Rayonier Advanced Materials: 50% cheaper in one day, but look before you leap

Outside of biotech (where binary outcomes are a dime a dozen), it’s rare to see a stock fall 50% in a day, even on horrible earnings – which is why the obliteration of Rayonier Advanced Materials (RYAM) yesterday more than piqued my interest. RYAM has had a short but tortured stock-market history. The company was spun off from parent Rayonier (RYN) barely 15 months ago, and produces both cellulose specialties (70% of FY14 sales), a feedstock polymer derived from wood pulp that goes in everything from cigarette filters to food thickeners to LCD displays; and commodity viscose (30% of FY14 sales), a raw material that goes into viscose staple fibers used primarily in the textile industry. At the time, RYAM boasted ~37% EBITDA margins (FY13), a dominant market share in the value-added cellulose specialty product arena, and tight, long-term customer relationships with premium specialty chems names like Eastman and Celanese. The stock traded above $45/share as recently as June 2014.

Fast forward barely a year and oh, how the picture has changed. The cellulose specialty segment – supposedly resistant to declining prices and cheaper competition due to its value-added, premium nature – has seen pricing collapse, driven by the advent of new supply from Brazilian and Chinese competitors and weak demand (partially a function of increased anti-smoking regulation in China, a major market for the company’s cellulose product). Multi-year contracts with long-term customers have meant relatively little, as prices tend to be negotiated yearly and take account of the changing supply/demand mix. A key customer, Celanese (14% of sales in FY13), completely dropped the company in FY14 and could presage further customer losses (more on this later). As a result, EBITDA margins have cratered, falling from the aforementioned 37% in FY13, to 23% in 1H FY15. These problems have been compounded by FX (~50% of sales are outside North America, with high-20s % in China).

Management, meanwhile, has been on a value destruction mission all of their own. In late 2014, the company added ~$90mm in long-term environmental clean-up liabilities that the former parent, Rayonier, had mysteriously neglected to provision for pre-spinoff (particularly galling given RYAM’s CEO came from the parent). More shocking, though, was the mid-2015 admittal that the company had too much capacity in its premium segment (cellulose specialty) and would spend $25mm to repurpose ~25% of its capacity in this area towards the commodity viscose product. Repurposing capacity away from supposedly high-margin, premium products towards a lower-end offering would be bad enough, but it gets worse. Management had spent ~$385mm to upgrade the commodity viscose line to cellulose specialty production just a couple of years ago – meaning management had willfully spent ~$410mm (about $10/share) to get back to a lower-margin business mix, with lower overall capacity (and hence lower growth potential). Adding insult to injury was the structure of the spin-off, whereby Rayonier added ~$930mm of net debt via a special dividend out to the parent at the time of the spin – thereby leaving RYAM precariously levered even as the market environment weakened considerably. As of 2Q FY15, most all of this debt ($830mm net) remains outstanding.

All this covers up until two days ago, and explains why RYAM fell from ~$45/share to ~$14/share over the last year – at which point, the company filed an 8-K explaining they had just launched legal action against their largest customer, Eastman Chemical (31% of sales in FY14), for breach of contract. Apparently the dispute centers around the ‘meet or release’ provisions of the supply contract, under which Eastman has the right to source a third-party price-point for the product they would buy from RYAM, and then force RYAM to either match the price (assuming it is lower) or allow Eastman to source their product away from RYAM. The locus of the disagreement concerns the amount of material covered by this clause: Eastman claims they can use the ‘meet or release’ provision for ALL their purchases, while RYAM claims it is just ~2.5% of their total sales. Either way, this catalyzed yesterday’s 50% obliteration, and provided the latest example par excellence for the well-worn Murphy’s Law precept: “anything that can go wrong, will go wrong – at the worst possible moment.”

RYAM’s CEO – who I think we have demonstrated has been a horrible steward of the business – was surprisingly blase about the whole issue, and had this to say:

Pricing negotiations are always spirited debates around a number of factors and threatened or actual litigation is one tool that parties can employ. Although Rayonier Advanced Materials would have preferred to address any concerns or negotiations around pricing privately, Eastman’s August 4 action required us to take the necessary steps to protect our contractual arrangement…We remain committed to resolving our differences with our largest customer in a constructive manner and continuing our 85 year relationship, which has been mutually beneficial to both parties, for many years to come.

This sanguine assessment, however, belies the fact that all the outcomes for RYAM are beyond bleak. Prices are generally negotiated yearly, in November/December, for the year ahead; as such, the timing of this move is strange (early-August), and begs a deeper explanation than ‘spirited debates around a number of factors.’ As the CEO mentioned, Eastman has an 85-year history with RYAM, and (to my knowledge) has not sought the courts to allow exit from contractual provisions with RYAM before; why do so now and risk the whole relationship?

The obvious answer is either 1) pricing outside of the RYAM contract has absolutely collapsed, making RYAM’s offering wildly uneconomic; or 2) Eastman is being offered large new supply (at cheaper levels) that meets their quality specs, and no longer needs RYAM in the long-term; or alternatively some combination of the two. It appears, in my view, that RYAM is becoming, or rather has become, the high-cost producer in a rapidly-commoditizing market. Ouch.

There is further evidence this is happening. As mentioned earlier, RYAM lost the Celanese business last fiscal year, due to the aggressive growth in market share won by Brazilian competitor Bracell. The largest cost (outside transportation and overhead) in producing wood pulp is, clearly, wood, and Bracell not only is fully integrated (ie, owning their own forests), they also have developed a process to create cellulose polymers from eucalyptus trees instead of the hardwood trees that RYAM relies upon. Since eucalyptus in South America (where Bracell sources) costs ~35-40% less than hardwood in North America (even before considering integration benefits, and also the currency benefits of the weak BRL), it is no surprise that Bracell should be far further down the cost curve than RYAM, and with increasing commoditization, in a position to win more business from previously-unattainable clients. RYAM effectively admitted this with its recent announcement to move a good chunk of its specialty production towards commodity viscose, as discussed.

So, RYAM lost the Celanese business because it couldn’t compete on price and didn’t offer anything extraordinary on quality; and this also could be happening with Eastman, behind the scenes. But even if Eastman doesn’t win the right to price away from RYAM on its current contract (thereby protecting FY15 revenue and margins), given most all of RYAM’s key client business will be up for re-negotiation over the next two years (including Celanese affiliate, Nantong, which constituted 18% of FY14 sales and likely goes the way of Celanese, ie, out the door), it is hard to see anything other than intense margin pain as the best case outcome for RYAM going forward.

This is why yesterday’s 50% correction may actually be too little. While of course a favorable ruling in the Eastman dispute would help RYAM stock short-term, it is tough to see how FY16 earnings are anything but substantially lower than FY15, as clients either force RYAM to match on price or walk away (the market remains in a grim oversupply, as competitor Tembec’s recent earnings release describes). RYAM is guiding to ~$210mm in EBITDA this year on revenue of ~$930mm (23% margin), putting the stock, at $7.6, at an EV of $1.16bn, ($327mm market cap, $835mm net debt), or EV/EBITDA of 5.5x, with net leverage of 4x. In reality, the valuation is a good deal higher, once you adjust for pensions ($141mm underfunding) and environmental clean-up liabilities ($157mm) – both of which are effectively debt for a company like this (in my view, in a wind-up they would be treated at least pari-passu with unsecured debt and perhaps effectively senior). Fully adjusted, I get 7x EV/EBITDA on FY15 numbers. This is not that cheap.

And while the business will throw of solid FCF in 2H 2015 (~$60mm?) and looks very juicy on a a one year, P/FCF basis, looking out to FY16 should provide nothing but more pain on both lines. Even just a 10% and 5% decline in revenues and margins respectively would see EBITDA fall to $150mm and net leverage balloon to ~5x (excluding pensions, environmental liabilities) on relatively generous cash flow assumptions; while in reality I think margins could fall a lot more (and clearly this doesn’t contemplate the loss of Eastman or Nantong business next year). At year end FY16, even allowing for organic growth in the equity through FCF-led debt paydown, at current prices the stock is ~8.8x adjusted EV/EBITDA on my FY16 EBITDA estimate – not a low multiple for a commoditized business stuck in margin purgatory and high up the cost curve. Bracell, meanwhile, trades at just ~3.3x EV/EBITDA.

None of this is in the consensus numbers (even though a good portion of the revenue decline can be justified purely on the strength of the USD), I think because analysts don’t appreciate the significance of the Eastman legal move and what it means for RYAM’s pricing power going forward. I should also add: I am NOT short RYAM at the moment (given the violence of the break lower), though I will look to initiate a position if the stock rebounds somewhat closer to $10 and/or via deep downside puts, later in the year.

Disclosure: no position in RYAM, RYN or Bracell (but may go short RYAM/long Bracell in the medium-term)

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Everyone loves a comeback – but why?

“Everyone loves a comeback” – you’ve probably heard that phrase applied many times to down-on-their-luck movie stars or sportsmen trying to mount a career resurgence. But the public fascination with comebacks applies equally to the capital markets. In fact, turnaround stories are a necessary product of how the market works every day: the very nature of the capitalist system pushes the winners to expand and gain share, and the losers to shrink, regroup, and try again (as long as they’re still in business). While of course every situation is a bit different, in general turnarounds can be great opportunities for investors, as whenever a company is radically changing the composition of its business there is a higher degree of uncertainty as to what that company’s future will look like – and hence there can exist considerably divergent views on the future value of a given stock (which allows you to make $$ if you get it right).

Where I differ from most, I suppose, is that instead of looking at restructuring companies as an opportunity to buy businesses on the dip, I instead try to identify situations where the turnaround is either doomed to failure, or will take a lot longer (and be more painful) than the market is expecting. Perhaps I am pessimistic by nature, but I have noticed that investors in general – and the sell-side community in particular – perennially over-estimate the likelihood of a comeback business regaining its former glory. I am not sure if this speaks to the poor quality of sell-side analysts (perhaps), who tend to believe a given company’s managers when they promise a successful turnaround; or perhaps it is to do with the eternal optimism of human nature as it pertains to the stock market (since, of course, over the long-term economies grow and stocks invariably rise). But in any case, as these overly-optimistic expectations are disappointed, the companies’ stocks tend to underperform, and as a result you can make money betting against these nascent comebacks either not getting off the ground, or taking a whole lot longer to get going.

Perhaps a few examples will help demonstrate this idea in practice. One of my largest investments on the short side over the last year has been Elizabeth Arden (RDEN), a beauty company that over-expanded into celebrity/designer fragrances, under-invested in their core brand, and as a result announced in the third quarter last year a fairly intensive restructuring plan to try to clean up the mess. Despite fairly clear signposting from management that turning the business would be long and painful (accompanied by a number of disastrous quarterly reports), sell-side analysts as recently as April this year maintained the same level of expected profitability (ie, EBITDA) for 2016 as they had in September/October 2014 (ie, when the restructuring plan was announced). It was only in recent days – once again, after another horrid earnings report – that the numbers started to come down meaningfully (though I still feel they are too high). I am no longer short RDEN (the stock has fallen ~50% in the last year), but the sell-side’s misreading of the depth of the company’s trough in performance is instructive, and, I think, related to excessive optimism that the business could be resuscitated easily.

There are numerous other examples, many of them in the consumer space. Aeropostale (ARO), the teen retailer, and Quicksilver (ZQK), the surf/skate retailer, have seen EBITDA contract for the last four years in a row – yet looking at sell-side consensus numbers, analysts predict profitability will improve sequentially in each of the next three. This is effectively calling the current year’s earnings the trough – the only problem being that if you look back at historical estimates a year, or two years ago, sell-side consensus similarly called a bottom in the then-current year and of course extrapolated similar, multi-year improvement…only to be disappointed time and time again.

Now, I am not short ARO currently, but it has been trying to restructure its business in the face of seemingly endemic structural challenges (the decline of mall traffic, the rise of fast fashion, a collapse in teen demand for logo product, a move away from denim, etc), and has been closing some stores and restructuring others for years. The story is similar, though a bit more complex, at ZQK (where I am still short as I think it ends in bankruptcy rather soon). I suppose you could argue after years of losses these businesses are bound to turn, but in my experience, capitalism doesn’t generally work that way – both negative and positive trends take a lot of breaking (that is, the winners tend to keep winning: look at Facebook and Twitter for a current example par excellence). As mentioned above, the sell-side consensus was consistently wrong in calling the bottom in both names, even though to even mildly-informed observers the odds of a successful comeback in both appeared significantly lower than their continued deterioration at most all points over the last few years. Why, then, do analysts (and thus the investors subject to their opinions) continue to make life so difficult for themselves and try to call the trough?

The answer is mostly related to incentives and roles in the market. I don’t mean to jump on sell-side analysts too much, but in general their job is to pick stocks to buy, which by necessity involves the hazardous exercise of trying to pick bottoms in restructuring stories like RDEN, ARO, and ZQK. As per the above, this is almost an exercise in futility. To me, it is far easier – and more profitable – to identify which turnarounds are likely to continue ad infinitum or end in tears than to call an inflection point on a struggling or perhaps structurally-impaired business.

There is one main reason why this is the case: often, management will signpost – either implictly or explicitly – that a turnaround will take a while or be quite painful. The example of Sodastream (SODA), the Israeli purveyor of homemade soda, is a case in point. In response to plummeting sales of their home soda-makers in the US, they announced a large restructuring and rebranding of their entire product line – away from soda and towards flavored water – in mid-2014. Such a large transition obviously carried significant risks: the water market is more competitive, has lower price-points (in general), and the company risked alienating its core of home soda enthusiasts in Europe. Furthermore the company would be transitioning from an older production facility in a controversial location (the West Bank) to a newer, more costly one in Israel proper.

To be fair to management, the company was fairly realistic in depicting a many-quarter turnaround, and stopped giving annual guidance (always a sign that the future outlook is probably bleaker than you think). They did not over-promise and under-deliver; but it should have been quite obvious to even casual observers that this was a major company-wide brand relaunch – a complete product overhaul whose success was anything but guaranteed. And yet, the sell-side consensus as of Dec’14 (about 4 months after the restructuring was formally announced) still pegged 2015 earnings (EBITDA) at 2014 levels ($60mm) – basically the all-time earnings peak for the company, and DOUBLE reported FY13 earnings ($32mm).

Fast forward a few more quarters, and predictably, the transition is taking longer, and costing much more in lost profits, than the analysts (but not the company, to be fair) expected. The street now expects FY15 earnings to come in at $39mm (and that number is heading lower), and the stock has fallen another 25% since announcing the initial restructuring. And yet, once again, the inability to execute on the turnaround plan dulls not the belief in its viability (as perhaps it logically should) but merely pushes back to next year (FY16) the sanguine forecasts for recovery (consensus FY16 EBITDA is $51mm at the moment).

Now, I have no stake in the Sodastream story either way at the moment (though I have shorted it in the past) – but it clearly encapsulates Wall Street’s almost religious adherence to the doctrine of the successful comeback, no matter the circumstances. Whether a function of the street’s role as a corporate cheerleader, or the natural optimism of most all market players, this is an opportunity for those willing to weigh the case for a comeback not on the basis of “once it bottoms, how much could it bounce?” but instead, “will it actually bottom or is there more pain to come?” And while still difficult, in my experience the latter question is much more solvable – and more profitable – than the former.

Disclosure: short ZQK, no position in SODA, ARO, or RDEN

Quick update on Avolon (AVOL)

Avolon (AVOL), an Ireland-based aircraft lessor, has been one of my core positions on the long side for the last six months or so. You can read my original thesis and follow-up here (for those with Seeking Alpha Pro access); for those without, AVOL was basically an under-covered, cheap name in a secular growth sector (aircraft leasing) with temporary obscurity a function of recent IPO, private equity ownership overhang, and investor lethargy. Not only was it cheap but it possessed the newest fleet in the industry, had demonstrated an ability to profitably trade aircraft on the side, and had articulated an aggressive but realistic growth plan for the next couple years.

http://seekingalpha.com/article/2974306-avolon-growing-underfollowed-business-at-steep-discount-to-comps-40-percent-upside

http://seekingalpha.com/article/3152756-avolon-update-impressive-q1-execution-valuation-gap-vs-peers-will-continue-to-narrow

That’s the background; AVOL stock was at $20 about 6months ago, and had trundled along, doing pretty well but not spectacularly, rallying to ~$24 by July. However, the situation has gotten considerably more exciting in the last few weeks. Firstly a Chinese leasing company, Bohai, reached an agreement to buy 20% of AVOL at $26/share via tender offer (a premium to the then-stock price of ~$24).

This drew out other bidders, and AVOL announced today both that a) a third-party (strategic) buyer bid $30/share; and b) Bohai responded quickly to top that new offer by bidding $31/share for the whole company. AVOL remains in negotiations with both parties, and it clearly seems the company is ‘in play.’

Clearly a takeout is not something I expected in my original thesis, but we can file it under that joyous category of ‘good things happen to cheap stocks’. Even at $31/share, AVOL trades at ~10-11x my estimate for FY15 adjusted EPS, and ~9x FY16. The P/B metric looks a little high at ~1.5x vs sector comps, but adjusted for the embedded fleet value, its more like 1.2x (vs comps in the 1-1.15x range). Buyers appear quite willing to pay a premium for AVOL’s best-in-class fleet (in age and aircraft mix terms), attractively-priced order book, and track record of successful execution – aspects of the name that were originally discounted by the market, but I speculated could command a premium valuation. Size plays a factor too: AVOL remains one of the smaller names in the space, so an easier bite to swallow for foreign strategics than one of the much larger names like Air Lease (AER) or Aercap (AER).

While I would have been happy with $28 to exit a position I put on at $20, clearly in an acquisition scenario the multiples should be a bit higher and already some analysts think there could be a bit of a bidding war here. Clearly there are at least two motivated buyers, and AVOL’s initial reaction suggests they are willing to sell the company – just at the right price after an active negotiation. I view anti-trust/regulatory risk as minimal given AVOL is not a large player globally, is based in Ireland (historically a decent geography for inbound acquisitions) and is not systematic to any single country in any meaningful way. Financial risk on the bids would be something to consider once a formal bid/merger agreement is announced, however.

I would take profits on the trade in the $31-32 range, if we get there.