Verso Paper Corp. (VRS) has been to hell and back. It’s really not an exaggeration. From the fateful day in May of 2008 where the IPO priced at $12.00 per share, to the ultimate low of 32 cents on March 6th, investors have seen nothing but red ink. ZachStocks issued a short recommendation on the stock in June of 2008 when the stock was just a bit over $8, and recommended covering the short on March 25 with the stock at $0.71 and for aggressive traders we suggested putting some capital to work on the long side. Now that the stock is above $2.00, the recommendation appears quite timely (although we had to wait a month or so for the stock to turn higher).
Today, Verso’s movement points to renewed institutional interest in the stock as the dynamics are quickly improving. There are two primary forces behind the recovery - one of which is very large in magnitude, but most likely a temporary fix. The second has much longer-term potential and could eventually carry this stock back to it’s IPO level or higher.
Stimulus Measures Benefit Paper Producers
Part of the Obama administration’s stimulus programs have been geared towards encouraging the use of alternative fuels for energy. Cutting our dependence on fossil fuels and relying more on renewable sources could decrease our dependence on foreign oil, and also lead to lower carbon emissions.
The paper industry has actually been able to collect millions in tax credits due to these stimulus programs as many factories burn what is known as “black liquor” and is a byproduct of the pulping process. Currently, Verso is receiving upwards of $50 million per quarter in tax credits which flow directly to the company’s cash balance. Considering the fact that there are only 52 million shares outstanding, this tax credit is a huge boost to a stock that until recently was valued at less than $2.00.
Unfortunately, these tax credits seem to be overlooked by most investors because although they funnel directly into GAAP earnings per share, the temporary nature of the stimulus program causes the cash flow to be excluded from “normalized” earnings figures. This is one of the rare instances where GAAP earnings are actually much more attractive than the more visible earnings from ongoing operations. The tax credit is only expected to extend until December so while there is still more incentive to come, the company will have to eventually work back into a profitable business model if it is to see the share price increase… And that’s exactly what VRS is expected to do.
Industry Inventory Levels Hit Rock Bottom
It’s no secret that we are in an extremely difficult economic period. During times like this, companies are looking for every opportunity possible to cut back on costs. Spending on advertising and marketing have taken a huge hit not only because of budget restraints, but also due to some of the biggest producers of ad papers (ever hear of GM?) going out of business.
As advertisers have quit spending, the printing business has suffered. In order to survive the downturn (and as a result of the rate of business slowing) printers have cut back on their inventory of paper. But the inventory cut has been a slow process. Basically, most printers stopped buying paper altogether and instead worked through the stocks in warehouses until there was little to nothing left. You can see from the chart to the right that there is very little room left to cut as far as inventories are concerned.
With no paper orders from printers, the paper producers like Verso have had their hands tied. The list of mill closings continues to rise as lower demand has required many in the market to either close up shop or declare bankruptcy. But the silver lining in this cloud is that once much of the capacity has been removed from the market, any upturn in business will go to fewer players - meaning more business for Verso.
Now if you’ve been reading ZachStocks for very long, you know that I am no bull and don’t expect the broad market to continue its climb much longer. But at the same time, there are some exciting opportunities in names that have been adequately punished and are now facing much better prospects. Verso just recently issued a five page “key issues” report which listed an expanding number of print projects which could cause orders to pick up and bring normal business back into play. That list includes:
- A new Food Network magazine which has already been tested and is now primed to hit the broad market this fall.
- National Geographic has a special “your shot” issue with more than 100 reader generated photos - the issue should be a strong month considering user content sells more magazines.
- Wheaties and Mens Health are partnering up with a joint advertising program which should include a direct mailing..
There are probably another dozen data points but you get the picture. The print business is seizing the momentary increase in consumer and investor confidence and will have to order paper stocks because they are virtually out of inventory. The orders will come to the few remaining pulp participants and Verso is set to handle the resurgent business.
As we look forward to the remainder of 2009, we anticipate inventory levels, for both producers and customers, to continue to decline. Additionally, there are some positive signs on the horizon, as we see the United Postal Service offering some attractive program postal rates to improve their volume and, secondly, as we move into the traditionally stronger second half of the year the supply/demand situation should be more balanced. ~Mike Jackson, President and CEO
The Debt Issue - An Improving Situation
Verso (and the paper industry in general) has a reputation for being over leveraged. Excessive use of debt can bring even stable companies to their knees with just a small hiccup in operating trends. But the huge capital requirement for building paper mills has led to many industry players building a business on borrowed capital.
One of the biggest investor fears in the spring and early summer, was that Verso would have to find alternative financing after falling behind debt covenants. With liquidity basically non-existent, this would almost surely lead to bankruptcy as the company would not have any financing choices. However, the company has managed to renegotiate with creditors and now does not have any significant debt repayments due until 2014, and has gotten the debt covenants restructured to allow them to stay in compliance.
The stimulus dollars from the black liquor fuel are now being put to work to pay down debt which is both reducing interest expense as well as increasing the financial stability of the company.
“All Systems Go”
With many of their competitors out of the picture, a customer base that has worked through its inventory, and a more stable financial foundation, Verso is looking like an excellent turnaround candidate. Of course the stock has rebounded to several times the low seen in March. But the percentage move was only because the low was so close to zero, making the mathematical headline more pronounced.
Trading back up to the IPO price of $12 will not likely happen this decade. But improving metrics could certainly take us halfway to that point - and that’s nearly a 200% return from the current stock price. On Monday, UBS upgraded competitor Sappi Limited (SPP) after a strong earnings report last week.
Verso will report earnings on Thursday and the release could turn out to be another catalyst to move the stock higher. In particular analysts will be listening for any signs of recovery or new orders from printing companies as well as insights into regulatory changes for the tax credits. Stocks are often unpredictable and volatile the week of the earnings release so it may make sense to build a long-term position over time, but in case the stock gaps significantly higher on the earnings announcement, it makes sense to start buying at least part of your position before the announcement.
Disclosure: Author does not have a position in stocks mentioned