|Shares Out. (in M):||42||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,395||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||929||EBIT||0||0|
I’m long Rayonier Advanced Materials (RYAM), the recent spinoff of Rayonier’s Performance Fiber Business. For the uninitiated, this is an 85 year old business that converts trees into specialty cellulose. The various grades of specialty cellulose are highly specialized, key raw materials in cigarette filters (acetate), along with a wide array of additional items: LCD screens, food (thickeners; casings for sausage), and certain industrial (tire cord, hoses, paints, lacquer) and pharmaceutical applications. RYAM is the market leader, with ~ 2X the specialized cellulose sales of its nearest competitor.
Why mess around? Here are the financials (2004 – 2013 are segment numbers excerpted from RYN’s 10-K):
Obviously there’s a nice trend in sales and segment profitability from 2004 through 2012, while the past year shows a bit of rough sailing. Right off the bat, my attention is drawn to two things, aside from the nice growth trend and health margins: 1) the solid revenue and EBIT performance in the recession of 2008 – 2009; and 2) the recent, heavy capex of 2011 – 2013 (“Jessup capex”) that is now in the rear view mirror (more on that later).
But on paper (no pun intended), the business seems to have stalled from 2013 to present. So is this business currently under attack, or is this a temporary hiccup? I’m going to argue that this is an attractive, high-return business that’s run into a temporary imbalance of supply and demand-- partially self-inflicted through the capacity expansion captured in the “Jessup capex” line above. In the wake of a c. 25% selloff after the most recent earnings call, I think it's a potential double as the market soaks up excess capacity and RYAM shifts its mix to 100% specialty cellulose.
I’ll take a step back first and sketch out the market for those who may be new to the space. Global demand for specialty cellulose, aka “Performance Fibers” derived from wood pulp, is about 1.6 million tons per year. For clarity, I’m limiting the definition of specialty cellulose—occasionally a nebulous term-- to RYAM’s target markets: acetate, high value ethers, and other cellulose specialties. We’re not talking about rayon and textile materials, commodity viscose, etc.. The global market for acetate—the key material in cigarette filters—is about 710,000 tons, (44% of the 1.6 million), growing at 1 -2 % annually; ethers is about 500,000 tons (31%), growing at 4 – 5% annually; and other cellulose is about 350,000 tons (22%), growing at 2 – 3%. Those growth estimates have been questioned by some (particularly acetate), but I’m comfortable with them — I note that the overall tonnage estimate and rough growth profile is echoed by RYAM’s peers. However, if you believe that cigarette consumption will plummet worldwide (emphasis on “worldwide” rather than in the US… see growing Chinese market…) in the next few years, taking the dominant acetate material supplier player with it, you might want to pass on this one. PCI Fibres publishes relevant industry segment research for those looking to dig deeper on overall market trends.
The specialty cellulose business is a technically demanding business that is dominated by a small handful of players. RYAM is solidly in first position, with 30% market share by volume-- roughly twice the sales of its nearest competitor. The competition is by no means a group of capital-constrained lightweights, however; it includes Georgia Pacific, through its recently- public Buckeye Technologies business (acquired 2013); Borregaard, a part of the Orkla group, which is the largest private company in Norway; Sappi, with $5.9 billion in overall company sales; Tembec, a $1.5 billion Canadian paper company; and Santeri, with $646 million in sales. It’s worthy of note that RYAM, in addition to having the dominant market position, is also the closest thing to a pure play on specialty cellulose—this is a key point when it comes to evaluating comps, since the high end is more defensible and offers more attractive margins and returns on capital than commodity viscose, fluff and other close relatives (let alone coated paper, which generates the majority of Sappi’s revenue, for example).
About 89% of RYAM’s 2013 sales (in dollars, as opposed to tonnage) were in specialty cellulose, versus 7% from absorbent materials and 4% from commodity viscose. Only 76% of the production capacity was devoted to specialty cellulose. RYAM has the number 1 global position in acetate; about 81% of RYAM's specialty cellulose production (61% of the company’s overall tonnage) is tied to cigarette filters. The remaining portion of specialty cellulose production was devoted to ethers (top 4 global position) and other cellulose specialties (top 2 global position).
RYAM’s customers have very specific needs, and they demand a very fine-tuned, customized production process (RYAM has significant R&D capabilities and produces 25 grades of specialty cellulose in varying degrees of purity). In grossly oversimplified terms, RYAM brings in raw wood (the primary cost input in specialty cellulose, at 26% of cost of sales, followed by chemicals at 17%; note that energy is only 6%), debarks and chips it, sends it through the digester house and bleach plant, dries it, packages and ships it according to the customer’s specifications. To the uninitiated, this sounds like a commodity business until you consider the degree of customization, refinement, and safety that each customer requires. One false step, and that cigarette filter imparts a very different flavor; a different false step, and that sausage casing or pharmaceutical material may cause harm to the end consumer. Consistency, precision, and production of a safe product are critical at the high end of the cellulose market. Accordingly, customers require a lengthy qualification process—a consideration that comes into play when we consider barriers to entry and switching costs.
The foregoing statements are more than generalities (“high switching costs” is a term that gets thrown around a lot…) —they are backed up by the average tenure of RYAM’s top 10 customers (38 years) and the fact that new entrants in specialty cellulose are few and far between. It’s not a huge market, the incumbents have already scaled the customer qualification wall, and the leaders have decades of process development behind them. When it comes to competitive advantages, in addition to scale and length of customer relationships, RYAM also pushes the idea that it is the only producer with the flexibility to use both hard- and softwoods, and the only producer to replicate its customers’ production processes onsite. Finally, although this advantage is not unique to RYAM, the high-end specialty cellulose players are able to downshift excess capacity to supply commodity viscose; the commodity viscose guys are unable to “upshift” to specialty cellulose. Note that specialty cellulose pricing is not tied to cotton pricing dynamics, as the commodity-grade business is; moreover, specialty cellulose pricing is also largely independent of commodity viscose pricing.
Companies in this segment typically develop deep supplier/ customer relationships. Contract structures reflect this: RYAM has long term deals with its major customers specifying purchase volumes over several years, and pricing is set once per year. Customer concentration is a risk for RYAM—the top 5 customers are 70% of sales--but exhibits to the form 10 show long term deals with Eastman Chemical (21% cellulose sales), Nantong Cellulose (19%), and Daicel Chemical (14%). Note the deal with major Chinese players; Nantong, for example, is a subsidiary of China National Tobacco, and RYAM has supplied them since 1994. I think this speaks to the strength of RYAM’s position—Nantong is better off shipping the product around the world than rolling the dice with more proximate suppliers. On a related point, I note that this is not solely a process/ experience driven advantage over potential entrants in developing countries; China, for example, is a net importer of timber, the chief raw material of specialty cellulose, and timber is expensive to haul…
Near Term Challenges… and Opportunities
It’s a capital-intensive business, and therein lies one of the most attractive features of this investment. RAYM is coming off a 3 year, $385 million investment to convert commodity production capacity in its Jessup, GA plant to specialty cellulose capacity. Note that this project was largely the direct outgrowth of its customer relationships; in other words, the plant conversion was not “built on spec,” as RYAM has multi-year purchase commitments in place from its major customers. The Jessup conversion project positions RYAM as the only pure-play specialty cellulose producer in the business, further increasing its production scale-- but it also adds 190,000 tons of supply to a market with 1.6 million tons of global demand. A Georgia Pacific/ Buckeye Technologies project added another 44,000 tons to supply, and a Santeri project added further to capacity. On the positive side, RYAM now has 675,000 tons of specialty cellulose capacity (vs. an estimated 1.9 million of total industry capacity)… but is left with a pricing lag while demand catches up. In response, RYAM is currently continuing some production of commodity products (11% of $ sales in 2013).
The pricing pressure from 2013’s added capacity was compounded by an industry-wide decline in demand from Europe (note the decline in RYAM’s sales mix year over year from European customers). Non-acetate end uses for specialty cellulose include tire yarn, paints, hoses, lacquers, and other industrial materials that suffered decrease in demand over the past year and a half. In response, those manufacturers with flexibility have focused their production firepower on segments of the cellulose market with more inelastic demand… in other words, to some of the end uses that RYAM targets.
The net result is unsurprising—RYAM and its competitors are fairly unanimous in predicting a 7% decrease in specialty cellulose pricing in 2014. Rather than pressure prices further, RYAM itself has chosen to channel some of its capacity into commodity viscose, opting to “feather in” (as the CEO puts it) the specialty cellulose supply over time. On its last earnings call, management dropped its sales expectations and lowered 2014 EBITDA guidance to 75% of 2013 levels (vs. 85% of 2013 levels as projected in June of this year). The stock market responded with a c. 25% price decline from mid-July’s $43 and change (the stock is at $33 as I write this). I would imagine that the audience (all 2 of you?) for this write-up needs no reminder of spinoff dynamics/ incentives, which are also in play.
Valuation and Potential Upside
As I mentioned earlier, this is a capital intensive business. One of the most appealing aspects of the investment is that the growth capex is in the rear view mirror; as I mentioned above, the company sank $385 million into additional capacity while under pre-spin parent RYN’s umbrella.
I value the company based on (EBITDA-capex). The company estimates $75 to $80 million of capex this year, in contrast to the triple digit expenditures of the recent past. Looking at 2014, which has its challenges as I’ve explained, the company’s projection is $265 million (75% of 2013 segment EBITDA, minus $25 million additional expenses). So 2014 (EBITDA – capex) is projected at ~ $185 million. At today’s market cap of ~$1.4 billion and EV of ~$2.3 billion, I view that as a very attractive proposition for a company with recession-resistant characteristics, high returns on capital, high margins and a leading market position, that has just completed a major capital spend.
The company is levered, with about $950 million of debt at reasonable rates ($550 million fixed). Principal payments range from $8MM to $11MM per year through 2018, and the company had $224 million of available credit at 6/28/14. While we’re talking about capitalization, the incentive stock plan created at the time of the spin is 4.5 million shares, or about 11% of the share count. Incidentally, the BOD declared a dividend of 7 cents recently, which equates to less than 1% yield.
As far as the upside is concerned, here are the major opportunities. First, while RYAM now has the capacity to produce 100% specialty cellulose, according to management 2014 production will wind up with a 75%/ 25% split (by tonnage) between specialty and commodity grades (again, RYAM can downshift to commodity production as needed). So the first opportunity is to improve margins by shifting capacity to 100% specialty as the market supports it, and as they obtain 100% customer qualification/ approval of the new Jessup capacity. The second opportunity, irrespective of a shift in product mix, is a simple recovery in specialty cellulose prices as demand catches up with supply. The third opportunity is to increase the company’s presence in ethers; specifically, the company wants to improve its top 4 position by targeting areas of high growth and less elastic demand—namely food additives and pharma end uses. A portion of the 25% commodity capacity could go in that direction as it migrates to specialty cellulose, and a portion of the acetate production could also migrate. On the last earnings call, management said that targeted ether segments are growing in the high single digits (vs. acetate at 1 – 2%).
Putting it all together, an upside scenario allows the possibility of a $500MM EBITDA business over the medium term, once the company runs at full specialty cellulose capacity (2017? 2018?). For illustrative purposes, 2012 and 2013 segment EBITDA averaged about $400 million. Add to that the potential of the incremental Jessup capacity, which CEO Boynton has pegged at $125 to $150 million (at 2013 pricing). After subtracting maintenance capex and additional standalone corporate expenses ($25 million according to the company), and applying a reasonable multiple, I see a potential double from here as the dust settles from the additional capacity and the investment community begins to appreciate its prospects.
A relevant M&A comp is Georgia Pacific’s purchase of then-public Buckeye Technologies, announced in April of 2013. It’s an indirect comp, because only about $230 million of the company’s $812 million in sales were generated by “chemical cellulose.” The company was running at ~22% EBITDA margins, and (EBITDA – capex) was only $70 million due to investment in the aforementioned 44K ton capacity expansion. On a normalized basis (adjusting for elevated capex), I view the $1.5 billion purchase price at 11 to 12 times (EBITDA – capex)… for what I’d argue is an inferior business.
A couple of notes on the “people” front are also worth mentioning. First, I note that CEO Boynton, who served as RYN’s CEO since 2012 (long-time employee), went with the spin (for reference, he owned 106,000 shares at the time of the spin, and is required to hold 6X his salary) along with 5 other members of the BOD. Second, I would note that Abrams Capital Management filed a 13G earlier in August.