Description

INVESTMENT THESIS:
Royal Group Technologies (RYG – NYSE; RYG.TO-TSE; RYG CN on Bloomberg) is a short because I believe the company is being paraded as a growth story when, in reality, it is essentially a cyclical selling mostly commodity products. I will outline below why I think the company does not deserve a premium valuation and why the stock has the potential to be re-priced downward similar to one of it peers, Masco Corporation (MAS-NYSE). The biggest concerns are accounting for its new plant, a declining and now permanently reduced ROIC, a poorly conceived strategy of introducing commodity products, and bank debt coming due next year.

DESCRIPTION:
Royal Group Technologies is a vertically integrated manufacturer of plastic, home improvement, consumer and construction products. The company is organized into two segments: the Product Segment and the Support Segment.

* Product Segment - Home improvement products consist of extruded PVC products (window and door profiles, siding, and roofing); Consumer products consist of extruded and injection molded products (window coverings, outdoor storage solutions, fencing, decking, gazebos, housewares, and furniture); Construction Products consist of pipe and fitting systems and commercial doors; Royal Building Systems and Foreign Operations include components of Royal Building Systems.

* Support Segment – The Support Segment is composed of a group that supplies to the Products Segment. Materials Manufacture involves production of PVC resin, chemical additives, compounding and recycling. Machinery and Tooling involves extrusion equipment, tooling, and computerized material handling systems. Services include distribution, research and development, plant construction, and property management services.

The company is based in Woodbridge, Ontario, Canada, but has plants located in North America, Europe, Latin America, and Asia. The company recently completed its 4.0mm square foot industrial complex in Woodridge, Ontario having consolidated 24 existing plants into 14 larger plants.

OVERVIEW
Royal Group Technologies has expanded its product line eleven-fold in seven years as a North American manufacturer and supplier of PVC-based products. Because the company has introduced so many new products, the reported sales numbers reflect growth percentage increases coming from a very low base. The sustainability of sales and the price points at which they can sell products is in question with a flat renovation market. Despite the product introductions, approximately 70% of earnings come from one product, vinyl windows, where the company has 38% market share. In the other product categories, market shares are approximately 5.0% to 10%.


NEW PRODUCTS
* More Products, Less Incremental Profit
The company has added a number of new products to its line up, which adds an incremental $9600 of potential sales to the average home. The company has the ability to offer up to $28,000 of products used in the average home versus $19,400 just one year ago. Its aim to be a growth company has forced it to come up with new products to meet the capacity needs of its new $1.0 billion Woodbridge plant. I have no problem with that. However, the products are lower margin commodity products in which it faces tremendous competition from other makers such as Micron, Certainteed (St.Gobain), Veka, and Chelsea Building. In the case of its fencing product it faces as many as thirty incumbent competitors. The company faces the unenviable choice of having to push unprofitable products like its pipes and fittings and window coverings, which are showing sales declines, in order to keep up the growth story.

* Input Cost Increases Will Affect Margins
Since January 2002, PVC prices increased approximately $0.07 from $0.28 to $0.35 where they are likely to remain, as the market is roughly in balance now. PVC price increases are just beginning to affect the First-In, lower cost inventories and will take until July 2002 (third calendar quarter) before these costs begins to affect the RYG’s margins. The company’s historic EBITDA margins have always trailed PVC price increases with a lag of 6 months. In 1994, the margins swung from a high of 26.0% to a low 19.0% as PVC prices increased. This happened again to a lesser degree in 1996 to 1997, even with a strong economy. Thus, RYG’s hope to achieve its historic 24.0% to 25.0% margins is most likely to fail in the current environment.

* International Sales Will Continue to Disappoint
RYG continues to be vulnerable to further disappointments in its international sales. It is a small player selling Window profiles in countries such as Argentina, Colombia, Brazil and Poland, and Mexico. It is increasingly unlikely that they will be able to turn these around as many of those markets are saturated and declining given their very weak economies (especially Argentina).

ACCOUNTING CONCERNS AT THE WOODBRIDGE PLANT
* Intercompany Transactions and Poor Disclosure
The other bigger issue has been the unusually large number intercompany transactions representing approximately 30% of total sales. This resulted as the company had a need for machinery and tooling equipment to be shared among its product groups, property management services, and the manufacture of its raw materials such as PVC resin. However, it is impossible to determine the costs of these services and whether or not they were accounted for properly using the public statements. The company has been unwilling to provide more details, which means that the investment community cannot understand approximately one-third of the company’s transactions over the past two years. Undoubtedly, this lack of willingness to disclose more information is intolerable in today’s environment.

* Excess Capacity at the Plant
Royal Group Technologies has spent over $1.0bn of capex to build the Woodbridge facility because the company was running out of space in its other buildings. Ten of the fourteen buildings are being used as they ramp up capacity and produce more vinyl. The plant can handle capacity for up to $3.0 billion of sales from it current $2.0 billion. In a slower sales environment, the excess capacity turns into a liability because capacity will remain underutilized.

* Aggressive Depreciation
The controversy surrounding the new plant has been its depreciation policy, which is aggressive and was documented in a report written by Al Rosen, a forensic accountant, two years ago. They are currently using a policy of 15 to 20 years, which is allowable, yet makes earnings and return number higher than reality.

* Real Estate Sales – No disclosure with respect to its real estate sales.

* Tooling Labor Costs – Some of the tooling labor costs were included in the $1.0 billion capital expenditure amounts in 1999 and 2000 without full disclosure.


RECENT FINANCIAL PERFORMANCE
* The company reported the most recent quarter with EPS of $0.28 per share up approximately 21.0% due its acquisition of Marley Mouldings in 2001. Internal growth was a much lower 9.0% compared to 2001, its most depressed year.

* The EBITDA margin was 20.2% compared to 19.2% in the prior year, up 100 basis points, which was less than expected due to SG&A expenses associated with marketing its newer products to home improvement retailers. While the margins are higher than its comparison universe its return on capital is only average. Return on Capital has declined fairly consistently: 1997: 12.7%, 1998: 11.1%; 1999: 11.6%; 2000: 10.5%; 2001: 7.1%; 2002 is optimistically estimated to be 11.8%. So the risk again is that the lower margin products permanently reduce the return on capital, making the Woodbridge plant an overexpansion.

* Approximately $128.0 million of debt is coming due this year and next which puts an additional risk on the company should free cash flow fall short.

* You only have to look at RYG’s comp, Masco Corporation (MAS-NYSE), to see a premium valuation vanish in an uncertain housing and macro economic environment. It is just a matter of time before the market realizes that RYG has the same building materials business exposure.




VALUATION

----Company --------------P/E-------------Price/Sales-------P/CF(TTM)
Royal Group (RYG CN) ----14.77X-------------1.02X-----------17.2X
Masco Corp. (MAS) -------13.86X-------------1.02X-----------8.6X
CFM (CFM CN) ------------12.27X-------------0.91X-----------15.6X
MAAX (MXA CN) -----------13.64X-------------0.76X-----------9.3X
Masonite (MHM CN) -------11.55X------------ 0.73X-----------10.0X

All of the above companies are public companies in the building materials industry. Clearly, the table above demonstrates that RYG trades at an undeserved premium to its comps. Based on the issues described above and the fact that most of the earnings come from one product, and the declining return on capital, I believe that a fair market multiple would be closer to a P/E of 11.0X under the market average. This would give a fair value on the equity of approximately $20.43 or 25% lower than where it is trading today.

Catalyst

CATALYSTS
* Accounting Concerns
* EBITDA margins
* Signs of weaker renovations market
* Product introduction failures