|Shares Out. (in M):||16||P/E||8||5|
|Market Cap (in $M):||80||P/FCF||5||4|
|Net Debt (in $M):||480||EBIT||56||61|
|TEV (in $M):||560||TEV/EBIT||10||9|
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Note - Xerium reports in two days, and it probably makes sense for a prospective investor to listen to the first quarter call to get a sense of whether things remain on track with prior guidance. I don’t have any special insight into near term operating trends.
Xerium has been written up in the past, and has a long history as a value-trap, however with substantial ups and downs along the way, including a very large move up after the company exited a 2010 chapter eleven restructuring. I think there is now another opportunity to participate in a substantial up move, following fourth quarter results and guidance which greatly disappointed holders. With the stock now down 75% from its 52 week high and down more than 50% since early January, I think the negative guidance is more than priced in, and if management can pace with its relatively unambitious guidance there is substantial upside. EV/EBITDA at 5.5x reduced guidance is on the low end of the stock’s historical range, and free cash flow yields are likely to average above 30% for the next few years.
Xerium is a manufacturer of clothing and rolls for paper manufacturers (more detail on this below). These are largely consumable products, requiring inter-year replacement, providing a relatively predictable revenue stream. These are also relatively high-touch, high-margin businesses, with gross margins in the low 40s and EBITDA margins in the low 20s.
Xerium is a company that has a stable customer segment, tissue and board producers, and a segment in secular decline, producers of graphical grade writing and newsprint paper. In many cases these are different factories run by the same companies, and both Xerium and those customers are reducing exposure to the weaker end market (graphical paper). The base case scenario is that growth in Xerium’s sales to stable segments, supported by a number of recent growth investments, roughly offsets ongoing structural declines from its declining customer segment. In two years, the free sheet customer segment should only represent about fifteen percent of company earnings, a level at which earnings could inflect and begin to grow. In the meantime the company should average roughly $20 million in free cash flow per year, reducing debt levels by 10% ahead of a large 2018 maturity, and representing a 25% free cash flow yield. By 2017, the company believes it will be generating $25 million of free cash flow, a 40% free cash flow yield.
Xerium’s leverage is elevated at 4.8x EBITDA, and the company has a large 2018 maturity, creating financing risk if it does not achieve its debt reduction goals. The company aims to move from a B credit to a BB credit over the next few years. As such, this is a relatively high risk idea, but with substantial upside. If the company can execute, on just deleveraging, assuming a stable EV/EBITDA at the current mid 5x EV/EBITDA multiple, the stock should double over the next three years. This is based on the company’s forecast of fifteen to thirty million annual free cash flow, implying $60 to $70 million of free cash flow applied to debt over the next three years, an amount only slightly below the current market cap.
In addition, as Xerium’s exposure shifts to better performing customer segments, there is potential for multiple expansion. This would be particularly the case as the company deleverages. I estimate graphical free sheet paper still represented twenty percent of Xerium’s EBITDA at year end 2015, but that number is falling quickly. Assuming a 15% annual decline in this part of Xerium’s business, by year end 2017 I estimate the free sheet paper will have fallen to a mid-teens percent of Xerium’s total EBITDA. The company has guided that those losses will be roughly offset by new sales from investments the company has made over the last three years. Several of these, including substantial production capacity in China to serve higher growth board and tissue customers, came on in late 2015.
Xerium has lost some credibility after a number of earnings downgrades, but its primary US competitor, Albany International, has reported similar trends and was slightly more optimistic in its outlook, with a customary disclaimer that in the event of global recession their guidance would be too high. This leads me to believe that Xerium’s current guidance is appropriately conservative. Here’s Albany:
“Our near and long term expectations for…Machine Clothing… we continue to view this business as capable of generating steady year-over-year adjusted EBITDA in the range of $180 million to $195 million per year depending on the currency environment…If currency stays at the Q3 and Q4 2015 levels, we are more likely to be in the upper half of that range. If currency reverts back to 2014 levels, we are more likely to be in the lower half…We are likely to see a slower start to this year than last year, partially because Q1, 2015 was so strong and partially because of this year’s economic headwinds. Nonetheless, for full year 2016 our margins and continuing productivity improvements should keep adjusted EBIDTA well within that $180 million to $195 million range unless of course there is a serious deterioration in the global economy.”
And Here’s Xerium:
“…our 2016 outlook. Adjusted EBITDA is expected to be $105 million to $115 million per year from 2016 to 2018, and our free cash flow is expected to be $15 million to $30 million per year from 2016 to 2018, depending on the currency environments and specific graphical grade market behaviors. Q4 2015 results were well below the trend line due to the magnitude and timing of graphical note closures and curtailments and the strength of the U.S. dollar… our outlook (includes) expectations that that decline will continue… We’ve made a conservative assumption here in our guidance, assuming a decline rate that would have these markets disappear pretty quickly. That’s conservative. It’s more conservative than some of the (other companies’) outlooks. Our exposure in machine clothing and graphical is much smaller than our other public peer” (referring to Albany International).
“this year, we’re going to get offsets from our new investments that we didn’t have last year, so that’s why we have an upper range to our guidance…hard to predict number here for us is the rate of the takeaway. We’ve got a hole in the bucket and it’s called graphical grade sales decline, and we misjudged that in ’15 and instead of a gradual decline in that, it was the worst ever decline, except for the ’08-’09 temporary down spike. So we’re just going to guide conservatively in this range, and Turkey will give us--it’s already given us good impact in this quarter, as is the Kunshan, China plant and these other projects. So already we see an improving quarter…we’re already free cash flow generative in this quarter as well.”
Despite a steady secular decline in uncoated free sheet, overall global paper volumes have been relative stable. Global paper and cardboard production by year has been:
Source: Statista, DSW Investment
If one assumes a 3% annual decline in free sheet paper embedded in those numbers, the remaining tissue and box grades are showing steady low single digit growth. The relative stability of the industry outside of printing paper gives me some confidence that with Xerium’s shifting product mix and increased focus on tissue and board it should be able to pay down debt and improve its financial position even in a slow global economy.
Xerium spent $140 million in cap ex over the last three years, more than half of which was oriented towards growth investments. Many of these have just come online, and their contribution will help offset legacy business declines. Among recent projects is a new clothing plant in China with state of the art designs for servicing tissue and containerboard production facilities. China is the fastest growing paper production region in the world, and the majority of Xerium’s recent investments have been there.
The company also recently opened a plant in Turkey to better service the European market, and expanded plants in Austria, Brazil, and Wisconsin.
$224,475 secured loan, maturing May 2019. Libor plus 5.25%, minimum 6.25%
$236,410 senior unsecured bonds, maturing June 2018. These bonds currently trade in the mid 80s (last quote 86.7, YTM 16.3%).
The company also has approximately $30 million of assorted smaller issuances, with maturities spread over the next four years.
Debt is relatively covenant light, and there are no likely default triggers before the June 2018 maturity.
To address the 2018 debt maturity of $236,410, one scenario is the company issues equity, particularly if the share price recovers somewhat. A ten million share issuance at $6 per share, combined with $40 million of free cash flow over the next two years, would reduce leverage to the low 3s, and would likely make refinancing terms substantially easier. Given the relatively high rate on the debt (8.75%), a ten million share issuance would reduce the free cash flow yield from 20% on the low end to roughly 15%, following the paydown of debt with issuance proceeds.
Xerium is run by a determined and charismatic CEO, Harold Bevis, who joined the company in 2011. The investment world was very positive on Mr. Bevis for the first few years of his tenure, however with recent setbacks, that sentiment appears to have disappeared. Bevis has aggressively invested in new capacity in growth markets. I tend to think he has made the right decisions, since the alternative was paying down debt but watching EBITDA simultaneously decline, given the company’s prior business mix. Bevis brought Xerium’s current executive team with him, so it is an increasingly experienced team.
Where I think management has fallen short is in recognizing the financial implications of its declining free sheet business, leading to far too optimistic financial forecasts. That failure led to overly optimistic guidance, a likely missed opportunity to sell the business, and alternatively a missed opportunity to issue shares and reduce leverage. Put another way, management’s optimistic forecasts led it to overvalue its business, resulting in some missed opportunities.
It is worth noting that XRM has some takeout appeal, either from one of the other public players in the clothing and rolls space, or from private equity. The company was approached last summer by American Securities, an asset manager owning 2.1 million shares, to acquire the remaining public shares. Terms were not disclosed and the transaction never moved forward.
Xerium also disclosed in an 8-K dated 4/1/16 that in the fourth quarter of 2014 it retained Bank of America to review strategic options. At the time the stock traded in the mid-teens, and management was optimistic about the potential for growth and deleveraging, which I suspect precluded a sale at a realistic price. I think management’s current view is much more muted and realistic, and think a deal could probably get done around $15 on the stock, which would represent a fairly undemanding mid 6’s EV/EBITDA multiple and more than a triple from today’s price. A sale to Albany International would make good strategic sense and likely be quite accretive for Albany, but might face regulatory hurdles. In addition, Albany appears more interested at this time in running its paper business for cash, while focusing investment on a separate aerospace business. There are a several international players who might also be interested in the company, especially if the company can demonstrate stable earnings trends.
Xerium manufacturers two products, primarily for paper producers, clothing and roll covers. The company is also fairy early in the introduction of non-paper related product, such as wood fiber based building products.
Paper machine clothing consists of continuous belts of engineered fabric, installed on paper machines, which carry paper stock through each stage of the production process (moved along by long circular rolls). Machine clothing types include forming fabrics (33% sales), drying fabrics (6% sales) and press felts (43% of sales). Press felts are designed to maximize water removal, reducing the amount water removal required later in the production process. The company is in the process of building a state of the art press felts facility in China for $40 million, with completion expected by the end of 2015.
Clothing replacement rates range from several times per year for press felts and forming fabrics to once a year for drying fabrics. Clothing is a small part of the total paper production cost, but it is critical to the quality of the end product. This quality component, relative to cost, tends to increase the ‘stickiness’ of customer relationships.
Xerium has roughly 15% market share in the clothing segment, about half of the largest clothing producer, Albany International. The segment has historically had less price competition than the paper and board industry, reflecting the finite number of players and relatively high barriers entry, including substantial annual R&D and accumulated intellectual property.
The roll covers segment replaces and refurbishes roll covers and spreader rolls. Rolls serve to move paper through paper-making machines. A typical paper-making machine can have up to 200 rolls, up to six feet in diameter and up to 39 feet in length. Roll covers are typically replaced every two to five years – during that period the covers are typically refurbished several times. Xerium provides both replacement and refurbishment. The company also offers maintenance and repair services for the internal mechanism of rolls. Refurbishment and maintenance represented 26% of 2013 roll sales. Xerium’s roll business, while cyclical, is less impacted by secular shifts within the paper industry, and should be a GDP rate grower over the long term.
Roll replacements and refurbishments are performed at Xerium’s plants. Service times are important, given most manufacturers only have one spare roll, and damage to the spare could lead to lost production time. As a result, plant locations are important, and Xerium has a fairly large global footprint to accommodate customers. The company is likely to add more locations in Asia over time, given the concentration of industry growth in that region.
Demonstration of EBITDA and Free Cash Flow Stability
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