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.

Knowles, no not that one

One good thing about the return of animal spirits is the increased corporate activity resulting in restructurings, spin-offs and so on to “unlock and/or create substantial value for shareholders” (or whatever presentations say nowadays). Sarcasm apart, there are often gems that surface into public ownership, which are part of larger conglomerates, operating in different segments, making them non-core from the company’s/shareholders’ perspective. Thus when shares of the new entity are distributed to existing shareholders, the shareholder base is oftentimes not “natural” and it takes some time before shares move to investors who can better value such situations. I believe that this is the case at hand with Knowles (KN).

Up until 2014 February KN was part of Dover Corp, an industrial conglomerate, when it was spun-off. Rationale given at the time was that while it’s a high growth business the capex requirement for Knowles was too much for Dover as it would have starved it’s other businesses. They wanted to focus on their slower growth albeit more predictable businesses hence the separation was pursued. Dover market cap now around $15bn ($13bn around the spin) while Knowles is $2.5bn. Furthermore, Dover pays a dividend while Knowles not (and not likely in the next few years due to reinvestment). So the above gives a flavour of why there is a difference in shareholder base. The two companies have very different business models and the implied “higher volatility” of the tech segment is clearly something industrials investors wouldn’t consider.

Knowles is essentially a technology company that sells (a) microphones, speakers and other audio equipment that go into mobile phones, tablets etc (c. 60% of sales; Mobile Consumer Electronics segment) and (b) components for hearing aid, defence and telecom use (c. 40% of sales; Specialty Components segment). Dover built this business by acquiring competitors along the way.

In 2013 KN generated $1.2bn sales (64%/36% split) and $274m EBITDA (70%/30% split, before overhead). Overall, it’s 8.7% increase in revenue year on year driven by a 16% revenue increase in MCE from higher volumes mostly in smartphones but drop of 2% in SC due to drop off in government spending and lower demand for specialty equipment in hearing aid. It’s worth highlighting that the SC segment is prone to fluctuations in government spending, telecom industry capex, which impact results.

There are almost two different businesses within KN. The SC segment is not terribly exciting from growth perspective, however KN does command the market in the supply of hearing aids and related solutions (65-70% share) with one meaningful competitor in Sonion (Danish private co, which just got taken out by Novo A/S). Aging, albeit more affluent and technology savvy population bodes well for the use of the currently under-penetrated hearing aid market. KN is developing new technology in this area and sees possibilities to use technology from it’s other segment (MCE) in hearing aids, which could make the end product less expensive by reducing high labour costs in the manufacturing process via automation.

MCE will grow more rapidly (and has grown - 52% since 2011) as handheld devices are becoming more sophisticated acoustically. KN’s focus is on microphones and according to third-party/company estimates the company has a 60-70% share of the market (total market of c. $0.7-0.8bn). In terms of the speakers, it has an estimated 15% share (behind AAC – 50% share and Goertek with 25%). Overall, KN is no. 5 in the entire MEMS market (micro-electromechanical systems, essentially the miniature equipment that goes into devices; don’t worry I had to get my dictionary as well) behind the likes of Bosch, HP and so on.

The key to the story is higher quantity and quality audio equipment that goes into handheld devices. The current average audio content of a smartphone (such as speakers, microphone etc) is between $2-3, which is expected to grow to $3-5 over the next few years. As the below chart shows prices of new products that go into smartphones are clearly following the trend of falling off after a while (indeed Knowles has cut pricing historically, though this is likely on the older equipment; if you look at product pricing of phones or tablets they follow a similar fashion) but coming in at higher levels vs before. Simply put, users want better sound quality in phones, whether its microphones for talking or recording HD videos or speakers for listening, voice control is just coming into life as well as wearable devices.

Source: Knowles presentation

Barriers to entry are high and KN’s moat comes from the fact that the product life is very short (just look at a release of a new iPhone/iPad every year) and getting new products that are more complex to scale would be tough for a new comer and not to mention the ongoing R&D (around 7% of KN’s sales). What’s interesting is that Nokia and Blackberry were both customers of Knowles emanating from a previous acquisition. As these companies all but blew up KN’s sales grew through as its products are practically in every OEM and the impact should be eliminated later this year so fundamentals would be improving.

A few years ago, KN began an internal restructuring process which management pegged at $40-50m annualised cost saving of which around half has been completed by end 2013. The company is reducing its manufacturing facilities from 18 to 11 and moving them to lower cost locations. On a recent earnings call they noted the possibility to bring these cost savings a bit forward in timing, which will help margins improve faster. Management guides operating margin expansion to 22% from the historical 17-18% partly generated from the above (on a non-GAAP basis mind you).

So what’s it worth? The listing took place at $30 per share and despite a lot of trading activity the price has gone…nowhere ($29 now). At current prices the company is trading at TTM EV/EBITDA 10x and forward around 9x. This is roughly in line with the historical multiples of Dover. The two closest peers are AAC Technologies (2018:HK) and Goertek (2241:CH). AAC traded at 14-15x historically and Goertek now trades at 14x forward.  While getting to AAC multiples would probably be a stretch as it generates EBITDA margins in the mid 30s, I think 10-11x is not out of the question. Interestingly, Goertek generates KN like margins and still trades at a premium. It is noteworthy that both AAC and Goertek are essentially manufacturers for OEMs using third party technology while KN has in-house research and design.

Let’s take a conservative approach: sales growing at 5% through 2015 (about half of historical), margins getting up to 25%, 11x multiple (20% discount to AAC) gets you to a share price of $40 (vs $29 current). Assuming flat margins and 10x multiple (more or less status quo) will get you to $30. Assuming, 25% margins and only a 10% discount to the multiple will get you to $46 per share.

So: increasing unit sales x increasing unit prices x expanding margins = $$$

Add a potential multiple rerating and we have an interesting situation on our hand.

Orora, a spin-off from Down Under

Orora is an Australian listed packaging business that presents an interesting spin-off opportunity. It used to be part of a large Australian packaging company named Amcor, however in order to focus the business it decided to split the business into two (1) remaining of Amcor to focus on specialty packaging (healthcare, personal care, F&B etc) and (2) Orora on fibre, beverage packaging in Australasia and packaging distribution in North America. All figures below in A$.

While admittedly packaging isn’t the most exciting business in the world (no offence meant to anyone), Orora could be a textbook spin-off case. Amcor is a much larger company with market cap of $13bn while Orora with $1.7bn, currently. Thus when investors received shares in Orora (1:1 distribution) Orora’s share price didn’t exactly tank but definitely saw sharp selling. Now the share price is up around 20% since the low point to $1.4 where it has been flat for the better part of last three months. Orora has a couple of things going for it, namely an on-going restructuring and capable management team.

As a quick detour, in the last three years Orora generated revenues of $2.9bn on average and EBIT of $150m across its two segments. The bear share of this is from the Australasia business, which produces corrugated packaging (think cartons, boxes, recycled paper and so on) and packaging for beverages (cans, glass bottles etc). In each of these segments it has significant scale and either no. 1 or 2 in the AUS/NZ markets, which is key in capex intensive, low-ish margin businesses. The second segment is Packaging and Distribution based in the US and engaged in distributing packaging materials and shipping/logistics services to clients, operating under the Landsberg and MPP/CK brands.

Now back to the story around Orora. Prior to the spin-off Amcor was busy restructuring the business and moving away from lower margin businesses, resulting in closures/divestment and reorganisation of Orora’s manufacturing facilities and operations in its home turf along with bolt-on acquisitions to gain scale and improve margins. Management noted that they are continuing to reorganise the business and identified around $95m cost cutting opportunities over the next few years. In fact, $12m has been achieved in 2013 and $16m in H1’14 (of $30-40m budgeted) with about $20m related capex to be spent over 2014/15. Now it’s unlikely that all of the c. $95m goes to profitability, as they’ll probably share some of the upside with customers, offset cost inflation etc. In any case, this programme will lead to meaningful increase to profitability.

Orora isn’t exactly what you’d call a high-growth business; in fact it’s a mature and defensive. Prior to the spin-off, management initiated a fairly aggressive dividend policy with a 60-70% payout ratio. Delivering on the restructuring is key if one were to see meaningful increase in dividends and value. In H1’14 ORA earned $52m after tax and management declared $0.03 per share dividend (around $36m or 70% payout) or 4.3% annualised yield based on current price.

Orora is left with $65m of benefits to be achieved over 2 years or so (considering that what has been achieved YTD H1’14 is probably priced in). Assuming that only 80-90% of this stays with them (some goes to share with customers, cost increase etc) we have about $35-40m post-tax net benefit, which assuming a 65% payout could add around $2c to the dividend. Assuming a 4% yield (based on current but further compressed) this could add $0.5-0.6 to the share price taking it closer to $2 for a c. 35-40% upside from current. Now of course this is over 2 years or so. The above assumes steady state i.e. no growth in the businesses and a defensive view on the restructuring. Additionally, as capex subsides management could use excess cash to buy back stock or pay down debt (which for now is fairly high at around 3x EBITDA on a net basis).

What makes me a bit more comfortable about this restructuring is Orora’s management. Prior to joining Amcor in 2009, the CEO spent 8 years at SPC Ardmona (packaged food business in Australia). He reorganised and grew the business via M&A and eventually sold it to Coca Cola Amatil (Australian beverage co) in 2005 after three-way deal talks. In addition, him and the chairman have been buying shares in the open market recently, which can be seen as a positive step.

To sum, Orora presents a possibly rewarding spin-off opportunity in a defensive business with the on-going restructuring serving as a catalyst executed by a capable management team, who have skin in the game.