Description

POLYMER GROUP, INC. Target Price: $30-35

Polymer Group (POLGA), which emerged from Chapter 11 in March 2003, is a manufacturer of nonwovens with strong growth potential. Nonwovens are essentially low cost substitutes for textiles. Prominent applications include diapers and feminine hygiene products for consumers and packaging and wiping products in the industrial sector. POLGA’s customers include consumer product companies such as Procter & Gamble (which uses nonwovens in the Swiffer, for example) and Johnson & Johnson and industrial companies such as Johnson Controls.

Demand for POLGA’s products at this time is very favorable. With 22 locations in 10 countries, the company’s facilities are operating just below full capacity. The growth in demand for its products globally has convinced management to add new facilities in Columbia and Mexico in the last two years. In addition, POLGA is building a new facility in China and expanding one of its US facilities. These facilities should be operational mid-year.

POLGA has been challenged, however, by increasing raw material prices following the hurricanes. The Company’s margins have been depressed the past three quarters since the Company’s ability to raise prices to customers lags increases in raw material costs. Nonetheless, POLGA has had complete success in eventually passing on these costs.

Thus, we think POLGA’s results are set to improve rapidly. We see EBITDA increasing from $114 million in 2005 to $127 million in 2006 to $147 million in 2007. The drivers of this growth will be:

1) The start-up of new facilities which should contribute an additional $15-20 million of annualized EBITDA on a base of $80+ million new revenue.
2) Stabilization or decline in raw materials pricing. This should allow POLGA’s sales prices to catch up with cost of sales and margins to return normal or even better.
3) Global demand for POLGA’s products from developing countries.

EBITDA growth will lead to increased cash to pay down debt, especially following the completion of the new facilities which are currently tying up most of the Company’s available cash flow. Paying down debt will increase earnings growth down the road.

Macro Thesis

We think the macro environment in which POLGA competes is attractive for the following reasons:

1. Growth. Over the last 10 years, volume in the nonwovens industry has grown at an average of 7% per year. Overall, this growth has been relatively consistent from year-to-year. Growth is expected to continue at a rate of 7% with growth in developed markets expected at 3.5% and in developing markets at 14.0%. Short-term, growth rates should be much higher given strong demand for nonwovens and pass-through of raw materials cost increases (more on this later). Growth in developed markets is expected to be driven by new applications for nonwovens for which, with a history of over-spending on R&D, POLGA should be well-positioned. Growth in emerging markets is expected to be volume-driven as developing economies modernize. Again, with its widely distributed facilities base, POLGA should be well-positioned to take advantage of this potential.
2. Little cyclicality in consumer sales (~55% of sales). Consumer market end products that use nonwovens include diapers, tampons and sanitary napkins, baby wipes, surgical gowns and dressings. Most of these applications are “defensive” in nature and sales of products for these end uses should prosper whether or not economic growth is strong.
3. Sales of industrial products (~45% of sales) poised for strong results. This more cyclical component of POLGA’s revenue base represents sales of products such as cable wrap, house wrap, protective apparel and flexible packaging, which is developed from polyolefin fibers. This segment has been posting strong year-over-year results and should continue to do so as economic growth persists in the industrial sector.

The Raw Materials Issue

POLGA’s principal raw materials are polypropylene, polyethylene, and polyester. Owing to rising oil prices recently, prices for all of these raw materials have risen (most notably in the months following Hurricanes Katrina and Rita). The net effect has been for POLGA’s margins to be compressed on a percentage basis although this impact has been offset by volume and price increases and cost-cutting.

Approximately 35% of POLGA’s sales are pursuant to long-term contracts that allow for the pass-through of raw material price increases on a quarterly basis. POLGA’s contracts with P&G and J&J are like this. The remaining 65% of sales allow for pass-through of costs with a 30-day notice period. Since most of POLGA’s facilities are running at capacity, obtaining the price increases has not been a problem. POLGA anticipates increasing the number of long-term contracts given the certainty these contracts offer regarding passing on increasing raw material prices.

Be all that as it may, with rapidly increasing raw materials costs, there is a lag effect between obtaining price increases and the impact of rising raw materials costs on cost of goods sold. In the wake of the hurricanes, POLGA’s EBITDA margin dropped from 12.6% in 3Q 2005 to 11.6% in 4Q 2006 to 11.2% in 1Q 2006. 1Q 2006 operating income was $8.1 million lower than 1Q 2005 solely because of raw material costs. Once raw material prices stabilize, POLGA’s margins will grow. Helping this matter are the higher margins that are expected to be obtained at the Columbia facility.

Model

Details of our financial model are provided below(1).

2003 2004 2005 2006 2007 2008 2009 2010
Total Revenue(2) 778.5 845.9 948.8 1061.6 1167.9 1249.7 1312.2 1377.8
Total Rev Growth 3.0% 8.7% 12.2% 11.9% 10.0% 7.0% 5.0% 5.0%

EBITDA 92.1 109.2 114.0 126.6 145.1 161.5 176.2 191.9
EBITDA Margin(3) 11.8% 12.9% 12.4% 11.9% 12.4% 12.9% 13.4% 13.9%

Net Income 16.4 27.8 40.7 52.3 65.0
+D&A(4) 64.1 61.6 59.1 56.6 54.1
-Cap Ex(5) 65.8 45.0 45.0 45.0 45.0
-Investment in WC(6) 25.9 17.8 13.7 10.5 11.0
=FCF Before Debt Service (11.3) 26.6 41.1 53.4 63.1
FCF Before Debt Service Growth N/M -335.6% 54.8% 29.9% 18.1%
FCF Before Debt Service Per Share ($0.58) $1.35 $2.10 $2.72 $3.22
Term Loan Amortization 4.1 4.1 4.1 4.1 4.1
Additional Debt Increase/(Decrease) 4.0 (22.5) (37.0) (49.3) (59.0)

P/E 31.1x 18.3x 12.5x 9.7x 7.8x
P/FCF -45.2x 19.2x 12.4x 9.5x 8.1x


Notes

1. Historical results exclude one-time and unusual items.
2. For the remainder of 2006, we have assumed 8% revenue growth in continuing business (ex-new facilities) as prices to customers were increased significantly in the past two quarters. Thereafter, we have (conservatively) assumed revenue growth of continuing operations at the projected industry rate of 7% per annum for 2007 and 2008 and 5% thereafter. We have also assumed that the new facility in Columbia produces $22.4 million of incremental revenues in 2006, below its $25 million run rate, since it takes time for new facilities to reach full utilization. Also, we projected new 2006 revenues of $12 million derived from the Chinese facility and $10 million from the U.S. expansion, 40% of their expected run-rate revenues, as the facilities are expected to be open for the second half of the year.
3. We have assumed that POLGA’s EBITDA margin will reach pre-hurricane levels by Q4 2006 as rising raw material costs are balanced out by new higher margin facilities and pass-through price increases catching up with raw materials. We then assume that EBITDA margin will grow at a rate of 0.5% annually. We believe that the business could push margins higher than our assumption towards 15% over time as was projected in the Company’s plan of reorganization. The upside, however, may be much higher. In 1999, for example, POLGA reported EBITDA margins of 21% for total EBITDA of $190 million.
4. We have assumed depreciation and amortization increases of $7 million in 2006 and then decreases of $2.5 million per year.
5. Capital expenditures are assumed to be ~$65 million in 2006 as the new facility construction is completed. Run-rate capital expenditures are assumed to be $45 million per management guidance.
6. Working Capital is assumed to be 16.7% of LTM revenues going forward, the rate in the most recent quarter.


Valuation


Enterprise Value
$509.6 Equity Value (19.5 million fully diluted shares)
(23.5)Cash
39.9 Minority Interest (8.5x 2006 minority interest)
433.6 Long-Term Debt
_______
$959.6 Total Enterprise Value

Comparable Company Analysis

While there are no pure play comparables for POLGA, a selection is shown below. Note that while Intertape Polymer Group is often mentioned as a comparable to POLGA, it is so only for certain elements of the oriented polyolefin part of POLGA’s business, which is less than 25% of POLGA’s total sales. It is not a good comparable. Generally, each of these comparables is much more cyclical than POLGA and has less growth potential.

In addition, we feel that P/E multiples do not do POLGA justice as its high levels of capital expenditures in the past few years have given it much higher depreciation expense than its competitors. Even so, our P/E ratios are projected at 31.1x, 18.3x, and 12.5x from 2006 to 2008.

Comparable Company Multiples
EV/ EV/ EV/
EBITDA EBITDA EBITDA
Company Ticker 2005 2006 2007

DuPont DD 9.4x 8.9x 8.4x
Intertape Polymer Group ITP 7.3x 7.3x 6.2x
Buckeye Technologies BKI 7.3x 7.9x 7.8x
Kimberly-Clark KMB 9.5x 9.0x 8.6x

Average 8.4x 8.3x 7.8x

Polymer Group POLGA 8.4x 7.6x 6.6x

Source: First Call Consensus

Using these multiples results in the following valuation targets.

EV/ EV/ EV/
EBITDA EBITDA EBITDA
2005 2006 2007

Valuation Multiple 8.4x 8.3x 7.8x

POLGA EBITDA $114.0 $126.6 $145.1

POLGA Target Value $25.67 $30.60 $34.47

Average $30.25


Discounted Cash Flow Analysis

Given the lack of good comparable companies, we have also used a DCF analysis to value POLGA. For our analysis, we used the same assumption as in our above model. Assuming an 11% discount rate and 7.5x terminal multiple, we arrive at a price of $36.40.

Implied Share Price
Discount Rate
10.0% 10.5% 11.0% 11.5% 12.0%
Terminal Mult Terminal Growth
6.5x $31.87 $30.94 $30.03 $29.15 $28.28 4.7%
7.0x $35.17 $34.18 $33.22 $32.27 $31.35 5.2%
7.5x $38.47 $37.42 $36.40 $35.39 $34.41 5.6%
8.0x $41.78 $40.66 $39.58 $38.52 $37.48 6.0%
8.5x $45.08 $43.91 $42.76 $41.64 $40.55 6.3%

Blending valuations from the discounted cash flow analysis and comparable company analysis supports our price target of $30-35 per share, a gain of 15-35% from current levels.

Sale Process

Matlin Patterson attempted to sell POLGA last year, but decided that the bids received (we believe in the low $30’s) were not inspirational enough to pursue a sale because they were based on LTM EBITDA and did not reflect potential growth. We assume that Matlin Patterson will revisit a sale when the new facilities are up and running. They may also choose to pursue some sort of transaction that improves the capital markets profile of the Company such as an equity offering or a merger with a public company. We think such a transaction will be a positive.

Potential Issues

1. Increasing polypropylene prices and other raw materials costs may continue to pressure margins for POLGA. Fortunately, with many operations running near capacity and long-term contracts, POLGA has been able to pass on much of the increased pricing albeit with a lag effect.
2. With over half of POLGA’s sales in international markets, the company does have some foreign exchange risk. However, if you are long-term negative on the dollar, this factor is a positive.
3. This is an illiquid stock with a small float.

Catalysts

1. Growth from new facilities.
2. Value-enhancing transaction.
3. Raw material price stabilization.

Bottom Line

Polymer Group is an inexpensive producer of nonwovens that has gotten little attention. The Company offers upside from attractive industry characteristics, new facilities, and deleveraging.

Catalyst

1. Growth from new facilities.
2. Value-enhancing transaction.
3. Raw material price stabilization.