Description

I am short Supremex, Canada’s largest manufacturer of envelopes, as I believe it is a value trap. The envelope manufacturing business is in secular decline (3-5% per year), but the market has recently rewarded SXP with a multiple reflective of a company that has modest secular growth (6.0x LTM EBITDA) following three quarters of growth in consolidated revenue and EBITDA. 

The primary reason for the positive revenue and EBITDA growth in each of the last three quarters, however, is the weak Canadian dollar, which has caused a temporary spike in sales to US customers. Sales to US customers likely account for more than 20% of SXP's LTM EBITDA, and a large portion of that is low quality swing purchasing that will go away virtually overnight if the CAD rallies against the USD. If/when that happens, it should cause a sharp decline in SXP’s earnings, trading multiple, and thus stock price. 

There are numerous other risks inherent in SXP's business (large pension obligation relative to value of company; potential for significant price competition/margin erosion; negative compounding impact of fixed cost absorption in a declining market, etc) which are easy to overlook in a frothy market, but which could cause the wheels to come off the bus entirely if the business (or stock market) encounters an unexpected speed bump.

I.                    Business Description and Overview

Supremex Inc. (TSX:SXP), headquartered in Montreal, Quebec, is Canada’s largest manufacturer of stock and custom envelopes (57% market share), with seven manufacturing facilities across seven provinces, and three warehouses/sales offices.

II.                  Capitalization

(in $CAD millions except per share)
Px: $4.45
Shares: 28.8
Mkt Cap: 127.9

Add LT Debt: 23.4
Add Cash (adjusted for dividend and taxes payable): -0.9
Add Pension and Other LT Liabilities: $4.4
Enterprise Value: $156.6

LTM EBITDA: $26.3
EV/LTM EBITDA: 6.0x

III.                Core business is in secular decline

~50% of the envelopes that SXP sells are used for transactional mail (i.e. billing), which is in rapid secular decline as the world continues to migrate towards paperless billing. ~20% of SXP’s envelopes are used for direct mail, which is in secular decline as online/multi-channel advertising eats up a larger portion of marketing budgets and ‘do not mail’ lists gain popularity. 30% of SXP’s envelopes are used for personal letters, holiday/birthday cards, and ‘other,’ and this group is also in secular decline because of email.

These are recent historical unit volume decline rates for Supremex, coupled with forecast decline rates from a 2013 Canada Post consulting report:

              SXP Unit Volume Sold in Canada:            

2010A: -4.1%
2011A: -8.1%
2012A: -9.4%
2013A: -4.9%
2014A: -5.0%
~~~~~~~~~
2015P: -3.5%
2016P: -3.8%
2017P: -3.9%
2018P: -3.6%
2019P: -3.8%
2020P: -3.8%

IV.                Recent Financials vs. Underlying Reality

SXP has posted year-over-year Revenue and EBITDA growth in each of the last three quarters, which has caused the stock to almost double from its historical trading multiple of sub-4x EBITDA, to its current multiple of 6.0x. However, more than 100% of the revenue and EBITDA growth in these three quarters has been from a temporary rise in sales to US customers who are buying from SXP exclusively because of the weak Canadian dollar. For reference, the summary results of the last eight quarters are pasted below:

SXP Consolidated Quarterly Revenue and EBITDA

                   Revenue     EBITDA

Jun-2013       31.9          6.1
Sep-2013      29.8          5.4 
Dec-2013      33.6          6.7
Mar-2014      33.9          7.3
Jun-2014      30.6          5.8
Sep-2014      32.2          6.3
Dec-2014      35.1          7.2
Mar-2015      34.7          7.0

The last three quarters of results appear to have convinced the Canadian retail set that SXP, which has a high earnings/fcf yield relative to the market, is now also a growing business. Of course, in reality, envelopes aren’t making a comeback, and this face value financial growth is just a short-term bump from the weak CAD, as well as higher selling prices in the Canadian business which offset topline volume declines but yield little in the way of additional FCF, as those prices are merely passing through raw material price increases (i.e. this is not pricing power). The key metric that matters in this business long term is unit decline rates in Canada, which have continued apace:

SXP Canada Quarterly Growth Rates:

                   Volumes(%)  ASP(%)     Total(%)

Jun-2013     -3.3            4.8           1.5
Sep-2013     -2.8           -1.8         -4.6
Dec-2013     -5.1            6.2           1.1
Mar-2014     -13.3          9.1          -4.2 
Jun-2014     -14.1          10.1         -4.0
Sep-2014      4.1            2.1           6.2
Dec-2014      -3.1           4.7          1.6
Mar-2015   -1.8              1.1          -0.7

LTM sales to US customers are currently ~$25.6 million, up from just $12.2 million in 2013. At the very least, the US should be generating the average EBITDA margin of SXP in its entirety (~20%), suggesting that of the $26.3 million of LTM EBITDA, at least $5.2 million is coming from US customers, and at least ~$2.7 million of that is coming specifically from the recent CAD weakening. The company does not disclose margins by country, but it wouldn’t surprise me to learn that US margins are actually quite a bit higher than Canada, given the FX tailwind (the right pricing strategy can capture both volume and margin in this kind of FX environment), in which case the leverage to US customers treating SXP as swing capacity could be even more significant.

If the $2.7 million of swing capacity EBITDA goes away, SXP’s normalized business would have ~$23.6 of PF LTM EBITDA, implying a PF trading multiple of 6.64x for a business in secular decline. To the extent that this short works quickly and effectively one day, it will likely be because the FX benefit goes away, causing both a sharp decline in earnings, and multiple contraction as the market realizes that it was overpricing the value of the temporal US business.

V.                  Other risks to the business

There are a number of other bad things that can happen to SXP which could accelerate the decline in financial results and benefit shorts:

a. As volumes continue to decline, intensifying competitive pressures could cause margins to collapse. There are just nine meaningful competitors in the Canadian envelope market, and none of them are able to take significant production capacity offline other than SXP. Pricing appears to have stayed rational (almost cartel-like) to date, but all it takes is one of SXP’s larger competitors to start a price war.

b. The shift away from paper could accelerate beyond the expected 3-4% annual declines, exacerbating the market and management issues that SXP already faces.

c. SXP is materially over-earning at current margins/ROIC as compared to US competitors. In the majority of the US, wholesale envelope pricing is ~30% lower than it is in Canada. The markets have shaken out differently in the two countries (envelopes are a regional business due to high shipping costs), but over a long period of time a shrinking commodity business like SXP should not be able to earn 20% ROIC.

d. A corralary to the last bullet point: Cenveo has been aggressively reducing recently acquired capacity in the US in order to support pricing. It would not be overly difficult or illogical for Cenveo to take some of the folding equipment it is taking offline in the US and ship it north to compete in the Canadian market, to compete for some of Canada's superior economics.

e. SXP has a very large pension obligation relative to the company’s market value (~$100 million obligation, currently slightly underfunded at an undemanding 4.8% discount rate, but with ~50% of its assets invested in equities). An adverse impact on the pension portfolio could add a significant unfunded liability to SXP’s enterprise value. If SXP wanted to offload this pension to an insurer, it would be on the hook for $10 – $15 million more than the current deficit on the balance sheet.

e. SXP has cut its work force from ~900 to ~500 over the last ~8 years. Ongoing secular decline necessitates ongoing cost cutting, but eventually in a multi-site industrial business, you run into fixed cost absorption issues that you simply can’t cut your way out of while still servicing your customers. When this eventually happens at SXP, earnings could get very small, very fast. In the interim, the need to freeze salaries and conduct continual layoffs creates both legal risk (it isn’t easy or cheap to fire people in Ontario) and operational risk, as talented employees aren’t going to stick around.

f. Concern that the three-year/$9m revenue contract (announced July 2014) will not result in significant shareholder value due to high CapEx, and likely low margins. The market seems enthusiastic that SXP will move into parcels and printed packaging (which is actually growing due to online/mail order), but there is very limited information on which to base that assumption. The reality is that a single customer asked SXP to purchase a $1m piece of off-the-shelf equipment for a $9m/year contract… if the implied IRR on that $1m investment were compelling at all, the customer would presumably have just purchased the equipment themselves.

In summary, SXP is trading at a low growth company valuation, but is still shrinking, and has a number of risks which could cause earnings to decline rapidly. 

Catalyst

    CAD strengthens and sales to US customers drop off; competitors start to get more aggressive on pricing and pressure margins and ROIC; market corrects creating large pension obligation