Sunday, 21 December 2014

Holiday links

This is going to be the last post of the year. This blog has certainly been fun to write and wanted to thank all of you who stopped by or reached out during the year, it’s been a pleasure. Posting will resume in the New Year. Meanwhile below is a bunch of links to keep you busy in the coming weeks.

Wishing everyone a (very PC) happy holidays and prosperous New Year.

A Dozen Things I’ve Learned From Bill Ackman about Value and Activist Investing (25iq)
Bill Gates’ list of best books in 2014
Bruce Greenwald on the Motley Fool, talking about value investing in Asia
Charles Brandes’ profile in the Globe and Mail
James Montier’s white paper on the world’s dumbest idea (shareholder value maximisation)
Another Montier link, this time on stock market valuation
Mark Mobius’ blogposts on Malaysia and oil
Mohnish Pabrai’s advice to a 12-year-old investor (Forbes)
Warren Buffett and the next 50 years (WSJ)
Brief history about Solomon Brothers (DealBook)
Interesting FT profile on chess master Magnus Carlsen
Very good post on the power of habits

Amit Wadhwaney lecture
Arnold Van Den Berg’s annual client review
Aswath Damodaran’s CFA talk on valuations and story telling
Charlie Munger talk from 2008 held at CalTech
Mohnish Pabrai’s talk at Boston College
Jim Grant’s top 2015 ideas (hint: Russia)
Warren Buffett Q&A at the Forbes 400 philanthropy summit

On the shortness of attention span: Norway and the concept of slow TV (TED)

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.

Tuesday, 2 December 2014

Zicom Group and Orion Marine

A few weeks ago two companies crossed my desk that happen operate in similar segments thus taking a hint (from what obviously is a) divine signal I decided to look into them a bit more.

Zicom Group
The company is an industrial conglomerate (headquartered in Singapore), founded in 1978 and listed in Australia. Core segments (currently) are (i) offshore marine, oil and gas machinery (ii) construction equipment (iii) precision engineering and (iv) industrial and mobile hydraulics (if this doesn’t get you excited I don’t know what will). To note the businesses will be housed in two segments, likely by the next half, into (i) and (iii), which will also house new technology / engineering investments (more below). Zicom is 36% owned by Giok Lak Sim (chairman and group managing director) whose two children are also directors in the business.  To get this out of the way upfront the company is a microcap c. US$46m market cap and US$40m EV and in a good month about a US$1m worth of shares trade.

There are a couple of reasons why this could be an interesting situation.

Committed management. While Zicom is a controlled company, the CEO is remarkably forthcoming in his annual letters and other communication (most recent example here). He has been buying shares since 2008 in the open market and has also acquired shares instead of his cash bonus. In addition, his salary has been frozen since 2007. I could go on for a while but I find it positively surprising in the context of most Asian, controlled companies.

New business. Since 2010 the company has invested in what it calls disruptive technologies in the field of electronics and medical technology (VC type investments generally related to its precision engineering portfolio). The company invested over S$15m ($12m) equity in four businesses (Orion Systems Integration, Biobot Surgical, Curiox Biosystems and iPtec). While such investments can go either way the company is saying that most of these are on the cusp of commercialisation which you can essentially view as a free call option (i.e. not reflected in the valuation). As noted above the business will collapse into two segments, which will help reflect the performance of these new investments.

Valuation. The company is relatively cheap on a statistical basis and trades at 0.6x book (vs 0.8x historical), 5x EBITDA (vs 3-4x historical), 5x free cash flow (vs 9x historical) and 14x PE (vs 7x historical). The shares yield around 4% and the dividend is paid out of conduit foreign income, which is not subject to Australian withholding tax. In addition, the balance sheet is strong with S$22m cash and gross debt of S$15m.

Now what can go wrong. The core segment is offshore marine, oil and gas machinery (it makes winches for rigs and supply vessels) and while sales and orderbook have picked up since last year this is quite cyclical (with normally a 1-2 year lag), however management is positive on the outlook. But this should be considered: while offshore exploration picked up since the financial crisis so did Zicom's sales and orderbook (though remains cyclical) but given where oil price is currently and possibly where it is headed 2015 E&P capex is at risk as well as Zicom's business, which is perhaps not yet discounted (though you could argue that at 0.6x book it is). Base case thesis on the stock seems to be a late, cylical upturn in their O&G segment, however I’d be cautious.

In addition to the above the following could be negative as well: (i) VC investments flop (ii) bad corporate governance (so far no evidence) (iii) continued weakness in construction segment (has been weak as of late), which has exposure to the Australian market and (iv) technicality if you are running a large fund but the stock is quite illiquid.

Apart from a spike in 2011 the share price hasn’t moved materially over the last five years. Profit warnings have also preceded their last three earnings release so I’d say the market was quite pessimistic about the stock. This has been recognised by mgmt and as noted in the chairman’s letter they intend to do something about it so there appears to be a catalyst (let’s see their approach).

Depending on your stomach for volatility on the oil and gas front I think this is a very interesting business, with good and aligned management in place and potential upside from their new investments.

Orion Marine
Orion is a slightly different animal. It is approx. $300m market cap, civil marine construction company that is listed in the US and operates mostly in North America and the Caribbean. The company was founded in 1994 as a construction project management business and expanded into its current shape organically and via acquisitions (most recently a $9m purchase of an Alaskan company).

Orion provides marine construction services (to marine transportation facilities, pipelines, bridges etc), dredging (essentially maintaining waterways/shorelines by removing or adding soil) and other specialty services (demolition, surveying, underwater inspection etc).

In 2013 the company generated sales of $355m (mostly by bidding for various contracts) of which 60% was from the private sector and 40% from various government entities (federal, state and local). Key markets/customers are: ports, marine infrastructure, oil and gas, defence/homeland security etc. As it’s a contracting company backlog is key, which as of end 2013 was $247m ($242m as of Q3’14).

As you’d have guessed it by now Orion’s performance is tied to the general economic cycle but with a lag (just like Zicom so the business is very cyclical). For instance, in 2009 revenues reached $293m with gross and EBITDA margins of 21% and 17% respectively. By 2011/12 the margins were down to 4%/1% and 5%/3%. 2013 seems to have marked a turning point as margins have improved to 9%/6% and on TTM basis 10%/8%. Historically, average margins are 14%/11% (gross and EBITDA, respectively) so the company is trending towards those levels. Key drivers for the decline was drop in demand and also pricing pressure on contracts. So as you can see the business is choppy.

I’ve been looking at this stock many ways but the key story seems to be the recovery in marine infrastructure construction in the US. Just to highlight a few potential avenues for capex growth in this segment: (i) private sector: energy sector growing, expanding and refurbishing waterside infrastructure (e.g. gas related projects – ammonia, LNG, chemicals etc) not just in ports but inland waterways as well (ii) local port authorities growing capex (port deepening etc) for increased cargo volume and larger vessels primarily due to the Panama canal expansion and (iii) government funded programmes to improve, maintain and restore the coast (think damages of recent hurricanes or that accident in the GoM in 2010).

I’d say barriers to entry are medium. You need specialised equipment and trained people (nothing one cannot replicate given the resources) but gaining access to government funded projects (especially on the defense side) require all sorts of clearing thus these relationships are very valuable. On the other hand given that around 40% of revenues are from the government when funding hits a dry spell it can get pretty painful.

Due to the cyclicality it’s hard to value this stock and figure out what are the recurring numbers but an EV/Sales approach could give an indication of what the market implies. If you look since 2008 the peak has been 1.4x (2009; it’s actually been higher but only for short periods so 1.3x-1.4x more reasonable), which dropped to 0.4x (2012; again 0.4x only for short periods and 0.5x is probably a better indicator). It’s currently trading around 0.7x. So those are the ranges.

In 2013 the company generated $355m in sales and this year they are on track to do $385m (mgmt noted Q4 should be on par with Q3). Using 2014 sales and most recent net debt as a base at 1.3x it’s an $18/share stock and at 0.5x it’s worth around $7. Given where we are in the cycle I think 1x eventually is not ridiculous (i.e. lights at the end of the tunnel but not fully out yet), which would imply around $14 (vs current $11).

Commodity prices drive oil and gas capex and while Orion remains bullish on the outlook of private sector projects in the near term I’d tread carefully here (at least in the very near term). As a result of the cyclicality using say the average revenue since 2008 is perhaps more defensive. The same multiples on those numbers imply a range of $6 to $15, and $12 using a 1x multiple (i.e. fully valued) though it could get interesting in the $8-9 range. I think on the long-term horizon this is a very interesting story to watch.

To note Arnold van den Berg, the founder of Century Management, whom I admire greatly, is a large shareholder in the company (around 9% stake) and his thesis is very similar (i.e. marine infrastructure boom in the US of which Orion would be a beneficiary). In a recent interview with Graham and Doddsville he noted that he’d be a buyer should the stock dip to around the $9 levels.