ValueSlant Value Investing Analysis Mon, 13 Feb 2012 17:49:47 +0000 en hourly 1 http://wordpress.org/?v=3.2.1 TheStreet (TST) – Trading Below Cash http://feedproxy.google.com/~r/valueslant/~3/UShPvWjnRsE/ /2012/02/13/tst-below-cash/#comments Mon, 13 Feb 2012 15:38:08 +0000 Elie Rosenberg /?p=1074 TheStreet.com (TST) has more than its market cap in cash and no debt. Is there value here?

TheStreet is an internet financial media company, probably still best known for its association with founder Jim Cramer. TST breaks revenues into premium services (2/3 of revenues) and marketing services (1/3 of revenues). Premium services consist primarily of selling subscriptions to investment commentary. It also includes subscription revenue from RateWatch, which is a database of bank rate and fee data, and license revenue from TheStreet ratings, which ranks stocks and mutual funds. Marketing services consist of selling ads on The Street’s network of websites. This segment also included Promotions.com, which is a marketing website that runs promotional contests on behalf of advertisers. TST bought this business in 2007 and sold it in 2009.

Here is a summary of the income statement from the past few years:

The major problem with the business is that there is no top line growth, while selling expense keeps growing. Backing out the Promotions.com business, revenues have been fairly stable around $57 million for several years. I was actually surprised how stable their revenues have been given the explosion of competition in the online finance vertical that has sprung up over the past few years. On the other hand, growth has been almost non-existent.

Gross margins are down from 07, but have been fairly consistent around 54-55%.  However, selling expense has gone from 20% to 30% of sales. While both subscription and ad revenues have actually grown slightly over the last two years, selling expense has grown faster. The company attributes this mainly to increased expense in marketing paid subscriptions. This makes sense given customer churn is very high there- about 3% a month. And while churn declined in the last quarter, selling expense keeps going up. TST is having to spend more on marketing just to keep its subscriber base flat.

TST appears to be caught in a bind wherein it can’t grow revenues, but it can’t cut expenses without taking a hit to revenues. If the business can’t be improved organically, which seems likely at this point, then it will have to look other means to unlock the value of the cash stockpile.

TST could deploy its $75 million cash balance in acquisitions that could benefit from its SG&A infrastructure and utilize its $136 million in NOLs. Of course that approach carries the execution risk of overpaying or not efficiently integrating the acquisitions. TST’s major acquisitions to date (RateWatch, Promotions.com, and Stockpickr) have not been particularly successful. Management said on their last conference call that they are more interested in working on improving their existing business than doing acquisitions. However, the current CEO Daryl Otte is departing so we might see a change of direction. Also, activist shareholder FiveT Capital recently sent a letter to the board imploring TST to explore M&A to enhance value.

The other strategic option would be try to sell the company and return all of the excess cash to shareholders. The best fit if there is one would seem to be another major online finance portal like AOL. An acquirer might not be keen on the TheStreet as it is not growing and its main website has a circa 2000 feel. However, it is the ninth largest site network in the finance vertical in terms of web traffic and has 90,000 paying subscribers. An acquirer might look at it as essentially buying $31.5 million in gross profit and the question would become how much of the $33.9 million in SG&A could be cut out when TheStreet is folded onto their platform. TheStreet’s paying subscriber base might also be an attractive audience to try to cross-sell other paid content products.

The capital structure clouds the acquisition scenario and the company as a value play more generally. While TST does not have any debt, they do have preferred stock. In 2007, Technology Crossover Ventures (TCV) invested $55 million in TST in exchange for a new class of preferred stock. The idea was to use the cash to diversify through acquisitions, although TST only ended up spending about $30 million of it. TCV effectively has veto power over share buybacks and any increase to the dividend. And notably there is also a $55 million liquidation preference. So 3/4ths of the cash balance would go to TCV in an acquisition.

I don’t know if TST would be an attractive asset for any of their competitors, but an acquirer might be willing to pay 1X sales (or 2X gross profit) with the intent to cut out some of the SG&A and further monetize TST’s large audience. So let’s say the operating business goes for $60 million. We would add the $75 million in cash to the purchase price, but $55 million of that will go to TCV. So $20 million of the cash would go to the common for $80 million total. That compares somewhat favorably with the current $56 million market cap. But this scenario is far too speculative to form the basis for an investment in TST.

For now TST appears intent on just staying the course and trying to make the business profitable. TST is minimally free cash flow positive and they pay a 5.8% dividend at these levels. But I am worried about the sustainability of TheStreet’s audience and the expense creep. If the common stock had unrestricted rights to the $75 million in cash then TST might be more interesting. They would have the options of returning cash to shareholders through a larger dividend or through selling the company. But without a clear path to unlocking the value of the cash and the core business stuck in a rut I am not a buyer.

Disclosure: No position

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Trident Microsystems (TRIDQ) – Value in Bankruptcy http://feedproxy.google.com/~r/valueslant/~3/TxVgPB88ABM/ /2012/02/01/trident-microsystems-tridq-value-bankruptcy/#comments Wed, 01 Feb 2012 21:34:06 +0000 Elie Rosenberg /?p=1059 Trident Microsystems (TRIDQ) is a recent bankruptcy where there might actually be a substantial recovery for the equity. There appears to be a. downside protection in the form of substantial value to the equity in a liquidation scenario, b. upside in a reorganization of the company as a going concern, and c. a party that will go to bat for the interest of the equity holders.

Background

Trident designs and markets microchips. They started off in PC graphic design chips in the 90s. As that market consolidated they sold off the PC graphics business in 2000 and started making video controllers for digital TVs. They did well in that business until 2008 when the market shifted to an integrated video and audio chip and Trident was left behind. Trident acquired several small business lines from Micronas in 2009  for $17 million in stock. In February 2010 Trident purchased the digital TV (DTV) and set top box (STB) business lines from NXP Semiconductor for 60% of TRID stock. The DTV and STB lines are now their primary markets, and they sell to customers like Samsung and Sony.

The operating results since acquiring the DTV and STB lines from NXP have been terrible to say the least with CFO of -79 million in 2010 and -38 million through 9 months of 2011. This led TRID to file for bankruptcy on January 4th. In their filings, Trident describes the events leading up to their bankruptcy:

Like many technology based industries, the set-top box and television industries in which the Company focuses its operations have been undergoing rapid changes which have made it difficult for the Company to operate profitably. The Company has faced increased pricing pressure from Taiwanese SoC suppliers who have recently made great inroads in penetrating the market. Additionally, industry semiconductor inventory levels are currently elevated due to slowdown in consumer electronics markets primarily driven by slowdown in Western economies, which has forced all market participants, including the Company, to further adjust pricing to manage inventory levels. These pricing pressures have been compounded by set-top box manufacturers who have been slower than anticipated in launching new products. As a result, suppliers have been straddled with higher than anticipated inventory levels and high development costs that cannot be offset by next generation product sales. In addition to these pricing and inventory pressures, there has also been a shift in the industry’s supply chain dominated by Asian OEMs (original equipment manufacturers) and TV manufacturers are increasingly depending on manufacturing SoC and FRC (frame rate converter) components for high-end TVs in-house, reducing the need to look to outside suppliers for products. As a result of the above items, the Company has experienced continued operatinglosses which have resulted in declining cash over the past year.

It looks like there would be substantial value to the equity even if the company were to liquidate in bankruptcy. And while the intentions of the players involved are unclear at this point, the company may be attempting to reorganize itself as a pure IP licensing company, in which case there may be further upside. Let’s start with a liquidation analysis.

Assets

TRID’s goal is to sell off most of the operating assets of the company through the sale of the DTV and STB business lines. So that leaves current cash on hand and proceeds from those sales as their primary assets. There is also value in the remaining payment from the RDA Micro IP license and a note receivable from NXP.

Cash

According to Trident’s testimony at first day pleadings, the company filed with $55 million in cash. On their Q3 11 call, the company projected ending 2011 with $25-35 million in cash, inclusive of a $20 million sale/leaseback transaction on a facility in China that was completed in Q4. So it is not entirely clear where the extra cash came from. Part of the extra cash is a $7.5 million initial payment received from RDA Micro for an IP license. That still leaves $12.5 million above even the high end of their estimate. It is hard to imagine that the operating results came in that substantially above plan. TRID had said that NXP was going to loosen payment terms (TRID outsources manufacturing to NXP as part of the sale agreement), and they might have gotten some other vendors to stretch terms as well. If that is the case those increased liabilities will be accounted for in TRID’s stated pre-petition trade claims, although it is possible some of the extended terms also relate to off balance sheet purchase obligations.

So far TRID has only released cash flow projections for the two filing entities, which showed a cash balance of only $13 million as of January 16th. It appears then there is cash at other subsidiaries. TRID will begin filing both consolidated and entity-by-entity cash flow statements in February so we will have a better picture of their cash balance.

RDA Micro IP License Payment 

On the day they filed, TRID also announced a $16 million IP licensing agreement with RDA Microelectronics. TRID has been paid $7.5 million and has yet to receive the remaining $8.5 million.

Sale of Set-Top Box Business

TRID will be auctioning off their STB business in a Section 363 sale process. Entropic Communications (ENTR) has placed a $55 million stalking horse bid for this business. The auction is scheduled to take place on February 23rd and a court hearing regarding the sale is scheduled for the 27th.

TRID provided stand alone financials for the STB business in their court filings on the asset purchase agreement with Entropic. The unit did $150.3 million in revenue and $34.6 million in gross profit from February to December 2010 and $95.2 million in revenue and $21.2 million in gross profit in the first nine months of 2011. Even if we annualize the 2011 numbers and assume $127 million in annual sales, ENTR’s bid is only .4X sales.

Beyond the current sales of the STB business, there is value for an acquirer in the IP and other capabilities that this unit can contribute to new chip designs. In both their PR and conference call regarding the stalking horse bid, ENTR made it clear that the STB business is an important strategic asset for them. In non-technical terms, ENTR’s main competitor in the STB business, Broadcom (BRCM), has developed a single chip that replaces two chips, while ENTR’s solution would still require that their customers buy two chips. (In technical terms BRCM is integrating MoCA into their SoC.) TRID’s STB technology will enable ENTR to develop an integrated chip to effectively compete with BRCM.

The stalking horse bid is low enough that the STB business will likely attract other bidders such as BRCM, STMicroelectronics (STM), or Asian players in the STB market. And given the strategic importance of TRID to ENTR I think it is likely they will be willing to pay more than $55 million if other bidders emerge.

NXP Note Receivable 

As part of the NXP transaction, NXP issued a $20.9 million note receivable to TRID, which is good towards work-in-process inventory to be purchased from NXP (NXP serves as a contract manufacturer for TRID). Given that TRID will be selling its operating units as going concerns this note receivable should have value, although it is not clear how that value will be realized at this point. Interestingly, while working capital in the STB business is generally included in the asset purchase agreement with ENTR, this note receivable is excluded. It is possible TRID will package the note with the DTV sale. Only $8.7 million of the note was on the STB books, so it appears the rest resides with the DTV unit. Another possibility is that TRID uses the note to offset some of the unsecured claims from NXP. TRID listed NXP’s claims at $15 million when they filed, but in a recent filing NXP said that TRID owes them $22 million. While some value from the note should be realized I am not sure how this will play out, so I will discount it 50% in my valuation.

Sale of Digital TV Business 

While TRID has not formally put the DTV business up for bid, they have mentioned in their court filings that they will explore the sale of their other business lines. More telling, in their motion for management incentives they have put in an incentive for selling the DTV business for at least $20 million and bonuses for additional executives if they sell it for $25 million. If the degree of difficulty of the other proposed incentives is any indication, we can be fairly certain management thinks they can get $25 million for the DTV business. Management has proposed incentives for selling the STB business for $45 million when they have a $55 million stalking horse bid in hand. And they have proposed incentives for recovering greater than 60% of unsecured claims when it is almost impossible to imagine a scenario where the unsecured claims are not met to that extent. (As you might imagine, the unsecured creditors have objected to the incentive plan.) Additionally, the unsecured creditors have filed an objection to force TRID to market the DTV business along with the STB business in the upcoming auction.

Backing out the STB business, TRID did $143 million in revenue and $35 million in gross profit in the first nine months of 2011. That is presumably almost all the DTV business (it is unclear what the lines bought from Micronas are contributing at this point but it appears to be very minimal). Assuming the DTV business is doing ~$180 million in annual revenue, $25 million seems like a conservative asking price.

Liabilities

Pre-Petition Unsecured Claims

One of the more interesting features of this bankruptcy is that Trident filed without any pre-petition interest bearing debt or DIP financing. Per first day filings, Trident filed with $215 million of unsecured trade claims, but $128 million of those are inter-company liabilities, which leaves $87 million of external claims. The inter-company liabilities are not “real” here, as they all sit at 100% owned subsidiaries so there is no point of making these claims against the parent.

A major question is what percentage of these claims will transfer with the sale of the DTV and STB business units. As those units make up substantially all of the sales of the company, it is likely that a large portion of the trade claims relate to them. The APA with ENTR basically says that STB working capital will be transferred with certain exceptions (mainly paid time off and severance accruals). In a court hearing, TRID estimated that $15 million in claims would transfer with the sale to ENTR. With the DTV business having larger sales than the STB business (~$140 million vs. $95 million in first nine months of 11), we probably can assume at least $15 million in liabilities would transfer with the DTV sale as well.

Rejection Claims 

Per the Q3 10-Q, TRID has $15.4 million in remaining operating lease obligations, but if  TRID rejects the leases the liability would be capped at one year’s worth of rent, which would be the $4.2 million owed in 2012.  Also, some of these leases might be assumed in sales of the business lines.

The 10-Q also states that TRID had $25.4 million of purchase obligations to vendors, but with $16.2 falling in the last quarter of 2011 and only $9.2 coming thereafter. These purchase obligations “represent unconditional purchase order commitments with contract manufacturers and suppliers for wafers and software licensing”. It sounds like something that would be transferred in the business unit sales, but it is hard to know. I should note it is also possible that TRID might not have made all of the $16.2 million in payments in the fourth quarter of 2011. (This might be why NXP has said TRID owes them $22 million while TRID has only said $15 million in their initial filing.)

I’ll assume a third of the lease and purchase obligations (third of $13.4) get picked up in the asset sales and TRID has to pay the rest ($8.9 million).

Post-Petition Cash Burn from Operations 

TRID had been operating at $-6.8 million in EBITDA per month for the first nine months of 2011 ($-7.1 million in Q3). The company has been trying to cut costs, and at the end of September they laid off 275 employees. The court filed cash flow projections for the 11 weeks starting January 16th show them projecting to burn $13.3 million in cash, which includes $2.9 million in bankruptcy related fees. So if we assume that is $10.4 million related to operations that would come to $3.8 million in monthly cash burn from operations. However, it is not clear whether any of that $10.4 million is being used to pay off pre-petition claims. Also, it is not clear if we are getting the full picture from the cash flow projections of only the two filing entities as it appears substantial cash is sitting at other subsidiary entities.

This is of course guesswork, but I will estimate they burn $5 million a month for three months until the STB business is sold (assuming it is sold by the end of March), and that they burn $3 million a month for three months after that until the DTV business is sold.

Restructuring Fees

I’ll estimate that they spend $20 million in legal and advisory fees related to the bankruptcy. On top of that, per the motion to pay the investment bankers they would owe them $2.3 million if the STB business sells for $55 million and the DTV business for $25 million.

Management Incentives

The debtors have motioned to approve approximately $4 million in management incentives for targets that they will almost certainly hit relating to the sale of the DTV and STB units and fulfillment of unsecured claims. The unsecured creditors have objected to the motion. I’ll assume it goes through and they have to pay the $4 million.

Here is the full model:

This shows a recovery of about 21 cents. Admittedly there are many unknowns, but I think there is more upside than downside in the assumptions here, most notably regarding what the STB and DTV units will sell for.

Reorganization

The liquidation value provides downside protection, but there might be more value to the equity if TRID can remain a going concern. That process would involve them reorganizing as an IP licensing company. TRID holds around 1900 patents relating to a broad range of applications in the digital TV space. Here is an interesting exchange from TRID’s Q3 11 conference call (transcript courtesy of Seeking Alpha, Bastani is TRID’s CEO):

Raji Gill – Needham & Company

With your purpose to license IP, transforming yourself to an IP company who would you license the IP to? Other SoC suppliers, to TV OEMs, software companies, who do you have in mind?

Bami Bastani, Ph.D.

I would say in general we see a convergence of TV with mobilities and other aspects of the industry so the patents that we have, have a broad range of applicability in these markets. So it’s not a one unique market segment, but the area that plays to our strength as everybody knows in motion, picture quality, and other aspects of TV. So a very potential wide range of users that we are probing.

TRID has done several IP licensing deals over the past few years, and just did the $16 million RDA Micro deal in January. I have no idea how to value TRID’s patent portfolio, but the equity at 15 cents is being valued at only $27.6 million so it wouldn’t take much licensing revenue to justify a much higher valuation. IP licensing companies trade for multiples of revenue due to their minimal operating expenses and large profit margins. This is total speculation, but let’s say as a focused IP company they can do three IP deals a year the size of RDA Micro. That is $48 million in revenue and if you attach any multiple to that there is substantial upside to the current market cap.

One sign that this might be the end goal here- TRID is selling their STB IP to ENTR, but the asset purchase agreement says that ENTR will grant TRID a “worldwide, irrevocable, royalty free, fully paid license”. That will allow TRID to still be able to sublicense that IP even after the sale.

The Players

  • TRID management- The current CEO, Bami Bastani, came on in June 2011 and is holding worthless stock options while other executive management only owns about 700,000 shares. So they are not particularly motivated to save the current equity holders. I think their motivation here is to reorganize the company and get a large equity stake. It is not so clear why TRID felt they could not restructure outside of Chapter 11 as they had no debt burdens and they were not quite on their last legs in terms of liquidity. One possible reason might be that management felt that if they were going to reorganize the company they wanted a larger equity cut, which is more likely to be granted to them in a formal reorganization.
  • Unsecured creditors- The unsecured creditors claims should easily be paid in full. Additionally, these are all trade claims with the largest non-related party claim at $9 million. While the unsecured creditors will certainly make their presence felt I don’t think they will cause too much trouble as long as the assets are sold off in a timely fashion and they can be sure they will be paid.
  • NXP- Maybe the most interesting aspect of this bankruptcy is NXP’s situation. NXP is the largest creditor, largest shareholder (58% of the stock), and they control two seats on TRID’s board. There doesn’t appear to be much risk of NXP’s unsecured claim not getting paid, so I think their primary motivation here will be to maximize value for the equity. They should prove to be an important advocate for equity holders.
  • Equity committee- An equity committee has not been formed yet, but given the likelihood of recovery for the equity an equity committee seems strongly warranted in this case.
Despite the recent run up, TRIDQ still might be attractive in the 14-15 cent range. You still have decent upside to a conservative liquidation value, and there is further potential upside in either a liquidation or reorganization. Of course this is a bankruptcy and things can go wrong, but I like the odds here.
Disclosure: I own shares of TRIDQ.

P.S.

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Xerium Technologies (XRM) – Recurring Revenues/High Leverage http://feedproxy.google.com/~r/valueslant/~3/XLTkWN8CCmw/ /2012/01/24/xerium-technologies-xrm-recurring-revenueshigh-leverage/#comments Tue, 24 Jan 2012 18:53:36 +0000 Elie Rosenberg /?p=1034 Xerium Technologies (XRM) makes consumable products for paper manufacturers. They sell two broad types of products: paper machine clothing (2/3 of revenues) and paper machine roll covers (1/3 of revenues). Paper machine clothing is a specialty woven textile that helps guide the paper fibers through the paper machine while allowing water to drain out. Roll covers are generally rubber or polyurethane and cover the metal paper machine rolls that roll the paper fibers through the machine. Paper machine clothing has to be replaced every few months, while roll covers are replaced every 1-2 years.

Xerium is an industry leader in a consolidated, mature market. With 15% market share they are the number two player in paper machine clothing behind Albany International (AIN). They are the largest producer of roll covers with 33% market share.

XRM sales are tied to the level of global paper production. While the paper market is highly cyclical and also undergoing structural changes, in the big picture paper production should be a steady slow grower in line with global GDP. As a global maker of products that can be fitted to any paper machine, XRM is not tied to a specific geography or segment of the paper market. So they should be able to adapt to the shifting of paper demand growth from Western economies to Asia, as well as to the decline in newsprint and printing paper which should be filled in with growth in packaging and tissue papers.

XRM was hit hard in 2009 as paper production capacity was taken offline and customers drew down their consumables inventories. The slowdown combined with their highly leveraged balance sheet forced XRM into tripping their debt covenants. That led to a prepackaged bankruptcy in March 2010, which enabled XRM to reduce their debt load by $140 million. The business recovered strongly in 2010 and the stock hit $24 in April of 2011. Since then the stock has gone on a sharp downtrend to the current price under $7.

Revenues have rebounded since hitting a trough of $500 million in 09. They came in at $548 million in 10, and are at $586 million for the TTM, though still off 08 revenues of $638 million. There is a note of caution going forward as bookings in Q3 declined to $134.5 million from the $140-145 million range of the previous several quarters. Paper markets cooled off in the second half of the year, and XRM management was cautious on the Q3 call in regard to near term sales.

Gross margin has been more of a problem than the top line since emerging from bankruptcy. The bankruptcy plan projected gross margins in the 41% range, but they have been well under 40%, falling to 36.6% in Q3 11. That has been caused mainly by cost inflation in raw materials. Another factor is the higher percentage of products being sold into the higher-growth Asian markets, which are lower margin. Additionally, XRM does not yet have an extensive manufacturing presence in Asia so they bear higher shipping costs when selling there. XRM is trying to offset the margin decline by increasing sales of their “new products”, which have innovative or advanced technology features that they think can command higher margins. They have been successful in growing new product revenues, but it has not been enough to offset the margin erosion.

This chart is a nice summary of the recent EBITDA numbers (note adjusted EBITDA adds back stock comp and restructuring charges):

Turning to the balance sheet, XRM still has a large debt load even after the bankruptcy. They currently have $475 million of debt and $43 million in cash. XRM was able to refinance in May to push out maturities. They have $231 million of first-lien floating rate debt due in 2017, which they are currently paying 5.6% on. They have $240 million in senior notes at 8.875% due in 2018. The first-lien debt only has $2.4 million of amortization a year and at current levels XRM has about $35 million in annual cash interest. While XRM is levered almost 4X EBITDA, they should not have a problem servicing the debt. However, they do have a total leverage covenant of 4.75X total debt/adjusted EBITDA, which falls to 4.5X in June. If revenues weaken in the next quarter and gross margins stay low it is possible XRM could put up only $25 million in adj. EBITDA for the quarter. If the weakness persists for a few quarters then XRM would start to get close on the covenant.

Here is the current market valuation:

Looking at run rate EBITDA, management has noted the fourth quarter of 2010 saw exceptionally strong margins due to high demand as customers restocked after the XRM bankruptcy as well as some one time items. So it is probably more prudent to annualize the the first three quarters of 11 EBITDA of $82.6 million, which comes to $110.1 million annualized. That is an EV/EBITDA ratio of 4.9X. The close comp AIN trades at 5.7X, but AIN is much less levered. The more interesting story is the free cash flow to the equity. Current cash interest expense is about $35 million. Cash taxes are about $10 million. (XRM has NOLs coming out of the bankruptcy but they are in jurisdictions where they are  not earning money so they have not been able to utilize them.) Management has guided to $30 million in capex in 2011. That leaves $38 million in FCF before working capital changes, or a 37% FCF yield:

A major caveat is that working capital has been a use of cash recently. Sales have been growing, but working capital has been rising faster as this chart shows (from XRM earnings release presentation):

This has hampered XRM’s ability to get cash out of the business and pay down debt. Management has targeted improved working capital management coming out of bankruptcy, but it has yet to manifest itself. TTM cash from operations before working capital changes is $63.1 million, but only $48.1 million with working capital changes. Sales were up $48 million over the prior period, but working capital was up $15 million. However, working capital did improve in Q3 and they were able to pay down $11.7 million of debt.

The potential investment thesis for XRM is pretty simple at the current market cap. If XRM can generate consistent free cash flow then value can accrue to the equity very quickly given the small size of their market cap in relation to their enterprise value and potential cash generation. At the current $6.75 a share price XRM market cap is $102 million. If they pay down $30 million in debt and hold the same enterprise value then the equity value increases 29%. As icing on the cake, the enterprise multiple might expand to something closer to AIN’s as the leverage profile moderates. Even one turn of EBITDA at these levels would more than double the price per share. Management has indicated their intent to delever and started the process in the last quarter. This slide from their October presentation seems to be indicative of their thinking (note the share price was higher at the time):

Of course leverage can cut both ways and XRM is tied to a volatile paper market. If the macro economy goes haywire then the things could get dire quickly once again for XRM. One difference this time around might be that customer inventories are not at the levels they were at before the 08 plunge, so a downturn might not hit sales as badly. And while they still do not have a great deal of breathing room on their debt covenants, in a potential breach they might get more relief from debt holders given their reduced overall debt levels as compared to the pre-bankruptcy period. I am very tempted by XRM, but for now I can’t get past the lack of stability in their markets combined with the high leverage.

Disclosure: No position

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Exiting Talbots (TLB) on Rumors of Potential Bids http://feedproxy.google.com/~r/valueslant/~3/ttoPVvYVfvw/ /2012/01/20/exiting-talbots-tlb-on-rumors-of-potential-bids/#comments Fri, 20 Jan 2012 19:09:55 +0000 Elie Rosenberg /?p=1022 I reported on Talbots (TLB) on December 9th as an interesting special situation. Sycamore Partners had put in an unsolicited offer to buy the company for $3.00 a share while the stock remained in the $2.60-2.70 range. Talbots stock spiked today from an open at $2.69 to the $3.10-3.20 range on a CNBC report that Golden Gate Capital and TPG were mulling bids for the company. This CNBC report was quoted in various news outlets (here for example) as saying Golden Gate and TPG had actually submitted winning bids for the company (not sure how they could both win- maybe a joint bid?). But the report itself just says that they are weighing bids and that the bidding process will unfold over the next several weeks.  The market likes at least a rumor that there is a bidding process going on. To date the company has only issued a vague “ongoing exploration of strategic alternatives” response to the Sycamore Partners buyout offer.

I think if TLB is intent on selling they will get  $3.50-4.00 a share, but I sold my TLB shares today. Given the unsubstantiated nature of these rumors, the sorry state of TLB’s business, and the TLB board’s less than perfect track record of preserving shareholder value the risk/reward above $3 a share is no longer compelling.

Disclosure: No position in TLB

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Mac-Gray Corporation (TUC) – Laundering Money http://feedproxy.google.com/~r/valueslant/~3/x5HWR35274w/ /2012/01/19/tuc-mac-gray/#comments Thu, 19 Jan 2012 19:14:51 +0000 Elie Rosenberg /?p=999 Mac-Gray (TUC) is an operator of laundry rooms in multi-unit housing facilities such as apartment buildings and colleges. They are the second largest company in the space with 86,000 rooms in 43 states.

Business Model

TUC contracts with facilities owners for the rights to manage the laundry room in their buildings. TUC supplies the coin or smart-card operated laundry machines and services the laundry room. In return, TUC pays a portion of revenues (ranging from 38%-60%) from the laundry services to the facility owner, and sometimes pays an upfront fee as well. The management contracts average seven years, after which time the parties can renegotiate the deal and typically new equipment is installed upon contract renewal. They also have a small segment (5% of revenues) that distributes laundry equipment to commercial buyers.

The business has some attractive features:

  • Stable recurring revenue- people will always need to do laundry
  • Somewhat captive target market- it is easiest to do laundry where one lives
  • Long term contracts
  • Ability to deploy capital into an easily scalable business model

Recent History and Earnings Power

In the 05-08 period, TUC pursued an aggressive acquisition strategy with the typical end result of overpaying and overleveraging the company. In the last 4 years the business has been slightly down to flat during which time management (prodded by activist shareholders) cut back on capital spending and deleveraged the balance sheet: TUC has done $66 million a year in EBITDA for the last two years. That appears to be a stable run rate for now. Where things get tricky is depreciation and amortization versus capex. TUC is showing $47.5 million in D&A, while cash maintenance capex on the current portfolio of facilities is around $25 million. About $13 million of the difference relates to the amortization of contracts acquired in acquisitions of competitors. The rest of the difference is caused by the accelerated depreciation on machine assets acquired in the acquisitions of 06-08, which are being depreciated over five years instead of the typical ten.

The business is still capital intensive due to the fact that equipment is typically replaced upon renewal every seven years. Capex from 08-10 was all maintenance capex, which includes equipment in renewal locations as well as in new locations to replace unrenewed contracts. Capex over that period averaged $24 million so that is probably a good proxy for maintenance capex, and is in line with management estimates of $20-25 million. (The upfront incentive fees paid to facility owners are capitalized in a separate account and amortized to cost of sales and not D&A and are thus not included in capex. The amortized amount has roughly matched the cash expense for the last few years.) So on an unlevered basis we get about $42 million in normalized pre-tax earnings (EBITDA-maintenance capex).

Cash interest is about $13 million a year at current debt levels. The normalized tax rate is 41%, and the currently high D&A serves as a nice tax shield. That gives us $26.7 million in normalized free cash flow:

As the company puts it in their investor presentation the three drivers of revenue are: number of laundry machines in the portfolio, cycles run per machine, and price of a load. All of these metrics have taken a hit over the past few years. The company has shrunk its laundry room portfolio 1-2% in an effort to conserve capital and not renew contracts on unattractive terms. Machine utilization also declined due to increased apartment vacancies during the recession. Management estimates that has been a $15 million a year hit to revenue from normalized vacancy levels. And lastly, the company has not increased laundry prices in two years even as their operating expenses have risen. Management feels the business environment is improving and they have announced a range of initiatives to grow earnings:

  • Investing capital in incremental facilities (not just replacing unrenewed ones) as well as acquisitions of competitors
  • Bringing on additional sales staff to target national accounts and expand geographic reach into states where they do not operate
  • Expanding into two new lines of business (to be named later)
  • Implementing price increases
  • Rolling out the “Change Point” electronic payment system (where the customer can pay by credit or debit card) in new or renewed accounts

Capital Allocation

The core questions for an investment in TUC are A. is this is still a good business that is worth reinvesting capital in? and B. if not, will management and the board return free cash flow to shareholders accordingly? From their history and recent comments, the answer to B is most likely no. That leaves us with the first question- will TUC be able to earn a decent return on reinvested capital?  This is a mature industry with lots of competition including large national players like Coinmach and many smaller regional players. And while on the face of it TUC should have meaningful competitive advantages due to economies of scale their ROIC numbers do not reflect that:

(Assumes constant maintenance capex of $24 million. Invested capital defined as shareholder’s equity+debt-cash. Tax rate assumed at constant 41% in line with historical average). While the numbers could certainly be worse, TUC is probably not earning its cost of capital. And while one might argue that invested capital is overstated due to the overpriced acquisitions that might prove the point- the only growth TUC has been able to manage in years is overpaying to buy out competitors at a poor ROIC. That leaves the “blame it on the economy” argument for the muted recent returns. While there might be something to that argument, for investors it doesn’t really matter unless one is very bullish on the economy rebounding in the near future.

One example where the impact of competition might go unnoticed is the new Change Point system. TUC is touting this a game changer for the industry. This technology enables customers to pay for laundry machine use by credit or debit card. It also electronically monitors the laundry room so that customers can be alerted by email or text when laundry is done and property managers can get real-time reports on laundry room status. While still in the very early stages (in 750 rooms at the end of 2011) this technology has increased same facility revenues 10% over previously coin-operated rooms (which still make up 70% of the units for TUC). This system will also enable TUC to more effectively adjust pricing as it can now be changed in any increment versus only 25 cent changes in coin operated machines. Certainly, this sounds attractive. But aside from the fact that this will take a while to roll out (it can only be implemented upon renewal when machines are changed out), their larger competitor, Coinmach, has the same technology. So over time any incremental profits from the new system will probably be competed away and given back to the facility owners in the form of a larger cut of revenues.

While management has not given detailed guidance, the capital allocation is clearly shifting from the deleveraging mode of the past few years to investing more capital in the business. Part of that emphasis might stem from the TUC board’s recent rebuttal of a $17.50 a share buyout offer from a shareholder. That valued TUC equity at $250 million, or a 10.6% FCF yield (assuming the above $26.7 million in FCF). That is probably pretty close to fair value for this business if there is no growth left in it. The buyout offer prompted management to update their business plan to include more growth initiatives.

In 09 and 10, TUC reduced debt by $75 million, and they have payed down another $13 million through three quarters in 11. Management has said there will be further deleveraging, but they have not revealed a target leverage level and it sounds like they think something close to the current level of debt is sustainable if they find suitable acquisition targets. The company put in a small dividend in 2010 and recently raised it to 24 cents a share, or $3.4 million, annually. They also recently announced a token $2 million stock buyback. So it sounds like most of the free cash flow in the near future will be going back into the business via the various announced growth initiatives.

Valuation

TUC trades at 9.3X EV/EBITDA-maintenance capex. On an unlevered basis TUC does not appear very cheap for a business with minimal growth prospects. It is cheaper on a levered basis at  a 13.3%  normalized FCF yield. It is probably fair to look at TUC on a levered basis given the stable nature of their business and their long term contracts. A 13% FCF yield could be attractive for what looks like a stable recession resistant business without risk of technological obsolescence. And there might be some embedded upside to run rate earnings with price increases, a possible rise in utilization as vacancy rates decline, and the roll out of Change Point. If the company were to commit to more aggressive return of capital to shareholders it might be an interesting opportunity. But I don’t think either the somewhat cheap valuation or the potential drivers of increased earnings are compelling enough to justify an investment in a minimal growth business without confidence in profitable capital allocation.

Disclosure: No position

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Recent Activist Targets- Wausau Paper (WPP) and Information Services Group (III) http://feedproxy.google.com/~r/valueslant/~3/FEloSS9U6oQ/ /2012/01/17/recent-activist-targets-wpp-iii/#comments Tue, 17 Jan 2012 06:06:35 +0000 Elie Rosenberg /?p=947 Companies with activists involved are always an interesting place to look for investment ideas. Here are a two companies with activist activity I have come across recently- Wausau Paper (WPP) and Information Services Group (III). 

Wausau Paper (WPP)

Wausau is a producer of paper and tissue. In the tissue segment, WPP makes tissue for the away-from-home market (for bathrooms in offices etc.). In the paper segment, WPP makes specialty papers for food processing and industrial uses. In the past few months Wausau has sold off their printing and writing paper assets as well as their remaining timberland assets.

WPP has spent the past several years restructuring their operations to focus on the tissue business and divest non-core assets. They reorganized the printing paper and specialty paper units into separate manufacturing plants with the plan to eventually exit the declining printing paper business. WPP could not find a buyer for the printing paper plant and on December 7th they announced they would be shutting down the plant and selling the brand names to Neenah Paper. They expect to net $20 million after plant closure expenses from the brand name sales and liquidation of working capital. On December 16th, WPP announced they would be selling off their remaining timberland assets for $42.9 million.

Starboard Value emerged as an activist in July and currently owns 9.3% of WPP. They have sent three letters to the WPP board. Their thesis is that WPP should focus on the relatively stable, high-margin tissue business and sell everything else. Since July, WPP has made progress to that end with the printing paper and timberland sales.  In their January 11th letter, Starboard asked for the company to sell the specialty paper business as well as consider the sale of the entire company.

The tissue business has been a steady top line grower with stable EBITDA margins in the 22% range (chart from Starboard letter):

2011 was a rough year for the tissue business, with softening demand and record high pulp input prices. Through 9 months of 2011 tissue sales were down 3% year over year and EBITDA declined from $57.6 million to $44.9 million.

Wausau is investing $220 million in an expansion of the tissue segment that will be operational in 2013. This expansion will add to their parent roll production capacity and position them to enter the premium end of the away-from-home market where they think their “green” focus will be popular. They are targeting an eventual $70 million incremental EBITDA contribution and a 14% after tax IRR for this project. Starboard in their letter stated that management has told them that $20 million of incremental EBITDA will come from in-sourcing parent roll production that is currently outsourced. So the bulk of the gain will have to come from expanding sales by entering the premium market. Starboard has questioned the riskiness of such a large investment to enter a market in which WPP is unproven.

WPP stopped breaking out the specialty paper financials from the rest of the paper segment in 2010, so it is hard to know how profitable it is currently. In a recent investor presentation, the company stated that specialty paper sales in 1H 2011 were $197 million. EBITDA margins based on the historical numbers in this segment are 6-7%. If we assume run rate revenue is $394 million that is about $25 million in EBITDA.

How much is WPP worth? Here is the current market valuation:

Given the valuation gap between the tissue and paper assets it is probably best to value WPP on a sum of the parts basis.

It is probably fair to say the tissue segment can do $70 million a year in normalized EBITDA, and perhaps more given they were hit in 2011 by high pulp prices that probably will decline. Starboard valued the tissue segment at 7-8X EBITDA based on the comps of CLW and KMB. The tissue segment of WPP on its own would probably trade somewhere in between CLW (currently 6.8X) and KMB (8.8X).

Starboard valued the combined printing and specialty paper segment at 4.5X-6X EBITDA. We could argue that having shed the printing paper business that the specialty paper segment should be valued at the higher end of that range. However, the fact that Wausau couldn’t give their printing paper plant away might show this range is a bit optimistic. There are no precise comps for this segment, but 5X EBITDA is probably fair.

Adding in the recent asset sales, we get about $10.50 a share, which leaves WPP modestly undervalued. (They also have some hydroelectric assets I have not assigned any value to, but which Starboard valued at $10 million.) Given the minimal attractiveness of the remaining paper segment and the execution risk of the large new tissue project I would need more of a margin of safety to buy WPP.

Information Services Group (III)

Information Services Group (III) through its wholly owned subsidiary TPI is the largest third party outsourcing consultancy firm. III was formed as a SPAC in 2006 and bought privately held outsourcing advisor TPI in November 2007 for $230 million. Senior management comes from AC Nielsen where they had success consolidating the media measurement industry. The original strategy was to use III as a platform to roll up small data and industry-centric consulting firms and fold their expertise into TPI, with management originally envisioning a $1 billion in revenue enteprise. The onset of the recession and shifting dynamics in the outsourcing industry have scuttled those plans, although III did do two small acquisitions in 2011.

III Market Valuation

Revenues declined from $175 million in 08 to $132 million in 09 and 10. While the core business has remained flat, III acquired two businesses in the beginning of last year that should boost revenues to the $180 million range for 2011. One was Compass, a benchmarking and analytics firm, and the other was STA, an IT sourcing consultant.

III Revenues (from IR presentation Nov 11)

Management has guided for adjusted EBITDA (backing out stock comp and acquisition and restructuring charges) of $19-21 million. They have done $13.1 million in adj. EBITDA through three quarters of 2011, although they did $6.1 million in the third quarter alone. If they can hit even the lower end of that range III might be a fairly cheap stock.

III Adjusted EBITDA (from IR presentation Nov 11)

I think we should subtract stock comp of about $3 million from EBITDA (it ain’t free), so that gives us $16 million in EBITDA on $99 million of enterprise value or a 6.2X multiple. That doesn’t sound extremely cheap in absolute terms, but on a relative basis consulting comps like Huron Consulting, Hackett Group, and FTI Consulting trade in the 7-9X range.  Also capex is very low at around $1.5 million, so EV/EBITDA-capex is only 6.8X.

III looks cheaper on a free cash flow basis. Due to the leverage, low capex, and amortization of intangible assets shielding income from taxes (~$10 million a year), III should generate very strong free cash flow. Working from $19 million in adj. EBITDA- assuming $3 million in cash interest, $11.3 million in D&A, a 38% tax rate, and 1.5 million in capex, III would do $12.7 million in FCF or a 28% levered FCF yield. However, the equity is levered with $54 million in net debt to a $45 million market cap. On an unlevered basis (FCF to the firm/EV) the FCF yield drops to 15%.

My concern with III is that their core business is stuck in a rut, having been essentially flat the last few years with declining margins. While the outsourcing industry is predicted to grow 5% a year, it is not clear that outsourcing advisory will grow at that same rate. There could be a number of reasons for this divergence:

  • As the outsourcing phenomenon matures, most large transformational outsourcing projects have been completed and the average outsourcing project has grown smaller. Consulting firms are typically geared towards large, long engagements where they can easily deploy a large amount of their human capital. Additionally, clients may feel the potential savings from advisory services in small projects do not warrant the advisory fees.
  • Another impact of outsourcing industry maturation is that a great deal of knowledge has  already been transferred from the industry experts to their clients. A company might feel they no longer need consultants after multiple outsourcing projects.

It also seems likely that TPI is losing market share. While they were the first outsourcing advisory specialist and are still acknowledged as the industry leader, they have plenty of competition including other outsourcing specialists as well as traditional advisory firms who have all felt the need to offer outsourcing advisory as the industry has expanded.

Carlson Capital, a 9% owner, sent a letter to the board of III on January 11th requesting that they explore a sale of the business and a change in board composition. Their central point is that the holding company structure of III is adding unnecessary overhead to TPI, therefore the value of TPI would be enhanced if it was taken private or folded into another larger consulting company. TPI is extremely cheap on an EV/revenue basis with a multiple of .55 (on 2011E revenues of $180 million) compared to 1-1.5X for peers, which could offer an attractive buy for a larger acquirer who can cut out overhead.

There have been two recent deals in the outsourcing advisory space, with PwC buying public Diamond Management in August 2010 and KPMG buying privately held EquaTerra in February 2011. PwC paid 14.5X trailing EBITDA for Diamond, so clearly a larger acquirer can pay up given the SG&A synergies and the potential for cross selling services. However, industry analysts have noted these companies are not an obvious fit with the Big Four or larger consulting firms. One of the values of firms like TPI is their independence and lack of bias in directing a client to the appropriate service provider. This source of value is mitigated at least to some extent if the corporate parent is offering outsourcing services themselves. It is also not clear that III has any interest in pursuing a sale of the company. For now it sounds like CEO Michael Connors wishes to pursue his vision by continuing to do tuck in acquisitions.

While III is somewhat cheap, I will stay away for now given my lack of confidence in the stability of the business, a decent amount of leverage, and management that does not appear willing to change direction.

Disclosure: No position in any stocks mentioned

P.S.

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Hudson Technologies (HDSN) – Taking Advantage of an EPA Phaseout http://feedproxy.google.com/~r/valueslant/~3/r0kKbbYudoc/ /2012/01/10/hudson-technologies-hdsn-taking-advantage-of-epa-phaseout/#comments Tue, 10 Jan 2012 17:58:38 +0000 Elie Rosenberg /?p=914 Hudson Technologies (HDSN) is a distributor and recycler of refrigerant gases. The company is poised to benefit from an EPA mandated phase out of virgin gas production of the leading refrigerant that will boost market pricing and volumes of reclaimed refrigerant where Hudson is the dominant player. Hudson stock remains depressed due to investor fatigue with the slow to develop shift in market dynamics and a general lack of Street recognition. The stock trades at 2-3X projected earnings when the market shifts, while the EPA is set to finalize substantially reduced virgin gas production quotas in the coming months. In the meantime, the company has expanded market share and is substantially profitable.

HDSN operates three business lines: aftermarket refrigerant distribution, reclaimed refrigerant sales, and refrigerant services. The only breakout by segment that HDSN provides in their filings is refrigerant sales (combined distribution and reclamation) versus service revenues. In the trailing twelve months refrigerant sales contributed 90% of revenues or $40.1 million, with service revenues at 10% or $4.5 million. Reclamation is currently a small piece of refrigerant revenues, probably somewhere in the $7 million range.

Aftermarket Refrigerant Distribution

Refrigerant gases are used in air conditioning and refrigeration units. They need to be replaced periodically due to leaking or gas loss during servicing. Hudson buys refrigerant, mainly from the big three producers (DuPont, Honeywell, and Arkema- who control approximately 90% of the virgin refrigerant market) and distributes it to contractors , large end users, and other distributors for aftermarket use.

Management targets gross margins of 30% in this segment and they have generally ranged from 20-30%. The refrigerant aftermarket is driven by demand for cooling (primarily air conditioning) and is generally a low single digit grower although it does have some exposure to weather and the economy. Cool summers reduce demand and in a weak economy customers can temporarily delay unit maintenance. HDSN saw refrigerant revenues drop in 09 due to customer inventory destocking at the onset of the recession, but refrigerant segment revenues have grown double digit percentages every other year since 2005:

Although the company does not explicitly break out new versus reclaimed refrigerant sales, the sense from management is that revenue growth has come primarily on the back of increased market share on the distribution side. The overall refrigerant market has been flat and reclaimed sales have been perennially weak.

Refrigerant Reclamation

Hudson is the largest refrigerant reclaimer in the US with two adjacent facilities in Champaign, Illinois and a management estimated 20% market share. The business model here is that HDSN will pay the end user or distributor for their used refrigerant gas and bring it back to their reclamation facility. Contaminants are separated out of the gas, the gas is laboratory tested to insure purity, and the gas is repackaged and sold at the market price for virgin gas. Management targets 50% or higher gross margins on reclaimed gas, which they think they can easily hit in a more robust environment for reclamation.

While there are several smaller players in the reclamation industry, HDSN is the industry leader both in terms of production capacity and sophistication of their process. The major refrigerant producers left the reclamation market years ago and do not appear to have a desire to get back into it, probably due to its small size relative to the virgin gas market.

While there are not huge barriers to entry in the reclamation business, HDSN does have some noteworthy competitive advantages. HDSN has strong relationships with the major gas producers. HDSN serves as the exclusive national reclaimer for DuPont and Arkema and has smaller deals with Honeywell distributors. These relationships allow HDSN to utilize the producers’ extensive distribution networks to ensure a supply of used gas for reclamation. The gas producers’ local distributors serve as collection points for end users to drop off dirty gas for reclamation.

Large scale reclamation technology is proprietary. The EPA (Environmental Protection Agency) commissioned a 2010 report on reclamation practices, which noted the vast difference between the systems of the smaller and larger reclaimers in terms of quality and efficiency. HDSN has the largest reclamation capacity and is widely regarded in the industry as having the most advanced reclamation technology.

Refrigeration services

HDSN provides refrigeration diagnostics and preventative maintenance, as well as energy optimization solutions. The company has attempted to position their client-site services as their growth engine for over a decade, but have not had much success. Service revenues have ranged from $3.5-4.6 million since 2005, although they are on the upswing in the past year. HDSN does not disclose gross margins for the segment, but management gives the sense that they are significantly higher than on the distribution side.

R-22 Phaseout

The heart of the investment thesis in HDSN surrounds the phaseout of HCFC refrigerant gases, particularly R-22, which is being mandated by the EPA. R-22 is currently the most widely used refrigerant and the primary target of the EPA phaseout. The Montreal Protocol is an international agreement, to which the US is a party, that phases out the production of various gases damaging to the ozone layer. The phaseout of CFC gases (of which R-12- branded as Freon- was the most popular) has already been completed. HCFCs such as R-22 are less damaging to the ozone than CFCs, but they too are being phased out per the next steps in the Protocol.

The Protocol calls for a gradual reduction in HCFC production from a baseline level leading to an eventual total ban on production. The EPA has chosen to accelerate that schedule to target a total ban on R-22 production by 2020. They are implementing the phaseout by allowing a declining percentage of R-22 demand to be met by virgin production. As virgin gas production is phased out the EPA wants to increase the usage of reclaimed gas to make up the gap in demand. Reclaimed gas is not subject to the limitations of the Montreal Protocol. However, R-22 prices must be high enough for reclaimers to be able to offer gas users enough of an incentive to bother to return the gas and not just vent it into the air. While venting of R-22 is technically illegal, the EPA cannot enforce the rule and venting is a widespread practice with the EPA estimating that over 90% of dirty gas is currently vented. The EPA’s plan is that limited virgin gas supply due to the declining allocations will cause R-22 prices to rise and spur reclaimed gas to fill in the demand gap.

In the EPA’s target scenario HDSN would benefit in several ways:

  • Higher R-22 prices would equate to more gross margin dollars on the distribution side (even assuming gross margin as a percentage remains a consistent spread between what HDSN pays producers and what end users pay HDSN).
  • Higher reclaimed gas sales volumes would boost reclaim revenues.
  • Higher R-22 prices would boost reclaim gross margin percentage as less of the selling price would need to be given to the end user to buy the gas back.

What’s Happened So Far?

The EPA started the more aggressive phaseout of R-22 with the 2009 Final Rule that went into effect in January 2010. Firstly, the EPA banned the sale of any new cooling equipment that utilized R-22 to eliminate the creation of any new R-22 demand. (Although there is a loophole to that rule that has been exploited – more on that later.) Secondly, the EPA issued new R-22 consumption (defined as production+import-export) allocations by gas producer for 2010 to 2014. The EPA attempted to estimate annual R-22 demand for that period and assigned a declining percentage of demand to virgin gas production with the theory that reclaimed gas sales would fill in the demand. Reclaimed gas sales would stay at a constant absolute level throughout the period, but rise annually as a percentage of total consumption and ensure a smooth transfer to the total ban on R-22 virgin production (chart from EPA’s Dec 09 “The US Phaseout of HCFCs” report):


In 2000, R-22 sold for around $1 a pound. From 2006-2008 the major producers increased pricing steadily in anticipation of the phaseout and R-22 hit a peak of $5 a pound in the middle of 2008. Reclaimed R-22 also rose from 1,960 metric tons in 2001 to 4,556 metric tons in 2008 (based on EPA numbers- which should be very accurate as all reclaimers have to report their production to the EPA). Yet since 2008, R-22 pricing and reclaimed volumes have both fallen despite the implementation of the EPA phaseout program in 2010. Current R-22 pricing is $4 a pound or a 20% drop from the 2008 peak. Reclaim volume in 2010 was 3,584 metric tons, or 21% lower than 2008, and based on the comments of reclaimers to the EPA in late 2011 they expect 2011 volumes to be about the same as 2010.

Clearly, the EPA’s plan to raise R-22 pricing and hike reclaimed gas volumes has not worked thus far. A court order in August 2010 provided an opportunity for the EPA to revisit the phaseout process. In brief, two gas producers claimed the EPA miscalculated the percentage of R-22 production allocations they should have received for the 2010-2014 period. The producers won the court case, and the court order vacated the EPA’s production allocations in the 2009 Final Rule. While the EPA put in a stop-gap interim rule for 2011 to incorporate increased allocations to the two snubbed producers, the EPA also took comments on how to revise the phaseout process for 2012 to 2014 to better meet their goals of higher R-22 pricing and increased reclaimed gas production.

The comments to the EPA of both refrigerant producers and reclaimers submitted in September of 2011 unanimously agreed that there is an oversupply of virgin R-22 in the market, which is causing the depressed pricing. The stakeholders raised several theories as to the cause of oversupply:

  • The EPA’s demand study was done prior to the onset of the recession and the declining economy contributed to lower R-22 demand.
  • Due to the advanced warning the industry received the transition to non R-22 cooling units has been implemented more quickly than anticipated, thereby reducing R-22 demand.
  • Distributors and end users built R-22 stockpiles prior to the initiation of the ramped up production phaseout in 2010.
  • The EPA has initiated a program called “Greenchill” to partner with large food retailers to reduce the environmental impact of their refrigeration usage. The success of the program reduced aftermarket R-22 demand on the part of food retailers, which is a major segment of R-22 usage.

On January 4, the EPA released their proposed rule for revised R-22 production allocations for 2012-2014. Incorporating stakeholder comments and interviews, the EPA proposed a range of production allocations, which would result in an 11 to 47 percent reduction versus the original allocations. The EPA proposed adjustments to the original allocations based on three new or revised assumptions:

  1. 6,000 mt of demand to be met by surplus inventory drawdown
  2. Between 12,500 mt and 19,700 mt of demand to be met by reclaimed volume (original allocation assumed 12,500 mt)
  3. Between 1,600 mt and 5,500 mt of demand met by R-22 reused within large food stores (impact of Greenchill program)

This table from the EPA Adjustment memo of 12/16/11 bridges the estimated demand to the virgin gas allocations proposed in the new rule:

This chart from the EPA memo compares the proposed allocations to the original allocations in the 2009 Final Rule:

The EPA is taking comments for 30 days from stakeholders and will issue a final ruling thereafter. DuPont requested a 20% reduction to the original allocations in a letter to the EPA before the release of the proposed rule. While the producers are in favor of reduced R-22 production to raise R-22 pricing and shift demand to replacement gases like R-410a, they also have to balance meeting the short-term needs of their customers, which is why DuPont did not ask for a sharper reduction. The reclaimers will surely ask for the maximum proposed reduction in their comments.

There are several questions remaining whose answer will impact the R-22 phaseout going forward.

Where will the EPA’s final ruling fall on the proposed range? The proposed range of reductions is quite broad (11-47%). But even in the worst case scenario we will see an 11% reduction to the original allocation, which was already declining annually. Based on DuPont’s comment if we assume the producers will ask from something in the middle of the range and the reclaimers will ask for the max reduction then the final rule should end up on the higher end of the reduction range.

Another unknown is when the EPA will issue their final rule. The peak selling period for R-22 is the first half of the year prior to the summer cooling season.  So the earlier the EPA releases the reduced allocations the more of an impact the proposed rule will have on production and pricing in 2012. The production of R-22 is technically illegal without R-22 allocations, as has been the case since January 1. However, if the EPA expects a significant delay in the release of the final rule they will probably release a “no enforcement” letter that will allow producers to operate based on the original allocations until the final rule is released. (The EPA released such a letter last year after the court order vacated the 2009 Final Rule allocations.) Given that there probably will be nearly unanimous sentiment expressed in the stakeholder comments on the proposed rule I do not expect a significant delay in the release of the final rule.

The biggest question is whether the reduced production allocations will be low enough to raise R-22 pricing. One potential problem is that R-22 inventories are not officially reported to the EPA, and thus the EPA is working off of inventory estimates derived from anecdotal evidence from stakeholders. Another issue is that the EPA did not fundamentally revisit their model for estimating R-22 demand, and in fact revised the estimates for R-22 demand about 6% higher in the proposed rule. The EPA did not go into detail as to why they revised their demand estimates higher. My guess is that it is due to the unexpected growth in R-22 units due to the dry-ship phenomenon. While the sale of new cooling units charged with R-22 was banned in 2010, manufacturers noted that the rule only prohibited the sale of units actually shipped with R-22 gas. New units could be “dry-shipped” without R-22 and then charged with R-22 in the field. While the air conditioner manufacturer Carrier petitioned the EPA in February 2011 to close the loophole, it does not appear the EPA will act to do so. The EPA might be willing to overlook the dry-ship units in the short-term as it will increase demand for R-22 and help boost R-22 pricing. However, the EPA’s revised demand estimates may be taking this increased demand into account at least partially. The Air Conditioning, Heating, and Refrigeration Institute (AHRI) estimates that 17 million residential R-22 units will be replaced from 2010-2015. If the vast majority of those are replaced with dry-shipped units as appears to be the case at present then that could drastically extend the long tail of R-22 demand with units expected to last for twelve to fifteen years. In their 2009 report, which assumed no new R-22 units after 2009, the EPA projected that 86 million R-22 AC units would in operation in 2015. 17 million dry-ship units would add 20% to that number.

Can we estimate R-22 demand ourselves? The best hard data points on R-22 demand come from 2010. The EPA has said that 86%, or 42,973 metric tons, of the 2010 consumption allocations were used by producers, and that reported reclaimed R-22 volume in 2010 was 3,584 mt. So in 2010 demand needed to be met by either new or reclaimed gas was 46,557 mt. I think we can assume that demand met by stockpiled inventory has at least not increased since 2010 when the more stringent production allocations went into effect. The EPA estimated that demand would fall by 15% from 2010 to 2012. Taking 15% off of the 2010 number would yield 39,573 mt of demand for new or reclaimed gas in 2012. Subtracting the 12,500 mt the EPA is targeting on the low end for reclaimed gas would yield a 27,073 mt allocation to new gas. For 2012 the EPA has proposed 25,100 mt allocated to new gas on the low end and 36,200 mt on the high end. This is before taking into account dry-shipped units, which have certainly added some demand since 2010. Even taking the middle of the allocation range, or 30,650 mt, would mean 8,923 mt would need to be met by reclaimed demand. That is still more than double the 3,584 mt of reclaimed production in 2010 and would almost certainly mean R-22 pricing would need to be much higher.

Precedents: R-12 and Europe

There are two phaseout precedents we can look at to see how the R-22 phaseout might play out. One is the phaseout of CFCs in the 90s. The most popular CFC is R-12 or Freon, used mainly in car air conditioners. R-12 production was phased out from 1993 to 1996. This was done through a combination of EPA production limits and an excise tax on production. Over that time period the price of R-12 rose from $3.50 per pound to $17, and eventually rose to nearly $30. While the R-22 phaseout is being implemented across a longer time span and there is no excise tax proposed, R-22 is a much larger portion of the refrigerant market than R-12 was (60% vs. 20%).

The EU is well ahead of the US in its R-22 phaseout, having completely banned virgin R-22 production in January 2010. Current R-22 pricing in Europe is approximately $15 per pound compared to $4 in the US.

Earnings Power and Valuation

I think HDSN can earn  ~$.50 of EPS in the near future with a potential peak of $1.00+ as the R-22 phaseout is implemented. You can see my full model here. Here is the summary of base and upside scenarios:

Here are the details of my base case:

  • My estimate above of ~40,000 mt for 2012 R-22 demand for new and reclaimed gas, the mid-range of the EPA’s proposed 2012 new gas allocation or 30,650 mt, which leaves 9,350 mt of demand to be met by reclaimed gas.
  • Average R-22 price of $8. EPA memo 12/16/11- “Currently virgin HCFC-22 is priced at around $4.50 per pound; some industry representatives suggest that this price would have to exceed $8.00 per pound for reclaimed HCFC-22 to become competitive”. The 9,350 mt of reclaimed demand would be more than a doubling of the current reclamation market.
  • HDSN reclaimed gas market share of 20%- HDSN management
  • HDSN 3.3% market share for aftermarket refrigerants- based on my estimate of HDSN ~$33 million in TTM distribution revenue and $1 billion market size (HDSN management)
  • TTM service revenues of $4.5 million
  • HDSN target gross margins of 30% on distribution and 50% on reclaim, my estimate of 50% gross margins on service.
  • Selling expense at 6% of revenues, in line with historical, assume scales as percentage of sales due to commissions.
  • G&A expense of $4.5 million. HDSN has done a very good job of managing G&A expense as sales have grown. G&A was $3.2 million on $23.5 million in revenues in 2006 and $3.9 million on $44.6 million in revenues in the last twelve months. There should be a good deal of leverage on this line.
  • TTM interest of $1 million
  • Historical normalized tax rate of 38% (34% federal, 4% state)
  • Fully diluted share count of 24.7 million

This scenario produces $.46 of diluted EPS. Cash EPS will be somewhat higher as the company has $20 million of NOLs although they are subject to $1.3-2.5 million annual limitations.

As the allocation to virgin gas falls annually, the price of R-22 should continue to rise to meet the increased need for reclaim supply. So although total demand for R-22 will be falling, HDSN earnings should rise as a higher percentage of the demand is met with reclaimed gas, where HDSN has higher margins and much larger market share. In the upside scenario, which could play out in 2014:

  • R-22 total demand falls 20% from my 2012 estimate to 32,000 mt, reclaimed gas reaches EPA target of 12,500 mt
  • R-22 pricing at $15, still below precedent of R-12 phaseout and at current Europe R-22 levels

With other assumptions remaining the same, in that scenario HDSN earns $1.02 in EPS.

If the R-22 phaseout plays out anywhere close to what is expected, HDSN is very cheap. R-22 reclaim demand will obviously not last forever so we should not assign a normal multiple to peak earnings. But the tail for R-22 demand is being rapidly extended as long as the EPA continues to allow R-22 dry shipped units. And as the virgin gas allocation continues to drop more of the market will be shifted to reclaimed gas where HDSN earns higher margins. This is clearly more than an opportunity for a single year of elevated earnings. To frame the big picture opportunity, the EPA estimated there will still be R-22 demand of 18,200 mt in 2020 by which time virgin gas production will be completely banned (and that does not take into account any demand from dry-shipped units). In 2011, total reclaim volume will probably come in around 3,600 mt. I think it is reasonable to put a 5X EPS multiple on $.74 of EPS, which is in the middle of the base and upside cases. That gives us a $3.70 stock. You can quibble on the multiple here, but in a nutshell if R-22 pricing moves up significantly then HDSN stock should do very well.

It also is worth noting that the replacement gas for R-22, R-410a, causes global warming and there have been motions to put an R-410a phaseout into the Montreal Protocol as well as a bill proposed in the House of Representatives. There is a chance that by the time the R-22 phaseout is done the reclaim volumes will be replaced by R-410a.

There is limited downside to a scenario where somehow the R-22 phaseout thesis does not play out at all. If we normalize trailing gross margin from 21% to 25% to smooth out the impact of FIFO accounting then HDSN would have done $5 million in EBIT on trailing twelve month revenues of $44.6 million. A normal multiple of 8X EBIT gets you to an enterprise value of $40 million, which is about equal to the current enterprise value with the stock at $1.65.

Margins

A risk to the thesis may be that other reclaimers could be willing to accept something less than 50% gross margins by either 1. selling their gas for less or 2. paying out more to users to secure dirty gas supply.

  1. Pricing for reclaimed gas tends to be in line with virgin gas pricing, which itself is typically uniform across the major producers. Many reclaimers are also distributors who buy from the producers, so they are unlikely to want to undercut their key suppliers on price.
  2. Having to increase payments to collect the dirty gas from distributors is a legitimate risk. In the 2009 Final Rule the EPA stated that the reclaimers had combined capacity of 16,329 mt. So there is a huge amount of excess capacity currently with 2011 reclaim volumes estimated around 3,600 mt. And there would still be plenty of excess capacity even if the EPA target of 12,500 mt of reclaimed gas is hit. This might incent reclaimers to bid against each other for dirty gas. HDSN probably has some leg up here due to their relationships with the major producers’ distribution networks, although they could always go elsewhere for a better price. However, HDSN has the most capacity of any reclaimer, and although there is no hard data available they appear to be the largest by a sizable margin (the typical reclaimer has several hundred thousand pounds of capacity versus several million for HDSN). HDSN enjoys economies of scale that the smaller reclaimers do not possess and has a significantly lower cost structure at higher reclaim volumes. That should enable them to offer compensation to buy back gas equal to that of their smaller competitors and still enjoy high margins.

Capex and Working Capital

HDSN maintenance capex is very minimal at $400 to $600 thousand (about equivalent to depreciation). Capex in 2011 will probably be closer to $1 million due to the $500 thousand contribution to the European JV. Working capital is seasonal with inventory builds in the first half of the year, and will certainly be a use of cash as sales grow. But HDSN currently has $5 million in cash and a $15 million line of credit available with $4 million currently utilized so they should not have an issue financing future sales growth. Their use of the line of credit peaked at $8.8 million in the second quarter of 2011.

European Joint Venture

In July 2011, Hudson announced it would be initiating a joint venture in Europe with two European partners. HDSN will contribute $500,000 and own 40%. The JV will enter the refrigerant reclamation and energy optimization markets. As noted above, the R-22 phaseout in the EU is well ahead of that of the US with no new virgin production allowed and R-22 pricing at $15 a pound. Additionally, the European reclamation market is underdeveloped and HDSN thinks it can utilize its superior technology and know-how to build a major reclamation business in Europe together with their partners’ distribution networks. HDSN thinks they will also have greater success in Europe selling their energy optimization services as the EU is also more advanced than the US in terms of offering incentives for carbon credits and other forms of energy usage reductions.

Management has not provided much guidance on the European venture other than that it will be operational by the end of 2011 and accretive to earnings in 2012. There appears to be little downside given the minimal capital contribution, and the JV could grow into a material contributor to earnings based on the reclamation dynamics in the EU. However, I have not accounted for any contribution from the JV in my earnings scenarios.

Why does the opportunity exist?

  • I think the primary reason the stock is so cheap is investor fatigue with the R-22 phaseout story, which was supposed to have started to play out in 2010. The stock got up to $2.85 in early 2010 and has traded lower since then based on disappointing R-22 pricing and low reclamation volumes. Investors are growing frustrated waiting despite the company performing well given stagnant R-22 pricing and the recent positive developments with the EPA allocation reset.
  • HDSN issued 2.7 million shares and 1.3 million warrants in July 2010 at $2 a unit (warrants exercisable at $2.60). This was obviously expensive capital and did not help the stock price. Management felt they needed some liquidity to prepare for the increased working capital demands with higher sales and were worried about getting shut out of the market. I don’t foresee a reason they should have to raise equity in the near future.
  • The last two quarters earnings have been weak due to gross margin pressure with gross margins coming in at 18.4% in Q2 and 12.3% in Q3 compared to the usual 20-30%. Management has said the decline is due to using FIFO accounting in a falling R-22 price environment. Even if R-22 pricing remains flat gross margins should stabilize as they work through the higher priced inventory.
  • There are the classic micro-cap factors as well- the stock trades less than 30 thousand shares a day and there is no sell-side coverage.

Ownership

Insiders own 38.3% of the company, with the founder and CEO Kevin Zugibe owning 22.8%. I view the insider ownership as positive here given that executive compensation is relatively modest. Hedge funds Becker Drapkin and Marathon Capital own 9.1% and 7.2% respectively. Although Becker Drapkin has often gone activist, they have been passive in this investment. One unknown is what management will do once the company starts generating some excess cash, but given the insider ownership and hedge fund holdings I think there are good odds that shareholders will be fairly rewarded.

Timeline

The timing on this investment is difficult to predict. Clearly R-22 pricing has to go higher at some point as production allocations fall annually and inventory stockpiles run out. The question is when that will happen. If the EPA gets the final rule out by the end of February and their revised assessment of supply and demand is accurate then R-22 pricing should start to rise by the second or third quarter. If they delay the ruling or get the supply/demand wrong again then it is hard to know how much longer it will take, but time is HDSN’s friend as the R-22 production allocations fall and stockpiles dwindle. The stock has had a nice run in the last few days in the wake of the EPA proposed rule, but still seems cheap if the R-22 thesis finally begins to play out. Even with the stock $1.60-$1.80 there should not be much long-term downside given the current normalized run rate EBIT of $5 million.

Disclosure: I own shares of HDSN.

P.S.

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Top Image Systems (TISA) – A Cheap Microcap Software Company http://feedproxy.google.com/~r/valueslant/~3/3lqJA9JPaNY/ /2011/12/22/image-systems-tisa-cheap-microcap-software-company/#comments Thu, 22 Dec 2011 20:46:13 +0000 Elie Rosenberg /?p=890 Top Image Systems (TISA) is a NADSDAQ-listed Israeli enterprise software company. TISA makes automated data capture solutions to control the flow of document based data through an enterprise. In a simple example, their software can extract data from a scanned invoice and feed that data into the company’s accounts in their enterprise software system.

TISA has undergone a turnaround in the last three years. Founder Izhak Nakar returned to an active role in TISA in 2009 when he purchased 20% of the company from a large institutional holder. Since then he has been acting as “Active Chairman” in a CEO-like role along with CEO Ido Schechter. Their turnaround strategy has moved TISA away from low margin hardware and third party software to focus on their core eFlow software platform. They have also focused on realigning the cost structure by closing non profitable offices and ramping up utilization of third party distributors. The strategy has succeeded. In 2008, TISA did $32 million in revenue with 53% gross margin and negative operating income margin. For 2011, TISA is on track for $28.5 million in revenue with 61% gross margin and 13% operating margin.

TISA looks like a cheap stock. Based on a fourth quarter in line with the prior three quarters (on the higher end of conservative company guidance), TISA should do $3.6 million in EBIT in 2011. The company eliminated its remaining debt in the third quarter. D&A is about equal to the very minimal capex (about $300 thousand), and TISA has NOLs to shield income from taxes for at least several years. So EBIT should basically be equivalent to free cash flow. There are 11.1 million diluted shares outstanding for a market cap of $23.5 million at $2.11 a share. There is no debt and $3.3 million in cash on the balance sheet. Netting out the cash that comes to a 17.8% free cash flow yield.

While TISA has much competition, they are operating in a rapidly expanding niche of enterprise software that has continued to grow through the recession, and is expected to continue to expand at a 9% growth rate. Document management software has a rapid and demonstrable return on investment. (TISA management claims there is usually a 6-12 month payback.)

The major difficulty for small makers of enterprise software tends to be sales and distribution. They can have software that is better than the bigger players, but they just cannot get their product in front of potential customers as effectively as bigger companies can. TISA has pursued a smart strategy in this respect by focusing on a few targeted areas:

  • Banking- secular trend of increased regulation forcing banks to better manage document flow
  • Digital mail room- a product that auto-manages a company’s email correspondence with customers
  • Integration of TISA products into the platforms of larger enterprise software partners such as Xerox

TISA is not trying to be all things to all customers, and their focused sales strategy should help them compensate for the lack of a huge sales force. Now that the expense structure has been cleaned up, TISA can focus on top line growth.

While TISA is a cheap stock with no fatal flaws, I am worried mainly about the sustainability of the top line. I think this is probably the major item holding the stock back right now. Quarterly revenue jumped from the $5 million range in 2010 to $7 million in 2011, but it has been flat for the last three quarters. TISA does have 25% of revenues coming from recurring maintenance fees, but the rest is from one-time software and service sales that tend to be lumpy for small enterprise software companies. A few big projects ending could have a large impact on revenues. TISA management says the sales pipeline has grown from $70-80 million to $100 million over the past year, but it is hard for an outside investor to have conviction that they will keep up their win rate in a crowded marketplace.

Another concern is expense creep. Now that TISA is focused on top line growth, they will have to invest more into sales and that of course carries the risk that they will not increase revenues in line with that increased investment. TISA is trying to expand into the US market where they traditionally have not had much of a presence with most of their sales coming from Europe. Sales and marketing expense jumped to $2 million in Q3 from the $1.5 million range while revenue remained almost flat. Additionally, management pay appears excessive as they are basically paying two CEOs. Schechter and Nakar will earn about $1.2 million combined this year, which is a third of EBIT.

There has also been some questionable capital allocation. The company had been working to pay off $15 million in convertible debt issued in December 2006. While TISA has been able to pay off most of it through cash from operations, they did a 1.4 million share private placement at $2.00 a share in June to pay off the remainder. As the debt was only bearing interest at LIBOR+.3% I am unclear as to why they were in such a rush to pay off the remaining $5 million. Issuing stock so cheaply seems to be a very expensive way of getting rid of cheap debt.

Without any hard catalysts, TISA is cheap to current cash flows but still essentially a bet that management can continue to grow revenues.

Disclosure: No position.

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Global Education & Technology (GEDU) – A Chinese Merger Breakup Arbitrage http://feedproxy.google.com/~r/valueslant/~3/VVeWfVeT9kk/ /2011/12/16/global-education-technology-gedu-chinese-reverse-merger-arbitrage/#comments Fri, 16 Dec 2011 17:55:32 +0000 Elie Rosenberg /?p=882 Global Education & Technology Group (GEDU) is a Chinese ADR that offers English language training in China. It has become embroiled in an insider trading scandal surrounding its pending acquisition by Pearson (PSO), the large British media and education company. Pearson announced on November 21st that they would acquire GEDU for $11.006 in cash per ADR. That represented a 105% premium to the prior closing price and a whopping 214% to the 30-days prior average trading price.

On December 5th the SEC filed an emergency court order to freeze the US brokerage accounts of four Chinese citizens accused of engaging in trading in GEDU on material non-public information in the days leading up to the announcement of the transaction. One of those accused had her brokerage account funded by an entity controlled by GEDU’s Chairwoman (and wife of the CEO). On December 14th the SEC filed an amended complaint which also implicated Yonghui Zhang, an employee of GEDU and the brother of GEDU’s CEO.

The question now is whether Pearson will call off or at least postpone the closing of the deal in light of the accusations. GEDU closed at $5.29 the day before the deal announcement and at $3.62 just two days prior.  With the stock trading at $10.40, if it falls back to $4 that would be a 62% gain. Even an announced delay in the transaction, which Pearson has said would close in Q4, would probably send GEDU stock tumbling. The potential downside is that the deal closes and the stock trades to $11- a 6% loss. It doesn’t seem anybody is interested in outbidding Pearson for GEDU.

An extensive presentation of the short thesis and links to the SEC complaints can be found at Absaroka Capital’s website. After Absaroka came out with their short report at 1:30 PM on December 8th, GEDU stock dipped from $10.85 to $9.55. At 2:35 PM that day, Fly on the Wall reported that Pearson had told Bloomberg the GEDU transaction was proceeding as planned despite the allegations. However, Bloomberg never published anything about Pearson’s response, so that rumor remains a rumor. In any event, after the Fly on the Wall report the stock recovered to the $10.30-10.40 range where it is still trading. The market clearly seems to think Pearson will close the deal with GEDU stock trading at just 5% below the buyout price.

My guess based on the information that has come out so far is that Pearson still goes through with the deal. The merger proxy discloses that Pearson has been angling to acquire GEDU since September 2010, having made no less than eight offers since that time. As Absaroka notes, Pearson is almost certainly overpaying for GEDU and it is probably not a good deal for PSO shareholders on its own merits, but I think that is irrelevant to the short thesis. The question at hand is whether Pearson will go through with the deal, and clearly setting the scandal aside they think GEDU is worth buying at $11.00.

As this securities lawyer notes, the central difficulty in the SEC’s case is establishing the source of the inside information. The only hard link proposed to GEDU insiders is the funding of one of the trader’s accounts by wire transfers from an entity whose sole director is the GEDU Chairwoman. That certainly looks terrible, but I am not sure it will be enough for Pearson to call off the deal if they really think it is a good one on its business merits. The Chairwoman might have to resign, and Absaroka thinks that Pearson would perceive that as a huge negative because of how critical Chinese government relations are to businesses in China. It is difficult to tell how much the Chairwoman matters to the business in this case. I am not sure her resignation what would be enough for PSO to back out of a deal they want to do so badly. That said the trade is perhaps still tempting as a mispriced option given you are risking 6% to the downside for 50%+ upside.

P.S.

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Mercer International (MERC) and Canfor Pulp Products (CFPUF) – NBSK Pulp Companies http://feedproxy.google.com/~r/valueslant/~3/IQwgMRwoRaU/ /2011/12/14/mercer-international-merc-opportunities-market-pulp/#comments Wed, 14 Dec 2011 22:27:51 +0000 Elie Rosenberg /?p=799 Following up on the NBSK market overview, let’s take a look at some individual NBSK pulp companies. The two publicly traded NBSK pure plays are Mercer International (MERC) and Canfor Pulp Products (CFX on the TSE and CFPUF on the pink sheets). Fibrek (FBK on the TSE) has about half of its sales from NBSK, but it is now more of a special situation following the recent Abitibi buyout offer. While clearly the future price of NBSK (which I discussed in the market overview) is what matters most for these stocks, it is worth taking a look at the individual companies.

Company Overviews

Mercer operates three pulp mills:

  • Rosenthal- Germany, 330,000 metric tons production capacity
  • Stendal- Germany, 645,000 mt capacity
  • Celgar- British Columbia, Canada, 520,000 mt capacity

They have a 74.9% stake in Stendal and fully own the other two. The mills have a combined annual production capacity of 1.5 million metric tons, making Mercer the second largest (and largest publicly traded) producer of NBSK market pulp.

Canfor Pulp Products owns 49.8% of the operating subsidiary Canfor Pulp Limited Partnership (CPLP), with the other 50.2% being owned by Canfor Corporation (CFP). Canfor Pulp was spun out of CFP in 2006. CPLP owns three NBSK mills in British Columbia, Canada with a combined capacity of 1.1 million mt, making them the third largest producer of NBSK market pulp. One of the mills also processes 140,000 mt of kraft paper (15% of revenues).

Revenues

(Note all currency figures in reporting units- MERC in Euros and CFX in Canadian Dollars- unless otherwise noted.)

Both Mercer and Canfor have high capacity utilization regardless of market pricing levels: They are both on the lower end of the production cost curve so it makes sense for them to keep running even as marginal producers take downtime during periods of lower NBSK pricing. (Canfor did take some downtime for capital projects with depressed market prices at the end of 2008.) NBSK market pricing is the primary determinant of revenues, and realized pricing is typically about 85% of list price.

Aside from market pricing for the commodity there are two other issues to consider- exchange rates and energy revenues.

Exchange rates can have a large impact on MERC and CFX revenues. NBSK prices are quoted in US dollars, while MERC operates primarily in euros and CFX in Canadian dollars. So any change in exchange rates flows straight to the bottom line, with both companies benefiting from a stronger US dollar. Canfor estimates that a 1 cent change in the exchange rate of US to Canadian dollars has the same impact ($6 million in EBITDA) as a $10 (US) change in the price per ton of NBSK. If the recent strength of the USD against the EUR and CAD holds, it will offset about half of the recent price declines in NBSK.

The pulp production process generates large amounts of biofuels as byproducts. These fuels can be used as internal power for the mills as well as sold externally. In the last several years MERC has invested in expanding its external energy sales. They are aiming to generate 700,000 megawatt hours in external sales and are close to that run rate in the most recent quarter. That should generate about €55-60 million in revenue, which has little incremental operating expense. The energy revenues are key to offsetting some of the volatility in NBSK pricing and effectively lowering the cash operating cost of the mills.

Canfor is a bit farther behind in terms of energy sales, having only $5.4 million in energy revenues in 2010. Canfor is increasing their biofuel generation as part of the “Green Transformation Project” largely funded by the Canadian government,  Energy sales will be several million dollars higher in 2011. Management is aiming to grow energy revenues to $50 million, but that is at least several years off.

Margins

The major operating expense for pulp makers is wood fiber, which is the raw material used to make pulp. Fiber makes up 40-50% of variable costs. British Columbia has an abundant supply of wood fiber, and has seen an uptick in harvesting levels in the last few years due to the pine beetle infestation. However, balancing the abundant supply is the reduced sawmill activity with the downturn in the construction markets. Pulp producers have not been able to source their fiber needs from residual sawmill wood chips alone and have had to use more expensive whole logs. In Germany, Mercer has also faced competition for wood chips from producers of various biofuels who are heavily subsidized by European governments. Mercer’s fiber costs per ton of pulp have risen 33% since 2006.

Mercer possesses the most modern asset base in the industry as well as some of the largest scale mills in Stendal and Celgar (chart from September 2011 Mercer presentation):

The young mill age helps to lower maintenance capex and higher uptime while the large mill size gives MERC economies of scale. From a mill operations standpoint, MERC should be on the lower end of the industry cost curve. Canfor also has some of the larger and most cost competitive mills in the industry albeit older ones.

This chart compares MERC EBITDA margins with Canfor EBITDA margins in their pulp segment (with corporate level costs allocated by percentage of total revenue): We see that Canfor has typically had higher margins, mainly due to the larger headwinds Mercer has faced with wood fibers.

Capital Structure and Allocation

Mercer

Mercer has 733 million euros of debt and 287 million of equity (including 132 million in cash). However, there are several points that mitigate the leverage risk:

  • The book value number is misleading as Mercer has received substantial government grants for capital investments that are netted against the book value of their assets. At the end of 2010 the government grants less depreciation stood at €298 million. If we add that back to the book value of equity we get €585 million of equity ($14 a share).
  • The German government has guaranteed €417 million of the €477.5 million of debt remaining on the Stendhal mill.
  • While pulp earnings are very volatile, the energy revenues should be steady as long as the mills keep running at full capacity. The way MERC management frames it is that the €5o-60 million in energy revenues basically covers the approximately €50 million in annual interest expense.

Mercer has used most of its free cash flow for deleveraging and discretionary capital projects. Capex has averaged in the €30 million range the last several years, although most of that is growth capex as the mills are all relatively young with low maintenance requirements. They have also instituted a 25 million USD stock buyback plan and have bought back $10.6 million so far this year.

The debt against the Stendal mill has a reserve fund that requires a year of principal and interest payments to be put in before cash generated by the mill can be distributed to Mercer. On top of this, in 2009 Mercer fell behind on principal payments on the Stendal debt and had to restructure the debt.  MERC reached an agreement with the Stendal lenders to defer €164 million in principal payments provided that no cash from the mill operations could be distributed to MERC until the  €164 million was put into the reserve fund. What this all means is that MERC equity will not see any cash from Stendhal, which is 43% of their production capacity, for quite a few years. MERC needs to put about €220 million euros into the reserve fund and the fund balance is currently €31.7 million. Stendal generated €36.7 million in cash from operations in 2010, and  €47.6 million through nine months of 2011.

Canfor

The Canfor Partnership has $114.3 million in debt and $466.4 million in equity ($25 million in excess cash), which appears to be a sustainable amount of leverage. CFX had been set up as an income trust (something akin to an MLP in the US) prior to this year when Canada eliminated the tax advantages associated with the structure. CFX converted to a regular corporate structure, but still plans on distributing the after tax free cash flow from the Partnership to shareholders. Canfor management has guided to maintenance capex of $10-$15 million and normalized capex of $15-$20 million. Capex has been higher this year (an estimated $67 million for the year net of government contributions) due to GTP environmental projects that are being primarily funded by the Canadian government.

Earnings Power and Valuation

The key question in terms of earnings power is of course NBSK pricing. We can look at what would happen in a range of cases. Current NBSK pricing is $846/mt (USD) in Europe and $890/mt in North America. NBSK peaked over $1,000 and fell close to $600 in the recent trough in 09. Given that operating costs have risen since 09 I think a reasonable range to look at is $700-$1,000. Both MERC and CFX look like they would be at breakeven on a cash basis on pulp sales in the $625-650 range, so more marginal producers would halt production at much higher levels.

Please see my model here for all the details but the major assumptions are:

  • Historical utilization rates and average selling price realization rates
  • Current exchange rates for EUR/USD and CAD/USD
  • The current cost structure with a change in fiber cost partially linked to a change in NBSK pricing
  • 2011 run rate energy revenues
  • $5 million in Paper EBITDA for Canfor’s paper segment
  • For Mercer adjust for the minority interest by subtracting the percentage of total capacity owned by the minority interest (10.8%) from the equity value.
  • For Mercer add value of NOLs.

In terms of valuation multiples, commodity paper stocks generally trade in the 4-6X EV/EBITDA range. For Mercer that is probably the more relevant metric than P/E or FCF yield given their leverage and the fact that most of the free cash for the foreseeable future will go to the debtholders. For CFX, FCF yield is very relevant as they will be paying almost all of it out to shareholders. The cash yield on CFX has bounced around as NBSK pricing has moved more quickly than the quarterly dividends. It is currently 16.3%. At the peak of NBSK in the summer the yield was about 8.5%.

At current NBSK prices I project $201 million in annual EBITDA for CFX and €191 million in EBITDA for MERC. At a 5X EBITDA multiple that would come out to a $12.85 share price for CFX and a $8.80 share price for MERC. On that basis both stocks are undervalued (CFX by 25% and MERC by 33%), so the market might be pricing in further NBSK pricing deterioration. It is worth noting that these scenarios assume the large recent gains of the USD hold.

Here are the scenarios:
Clearly both MERC and CFX are extremely leveraged to NBSK pricing. The big question is whether the NBSK run up to $1,000 was an aberration (caused by the Chile earthquake, dissolving pulp diverting capacity, and a slew of China paper starts) or a “new normal” given the permanently shuttered NBSK capacity and growing Chinese demand. At some point I think you have a margin of safety given that demand for NBSK is not going to evaporate and MERC and CFX are both relatively low cost producers. But given the sharp downward trend in pricing in the past few months and elevated producer inventories it seems like there is still some time to wait for a bottom. (It will also be interesting to see whether CFX can maintain their .40 cent quarterly dividend. At current pricing it still looks safe, but probably not if NA prices fall to $850.)

MERC or CFX?

Given the current valuation gap between them is not large, I like CFX better given the higher pulp margins, lower leverage, and large cash yield. The main advantage of MERC is the large energy revenues, which will help to smooth out earnings. MERC also has newer assets, and I like that they are buying back stock. But MERC still needs to delever (and all of the Stendal cash flow will be going to that end) so for the time being it looks like equity holders will be better rewarded with CFX.

P.S.

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Disclosure: No position in stocks mentioned.

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