Newspapers, no matter how prestigious their brand is, whatever their business model or specific audience is, almost all are facing a secular decline in circulation and readership. From 1994 to 2004 more than 90 daily U.S. newspapers closed, circulation declined 8% and almost 5 million readers have been lost these last 10 years.
The only way to maintain readership and attract a share of the growing online advertising budgets is to, well, publish online on the paperless world wide web. Publishers also try to save as much money as possible on their newsprint paper costs. They are reducing number and size of pages and using lighter paper. The last 5 years daily newspaper consumption has fallen 1.5 million metric tons (1 metric ton = 2205 pounds) or about 15%. North American newsprint consumption for all uses declined 5% in 2005 alone.
The paper industry has been very disciplined in reducing capacity by closing unprofitable mills or converting newsprint machines to produce other paper grades. Since 2001 output capacity per year has been slashed by 3.5 million tons. At the end of 2005 total North American newsprint capacity reached 13.2 million metric tons.
The result is that newsprint paper prices increased from $475 per ton in 2002 to slightly above $670 in the past few weeks.
However, price increases did not compensate for the reduced volume sold and cost increases-- notably transport, energy prices and the strengthening of the Canadian Dollar. This last issue is not a small one since about 60% of Abitibi capacity is located in Canada.
The bottom line is that profit margins vanished and the newsprint industry which has been traditionally a low return/capital intensive industry is trading at a depressed valuation.
The stock is unloved for good reasons. It's been the worst performer on the main Toronto stock market index for the last 20 years, it has a leveraged balance sheet--though some assets are registered below their fair value. Such an investment can be classified in the "deep value" category. Therefore we urge readers to conduct further research and allocate only a small portion of their investments to this stock.
Despite all of the negatives listed above, Abitibi Consolidated, a Canadian company listed both on Toronto and New York stock exchange (ABY), is a good long term investment due to its low cost advantage and to inevitable industry restructuring that is starting to accelerate.
(figures: in Canadian Dollars "C$" or U.S. Dollars "$")
Montreal-based Abitibi Consolidated is the global leader in newsprint and commercial printing paper. They also have a wood products business integrated with their paper mills operations.
Main figures (source Yahoo!):
quote: $2.72 = C$ 3.17
Shares outstanding: 440 million
Market cap: $1.2 billion = C$ 1.4 billion
Revenue (TTM): $3.5 billion = C$ $4.08 billion
Enterprise value: $4.39 billion = C$ 5.13 billion
Enterprise value/EBITDA: 6.9
GAAP earnings per share: -$ 0.55 = -C$ 0.64
EBITDA (TTM): $643 million = C$ 751
The company is divided in to three main operations: newsprint (sold in North America and international markets), commercial printing paper and wood products.
(source: company presentation)
Paper used for newspapers, inserts, directories, guides, general commercial printing.
TTM volume: 3,581 tons
TTM sales: C$ 2,660 mil.
Despite secular decline for demand of this product in North America and a low single digit demand growth in the rest of the world, we think this is the most attractive part of the business. The company has a strong low cost advantage and should already have, or be close to having, all their newsprint mills in the best half of the cost curve as per their 2005 shareholder's letter.
Capital expenditures are limited and this sector enjoys a strong cash flow. We expect that consolidation of the industry and closing of competitors mills with higher costs will further improve already healthy cash flows. Part of these cash profits will also be used to convert some of the newsprint machines to produce the commercial printing paper grades that are enjoying better growth prospects.
Abitibi is also the largest newspapers and magazine recyclers in North America collecting about 1.9 million tons of waste paper per year .
2) Commercial printing papers
Paper used for telephone directories, catalogues, inserts, flying, tabloids, digests stand-alones, books, magazines, catalogs, financial printing...
TTM sales volume: 1,775 mil. tons
TTM sales: C$ 1,529
Commercial paper demand is enjoying a slightly better demand growth than newsprint. Overall the segment should see a yearly North American demand increase in the low single digits. It may seem poor compared to other industries but it is a wonderful environment in the battered paper industry. Don't forget that it has been in the doldrums for many years and that capacity has not been increased but barely switched from a paper grade to another.
Some grades like uncoated groundwood specialties are even enjoying growth rate in excess of 20% per year.
This is also the most capex hungry business. We expect that a great part of the yearly normalized C$ 180-200 million capex will be used to convert newsprint machines to commercial printing products.
Unfortunately all the Abitibi mills producing this kind of paper (and about 65% of newsprint capacity) are located in Canada. The 40% increase of Canadian Dollar in the last 5 years has badly hurt profit margins.
Canadian Dollar 5-yr. chart
To give an idea of the damage done by Canadian Dollar increase, the impact calculation is reported in the 2005 annual report. Management estimated that unfavorable currency moves (in fact the Canadian Dollar increase) weighted for C$ 265 million on EBITDA (about 20% of market cap or 6% of enterprise value).
The unfavorable forex impact is caused by the fact that the company records in U.S. dollars about 78% of its revenues but only 14% of its manufacturing costs. As a partial hedge, all of its long term debt is issued in U.S. dollars.
If the Canadian dollar would just reach the average 5 year price level, the positive impact would be huge. According to variance analysis posted by the company in their last 2005 10K filing we would expect an improvement on earnings per share of about C$ 0.80 (about $0.68 per share).
3) Wood products
Used for roofs, housing, remodelling, mobile homes, flooring
TTM sales volume: 1,925 million board feet
TTM sales: C$ 792 mil.
Though it is the main wood products producer in Eastern North America, the business represents a tiny share portion of the whole company. It is integrated with paper mills and has been suffering first from anti-dumping duties (most of them refunded in December), from a strong Canadian Dollar and from the U.S. housing slump.
In October the company shut down 20% of their timber capacity and closed four sawn mills, laying off 380 workers.
Current EBITDA contribution will be improved when the housing industry recovers but we don't think that, contrary to their newsprint business, it will have any special cost advantage.
(source: company SEC filings)
ABY is trading at a rock bottom 0.57 times GAAP book value.
A few remarks on our back of the envelope adjusted Net Assets Value calculation:
- In November the company received a $235 million as anti-dumping bill, charged by U.S. government in recent years. Such an amount is not reflected in the last available quarterly report dated September 30th.
- Hydro electric power generating assets: we believe these are under-rated, since it's a cheap alternative to oil which, despite the latest slump, is still trading at historically high prices. We have the means to make a comparative evaluation to understand what the market value of these assets is, but there is good news in this respect. Within this quarter, the company will spin off a minority interest of 47.5% of these hydro assets in an income fund to maintain control on one of the main low cost factors.
We will assume that hydro assets are of higher quality and offer a more stable and profitable stream of income than the average assets. Since full company is trading at 6.9 x EBITDA we will assign a very conservative 9 x EBITDA multiple assuming a similar equity/debt proportion. Is it scientific and accurate? Definitively not, but it's simple and conservative enough. The IPO pricing in the next couple of months will provide a quick double check on our evaluations.
- Timberland: market value of timberland is not easy to assess. Basically it depends if it is located near a profitable sawn mill or paper mill and to what extent overall costs to sawn logs and transport logs for industrial purposes is cheap or not. We would say however that the general rule here, like other real estate assets, is that they tend to increase in value over time but are recorded according to official GAAP accounting rules at cost less amortization. We will use a conservative assumption here: Adding back the amortization deduction mentioned in balance sheet (C$ 184 million) plus a totally arbitrary but conservative enough 10% on top of historic costs to recognize the long term appreciation of these assets (C$ 33 million). In total we will add C$ 217 million on top of GAAP timberland value.
- Pension underfunding: according to the last annual report covering the fiscal year ending in December 2005, pension defined plans were underfunded by C$ 700 million. Pension accounting is rather tricky and such under funding does not require an immediate cash funding by the company. But since we believe their estimated future assets yields and salaries increase are conservative enough we will detract these C$ 874 million from book value (special thanks to Ben McClure of the Investopedia.com website for his opinion on this item).
- Goodwill: to be very conservative we will erase all goodwill value assuming that all their previous assets or company acquisitions were concluded at prices that will not grant a positive return on investment. Note that the company is performing impairment tests on those assets each year and last time at the end of 2005 it evaluated that the value of those assets was intact.
- Property plan and equipment: according to the successful value investors at Third Avenue management who own 6% of outstanding shares: The low cost newsprinting plants are trading far below their replacement costs and their value to a properly funded private buyer would exceed their balance sheet value. To be conservative, due to gloomy prospect of the industry and lack of proper benchmarks, we will consider PP&E as a correct estimated value of all company mills.
Here is a sum up of our fair Net Asset Value estimate (all figures in millions except per share figures):
- Debt: after the hydro assets IPO, payment of U.S. softwood duties, purchase of the remaining minority interest in a paper mill located in August and simultaneous sale of 55.000 acres of timberland related to the mill, management expects to be free of long term debt (to be repaid in 2007 and 2008). These two years are a critical time to face what will presumably still be a gloomy period, and to have the time to be part of the coming industry consolidation.
Here is a rough idea of how the long term debt repayment schedule should look like at the end of first quarter 2007 (in million):
2009: $151 (about C$ 177)
2010: $399 (about C$ 399)
2011-2015: $1,211 (about C$ 1,424)
2018-2030: $ 991 (about C$ 1,165)
Company long term debt is rated B+ by Standard and Poors, deep in the junk area.
We will not mention net income in this write up for two reasons. First because in case of very leveraged company we prefer to focus on cold hard cash. Second because net profits, taking into account the heavy non cash assets amortization will prevent having a true sense of business cash generation potential.
Here is a free cash flow graph calculated by the company as EBITDA less interest expenses less capex (all figures about and excluding "special items"):
(source company documents)
We calculated our own "free cash flow" on a more conservative basis replacing "interest" by "financial expenses" which include, among others, premium and other elements related to early debt retirement. Since the company is highly leveraged and operating in a difficult market, early retirement of debt is not a discretionary use of funds but a quasi-obligation.
According to these figures we estimate that if there are no major changes in the industry and foreign exchange funds normalize, yearly free cash flow should be:
C$ 544: EBITDA
-C$ 240: financial expenses
-C$ 180: capex
=C$ 104: normalized free cash flow (should be used mainly for debt repayment and cash contribution to pension fund)
In case of either industry consolidation, a materially weaker Canadian Dollar or a smoother decline in newsprint demand, the effect on EBITDA would be material.
CEO John Weaver is at the helm since 1999. He is a 30 year veteran of the paper industry and first started as paper machine superintendent and then climbed all the stairs of the corporate scale up to the corner office.We like his strategy of cost cutting and improving free cash flow generation to repay long term debt.
Selling, general and administrative expenses are already the lowest in the industry at 3% of sales, along with a heavily unionized industry management that is not shy of closing or idling unprofitable mills, all serve to strengthen the company's low cost advantage.
Excessive stock options grants are not an issue here. There are only a few thousands of stock options outstanding at a strike price which is double the current quote. All the remaining options have strike prices which are several times higher than the present stock price.
The elephant in the room
George Staphos, the Bank of America analyst in charge of the paper and forest industry, a report at the end of November mentioning "the elephant in the room" phenomenon in the paper industry: Mounting mergers and acquisitions, private equity deals, spin off and other various resource conversion activities to rationalize the industry, reduce output, close unprofitable mills and bring out valuable assets.
This is in our opinion the strongest catalyst for a material share price increase.
"Canada's battered forestry sector is ripe for consolidation. With the competitive cost nature of our business, as it becomes more commodity pricing... we must find ways to consolidate the industry and even to consolidate on a local basis, say for instance, our sawn mills.
In the newsprint business, specifically, I think there continues to be room for consolidation, whether it's among small players or even perhaps with us and a small player." This Abitibi CEO opinion expressed last October is shared by many industry participants and by some smart investors.
Third Avenue Management, the famed value shop run by Marty Whitman, is also very optimistic on the prospects of the paper industry mainly via mergers and acquisitions. They also own 38% of an Abitibi competitor, Catalyst Paper, a C$ 1.8 billion sales Canadian paper producer.
Contrary to their passive investor behavior Third Avenue Management launched last fall a hostile tender to increase their Catalyst stock holdings, and obtained it to nominate four new directors. Three of them have extensive experience in mergers and acquisitions. Yesterday the CEO and CFO of the company resigned. A forthcoming merger or assets conversion seems in the card. We are not sure that Abitibi will be involved but it will be good news for the stock in any case.
Canadian billionaire Jimmy Patison (net worth estimated at C$ 4 billion), a major shareholder of Canfor, a C$ 3.8 billion sales Canadian forestry firm, is a strong believer in the need to consolidate Canadian timber companies. According a Globe Investor column dated November 2006. He started to aggressively increase his holding in Canfor this spring. The Canadian anti-trust authority has not been very cooperative on the consolidation issue so far but things are changing.
Last week Canada's Competition Bureau decided not to challenge the Domtar's merger with Weyerhaeuser Co.'s (WY) fine-paper businesses. Weyerhaeuser, the biggest North American forest products company, plans to spin off its fine-paper products businesses into a new, publicly traded company, which will then merge with Domtar, a $4 billion yearly sales Montreal-based paper, timber and packaging company, in a deal valued at $3.3 billion.
What to expect from an investment in Abitibi ?
The weakening Canadian dollar, falling energy prices and coming hydro power IPO recently propelled the stock higher. It already gained 20% from its end of November lows.
When industry consolidation accelerates we expect a further boost.
Like for every leveraged company risks and rewards are huge. If no dilutive equity deal is required to refinance debt, we see Abitibi market value at least doubling or tripling in the next 3-5 years. Even in the case of a moderately dilutive equity deal, we expect a low double digit return on the investment.
ABY 1-yr. chart
Disclosure: at the time of posting the author was long Abitibi.