Glatfelter Needs To Rejuvenate Volume Growth

| About: Glatfelter (GLT)

Summary

Glatfelter has been a long run of poor performance, as its traditional core markets erode and growth markets are too small to really change the trajectory.

Cash flow generation should improve as the company moves past a reinvestment cycle, and that cash flow could be used to acquire more growth in specialized markets.

A fair value in the low-to-mid $20s doesn't offer much upside today, and Glatfelter likely needs to show a turnaround in volume growth to sustain higher multiples.

It's been a while since I've written on Glatfelter (NYSE:GLT), but this specialty paper and engineered fiber product company has remained frustratingly underpowered on growth, with year-over-year revenue contraction reported in every quarter since the fourth quarter of 2014. Meanwhile, Finland's Ahlstrom has been on much better footing with respect to volume growth, revenue growth, and margin improvement.

Glatfelter isn't unfixable, but it is going to take time and I don't think the company has any obvious quick fixes. What's more, there's a surprising amount of volatility here - the shares' 19% drop on the day of its last earnings was arguably excessive, but the subsequent post-election rally likewise seems more than a little optimistic. I believe the underlying markets for many of Glatfelter's specialty products can support mid single-digit long-term revenue growth, but the specialty paper business is likely in long-term decline and there's still work to be done to improve the specialty businesses. With an okay valuation today, but not especially bright prospects for near-term volume growth, these shares look uninspiring after the rally.

The Third Quarter Wasn't That Bad

While Glatfelter's results for the third quarter and guidance weren't stellar, I wouldn't have said that they were bad enough to drive a 19% share price decline. By the same token, it's not a well-followed stock and the volume is not that large, and that can contribute to volatility.

Revenue fell 3% as reported in the quarter, the seventh straight quarter of year-over-year contraction, with a 2% decline in volume setting the tone. All three divisions saw revenue declines, with Specialty Papers (the largest) down 5% on a 3% volume decline. Revenue fell 2% in Composite Fibers, as volume ticked up 0.5% on double-digit growth in Tech Specialties and Composite Laminates, while Food/Beverage volume continued to decline (down 3%) on "inventory adjustments" at customers and wallcovering volumes were flat. Advanced Airlaid saw a 2% decline in revenue on a similar move in volume, as strong growth in wipes was offset by a decline in hygiene products.

Gross margin did improve almost a point, and adjusted operating income was up about 26%, supporting a 150 bps improvement in operating margin. Specialty Papers was the only segment to show growth (up 7%), but both Composite Fibers and Advanced Airlaid maintained segment margins above 10%.

Is Competition A Greater Cause For Worry?

Benchmarking Glatfelter can be challenging, as many of its competitors are either not publicly-traded or do not break out their results with the detail necessary for a true "like for like" comparison. To that end, I would note that management's report on its Specialty Paper business was that volume declines were consistent with the trends in the broader industry, and has been the case for the most part in recent quarters.

Looking at Composite Fibers, though, I'm a little more concerned. Ahlstrom has been reporting better results in its wallcovering business and has also been seeing growth in its beverage business (single-serve coffee). To some extent this was probably inevitable; Glatfelter previously enjoyed around 75% share in filters used in K-cups and it is difficult to maintain that sort of market share, particularly when it was established with market leaders that are now seeing their business challenged by newcomers. Purico, too, has been trying to make inroads here, but there's less incremental data by which to judge its success.

As far as Airlaid goes, the largest player (Georgia-Pacific) is privately held and not much use as a benchmark. I can say that Domtar (NYSE:UFS) has been doing better of late in its personal care segment, but Glatfelter is continuing to see good growth in its specialty wipes business.

What Can Management Do To Drive Better Results?

Given the weak run in reported performance, I think Glatfelter has work to do to convince investors that it has credibility as a GARP-type story. I don't see that coming from the Specialty Paper business, and management is looking for earnings in this segment to decline in 2017 on weaker pricing and mix. Strong market share in segments like envelopes, book paper, playing cards, and so on really isn't translating into any meaningful margin leverage (segment margins are sub-10%), and these really aren't growth categories. There will probably always be demand for carbonless paper, FDA-compliant paper food packaging and so on, but not enough to make this a real growth segment.

I believe this could also be true of the Advanced Airlaid business. Growing demand for personal care products in emerging markets can provide some volume growth potential, and Glatfelter is gaining share in specialty wipes, but the overall growth potential here does not look robust over the long term.

Composite Fibers can grow, but I still believe there's more work to do here. Ahlstrom has benefited from a skew towards more specialized products (including products used in auto/truck, apparel, power generation, water, medicine, and life science), and I would like to see Glatfelter acquire its way into more specialty businesses; segments like technical specialties and composite laminates are attractive, but they are less than 10% of the company's overall sales.

The wallcovering market should improve (or at least not get much worse), but this likely won't be a growth opportunity without healthier economies in markets like Ukraine and Russia. As far as food/beverage goes, the company's strong position in tea and coffee is nice to have, but no longer seems positioned to drive above-average growth.

The Opportunity

Glatfelter looks squeezed between larger contributors that aren't growing much (like Specialty Papers and segments of Composite Fibers and Airlaid) and faster-growing businesses that aren't large enough to make their growth contributions truly meaningful. What's more, with debt around 2x EBITDA, the company's flexibility to acquire more growth could be a little limited. Still, going to 3x leverage wouldn't be disastrous in my opinion, and the company could conceivably buy a meaningful amount of revenue (and/or businesses with better long-term growth prospects) with that extra debt.

I'd also note that Glatfelter is on the tail end of a capex reinvestment cycle that should stimulate more free cash flow production - free cash flow that can be used to pay down debt, fund dividends/buybacks, and/or fund acquisitions that drive more growth. My preference really would be the latter.

As is, I'm looking for long-term growth in the range of 3% to 4%, as I'm less confident in the Specialty Papers business than I was before; a strong recovery in wallcoverings could be a source of upside, as could a resumption of growth in the food/beverage business. I think margins will get better from here (in part due to the capex investments), and I believe mid-single-digit FCF margins will support annualized free cash flow growth in the mid-teens going forward.

The Bottom Line

Whether using discounted cash flow or EV/EBITDA, I arrive at fair values in the low-to-mid $20's, and that doesn't argue for Glatfelter as a must-own stock. That said, the demonstrated volatility does at least make this a watchlist candidate, as there could be another opportunity to buy shares on a post-earnings freakout. What's more, while I'm not impressed by the growth potential of much of Glatfelter's core business, that core can still generate free cash flow for years to come and the right reinvestment (into faster-growing, higher-margin specialty businesses) could upgrade the overall growth and value potential.

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.