Verso is a leading North American producer of graphic paper used in magazines, trade journals, and catalogs, as well as specialty labeling and packaging papers. After entering bankruptcy in Jan 2016, Verso re-emerged shortly thereafter in July and since then has succeeded in de-levering the balance sheet. Concerns about further graphic paper declines have pressured the stock, although continued capacity reductions by Verso and other players have supported a stable pricing environment. At current levels, VRS is trading at 3.8x EBITDA and a 22% FCF yield.
Verso entered bankruptcy in 2016 following a merger with another paper producer, NewPage Holdings. After restructuring its debt and emerging from bankruptcy, paper market conditions improved following a number of capacity reductions.
Through bankruptcy, Verso reduced their debt from ~$2.9bn (~11x ND/EBITDA) to $380m (1.4x ND/EBITDA). Further debt reduction was driven by a combination of improving market conditions and pricing, as well as a large working capital tailwind as inventories and accounts payable normalized. With a cleaner balance sheet, Verso can direct FCF to returning capital to shareholders.
Temporary working capital headwinds of $75m pushed VRS into a slight net debt position in 1q19. The poor free cash flow conversion in the quarter led the stock to sell off, though the issues seem to be temporary. VRS generally has a seasonal inventory build in 1q ($25m) and also experienced a one-time inventory build along with the planned closure of their Luke Mill in Maryland ($50m). As Verso works through this temporary inventory build on top of their normal FCF generation, they should move back to a net cash position.
While the graphic paper market has been declining 5-7% per year, capacity reductions have allowed utilization rates to remain in the 90s, maintaining prices and margins. There have been multiple announced capacity reductions planned over the next two years, which should sustain current pricing levels.
Following a period of overcapacity in 2016-2017, paper prices in North America began to rebound as supply tightened materially in late 2017-2018. Utilization rates increased to the 90s, and are expected to remain at current levels as additional capacity comes out of the market in 2019 with the closure of Verso’s Luke Mill. Luke Mill represents ~25% of Verso’s graphic paper capacity (15% of total capacity), and 11-12% of the market for coated freesheet paper.
Capacity is also coming out of the European market, which is a major source of imports in North America. Based on our conversations with multiple European producers, we believe the capacity reductions in Europe will lead to a decrease in exports to North America as producers look to direct more of their sales to regional customers given the high shipping costs for paper.
While the majority of Verso’s business is facing declining demand, roughly a third of their business is geared towards “Specialty” product lines. These include water, oil, and grease resistant food packaging / beverage container labels, pressure sensitive labels, thermal printing paper, as well as containerboard. These categories are growing roughly in-line with GDP. Declines in graphic paper demand combined with conversions of existing machines have increased Verso’s specialty penetration from 20% of sales to 34% of sales over the past 2.5 years. Following the closure of Luke Mill, the mix of specialty paper should increase to 35-40% of sales.
While Verso has successfully converted some of their graphic paper capacity towards growing product lines in the specialty category, any further conversions would be expensive.
Many factors contribute to both the eligibility and the cost of a machine’s conversion, including the type of paper currently produced, the width of the machine, the type of pulp used, etc. Verso’s last major capacity conversion was an $18m investment to convert an idled machine at their Androscoggin Mill from graphic paper to 200k tons of linerboard production (at a cost of $90/ton). Any other conversions would likely be a multiple of that number, potentially costing well into the hundreds of millions per machine (peer conversions have ranged from $700-1,100/ton).
Verso’s former CEO, Christopher DiSantis, was a proponent of investing to convert Verso’s capacity from graphic paper to specialty paper. However, in April Disantis was removed as CEO and replaced with Leslie Lederer, the former Chairman of Catalyst Paper. Lederer was brought in as interim CEO of Catalyst in 2017 following their entry into bankruptcy in order to sell off the different pieces of the business.
While Lederer has yet to announce any strategic plans, we believe he is oriented towards harvesting cash from the business until a buyer can be found. Given Verso is unlikely to spend beyond the ~$45-50m of maintenance capex needed to sustain the business and the balance sheet is now clean, VRS has the ability to generate $135m of FCF following the Luke Mill closure, which can be returned to shareholders.
It is worth noting that Lederer’s employment agreement essentially states the purpose of his role is to sell the business. Under the terms of the agreement, Lederer was granted 67,720 RSUs, 5% of which vest on each of the 90th / 180th day following his employment, while the remaining 90% are only eligible to vest upon a change in control.
Based on our estimate of EBITDA following the Luke Mill closure, we believe Verso is worth $30/share, or 73% above current levels.
Our mid-case assumes both pricing and costs stay in-line with current levels, while volume decreases due to capacity reductions at Luke Mill. Our exit multiple of 5.5x values the Specialty Business at 6.5x EBITDA (a 1x discount to comparable transactions), and the graphic paper business at 5x EBITDA (a 1x discount to Nine Dragon’s acquisition of Catalyst’s Graphic Paper mills).
Our low case assumes a 15% further decline in graphic paper volumes on top of the Luke Mill closure, in addition to a 2% decline in specialty volumes, leading to an 8.5% decline in overall volumes. We assume a 7.5% decrease in pricing with some offset on Variable Costs / Ton, leading gross margins to decline from the current run-rate of 15-16% to 12%. We value the entire business at a 5x exit multiple.
Our upside case assumes the same fundamental drivers as our mid case, but assumes VRS trades for 6x EBITDA. In addition, we assume that that Verso repurchases $68m worth of stock, equal to 50% of run-rate FCF.
We do not attribute any value to VRS’s $305m of NOLs, and in our low and mid cases, we do not assume VRS repurchases any stock..
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Ongoing share repurchases at highly attractive prices, potentially followed by a sale of the business.