Description

I am recommending the purchase of Xerium Technologies (XRM), which I believe presents a compelling risk/return proposition, with total return potential of over 50% over the next two years with very modest downside risk. XRM manufactures consumable products used in the paper production process, primarily clothing and roll covers. XRM executed an IPO in May 2005 at $12/share, which represented a partial exit for Apax Partners, which purchased the company in an LBO in 1999. Apax continues to own about half of the Company, and this does represent an overhang on the stock. The description of the business below is purposely brief since there is ample background info on the Company’s website (www.xerium.com) and in its public filings.

XRM’s clothing products, which represent approximately two-thirds of revenues, are engineered synthetic textile belts that transport paper as it is processed along the length of a paper-making machine. Clothing contributes to the forming, pressing and drying stages of the paper-making process. Because paper-making machines vary in size and design, clothing is customized to each individual paper-making machine. XRM is the #2 producer of clothing (publicly traded Albany International is #1 with about 30%) with a global market share of approximately 15%.

Roll cover products, which account for about one-third of XRM’s revenues, provide a surface with the mechanical properties necessary to process the paper sheets in a cost-effective manner that delivers the sheet qualities desired by the paper producer. These products cover the rolls on a paper-making machine, which are the large steel cylinders over which clothing is mounted and between which the paper travels as it is processed. Like clothing products, roll covers are customized to each individual paper-making machine. XRM is the #1 global producer of roll covers with a global market share of approximately 33%, with two other competitors each holding about 15% shares.

Although XRM’s products have important functions in the paper-making process and can influence paper quality and production costs, the clothing and rolls account for a very small percentage of production costs (~2-3%). Clothing and rolls with certain properties can facilitate the producer’s substitution of less costly raw materials (eg recycled fiber), allow them to run their machines faster, reduce energy consumed in the drying process and minimize downtime. Although paper producers obviously are cost conscious, XRM’s products have a real value proposition and, given their modest proportion of the overall cost of production, these products may not be subject to the same intensity of price pressure as other inputs to the process (of course, price always matters). Moreover, because the products are consumables, their demand is driven by paper production, which has been very stable over time. The volatility of the paper market is driven largely by changes in market pricing of paper products, while swings in actual production volume are much more muted.

In sum, XRM is a global leader in a mature, stable market with recurring sales of consumable products and significant barriers to entry. Its revenues are diversified both by customer and by geography. These are the attributes that made XRM a solid LBO for Apax. As evidenced in the figures below, which provide a snapshot of the Company’s finances and valuation, XRM generates strong margins and cash flow. All figures are 2005 actuals (in millions, except per-share data) but with adjustments to add-back IPO costs and restructuring/one-off costs.



Revenues $582
EBITDA $149
EBIT $101
Operating EPS $0.55

Shares Outstanding 43.7
Price (4/21) $9.17
Market Cap 401.0
Net Debt 589.1
TEV 990.1

TEV/EBITDA 6.6x
P/E 17x
Div Yield 9.8%

These numbers may only be mildly interesting in isolation, but I believe the results are temporarily depressed due to some self-inflicted missteps but that these issues have abated and the Company is poised to increase performance to more normalized levels, at which the current valuation represents a compelling opportunity. EBITDA in 2005 represented a four-year low and was down by almost 15% since 2003 when XRM did $174mm of EBITDA and over $60mm of FCF (defined as OCF-capex). At today’s value, the 2003 performance, which I believe is achievable on a run-rate basis within the next 12-18 months, would represent over a 15% FCF yield and a single-digit earnings multiple. I estimate maintenance capex runs roughly $15mm annually so the FCF figure above allows plenty of growth and cost-save capex.

XRM went public at $12/share but blew its first few quarters as a public company, due in large part to a botched plant consolidation, which was of course a mortal sin in the market and somewhat puzzling given management’s track record with prior successful consolidations. In any event, the stock was thereafter relegated to the roach motel and traded as low as six bucks and change before rebounding to current levels. I believe the company has resolved most of these operational issues and that it will gradually begin to recover to more normalized levels of profitability and free cash flow. Moreover, recent events suggest that XRM, which remains rather leveraged, should comfortably be able to remain in covenant compliance while funding its generous dividend and modestly delevering at the same time. The Company has very significant operating leverage, with each incremental sales dollar generating up to 50 cents on the bottom line so even a very modest improvement in the top line can drive much higher earnings and cash flows from currently depressed levels. Finally, the CFO recently bought shares at current levels, and though the amounts weren’t huge it is a vote of confidence.

Catalyst

Improving financial performance and higher FCF
High and sustainable dividend (9.8% yield)