Description

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RYAM – Short – $12.86/share

Summary

Rayonier Advanced Materials (“RYAM” or the “Company”) is a compelling short investment due to the persistent volume and price pressure on its business going forward, high financial leverage, “hidden” liabilities which makes the valuation far more expensive, and risk of a major contract loss or pricing reset going forward.  Though RYAM has squeezed higher in recent months, I believe this is nothing more than another over-leveraged commodity-oriented ship rising in the junk rally, and unlike many other poor businesses that have rallied in recent months, the outlook for RYAM’s end-demand is one of secular decline.  Essentially, although the Company has meaningful pressure in all areas of its business and a tremendous amount of execution risk in order to achieve aspirational cost savings, it trades at a valuation that prices it above key customers that have demonstrated a willingness to crush RYAM’s earnings power.  Although there is some chance that RYAM’s equity is worthless over the coming years, my base case is for over 70% downside, even assuming a very rosy scenario for underlying demand trends and the Company’s cost cutting initiatives.  At current levels, I believe RYAM is a compelling risk/reward as the good news is more than priced in and the Company is susceptible to a number of risks going forward that could meaningfully impair the equity.  My fair value for RYAM today is ~$3.80 / share.

Business Description

Rayonier Advanced Materials is a global leader in the production of specialty cellulose, which is a natural polymer used as raw material in the production of a variety of consumer goods including cigarette filters, LCDs, plastics, sausage casings, tires and other random items.  The bulk of RYAM’s sales are acetate, which is used in acetate tow which eventually becomes cigarette filters.  The other primary form of “specialty” cellulose are ethers.  RYAM also produces commodity products including commodity viscose and fluff used in the production of certain textiles and absorbent materials such as paper towels. 

Without getting into too much detail, specialty cellulose is manufactured by taking logs, debarking and chipping the wood into uniform dimensions, cooking and washing, bleaching, and then machining, drying and packaging as the last step.  A log goes in, and specialty cellulose comes out.  The industry does have decent barriers to entry as volumes are typically set under contracts, albeit with pricing set annually, and it can take some time for new entrants to gain the acceptance of customers for higher grade product.  Commodity products are as they sound, and for the most part, RYAM is a price taker for everything they sell, including specialty cellulose…not a good spot to be in when there is a period of excess capacity and little/no volume growth.  Key competitors include Buckeye Technologies (part of Georgia Pacific), Borregard, Tembec, and Bracell (Sateri).  As I have already alluded to, the majority of RYAM’s business is related to acetate tow, which is use for cigarette filters.  In the last three years, 60% of revenue was related to cigarettes, which are now flat to declining for much of the world.  Acetate makes up approximately 80% of specialty cellulose volume for RYAM, with the remainder coming from ethers and other specialty products which have grown faster in recent years, but are more GDP growth-oriented in nature and volumes could be more cyclical.  At a high level, RYAM’s specialty business does require some technical expertise, although the excess capacity in the industry and declining volume trends has led to persistent pricing pressure and the constant risk of share loss as contracts are renewed.  RYAM also has significant customer concentration, with its top three customers in 2015 making up 59% of revenue.

Why does this opportunity exist?

• ·         Like all things commodity, RYAM stock has surged higher despite being in an oversupplied commodity industry, and especially after raising low-ball EBITDA guidance by a whopping 5.5% last quarter.  Importantly, unlike other commodity rallies, key RYAM end-markets are in SECULAR decline, making this a more ideal short in my view.  Over the long-term, I do not expect there to be a material inflection in demand, and in fact, any slowdown in global growth is likely to impact RYAM significantly relative to the current earnings run-rate. 

• ·         The Company recently renewed contracts for a material portion of their customer base.  However, in my view, contracts represent a risk to future results.  It can probably only get worse for them given the industry oversupply, persistent demand pressures, and declining tow pricing.  More importantly, the likelihood that any of their key customers entered into long-term contracts that were favorable to RYAM given the current market backdrop is extremely low, especially as other suppliers are aggressively trying to win business.  Although volumes in the contracts typically have minimum levels, pricing is importantly the wild card and is typically set in the fourth quarter of every year.  Therefore, while the market may rejoice renewed contracts, I believe they were likely unfavorable from a volume standpoint and the key variable of pricing is yet to be determined.  Importantly, in 2015 RYAM’s largest customer, Eastman, essentially went public with their pricing negotiation via a lawsuit to get favorable terms, demonstrating how fragile the industry is and the balance of power between RYAM and its customers.

• ·         Contribution margins are purposefully kept under wraps.  However, using some previous disclosures, one can triangulate that the specialty cellulose volume is very high from a contribution margin standpoint.  Given this is an oversupplied commodity industry, I would expect pricing to be under pressure longer term until contribution margins compress to more reasonable levels.  Although market participants seem to feel comforted by pricing that will only decline 2% again next year, I estimate contribution margins on specialty cellulose volume to be approximately 65% on incremental tons, suggesting volume declines are also very negative for RYAM’s results going forward.

• ·         Key liabilities on the balance sheet are being ignored, but represent real cash obligations in the future.  When pushing street analysts, they simply respond with “that’s too complex so we just ignore it.”  I believe environmental liabilities and a significantly underfunded pension are real liabilities, and importantly, will be real cash out the door over the coming years.  Environmental liabilities are already being paid for, and although there is no pension funding requirement in 2016, I expect that to change going forward.  Collectively, on a present value basis, I estimate these liabilities which are currently being ignored are approximately $5.85/share and will lead to cash flow disappointments in the future.

• ·         In conjunction with the Company’s Q4 2015 earnings release where EBITDA guidance was significantly below expectations, the Company announced an aggressive cost reduction “transformation” plan aimed at right-sizing the business for the future.  Although this looks great on paper, I believe few investors are doing the math regarding what this might actually mean and how achievable this plan might be.  A pie in the sky cost savings plan to remove nearly 20% of the 2014 cost base is being taken at face value.  Additionally, because most of the weakness in recent years has been pricing, it isn’t clear exactly what cost reductions can even be done, as volumes are not that far off from historical levels and have even grown in their commodity segments.  In reality, the company admits the low hanging fruit has largely been taken out and things will get far more difficult.  As I will show later, the valuation even including these savings is stretched.

• ·         FCF valuations ignore the significant benefit from working capital this year, stock compensation, and the fact that free cash flow is incredibly leveraged.  When including future pension funding, environmental liabilities, and stock compensation, the free cash flow looks far less attractive, especially when considering the excessive financial leverage and unsustainability of the current earnings run-rate.

• ·         Valuation is stretched even assuming the best scenario.  There is little margin for error on pricing or volumes, both of which I expect to decline in the future.  Given the leverage, there is some chance this is a $0 long-term, though my base case is that it continues to remain solvent with a far lower equity value in the future.  Any small negative change in pricing or volume, which could be very likely as contract pricing is reset annually, could significantly impact RYAM’s financial position, valuation and solvency.

Summary Financials/Capitalization

Below is a brief snapshot of RYAM’s historical financial performance.  I have excluded the “other operating expense” line in calculating EBITDA, as it is related largely to environmental expenses which I factor into valuation later.  Note, the company discloses pricing and volume for cellulose specialties, so one can see just how weak the performance has been over the past several years, with continued expectations for weakness in 2016. 

RYAM’s current capitalization is below.  I have shown the enterprise value both including and excluding “hidden liabilities” just in case investors want to continue to ignore real cash outflows in the future.

Demand Pressures

In addition to the challenged balance sheet, excess capacity, and contract risk, one aspect I like about shorting RYAM is that the end markets are generally in long-term decline.  Assuming RYAM hits its 2016 guidance, this will be the fourth consecutive year of volume and pricing declines for specialty cellulose.  Because RYAM produces mostly acetate, which is used in cigarette filters, they are fighting an uphill battle with the demand they have, and I believe they will continue to have a difficult time growing volume in the future.  China, the one bright spot for cigarette consumption in the past, is not even growing at this point, setting up more pain ahead.  A quick snapshot of industry demand is below:

Although acetate is roughly 80% of what RYAM produces in specialty cellulose, none of the other consumer end-markets scream “growth” to me.  At best, they are in mostly cyclical industries, and RYAM has less exposure to ethers which is the fastest growing piece of specialty cellulose.  When taking RYAM’s business mix in specialty cellulose and applying the growth rates above, it seems that they will be challenged to grow going forward.

Some of the recent declines in acetate have been due to customer destocking, but according to key industry participants, the outlook is not very rosy for acetate tow pricing, which should impact RYAM’s pricing going forward.  Both Celanese (former RYAM customer) and Eastman Chemical have experienced soft acetate tow pricing in Q1 of 2016, although volumes appear to have leveled off.  Celanese is also reducing acetate tow capacity permanently at a facility in Belgium.  As pricing for RYAM’s customers is depressed, I expect continued weakness is specialty cellulose pricing going forward.  Also of note, although key customers have stabilized volumes, RYAM is still expecting volumes to be down 6-7% this year for specialty cellulose, likely due to market share losses (discussed later.)  I thought the following quote from Eastman’s Q1 2016 call sums up the outlook for acetate quite well:

“So on the cigarette side, we see primary demand being very consistent with our views we've shared in all the previous calls. Outside of China, it's sort of down 1% to 2% like it's been for years. Inside China, we're still not seeing any signs that there's some significant change in primary consumption of cigarettes so I'd call it sort of flat, maybe up 1%. But there's some uncertainty here in the short-term as the economic pressure in China could affect people's rate of purchasing cigarettes.”

This is a problem, because the industry seems to be oversupplied.

One competitor, Bracell, represents the largest risk to industry pricing, as they have the stated goal of gaining market share in specialty cellulose over the long-term and have actually grown specialty volumes over the past several years.  They also are vertically integrated giving them a cost advantage and have a clean balance sheet, so fighting for market share on price doesn’t seem to be a problem.  In their most recent earnings presentation and call (which must be listened to as there are no transcripts I’ve found), they were pretty clear:

Specialty cellulose is higher margin, so they want to continue to mix into that business (and probably decrease margins for everyone).

Other industry players have noticed too, as Borregaard views Bracell’s strategy as having “significant supply growth potential” in a recent investor presentation.

To sum up the specialty cellulose market for RYAM – demand should remain weak, there is too much supply, better capitalized competitors are trying to win share, and pricing and volume should suffer as a result. 

The outlook for the commodity fluff business doesn’t look much better.  This is a commodity segment for a reason, and industry participants are very much price takers.  Because much of RYAM’s business is in specialty, I will spend less time discussing this issue, but suffice it to say, the industry also looks oversupplied and pricing has begun to weaken even before significant capacity has come online.  The following data is from a Jefferies research piece highlighting the industry issues.

Rayonier’s commodity segment is mostly fluff production, although it can be switched relatively easily into…well…other commodity production. 

Contract Risks

I believe contracts for RYAM may be a ticking time bomb and represent more risk than stability.  Although minimum volume levels have been established, RYAM’s recent volume history where inventory destocking caused volume declines in specialty cellulose suggests that volumes are anything but air tight.  In fact, although the Company has given pricing guidance for 2017, they are curiously quiet about volume guidance, which is odd considering the volume is the more “known” of the variables in contracts.

RYAM has recently locked up their three largest customers with contracts over the next few years, but pricing is typically set annually in the fourth quarter prior to the following year, and volumes seem to represent more minimums than any level RYAM would view as great.  Given the macro backdrop and over-supply, I think it is highly unlikely any of these three customers locked into contracts that were favorable to RYAM versus existing terms.  Industry contacts we have spoken to have speculated that RYAM has continued to lose volume at Eastman, and is losing somewhere between 10-20k tons per year for both 2016 and 2017.  Given how tight knit the industry is (there is actually a specialty cellulose conference in London every year), we don’t think Eastman will prove to be the only example of this.  Could this be why RYAM hasn’t yet given volume guidance for 2017?  Eastman sued RYAM last year to try to get pricing down based on most favored nation clauses in the contract, and I think more tough negotiations are likely coming.  MFN clauses also make RYAM more susceptible to aggressive market share tactics of competitors, as pricing much be matched if a customer gets a better offer from another party.  RYAM has already lost significant business with Celanese in recent years, suggesting that barriers to switching are not as high as many market participants believe.

Given the negative trends discussed regarding demand, I think there is real risk that both volumes and pricing will continue to move lower over the coming years.  This will be further driven by aggressive competitors that continue to seek market share and win additional business.  Additionally, although RYAM purposefully tries to hide contribution margins, likely to protect pricing, I think customers know how profitable specialty volumes can be and are actively seeking cheaper supply.  Using past disclosures from the Form 10 and calls with industry consultants where we learned the relative variable costs for specialty, fluff and viscose, one can decipher just how profitable specialty cellulose production likely is for RYAM.

Ultimately, although there are barriers to entry and contracts/relationships do matter, this is a commodity industry and contribution margins should head lower over time.  The 65% contribution margins for specialty will significantly impact profitability as demand stays weak and if RYAM loses contracts/market share.

Environmental and Pension Liabilities

One aspect that I believe investors are missing are the “hidden” liabilities from environmental clean-up and a large underfunded pension. The pension plan speaks for itself – it is large, underfunded, and will need to be trued up at some point as their investment returns are unlikely to match projections.  Although no cash funding was required in 2016, the Company seems to be evaluating what might be necessary in 2017 and beyond which is obviously going to impact free cash flow.  For environmental liabilities, the Company does include the expense in EBITDA, however, at the multiple that RYAM trades at, I believe this understates the true present value of environmental liabilities.  As of Q1 2016, the undiscounted expected cash outflows for the next 20 years totaled ~$156mm, or approximately $3.60/share.  If one were to assume a straight-line treatment of this liability and discount the after-tax cash flows back to today at the RYAM cost of debt, the liability equates to ~$86mm on a PV basis.  For this calculation, I’ve assumed the terminal year liability is 50% of the current undiscounted amount, but I note that each year the company has accrued enough new liabilities such that the overall liability continues to remain steady, even though they have been spending on environmental remediation each year.  Although most Street analysts only count the typical net debt, I believe these represent very real cash outflows and should be counted in valuation.  Amazingly, analysts I have spoken to simply say that “environmental liabilities are complicated, so we ignore it” and “we just haven’t really factored in the pension liability.”  Based on my math, all else equal, including these liabilities would drive target prices down by approximately $5.85/share.

Cost Savings

On its Q4 2015 earnings call, RYAM announced a transformational cost savings plan that it hopes will reduce expenses by $105mm from 2015 and reset the Company’s cost structure to offset declining volumes and pricing seen in specialty cellulose.  Although the 2016 savings appear achievable, my conversations with the Company suggest much of the low hanging fruit has largely been tapped.  In fact, while there are specific items for 2016, 2017 and 2018 are much more theoretical in nature and represent significant downside risk to the stock, as they have largely been included in analyst estimates already.  For the purposes of valuation, I have assumed the Company is successful in achieving all of their targeted cost savings.  Just to show the magnitude of the savings, if achieved, it would represent almost a 21% total reduction in cash costs since 2014.  This, in a period where aggregate volumes are up versus 2014.

Projections

Projections for my base case, and the EBITDA-CapEx output for the bear and bull cases are presented below.  Pricing and volume assumptions for the various cases are on the right side of the image.  Of note, the base case assumptions are far better than trends RYAM has achieved in the past several years, and all cases assume perfect execution on their cost saving initiatives.  Overall, I think the base case assumptions are rather generous as they don’t assume material share loss or significant price deflation despite the many pressures I’ve already outlined.  Key assumptions include:

• ·         Contribution margins on volume consistent with economics illustrated above.

• ·         2% general inflation on cash COGS and SG&A, offset by full-achievement of cost savings

• ·         CapEx assumed to fall from $90mm this year to $55mm (maintenance) in all future years

Bear Case Output

Bull Case Output

The bear case, which is actually better than historical trend and assumes full cost savings, would leave essentially no free cash flow in 2019 and beyond, making the $600m+ traditional debt balance problematic. 

Valuation

Given what we’ve seen from Eastman, I do not believe this should trade at a premium to its customers, especially when some of their profits are from commodity products and because of the contract risks.  As of today, Eastman and Celanese trade at approximately 8x 2017E EBITDA and 10x 2017E EBITDA-CapEx, and both businesses are expected to grow.  The valuation analysis below is presented for the base case estimates.  As you can imagine, using the bear case numbers get to ugly answers for the equity.  I reiterate again that I believe my base case estimates are very generous given industry pressures and what we’ve seen from the Company in recent years.  For the “high” valuation case, I assume the market ignores the pension underfunding, and I capitalize $7mm of environmental costs at the “high” multiple, which is more favorable than the PV approach.  I also present an EBITDA multiple approach, but I don’t think that is particularly relevant for such a capital intensive business.  It is interesting though that when you ignore key liabilities and this trades at the high end of the range on an EBITDA basis, there still isn’t much upside in the stock from these levels.

Conclusion

At the current price, I believe RYAM is a compelling short.  It is hard to see what can really help the Company beyond the cost savings I’ve already included, and there are numerous things that could hurt them including falling demand, oversupply, lost contracts, pension funding, and an overleveraged balance sheet.  If things get incrementally worse than I’ve projected from both a volume and price standpoint and/or if cost savings do not materialize, RYAM could be a worthless equity over the medium-term.

Risks

• ·         Somehow pricing goes up.

• ·         Against all odds, smoking ends up being really good for humans and demand picks up considerably

Catalyst

• ·         Numbers have finally adjusted high enough to compensate for management low-balling guidance.  I expect misses going forward, and Street estimates are now above Company guidance.  The Company said on the Q1 2016 call that most of the FCF for the year has already been generated and it will be the best quarter of the year.

• ·         2017 guidance for volume and EBITDA should disappoint

• ·         Pension funding for 2017 could significantly impact free cash flow

• ·         Disappointing pricing or lost business with key customers

• ·         Global recession/China exploding could significantly hurt demand for acetate tow

• ·         Potential dividend cut