Sunday, 21 December 2014

Rayonier Advanced Materials

Rayonier Advanced Materials (RYAM) is a supplier of specialty cellulose used in a myriad of products (cigarette filters, pharma, electronics, etc). The stock was recently spun-off from Rayonier, a timber REIT, which in my mind makes it a very interesting situation. With a REIT you get an investor base that’s dividend focused, however when you are given a share of what essentially is a commodities business (RYAM), which is going through a bit of a rough patch (near term overcapacity à lower prices à mgmt. guidance cuts) some investors are likely to dump the stock. Which is exactly what happened. RYAM started life around $40/share in June this year, reached high of almost $44 and now it’s bobbing around $22.

So what is RYAM exactly? The company buys woodchips and through it’s chemical processing produces what is called dissolving pulp (some call it natural plastic), which is then sold to buyers either in a speciality or commodity forms depending on grade. The company is the largest producer and has almost twice the capacity, as it’s next competitor. The key here is the specialty product, which is 2x of the price of the commodity version.

This market overall is around 1.6mt and RYAM controls 1/3 of the capacity and the top 3 control 70%. It’s two main competitors are Tembec (listed in Canada) and Buckeye (owned by Koch’s Georgia Pacific). While it is still a commodities business there are barriers to entry: (i) capital costs are substantial (RYAM spent around $2,000/t on a c. 0.2mt commodity to specialty production capacity conversion…imagine greenfield) and there has only really been one plant built – by Sateri (HK listed cellulose co) in Brazil - in the last 10+ years, (ii) customer relationships matter as constant supply of high specification product (e.g. for pharma) is needed and contracts are negotiated for 3-5 years. RYAM is currently around 80% specialty producer (after the capacity conversion), while it expects to be fully speciality by 2018.

Current market cap is around $1bn to which you have to add $0.9bn in net debt for total EV of $1.8bn. For this you get 2 manufacturing facilities in Georgia (0.52mt capacity) and Florida (0.155mt capacity), 85 years of experience, global distribution system operating in nearly 40 countries and 3 year average EBITDA of $360m (historical margins of 30%). In addition, the CEO of Rayonier decided to go with RYAM after the spin. Call it what you will, when mgmt. makes such a step I tend to look at it positively.

However, 2014 has been a tough year for the company and EBITDA is going to be around $100m lower year on year. The reason for that is a perfect confluence of negative events thus the outlook is pretty bleak in the near term (just look at downward consensus revisions on Bloomberg)
  • Global production capacity of specialty dissolving pulp increased by 15-20% over the past two years with the majority from RYAM and other smaller players
  • Before you shake your head in disbelief bear in mind that RYAM built it because their customers asked them to do so and this could be important for the long term
  • This market grows 3-4% p.a., so will take about 4-5 years for this extra capacity to be digested (assuming no more new capacity or conversions of course, which is a big if), which results in limited pricing power for now
  • RYAM noted that it plans to “feather in” this capacity, bring some capacity earlier to maintenance, move volume to commodity products to reduce the effective capacity in the specialty market
  • However you also have to take into account the rationality of the other players, whom (e.g. Sateri) have been actually increasing volume at the cost of lower prices and to the detriment of RYAM

Source: Historical product prices. RYAM

So the outlook is pretty bleak and if I try to reverse engineer what the market implies I get to around $1,700/t price for the specialty product. I’m fixing the following: 90% utilisation rates, 80/20 specialty/commodity mix, $700/t commodity prices, 27.5% EBITDA margin and 7.5x multiple. This gets you to around $250m EBITDA.

I’m trying to estimate what this business could earn under various scenarios and how might the market price the stock then. The downside case assumes that the company will be selling more commodity products while the upside cases assumes that pricing will recover to a certain extent along with the margins:
  • Downside: 70% specialty volume, $1,600/t specialty price, 25% EBITDA margin and 7.5x multiple – implies EBITDA of $200m
  • Upside: 80%, $1,800/t, 32.5% and 8x – EBITDA around $310m
  • Upside (II): 100%, $2,000/t, 35% and 8x – EBITDA around $425m

And the resulting share prices are: $14, $37 and $58 vs the current $22. If discipline returns to the market, along with pricing power, run rate EBITDA could revert back to $300m+ levels thus the market could be price the stock around $40 (roughly where it went public). Though I certainly think that you’ve to look through the next 12-24 months to get there.

In terms of risks, the company is highly levered (over 3x EBITDA) which it plans to take into the 2s, but happy to go up to 4x for strategic M&A (always be mindful of “strategic” and “M&A”). However, the obvious key risk is (assuming nothing goes wrong operationally) is that it’s a commodities business so it’s prone to cycles (both on the supply and demand side). For this I cannot come up with a mitigant apart from that you have to buy at “maximum pessimism” (as coined by the great John Templeton) or be prepared to stomach some volatility. You can ask the eager RYAM shareholders about this who bought in at $40.