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)