Description

The following is a short sale recommendation for Wellman, Inc. As a result of increased production costs, decreased demand for its products and ill-conceived financing transactions, Wellman’s operating performance and balance sheet have deteriorated substantially in the past eighteen months. I believe these conditions will continue into the foreseeable future, with the Company’s cost-cutting and lean manufacturing initiatives doing little to buffer this business decline.

Wellman is a manufacturer of PET resins for the packaging industry and polyester fibers for the home furnishing and industrial fabric businesses. In the packaging business, Wellman’s PET resins are used primarily in the manufacture of plastic soft drink bottles and other food and beverage packaging. The Company’s polyester fiber products are used in the apparel, non-wovens, home products, and industrial products. End user demand for both of these businesses have declined substantially over the past couple of years, leaving the company with under-utilized capacity and consequently, depressed gross margins. In fact, due to a bleak future in the staple polyester fiber business, the Company recently decided to convert the fiber line in one of its facilities (which has been idle) to a solid state PET resin line. The Company took a $135 million impairment charge related to this conversion in Q1.

After the stock dropped earlier this year based on Q4 and FY2003 numbers, the stock has recovered a bit, mainly due to a refinancing of its debt, which extended the maturities on $625 million (net $490million) of debt due in July 2004 out to 2009. I view this as a short-term positive catalyst at best, since nothing operational has changed at the Company. At the current stock price of $7.80, the Company trades at over 13x, LTM EBITDA basis. I expect the stock price to quickly go below $5 and the Company to be in danger of undergoing a balance sheet restructuring. I have highlighted some reasons why the stock will see continued pressure:

INCREASE IN TOTAL DEBT
In February 2004 Wellman completed $625 million of new debt financings, consisting of a revolver and two term loans. In addition to refinancing bank facilities, the Company is using the proceeds to repurchase a $150 million sale leaseback it entered into in 1999, to purchase an accounts receivable securitization program for $28 million and to prepay a $87 million raw material contract. This increased the overall net debt from $170 million to $490 million, with debt/total capitalization going from 22% to over 50%. While this extended the maturities on the debt for another five to six years, alleviating short-term liquidity concerns, I believe it will become a significant burden as operating performance continues to stumble in the next several quarters. Interest expense will increase by approximately $35 million, leaving the Company little room for error in managing future liquidity needs and executing its business plan.

CONTINUED PET MARGIN DECLINE
With this additional leverage, the Company has now put itself in a “do or die” situation. Wellman must now depend primarily on improved PET margins in order to make any improvement in its profitability. Even with the planned cost reduction programs, the Company needs a margin recovery to make any sort of sustained progress. The two inputs to its PET margins are raw material costs (crude oil and natural gas) and selling prices. I don’t have meaningful insight into predicting commodity prices, so I won’t linger on where crude and natural prices might go in the next few quarters. Suffice it to say that if natural gas prices stay at or above current levels it will be very difficult to pass along added costs to its customers. In terms of selling prices, the steady decline in demand of PET resin related products has given large consumer packaging companies greater leverage in recent pricing negotiations. A proposed price increase of $0.06 per pound has already been revised downward. Realistically, there doesn’t seem to be any short-term catalysts to provide any sustained margin improvement.

EXCESS SUPPLY IN THE MARKET
Even if demand were to hold steady or mildly improve, it would be offset by an increase in market capacity. Gruppo Mossi, one of the largest PET resin suppliers in the market, recently announced plans to add capacity in its main Altamira Mexican plant. Numerous other resin producers have followed suit, in an effort to maintain or increase volume market share. In 2003, over a billion pounds of additional resin supply hit the market, and current weak demand has not allowed the market to work through this over-capacity. This supply/demand dynamic is not likely to change until well into 2005 at the earliest.

HUGE OVERHANG CREATED BY PREFERRED STOCK
In February 2003, Warburg Pincus invested $126 million in the form of convertible preferred stock and received a warrant to purchase 1.25 million shares of the Company’s common stock at an exercise price of $11.25 per share. The conversion price on the preferred is adjusted downward on a dollar-for-dollar basis if the stock price does not reach $23.00 by the end of 2007. Assuming exercise of all warrants, Warburg Pincus will own approximately 30% of the Company and under certain conditions if the stock price continues to fall, up to 49% of the Company during the next five years. The Preferred Stock may be converted into shares of the Company’s common stock at any time. The Preferred Stock became convertible in the fourth quarter of 2003 when the Company publicly reported cash earnings per share of less than $1.50 for the trailing four calendar quarters ending September 30, 2003, as stipulated in the purchase agreement. While it is unlikely that Warburg Pincus will force a conversion (which would represent an additional 21 million shares), going forward the Company is required to calculate EPS based on this fully diluted number (unless it has an anti-dilutive effect).

Note: one potential risk of shorting the stock is Warburg Pincus’ commitment to the Company. Although they are unlikely to commit further capital to this company, any equity infusion that reduces the debt would positively affect the cloud surrounding this stock.

Catalyst

- Next quarter earnings release, showing no material improvement in margins
- Potential violation of new debt covenants