference shareholders (and the poison pills that they both hold against the other party) has resulted in poor investor sentiment on BOTH classes of security.

Risks

·      Business in secular decline

·      Battle between common and hybrids continues to be drawn out

·      Management exploitation

Catalyst

No hard catalyst, except in the blue-sky scenario where it is found that Spicers Limited is in breach of SPS undertakings. Unlikely that any third party will offer to acquire Spicers until capital structure is resolved.