What's Wrong With Resolute Forest Products

| About: Resolute Forest (RFP)

Summary

59% of Resolute’s sales mix involves selling products, specifically newsprint and mechanical papers, which are experiencing long-term decline in demand.

For years, management has indicated that it would like to diminish the importance of these products to the company.

It has done a poor job in trying to accomplish this objective.

Even though the stock looks undervalued right now, it may not rise significantly until they are successful in accomplishing this.

Resolute Forest Products (NYSE:RFP), which is most notable for being the largest newsprint manufacturer in the world, looks like it is significantly undervalued in the stock market. Based on a recent stock price of $5.89, 89.5 million shares outstanding, net debt of $571 million, and latest twelve-month adjusted EBITDA of $267 million, the stock looks significantly undervalued. Enterprise value to adjusted EBITDA is just 4.1, and there is even the realistic prospect for earnings to improve in the coming years. However, it's understandable why investors don't tend to like the company and its stock.

Resolute manufactures commodities, and it has very little control over selling prices. Nevertheless, it can control the businesses it's in, i.e. the products it makes, but the company has done a poor job thus far in diminishing the importance of products that are experiencing declining demand.

Unfortunately for Resolute, newsprint and mechanical papers make up about 59% of its sales mix, and both of these products are experiencing long-term and permanent decline in demand due to the growing use of digital media. The company has indicated that it would like to diminish the importance of these products, but it has not been successful in doing this in a meaningful way.

Since emerging from bankruptcy in December 2010, the company has tended to be years too late in shifting its product mix away from these products with declining demand. Furthermore, the initiatives it has taken to do so have been relatively small in scale.

A couple of years ago it started to shift towards more lumber production, but this was years after other large lumber producers, specifically West Fraser (OTCPK:WFTBF), Canfor (OTCPK:CFPZF), and Interfor (OTC:IFSPF), started acquiring sawmills in a big way. Furthermore, Resolute has only increased lumber production capacity in a relatively small way.

Now, more recently, it has started a relatively small scale move into tissue, but again it's probably years too late. Industry wide there has been and continues to be a significant increase in production capacity for tissue in recent years, and this is likely to make manufacturing tissue much less profitable in the coming years than in past. On top of that, Resolute's recent acquisition of tissue and tissue products manufacturer Atlas Paper is starting to look like a real blooper. It paid $159 million for the business last November, and it was supposed to generate annual EBITDA of about $23 million. However, since the acquisition, it has generated cumulative EBITDA of negative $2 million.

Also, an obvious way to move away from newsprint and mechanical papers is to divest or spin-off some or all of its exposure to these products. However, the optimal time to have done this is many years ago, when it became quite obvious that these products had entered a period of continual and permanent decline in demand.

I think Resolute is undervalued, but it's understandable why investors don't like the company and don't want to own the stock. The company has large exposure to products with declining demand, and it has done a poor job of reducing the importance of these products in its sales mix. Consequently, the stock has a hard time rising in a sustainable way, and significant price appreciation may not happen until it successfully transforms the company away from these products.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.