Description

Investment: (Base Case Potential Return: 50%)

            We are recommending going long Companhia Providencia (PRVI3 BZ), the leading producer of nonwoven fabrics (used in end products like diapers and automotive interiors) in Latin America, and the third-largest producer of PVC pipes in Brazil. We find Providencia’s core nonwoven market particularly attractive due to the consolidated competitive environment, low product penetration, favorable demand dynamics, and constricted industry supply growth. On our estimates, Providencia is trading at a 10.5% 2008 and 13% 2009 free cash flow yield. While this in itself should provide 50% upside to the stock we believe the true opportunity lies in management’s ability to continue to make accretive acquisitions and add leverage to the balance sheet as Providencia will approach a net cash position in 2008.

Shares Outstanding: 85.723 mil

Share Price: 14.5

Market Cap: 1.242 billion

Net Debt: 110 million

EV: 1.352 billion

FCF Yield 2008: 10.5%

FCF Yield 2009: 13%

EV/EBITDA 2008: 7.0x

EV/EBITDA 2009: 6.4x

Free Cash Flow Yield 2008 at 7% = 21.9 R per share or 50% upside from current

Business Background:

Until late 2005 Providencia was a family owned and operated business when the untimely death of the founder and CEO threw the company into disarray. Neglected and lacking a professional management team, marketshare, sales and margins declined. In February 2007, a group of private equity funds saw an opportunity to turn the business around. Under new management, the company raised pricing on finished goods, renegotiated raw material contracts and acquired a Brazilian competitor leaving the market with only three viable participants. Since the beginning of Q2 EBITDA margins have dramatically improved from 18% to 26%. Management’s goal is to reach 30%+  margins by the beginning of 2008 through further price increases, higher capacity utilization and a greater concentration on LatAm sales.

Providencia operates in two key businesses: nonwoven textiles, which account for 80% of revenues and 90% of operating profits, and PVC piping, which account for 20% of revenues and 10% of operating profits. In the textile business Providencia produces a number of products including highly resistant automotive interiors and ultra-thin fabric liners for diapers. Many of the end markets for these materials are growing rapidly as the demand for consumer goods in Brazil has soared due to wealth generation in the middle and lower income brackets. Based on announced expansions and our forecasted growth in demand we believe the company should experience further margin upside and will reach target EBITDA margins by the first quarter of 2008.

In the PVC business Providencia currently is the third largest player in Brazil with 8% marketshare. Like its competitors, the company produces finished PVC pipes and solely serves the domestic market. The majority of demand is driven by Brazilian residential real estate and as such has started to experience explosive growth. Unlike the US, Brazil appears to be at the early stages of a residential real estate boom following an extended downturn from 2000 to 2005. Through the first half of 2007 demand for PVC products has increased 17% y-o-y. Eventually the company intends to sell this business as it wishes to become a pure play in the nonwoven textile space.

Nonwoven Overview:

 Essentially nonwoven textiles can be made with two types of technology: carded (high cost) and spunbond (low cost). Because the global market is a mix of spunbond and carded capacity (~40/60) pricing is set at acceptable returns for carded producers. Overtime the industry will replace carded capacity with spunbond; however, there are two factors which should slow this develop considerably. First there is a limited amount of new spunbond capacity. According to industry experts the availability of high quality low cost machinery is extremely tight on a global basis and order books are 2 to 3 years long. Secondly, many of the leading global textile producers have been content to reinvest cash in other business streams or acquire existing capacity allowing for supply to tighten. This has caused global industry consolidation over the last decade and left many markets with only a handful of sizable participants.

LatAm Nonwovens:

In our view the supply demand outlook for Latin American nonwoven materials looks favorable. The forward supply of new capacity is set for the next two years as there are only two new factories being added in Latin America. Providencia intends to increase capacity in Brazil and PGI is adding a line in Argentina. Given that the Latin American market is an effective oligopoly between 3 players (two of which have private equity influence) additional capacity seems to be added in a rational manner. Furthermore new entrants maybe dissuaded by the recent failure of Isofilme to enter the market. Based upon industry forecast and our firm view we feel that supply should grow at a slower rate than demand over the next two years. In Brazil we expect supply to grow 15% as Providencia’s 9^th line is brought into production. During this same time we expect demand to increase between 18 and 22% driven by higher diaper penetration (currently 35% compared to other LatAm countries at 70%), greater use of hygiene products and continued strong consumer demand for staple goods. This should provide for a favorable pricing environment and may add additional margin upside to our 2008 and 2009 estimate.

Why do the IPO:

One of the main questions we had for management was why they decided to do the IPO only 5 months after buying out controlling shareholders. Their answer was two fold. First, the company was presented with the opportunity to acquire Isofilme who had entered the Brazilian market in 2006 and quickly come to realize that it lacked the scale needed to effectively compete against existing players. Larger customers such as P&G and Kimberly Clark require at least two running lines of capacity to insure supply consistency and were unwilling to sign contracts with this smaller player. Providencia’s new management saw this as an opportunity to reduce competition and add capacity at an attractive price (close to replacement cost). Without the IPO this purchase along with the company’s existing capex plans would have severely limited further acquisitions as the balance sheet was fairly levered (3x Net Debt/EBITDA).

 It is our understanding that at least two quality assets of significant size are for sale on the global market: one in Latin America and one in the US. With the proceeds of the IPO, internally generated cash flows and additional debt management could make an acquisition in the range of 400 to 500 million R and still maintain a reasonable amount of leverage (2 times Net Debt/EBITDA). Our recent conversations with the CEO and CFO have confirmed that they would be interested in buying one of these assets if available at a reasonable price. We are further lead to believe that Providencia may be preparing to make a bid as management recently extended the amortization of goodwill from 5 to 10 years (in Brazil a portion of your goodwill is tax deductible). By reducing this tax shield they may be making room for additional tax shelters that would afforded under higher debt and goodwill levels. If management is able to acquire PGI’s LatAm assets (our best guess at the target) the company would have an effective monopoly on LatAm production by controlling 75% of capacity. While this or a similar acquisition would likely add significant upside to our fair value estimates it not accounted for in our base case scenario.

*Note that private equity sold zero shares in the issuance and according to management are long term holders in the company

Use of Cash:

Based on our conversations with the CEO the company is content with the planned capacity additions and will look to grow through acquisition as they continue to consolidate the market. He also stated that if opportunities do not arise the company will begin to return cash to shareholders. This management team (likely prompted by it private equity shareholders) will not keep cash idle on the balance sheet. We expect at least a 25% FCF payout ratio translating into a 2.5% dividend yield next year. Without an acquisition this dividend yield could easily reach 8% or 9%.

Risk:

Real appreciation

Irrational forward supply addition by competitors

Slowing global economic growth

LatAm political risk

Catalyst