|Shares Out. (in M):||43||P/E||0||0|
|Market Cap (in $M):||600||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
“Given management's bullishness on the business, the savings from a potential bond refi and the synergies in this deal we are surprised at the meager multiple paid by RYAM. The percentage is alright in isolation but we believed this debt-weighted capital structure was inverting and think the shares were negatively impacted by the large seller you mentioned.
Again, we are surprised at the low takeout price.”
“We could not agree with you more. It's incredibly frustrating.”
Market Cap: $600M ($874M pro forma for Tembec and convertible preferred)
Share Price: $13.88
Target Price: $28.00
If we hopped in our VIC time machine and went back to May, there was a minor bout of outrage, as indicated above, in the comments regarding the acquisition of Tembec (TMB CN) by Rayonier Advanced Materials. Specifically, how Tembec was “stolen” by Rayonier for too low a price. We agreed with those posters at the time and we still agree, even after shareholders in Tembec agitated and received a bump in their consideration: RYAM got a great price. And yet as we stand here today, despite an initial 30% run in the price after announcement, RYAM is trading today less than 5% above its pre-deal price. We see an opportunity.
We want to lay out the issues and tell you why we think the current price is an exceptionally compelling entry point, enabled by the Tembec deal on one hand and fear (unjustified, we think) about FDA action on cigarettes on the other. We see FCF per share of between $3.00-4.00 (depending on cash tax rate due to Tembec’s NOLs) and upside to the share price of over 100% within a year. At the current quote RYAM is trading at 4.5x run-rate EBITDA and with a 22% run-rate FCF yield.
Capital Structure and Valuation
One disclaimer: for the purposes of the analyses below, we treat the convertible preferred on an “as converted basis” – they mandatorily convert in 2019 using a collar mechanism between $12.91 and $15.17.
Bridging to 2018 run-rate FCF / share
Synergies / EBITDA from Capex
We think the synergies in this deal are achievable and could possibly have upside (although we don’t underwrite this) in the form of additional high return capital projects above the $15M RYAM identifies. To give you a sense of why we believe this, we’ll share an anecdote that we think might be helpful. Tembec has been exceptionally highly levered for many years and we believe that has left the company starved for capex – particularly since a significant amount of their capital in the last few years was spent building their cogen plant. For the sake of comparison: from 2014-2016 RYAM spent ~9% of revenue on capex vs. Tembec @ 2.5% ex-Cogen spend. Just taking Tembec’s segment revenue and capex for specialty cellulose (~1/3 of total revenue and ~1/2 of capex ex-Cogen), capex was ~4% of segment revenue – still less than half the spend at RYAM.
Back to the anecdote: Modern sawmills are outfitted with lasers (such as seen here: https://www.youtube.com/watch?v=JCrfytpvJGY) that maximize the yield based on the prevailing prices for wood products – this is not a new technology, it’s been widely used for many years. Tembec’s mills don’t use lasers – they just eyeball it. They didn’t have the money to spend for these low-hanging fruit projects. The $15M identified by RYAM is the initial cut of these projects, but we think more upside could be found after they assume ownership.
Stepping outside of run-rate, how much FCF could RYAM generate over the next 3 years?
See below, but the upshot is ~$8.20 - that’s ~60% of the current stock price. This analysis includes the accelerated capex spend discussed on the call and a more realistic look at the phasing of synergies over the 3 years and some incremental debt paydown. We model a modest decline in core RYAM revenue and profit during the period, offset by synergies and stability in Tembec. We model a 25% tax rate given some utilization of the Tembec NOLs – but the phasing of those will depend on expense allocation to Canada.
RYAM: Rayonier Advanced Materials is a world-class specialty cellulose producer that was spun off by Rayonier in 2014. RYAM has been written up twice on VIC (one long, one short), both are good to read for background. The primary controversy with RYAM is (and was) their exposure to acetate pulp, the primary input for acetate tow which is used to make cigarette filters. RYAM has significant customer concentration due to the consolidated nature of the tow market with their top 3 customers representing over 50% of sales: Eastman (25%), Nantong Cellulose Fibers (17%), and Daicel (14%). Acetate tow is plagued with secularly declining demand and tough competitive dynamics, with a strong USD creating a challenging dynamic for U.S. mills.
In our opinion RYAM was spun with too much leverage into a specialty cellulose market that was rapidly becoming oversupplied as global producers looked to move up the value chain (into specialty from commodity viscous). We believe this trend has stopped which has left the market (particularly for acetate) in a markedly better place today than it was a few years ago. That isn’t to say we won’t see the capacity additions that have been announced come to market – rather we have seen a slowdown in announced additions. APRIL is bringing a large BEK plant online in Indonesia this year and next which is expected to impact pricing in commodity grades, but so far has not had a significant impact as it has ramped more slowly than expected.
Downstream players such as CE and EMN have opined on improving end markets in acetate tow:
“As it relates to destocking, outside of China, we're pretty confident the tow destocking is over. And that's been pretty consistent for the last several quarters. Within China, we also believe the destocking of tow has been completed.” (Curtis Espeland, CFO, Eastman Chemicals, 6/7/17)
“The tow industry, that's cigarette filters, and that the world of tow is such that there's about 800,000 tons of it manufactured in the world, which includes about 300,000 in China, a little bit less than that. And to David's point, what happened is that we saw Chinese invest more money to become more self-sufficient. They imported about 120,000 tons of tow a few years ago, into that supplement that 300,000. And they've since invested money and Celanese participated in that because we're joint venture partners with Chinese National Tobacco Corporation. At the same time, consumption dropped in China, it took a step change in China, in part because the Chinese government quit gifting cigarettes. And I can explain that to you later, but you saw sort of a step change in demand in China. Those 2 things combined, it dropped that 120,000 tons to roughly -- 120,000 tons to roughly 20,000 tons. So the 500 kt that was outside of China contrasting with 100%, 30%. The other party involved in that of course, were the cigarette companies themselves that also open contracts and we promoted that. That -- so we saw a very large amount of money come out of this industry over a short period of time. China is that the 20-ish kt. I think their intention is to stay roughly there. That's my view, my personal view. So I don't think that's going to change very much going forward. The industry has now stabilized” (Mark Rohr, CFO, Eastman Chemicals, 5/10/17)
“So what that means from a volume trend this year, is first half of the year, what you saw first quarter was kind of comparable to the first quarter last year. It's kind of -- it was lower, but we do see good visibility as we work through this customer transition that tow volume will increase second half of the year. So that's important as you think about how that sets us up for 2018. Now we're still a little early to talk about '18, but our goal is to see stability and potential earnings growth in this business both with gaining stability in tow demand, imports from China and then getting the benefits of some of these new applications” (Curtis Espeland, CFO, Eastman Chemicals, 5/10/17)
And on supply/demand in specialty pulp:
“The dissolving pulp markets next…We continue to see strong demand and in terms of capacity, if we look out towards capacity that's been announced in the marketplace, we expect over the next 4 or 5 years, for it to grow at about 5% and that is consistent with our expectation on the demand side. So we continue to feel that the market is encouraging and in balance” (Stephen Binnie, CEO, Sappi Ltd. 8/3/17)
TMB CN: We encourage readers to browse Teton0321’s excellent Tembec write-up from April. We will avoid too much repetition but Tembec is a primarily Canadian forest products company (albeit with a stellar mill in France), with the largest chunk of EBITDA coming from Specialty Cellulose – albeit of a very different mix than that produced by Rayonier (very little acetate).
This summary slide from the deal presentation is the cleanest representation of the separate companies and pro forma mix of business. Note the diversification away from Acetate Pulp for RYAM – we think this is key to a potential re-rating.
There is a wrinkle to what we wrote above regarding the improved market for acetate (although we should double down on the points that this matters less going forward given less reliance on acetate):
Recent FDA efforts to reduce nicotine in cigarettes
What happened: In July the FDA announced a new framework towards cigarettes with the aim to make cigarettes “minimally or non-addictive”. The market reacted by selling off all cigarette stocks, particularly those like Altria with large US operations (-14%).
Why it matters: Acetate represents 28% of pro forma revenue and is in a slow, but likely irreversible, decline. The reduction of nicotine has some scientific backing that suggests that it would reduce addiction (https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3632983/), and clearly the FDA is devoting resources to this hypothesis – which would reduce cigarette volumes and therefore tow demand. The United States is a very minor market in the grand spectrum of global cigarette consumption (~4% share – for reference China is ~45%), but if our experiment on reducing addictiveness proves effective, it could catch on elsewhere, impacting global demand. There are good points against this proposal too: smokers might resort to smoking more to get the same nicotine fix or go to black market cigarettes which would introduce other health risks outside of the FDAs regulatory umbrella.
Here is Celanese’s CEO on the topic:
Laurence Alexander, Jefferies - VP and Equity Research Analyst
Okay. So switching over to our favorite bugbear: tow. Can you talk a little bit about sort of -- to the extent that the U.S. becomes more aggressive at trying to reduce nicotine exposure, how does that -- what's the implication for tow demand? And I think you've been talking in the past about a 1%-or-so industry decline rate. Has that changed?
Mark C. Rohr, Celanese Corporation - Chairman, CEO and President
Well, I -- who knows? I mean, cigarettes are not growing. Under any circumstance, they're not growing. And governments around the world continue to take initiatives to try to moderate or throttle that growth. Or in the case of the recent suggestion by the U.S. government, to take steps to actually reduce the nicotine levels in tobacco to reduce the addictive nature of it -- of that product. Those things are going to happen. But I'd also say, Laurence, they have been happening. They have been happening for decades now. There's still, order of magnitude, 6 trillion cigarettes consumed in the world. That's trillion. So 1,000 per man, woman and child or 800, whatever the right math is. It's hard for me to see that in a reasonable time frame, that dynamic has any real implication versus the industry that's still running with a lot of spare capacity in their steps that will be taken over a long period of time to address the decline rate, whether it's 1% or 2% or even 3%. So I kind of don't think that's -- I'd have a hard time worrying about that, the implications of that.
Our take: It’s bad but the impact will probably not affect RYAM for years and the impact will be minor given how small the US market is. It will take years for the FDA to come up with a plan, years to see if it works, and likely longer still for other global markets to adopt similar policies. In the meantime the acetate business is a 2-3% decliner annually in our model.
We think RYAM is an exceptional value at current levels. With the stock below $14 we think it’s trading at a greater than 20% FCF yield and the pro forma business is worth more (on a multiple basis) than RYAM standalone given the diversification away from acetate. We’ll be the first to admit that acetate isn’t the best business in the world, but it is now only 20% of sales. The remaining businesses are far more stable and attractive. Domtar (UFS) trades at an ~12% FCF yield and we would posit faces similar secular and competitive pressures in their paper and fluff pulp businesses. That same valuation represents over 70% upside to RYAM.
As for why now? The deal will close in November and RYAM already adjusted their guidance for the impacts of the hurricane. We think increased liquidity and both buyside and sellside interest following the deal close will drive a greater appreciation of the pro forma entity.
And for our formerly dejected Tembec longs (hopefully less dejected after the bump): give it a look.