Description

(Note: All $ figures below are in Canadian Dollars unless otherwise specified)

Summary

• Tembec is a Canadian based forest products company that is underfollowed due to recent past challenges and a currently small market capitalization (sub-US$250m).

• Those challenges were either temporary or have turned into positives.

• Tembec’s earnings, cash flows, and capital structure are rapidly improving.

• We believe that the stock is worth at least 3x its current price.

Company Brief Overview

Tembec is a Quebec based forest products company that produces lumber, paper pulp, paper, and specialty cellulose pulp. Tembec operates in North America and France and is listed on the TSX. Tembec’s fiscal year ends in September and in Fiscal 2016, the company posted revenue of $1,499m: 37% to US, 19% to Canada, 19% to Europe, 12% to China, and 13% to other regions. The vast majority of earnings come from the United States, Canada, and Europe in specialty cellulose and paperboard products. Specialty cellulose generates roughly 45% of total profit, paperboard 40%, lumber 10%, and pulp 5%.While we expect this to continue, lumber earnings should become a more significant contributor in the future – more on that later.

Primary Profit Drivers - Specialty Cellulose and Bleached Paperboard

Quick description of specialty cellulose: Specialty cellulose is a small, specialized segment of the overall pulp market. The pulp market is 65 million tons (for paper, etc), the dissolving pulp market is 6.5 million tons (viscose or rayon – think inside lining of a suit jacket), and the specialty cellulose market is 1.5m tons (where Tembec operates primarily). Customer relationships are lengthy, the qualification process is intense, and the cost of the amount used in a product is a very small percent of the end product purchase price. Specialty cellulose can be used in anything from toothpaste, to pharmaceuticals, to cigarettes. Rayonier Advanced Materials is the largest producer, but focuses on acetate (cigarette filters). Tembec is the leader in ethers (industrial products, pharmaceuticals, food, coatings). The top 5 industry participants control roughly 90% of the global market (Source: Borregaard September 2016 Capital Markets Day). After a few years of price declines (margins were previously at unsustainably high levels), specialty cellulose pricing is rising again outside of acetate. Pricing is usually based off of annual contracts, which have just recently gone into effect January 1, 2017, but have not yet been reflected in quarterly earnings.

Quick description of bleached paperboard: Bleached paperboard is a highly consolidated market in North America, with the top 5 industry participants controlling 92% of the market (Source: Risi). Bleached paperboard is used in folding cartons (think of the white box that a Visine bottle comes in), liquid packaging, cups, and plates. This is a very defensive set of end markets with high producer concentration, but imports and a strong USD are keeping a lid on pricing for now. The order book for 2017, in management’s own words, is “rock solid”.

Brief History and Opportunity

Tembec was formed in 1972 and went public in 1979. The company started with the dissolving pulp mill in Temiscaming, Quebec. The company subsequently grew by building a high-yield pulp mill at the Temiscaming site in 1984, diversifying into lumber in 1986, and producing coated bleached board out of Temiscaming in 1989. Tembec expanded overseas in 1994 by taking a 50% stake of the Tartas, France mill in 1994 and became the full owner in 1999. In 2006, current CEO James Lopez took over. Due to way too much leverage going into the housing downturn / financial crisis, Tembec went through a significant restructuring, recapitalization and streamlining process during 2007-2009. In late 2011, Tembec announced a major investment initiative focused on producing “green” energy and improving cost and productivity of its mills.

In March 2012, the Company announced a major capital investment to upgrade its specialty cellulose mill in Temiscaming, Quebec. The project involved the replacement of three low-pressure boilers with a single new high-pressure boiler designed to burn waste sulphite liquor generated by the specialty cellulose manufacturing process. The project also included the installation of a new 60-megawatt electrical turbine. Tembec secured a 25 year purchase power agreement with Hydro-Quebec that produces roughly $28m in incremental electricity EBITDA. The project also aimed to improve margins and production capacity for an incremental ~$20m EBITDA benefit, but this was dependent on market conditions.

This all seemed great at the time, but in the interim from construction start until finish, the investment ran over budget and longer than expected. The investment was originally expected to cost $190m and to come online in the spring of 2014. The eventual cost of the project was $273m and didn’t come online until early 2015. It was also completed during a time of weak specialty cellulose pricing as European demand was soft and Rayonier was executing on a commodity pulp to specialty pulp conversion (Rayonier since gave up on the project) – giving buyers the upper hand after many years of an extremely tight market.

The project construction also coincided with declining interest rates and significant cash pension contributions (as shown below). Pension contributions should be a positive cash flow statement adjustment in 2017 for the first time in recent memory.

Pension improvement is just the beginning of the opportunity. 2016 vs 2015 EBITDA more than doubled from $70m to $148m (chart below), not from pricing, but from operations at Temiscaming running efficiently after a tumultuous few years. Now, 2017 volumes of specialty cellulose sold are expected to improve (outside of acetate which comprises roughly 10% of Tembec’s specialty cellulose revenue) and pricing is increasing due to less cotton linter pulp availability and rising demand. This is the first price increase (5%-10% depending on grade, ex-acetate) in a few years.

We believe $180m is a very achievable EBITDA estimate for this year or ~150 bps of yr/yr margin expansion, which is roughly in-line with consensus. This assumes the benefit from specialty cellulose price hikes and volume increase, but keeps other product segment profit contribution flat. Further, there is likely more earnings upside ahead. To quote management on the last call, “…we see significant improvements in the company's EBITDA margin over the next 3 years.”

Earnings upside is expected over the next few years from not only increasing specialty cellulose pricing and volumes, but also from quick return lumber mill improvement projects. Going forward, Tembec is focused on its 6 neglected sawmills and has a 3-year plan to spend $50m on pretty basic scanner tools that are expected to generate an incremental $35m in EBITDA from greater productivity. Even after the incremental spend above maintenance CapEx ($30m-$35m) of ~$15m per year for the lumber projects, Tembec will generate significant cash flows.

The big investment spend, and hence large project risk, is in the rearview mirror now that the Temiscaming project is complete. Free cash flow, as a result, is ramping and expected to stay that way (chart below). Further, the cost of financing has a real chance of being reduced dramatically in the next year as the call price on 70% of the company’s debt steps down in October. We believe that this alone could drive a 20% improvement in free cash flow in fiscal year 2018 versus 2017.

Tembec is levered, but is declining fast from 10.2x at year-end 2015 to 4.5x at year-end 2016 to 3.3x expected at the end of this year (chart below). We believe that the deleveraging cycle should continue accruing value to the equity.

Valuation

Discounted Cash Flow

We expect Tembec to turn fiscal 2017 generating a roughly 30% free cash flow yield (3 quarters away) at a $3.00/sh stock and be levered just over 3x (ex-value of tax assets). The majority of this free cash flow is coming from relatively resilient specialty cellulose and bleached paperboard earnings. Using a simple DCF and a 10% cost of capital, we arrive at $9.40/sh of equity value including the value of lumber earnings (discussed further below in “Upside Earnings Kickers” section) and Tembec’s Canadian tax assets of roughly $600m (which we DCF at a value of $115m).

Comparables

Using Borregaard and Rayonier as specialty cellulose comps and Clearwater Paper and IP as bleached paperboard comps (these comps comprise ~85% of Tembec’s earnings verticals), we arrive at forward average EV/EBITDA and recurring free cash flow yields of 7.85x and 7.4%, respectively. On a peer EBITDA multiple valuation, we arrive at $8.80/sh for Tembec equity and on a peer FCF yield multiple valuation, we arrive at $12.00/sh for Tembec equity. In the case of the peer EV/EBITDA multiple, we are not giving credit for the quick return lumber projects, but we are giving value for Tembec’s considerable Canadian tax assets ($115m present value). In the peer free cash flow valuation, we are not discounting for Tembec’s higher than peer leverage and we are giving credit for debt refinancing (discussed later). The average of these two peer valuations results in an implied stock price of $10.70/sh for Tembec.

Combined

A bottoms-up standalone Tembec valuation and a peer valuation are both yielding an equity valuation of over $9/sh - a triple from here.

One final methodology to arrive at a similar valuation
In summary, Tembec should exit this year generating roughly $73m per year in free cash flow based on its existing earnings run-rate trajectory and including growth capital expenditures at the lumber mills. At 10x, this is a $7.30/sh stock plus the upside kickers below result in a stock value of $9.50/sh+.

Tembec also has opportunity to reduce financing costs beyond debt pay-down. We believe that this event is highly likely. Nearly 70% of Tembec’s debt is comprised of its US$375m 9% Notes due 2019. The call price on those bonds steps down from 104.5 to 102.25 in October 2017. The opportunity to refinance at that time seems very good as leverage will be close to many of its paperboard peers that have 7-10 year debt at sub-5%. If Tembec can refinance its 9% Notes this Fall at 6%, that will generate ~$15m in interest expense savings or ~$10m fully taxed. At 10x, this is an incremental $1/sh of equity value (100m shares).

Tembec’s lumber mills are outdated and incremental earnings upside appears to be of low risk and very well vetted at this point. If Tembec can produce the incremental $35m by 2020, it is worth another $1/sh valued at 5x EBITDA and discounted back or $2/sh if valuing it as 10x cash flow and discounting back (and utilizing the company’s significant Canadian tax assets).

In summary, clearly identifiable upside kickers provide an additional $2/sh - $3/sh of value off the base $7.30/sh.

Risks

The softwood lumber agreement could create volatility and drive down lumber earnings. It is tough to gauge this risk precisely, but if there is a duty, it would likely push up the price of lumber which would help offset some of the increased taxation. The lumber agreement between the US and Canada expired October 2015. In the 5 quarters preceding its expiration, Tembec generated $25m in lumber EBITDA. In the subsequent 5 quarters after the expiration, Tembec has also generated $25m in lumber EBITDA. What is probably more important to lumber earnings in the future is the health of the US housing market, Chinese demand, and perhaps most importantly, the success of the above discussed quick return projects.

Trump. This is a Canadian company that sells over a third of its product into the United States. We do not believe it is likely, but perhaps there could be incremental duties placed on Tembec’s non-lumber products.

Supply. In pulp (specialty and commodity) and paperboard, supply is always an issue and a concern. Outside of international capacity on the hardwood commodity pulp side (ie Brazil), it is hard to imagine a big influx of specialty cellulose capacity near-term given relatively modest margins for the industry today and a very difficult, long duration qualification process.

Strong Canadian Dollar. Tembec benefits from a weaker reporting currency.

Recession. Tembec’s end markets include construction industries and general GDP sensitive industries.

Additional Information

Tembec’s products and their applications:

Tembec’s manufacturing footprint by product:

Key shareholders – top 3 hold nearly 50%:

20.0%: Prem Watsa (aka the Canadian Warren Buffett)

17.9%: Bennett Management

10.6%: Oaktree Capital Management

Management:

The CEO has been in his current role for 11 years and with Tembec for 28 years. The CFO has been in his current role for 20 years.

Quick Financials:

Catalyst

• The next reported quarter will be the first quarter with the realized specialty cellulose price increase reflected in results.
• Debt refinancing opportunity in two quarters.
• In the interim, a simple delivery of results similar to that of the last couple quarters will help investors realize that this small cap stock is producing material free cash flows now that the investment cycle is behind them. As the stock appreciates and market cap grows, it should attract more and more investors that have been limited by market cap size and/or liquidity.
• Potential sale to Rayonier, Georgia Pacific, Borregaard, Sateri, Sappi.