Description

An investment in Tredegar Corporation (“TG” or the “Company”) presents an opportunity to own a highly cash generative franchise films business with several material, near-term catalysts.

Business Overview & Investment Set-up

TG is a Richmond, Virginia based manufacturer of plastics and aluminum products.  The Company operates two segments: (1) Film Products, which comprises 63% of revenue and serves the personal care, plastic packaging, and surface protection end markets and (2) Aluminum Extrusions, which comprises 37% of revenue and serves the building and construction, consumer durables, machinery, and transportation end markets.

Reason for Mispricing & Variant View

Terphane Acquisition

The underperformance of a large acquisition obscures TG’s earnings power and casts doubt on management’s ability.  In October 2011, TG acquired Terphane, a Brazilian plastic films manufacturer of food packaging products, for $182.7 million.  In the TTM June 30, 2011, Terphane produced revenue of $160 million and adjusted EBITDA of $44 million.  Performance began to deteriorate in 2013 when revenue declined 8.9% year-over-year. While TG did not disclose Terphane’s operating profit for 2013 and 2014, we know it declined significantly (perhaps negative) based on (1) management’s commentary (2) Terphane’s financial information published in Brazilian trade case documents.  If we include the $80 million in capex spent to nearly double Terphane’s production capacity, the total Terphane investment amounts to approximately $260 million, over a third of TG’s current market capitalization.

While Terphane is disappointing, the situation is not as bleak as recent performance indicates.  This is a cyclical industry and management was very clear about Terphane’s near-term prospects from the inception of the deal.  On the October 26, 2011 M&A call, CFO Kevin O’Leary stated “we believe Terphane is at the peak of a cycle right now,” and accompanied his comments with the following chart:

Furthermore, he clarified the purchase multiple by stating, “in evaluating this acquisition, we would suggest that taking the average of the multiples based on 2010 and on the last 12 months ended June of this year is more representative of an appropriate multiple for this transaction.”

Despite deteriorating Brazilian economic conditions, Brazil continues to develop and grow its middle class, which calls for more consumer packaged goods and greater demand for Terphane’s products.  As Brazil’s sole BOPET films manufacturer, Terphane remains well positioned to benefit from this demand growth.

Management has been proactive in running Terphane, placing a new, proven leadership team in Brazil at the start of 2014.  Finally, Terphane’s competitive position is protected in the form of anti-dumping duties placed against several countries. These anti-dumping duties are currently applied against the UAE, Mexico, and Turkey and they were recently extended to China, Egypt, and India for a provisional six month period beginning November 2014.  A final determination—extending these duties beyond six months—is expected in April 2015.

Brazilian Trade Case

Terphane has a history of successfully petitioning for anti-dumping duties against foreign competition.  The trade case documents from June 2014 provide a look into Terphane’s financial performance, which is not disclosed in TG’s financials¹.

Since 2007, the anti-dumping duties from the first campaign expired, and China, Egypt, and India emerged as major exporters of BOPET films into Brazil with collective output rising over 3,300% relative to 2009 levels.

This dramatic level of import growth occurred when the domestic market rose by a comparably low 22.7% during the same period.  Furthermore, prices charged by the three nations under investigation decreased by 15.1% while prices increased by 91.8% for other nations, indicating that Egypt, China, and India are likely dumping their products into Brazil at below market prices.  

The net effect is a significant decline in Terphane’s market share and profitability.  In 2013, Terphane’s market share slipped to near 2009 levels and gross profits declined 42.9%.  While data for 2014 is undisclosed, we believe these negative trends persisted throughout the year.

In response to these trade practices, Terphane embarked on its third anti-dumping campaign in April 2014.  By June, Brazil’s Ministry of Development, Industry, and Foreign Trade determined that BOPET film producers from Egypt, China, and India undercut the domestic industry.  Following this determination, a provisional anti-dumping duty was placed on these producers for a period of six months, with final determinations expected in April 2015².

Terphane generated $160 million in revenue and earned $44 million in EBITDA when acquired by TG three years ago.  As Brazil’s sole domestic producer with a near doubling of production capacity and pending import protections, we believe it is likely that Terphane returns to at least previous levels of revenue and profitability.

Loss of P&G Business

TG’s films segment lost a $51 million account with P&G resulting in revenue and operating profit declines of $33.9 million (3.6% of 2014 revenue) and $7 million (11.8% of 2014 operating profits), respectively.  This caused investors to fear a continuing erosion of business with TG’s largest customer. 

Although this loss is significant, we do not think that the P&G business is in permanent decline.  First, TG has a multi-decade relationship with P&G as a supplier on numerous product lines.  Secondly, share shifts are common in this industry.  Griffon Corp, the only public peer with P&G disclosure, exhibits similar trends in their P&G business.

Through our channel checks, one competitor stated that additional share losses are unlikely and this is business as usual for P&G. Additionally, our channel checks revealed that Kimberley Clark, which is mostly vertically integrated in its personal care business, is adopting an outsourcing model as part of its FORCE (Focus On Reducing Costs Everywhere) cost savings initiative, which could result in significant new business for TG, a top 3 player in the industry.  As the $51 million account loss anniversaries, we expect the personal care business to continue its steady growth trajectory. 

Valuation

On an EBITDA basis, TG trades at a 37% discount to Film Products peers and a 9% discount to Aluminum Extrusion peers.

At $20.67 per share, the market is ascribing a negative value to Terphane, which cost nearly $260 million when considering both price paid and additional capital deployed. The analysis below analyzes TG ex-Terphane by capitalizing the legacy Films segment using 2011 EBITDA, which mostly excludes Terphane (acquired late 2011), the Aluminum Extrusions segment using 2014 EBITDA, and the corporate costs using 2014 expenses.  Notably, the assumptions underestimate the actual financials as the 2014 corporate expenses, which include Terphane expenses, are larger than the profit decline in the legacy films business since 2011 (the legacy film business profits may actually be higher than 2011 levels).

This analysis implies negative value of $69 to $273 million for Terphane. With its dominant market share position, favorable end markets, and protection from import competition, we think Terphane is likely worth at least TG’s initial investment.  The table below analyzes TG’s intrinsic value based on a valuation range for Terphane from $262.7 million (acquisition cost and capex) to $0 (100% Haircut). 

Even if we consider the entire Terphane investment as worthless, applying a 100% haircut, the resulting valuation still implies a 10% to 41% upside for TG.

Conservatively, TG can earn $140 million in EBITDA by 2016 compared to $100 million in 2014 when Terphane was at a cyclical trough. We believe the entire bridge to 2016 profitability can be achieved by Terphane alone.  This business did $44 million in EBITDA prior to acquisition and with the impending restrictions on foreign competition, the doubling of production capacity, and an eventual stabilization in the Brazilian economy, it could conceivably achieve $80 million-plus.  

At $140 million in EBITDA, TG shares are worth $28.73 at the low end of our valuation, presenting 39% upside from current share prices.

Catalysts

Brazilian Anti-dumping Duties

Provisional six month anti-dumping duties have been in place since November 2014.  A favorable final determination, expected in April 2015, will enforce anti-dumping duties on Chinese, Egyptian, and Indian competitors.  Given two successful precedents, the provisional duties in place, and the pressure on the Brazilian government to revitalize the domestic economy, we like Terphane’s chances.  Combining the benefits of reduced competition with additional production capacity and a new management team, it is reasonable that Terphane can generate more than the $44 million in EBITDA it did when acquired in 2011.

Corporate Actions

A potential sale of TG or one of its businesses may result in further value creation.  On September 6, 2013 TG’s former CEO John Gottwald, his brother and TG board member, William Gottwald, and their father, Floyd Gottwald Jr., filed a 13-D revealing a 23% ownership stake in the company.  Citing actions taken by TG’s board and management, as well as TG’s financial condition, operating results, and prospects, the Gottwalds stated that pursuing “strategic alternatives” would be in the best interest of shareholders and also indicated that they would be nominating a slate of director at the following annual meeting.  On February 19, 2014 the Gottwalds entered a one year standstill agreement with TG contingent on the termination of the company’s poison pill, a reduction in the board from 12 to 11 directors, the nomination of three additional board members, and the formation of the “Strategic Finance Committee”, which is authorized to review and evaluate “strategies to create additional value for shareholders.”    

On April 3, 2015 TG amended its credit agreement with JPMorgan to eliminate a covenant regarding the minimum balance of consolidated stockholder’s equity.  TG would only breach this covenant if there were a goodwill writedown or a return of cash to shareholders.  GAAP requires an annual test for goodwill impairment therefore, we believe if there was a goodwill impairment, it would have occurred in the FYE December Q4 2014 results.  The Strategic Finance Committee has been in existence for over a year, TG’s stock price is down 11.7% since the committee’s existence, and the standstill is about to end.  As a result, we believe that it is quite likely TG will announce a stock repurchase or special dividend in the near term. 

Asset Monetization

TG has a 20% stake in Kaleo, a specialty pharmaceutical company that licenses its FDA approved product, Auvi-Q, to Sanofi, which is listed on TG’s balance sheet at $39.1 million.  In April 2014, Kaleo received $150 million in debt funding from PDL BioPharma, which manages a portfolio of patent and royalty assets, to help commercialize its new product EVZIO. TG has a history of selling non-core assets—selling its stake in Falling Springs, a mitigation banking business, for $16.6 million in 2012, and corporate real estate for $4.7 million in 1H 2014.  We think monetization of Kaleo, a non-core asset with a proven, revenue-generating product, is highly likely.

Sources

₁Brazilian Trade Case Filing:

http://www.legisweb.com.br/legislacao/?id=271989

 ₂6 Month Provisional Anti-dumping Duties:

http://www.camex.gov.br/legislacao/interna/id/1307

Catalyst

Brazilian anti-dumping duties

Corporate actions from Gottwald Group

Asset monetization