Buckeye Technologies - Undervalued Leader In Profitable Niche Market

| About: Buckeye Technologies (BKI-OLD)
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Buckeye Technologies (NYSE:BKI-OLD) is a leading producer of cellulose based specialized products. Its products are used for a wide range of products, including tire cord, high end stationery, currency, LCD TVs, food casings, diapers and cigarette filters. Despite the diversity of end uses of its products, Buckeye has an extremely focused business allowing it to focus its resources on strong investments and other ways to reduce costs. While the company is currently experiencing some softness in its markets, and is threatened by an industry shift towards Buckeye's more profitable business, management's discipline in managing capital and the stability of revenue streams should keep the company strong. The recent market weakness has caused the price of the stock to plunge, providing a strong valuation. Because of these factors, Buckeye Technologies currently represents a strong investment.

Specialized Cellulose Market

Within the cellulose market, Buckeye specifically operates in the "high alpha" or higher purity content portion of the market. Buckeye Technologies operates specifically in 2 segments within this market: specialized fibers and nonwovens. Specialized fibers represents over 90% of the company's operating income as nonwoven is more commoditized. Consequently, much of the following analysis will focus on specialized fibers, as this will drive the company's fortunes.

The market for specialized fibers is actually not commoditized. The process to make these fibers is quite technical and Buckeye creates products specifically to the specifications of Buckeye's customers. This creates a lot of trade secrets and relationships that cannot be duplicated. Additionally, the business is extremely energy intensive as its second largest capital project in recent history was for $49MM to install new steam turbines to solely save the company on energy $8MM in energy costs per year. The demanding production processes and the energy intensiveness require significant capital investment which creates barriers to entry.

Competitor Analysis

The number of competitors is small; its main public competitors are Rayonier (NYSE:RYN), Tembec (OTCPK:TMBCF), and Archer Midland Daniels (NYSE:ADM), and there are about 4 private companies in the industry. The major differentiator between Buckeye and its public competitors is Buckeye's focus. Buckeye exclusively operates the specialized cellulose markets, while Tembec operates in the lumber and pulp markets, Rayonier operates in the timber and real estate markets, and Archer Midland Daniels operates in everything from the fuel to the agricultural feed markets. The competitors' other segments are significantly less profitable and lower returning than its specialized cellulose line. This is illustrated by the following table displaying the operating margins, and the return on invested capital for the specialized cellulose market and the whole company for the 4 aforementioned companies, over the past 2 years.

Source: Company's 10K

ROICs and Operating Margins are significantly higher within the specialized cellulose market than for competitors' other lines of business, as seen by comparing the top 2 charts to the bottom 2. Buckeye provides the purest exposure to this relatively auspicious market. Even within the specialized fibers market, Buckeye has produced its product at the second highest operating margin each of the past 2 years and at the second highest ROIC on average over the past 2 years. Gross margin would have been slightly more illustrative of production efficiency, but this data was not broken out for competitors. Rayonier does appear to have a very strong business in this area; however, these margins are not totally representative of the efficiency of production. More than a quarter of Buckeye's sales is related to its nonwoven business, which has miniscule margins, while slightly under 1/5 of Rayonier's sales come from a similar line. If you remove $239MM and $194MM (nonwoven sales) from sales of Buckeye's and Rayonier's sales respectively, the difference in operating margins narrows.

Another major point about competitors is that many of them are expected to increase capacity in the specialty cellulose market. In its most recent 10K, Rayonier announced that it would focus its capital expenditures on its performance fiber segment, and is converting much of its fluff pulp line to the specialty area. Tembec is installing a new turbine at the specialty cellulose plant in France so that it can increase production efficiently. Sateri, a private producer in the area, expanded its Brazil facility in 2010. In some respects, this reflects well upon Buckeye because it indicates strong future prospects for the industry. At the same time, it appears more negative because supply may be increasing rapidly. The fact that Buckeye Technologies sells much of its product in America, and smaller sums in Europe and Asia, while Rayonier sells much of its product in Europe and Asia and Tembec primarily sells internationally (no sales offices in America), may insulate Buckeye from this supply expansion, as each has a unique market. However, this is arguably the biggest risk to the company.

It is worth noting the relative growth rates of the companies in the area, to provide context for valuations forthcoming. Buckeye has increased sales of its specialty cellulose sales by about 3.6% CAGR, and operating income by 16.4% CAGR over the past 5 years, which includes the recession. Rayonier on the other hand has only increased sales in this area by 1.9% and EBITDA, a close proxy for operating income, by 14.1% over that same time period. Additionally, Tembec's revenue and operating income has dropped 3 out of the past 4 years. Archer Daniels Midland's revenue has grown about 30%, but its operating income has fallen 30% over that same time period. Additionally, over the past 10 years, Archer Daniels Midland has had 2 periods greater than 1 year of negative FCF ttm and 3 shorter periods; Rayonier has had 1 of these extended periods of negative FCF ttm and 2 shorter periods; Tembec has been FCF negative 2 out of the past 4 years. On the other hand, over this period, Buckeye has had a negative FCF ttm for just 2 quarters. These statistics illustrate the skill of management and the strong economics of its market. Thus management's declaration to expect 3%-4% market growth, especially knowing that Buckeye has grown sales at 3.94% since 2004, is reasonable.

Future Drivers

This 3% to 4% top line growth will likely be coupled with margin expansion, which will create significant profits for the company. Since 2004, the company has relatively consistently grown its gross margin from 11.79% to over 25% the most recent quarter, and its operating margin on specialty fibers from 6.11% to 24.09%. There is evidence that the company will be able to continue expanding margin on the gross and operating level. One of the major advantages of the company is that its Foley factory, which produces 465,000 tons out of the company's capacity of 573,000 tons, is surrounded by slash pine timber forests, which are a key input into Buckeye's products. The transportation costs for these supplies are minimal compared to those experienced by competitors. Thus as overall price levels rise, Buckeye's gross margin will continue to rise relative to competitors because its transportation costs are minimal. On a different note, the company has "raw material pricing and availability issues at our Memphis specialty fiber plant" according to Buckeye's most recent 10-K. It does not see this ending soon; however, this is an asymmetrical issue because the upside from an easing of supply issues is greater than the downside because the issue has already driven utilization at the plant to 55%.

Source: BKI 10K

Energy savings through capital expenditures should also help support gross margin. Since the production process is energy intensive, much of Buckeye's profits have resulted from energy saving. Buckeye recently completed a $49MM 3 year project that is expected to save the company at least $8MM a year and bring the plant's energy self sufficiency from 85% to 95%. However, $8MM is conservative because the company states this project will save it 200,000 barrels of oil per year which at today's prices is about $20MM, and the project will allow it to send energy back to the grid for profit. Given the company's track record, further beneficial projects are likely.

Finally, in 3Q 2013 the company is shifting 42,000 tons of fluff pulp to specialty fibers at the Foley plant, and this will increase gross margin. If the company had hypothetically made that switch for the 2012 assuming no decrease in the price of specialty pulp, the company's operating margin would have 25.72% compared to 18.73%, and sales would have been $998MM compared to $885MM. While prices may not rise as fast due to the increased supply from the company and competitors, this effort is likely to increase the company's margin in the future.

The main concept that will drive operating margin moving forward is capacity. As mentioned earlier, the Memphis plant is only operating at 55% capacity, which represents a significant amount of possible profits because it just produces specialty cellulose. The company just finished closing its Delta nonwoven factory which will increase the capacity of all nonwoven facilities moving forward, which combined are only operating at 75% capacity.

The company also has a few other notable strengths worth mentioning. The company sells its product to a huge variety of customers often giving it leverage over them in terms of pricing. Although the company has about half unionized labor, it has had good relations and experienced zero strikes. The company also has leverage over its suppliers as its key inputs are raw materials allowing it to only be contractually obligated to purchase $91MM in the coming year which compares to total costs of over $700MM last year. The company has a relatively small pension liability of $30MM, which will only cost it $3MM each of the next 2 years. The company's production also provides it with significant alternative fuel credits. For example, the company received a benefit of $77.7MM in 2010 and has $45MM in assets that will be used through 2016. More could accrue, but they are difficult to predict. Finally, the company is opening a bio refinery to explore the possibility of renewable fuels. This could be another source of revenue in the future, although not in the immediate future.

Risks And Weaknesses

There are a few weaknesses and risks of the company that are worth noting. It is worth reiterating that this company is not a major growth story, as top line growth beyond historical figures is highly unlikely. The increased supply in the markets could already be affecting the company, as this could be the cause of the recent softness in the wood and cotton markets the company experienced, which caused 1Q revenue to fall 15% yoy. Prices were lower but not substantially because the fall in performance was also affected by troubles in the European market and the steam drum failure at its Foley plant. The disappointing performance can be summarized by the following chart from the company's 1Q 2013 presentation.

Source: BKI IR

The company also is subject to significant environmental regulation because of the pollution inherent to production. According to Buckeye's recent 10-K, the company "expect(s) to incur additional capital expenditures related to our wastewater treatment and discharge of between $40 million and $60 million over at least five years, possibly beginning as early as fiscal year 2014." Thus while the company's discretionary capital expenditures such as the Foley plant turbine or the shift to more specialty fibers are quite profitable, the company must also spend a significant amount on other less profitable ventures.

The company may not receive the valuable tax credits for alternative fuel that it has in the past. This is accounted for in the forthcoming DCF. Also, the company has had some issues at the Foley plant with 4 incidents in the past 3 years. It has been able to recover some losses from insurance but these have sapped earnings and it is a troubling trend.

Financial Analysis And Valuation

The company has a very healthy balance sheet, reflects the guidance of management. In June 2009, the company had long-term debt of $327MM; since then the company has delivered significantly and has long-term debt that of $82MM. This has allowed the company to pay less interest, increasing earnings. It has allowed the Buckeye to almost double book value over that period. The company can only delever so much and the company will have to find alternative ways to spend its cash flow. This could come as increased dividends, share buybacks, which the company currently has authorization to buy 4MM or 10% of outstanding shares, or further investment projects. These could be catalysts for the stock.

The company's relative valuation is not particularly meaningful because its competitors have vastly different businesses. Its valuations can be seen below. The only meaningful relative valuation comes from the following article, which recommends an 8.5X EBITDA multiple for Rayonier's timber business. If one adjusts this by the average ratio of BKI's and RYN's operating margins and ROIC over the past two years, one gets an EBITDA multiple of 5.3, which represents a slight premium to its current price.



FCF Yield





Source: Google Finance

However, the other valuation metrics for the company are more telling. Its historical valuation based upon P/E can be seen below. The company is not trading at historically low levels; however its historically low valuations occurred during the recession with a P/E ratio of 2.8 and a FCF yield above 25%. However, the P/E ratio of the company is lower than any time in the past 5 quarters, and lower than any time before Sept 2007.

Source: ycharts.com

Absolute Valuation: DCF

To further illustrate the value of the company, a DCF was performed on this company. This company lends itself to a DCF because it is relatively mature with stable revenue streams, and the growth of its margins can be explained and predicted to some degree, which is illustrated by the high R2 values in the graphs of margins seen earlier.

First, a revenue model was made using qualitative ideas about the company and historical trends. Historical data on sales and operating income in specialty fibers, nonwovens and corporate were analyzed. The results of this data are summarized by the following table.

Source: BKI 10K

Given this data, revenue in the specialty fibers was grown at 4% per year, which matches company guidance, nonwoven's was grown at 1% per year, and corporate costs were grown at 4.27% per year. The first future period, or 2013 results, were assumed identical to 2012; in other words no growth. This was done to reflect the softness that currently exists in the market. However, to account for the energy savings from the Foley turbine, $8MM was added to the operating income of the specialty fibers segment. Corporate operating income was wildly inconsistent over the years of analysis. To account for this, the values were averaged over the time period, and this value was used in 2013. From there, its value was grown at the rate of "sales" in the corporate category. A major alteration had to be made to account for the shift of 42,000 tons of fluff pulp to specialty fibers. Capacity analysis was performed using data from the company's 10-K and a June presentation. The results can be found here.

Source: BKI 10K

In 2014, the specialty and nonwoven revenues were multiplied by the above figures in addition to growing at the prescribed rate. However, it would be non-conservative to assume that the increase in supply was not accompanied by somewhat lower prices. Consequently, the operating margin for specialty was multiplied by 5/6, and the operating margin for nonwovens was multiplied by 6/5. This factor was continued for all years into the future. From there on, revenue was grown at the expected rate. The operating income, or EBIT for the model, was found using the revenue as an input into a regression, in the graphs earlier, to predict operating revenue.

Other model inputs are summarized by the following table:

D&A growth rate, Working Captial Growth Rate, and CAPEX growth rate were found by examining results from 2004 to 2012. Changes in working capital did affect results but there was no pattern and in the aggregate they only had a slight positive affect so 0 was assumed to be conservative. Interest payments were assumed constant because it appears the company is trying to keep its debt levels low. The tax rate of the company has been wildly inconsistent as well because of the many credits as well; 30% was chosen because of the relatively consistent deductions it gets and assuming no other credits to be conservative. The 4.5X exit multiple was used to be conservative by assuming some degree of margin compression. The return on debt was found from the company's 10-K. So was the tax fuel credit, which was added back after taxes in equal chunks between 2013 and 2016. Finally, the beta used in the model was not the current beta of the company listed on major sites (2.48) because it does not accurately represent the "riskiness" of the company. To put this number in perspective, this figure would make the company apparently riskier than Tesla (NASDAQ:TSLA), which has to turn a profit and possesses a beta of 1.1, or a company like Under Armour (NYSE:UA), which has extremely rich valuations but only a beta of 1.6. The beta is a side effect of the companies rise from obscenely low valuation levels during the recession. As mentioned earlier, the company's revenues are stable. Additionally, the company's investment hurdle rate, estimated by the WACC, which uses beta as an input, should not be particularly high. The company often invests in energy saving projects with relatively consistent results as opposed to risky drug research or a new product line for example. To get a more accurate beta to estimate the WACC, the average unlevered betas of the industry was calculated and then this value was relevered using the companies D/E ratio. Work for this can be seen at the end.

Using these inputs, a share price of $35.80 was obtained, which represents a 36% premium from the share price of $26.34 as of 11/14/12. This model is generally conservative. The tax rate is higher than it has been on average, a margin compression was assumed in response to greater industry supply, growth rates were assumed below historical levels, no other tax credits were assumed other than those that management explicitly stated will be used, and the effect of increased supply from the fluff pulp to specialty cellulose pulp was accounted for, among other concepts. The only item that may be non-conservative is the growth of margins because there may be an upper limit and its prediction was extrapolation. However, some margin expansion is very likely. To try and remove any effect of inflated margins and to illustrate a bear case, the model was run assuming 0 revenue growth in all lines of business while corporate costs and CAPEX still increased, which is very conservative because the company would likely decrease CAPEX if revenue fell. In this case, the company has a share price of $23.65 compared to a current price of $23.76. This indicates that the market believes the only revenue growth for the company comes in the form of the company's conversion of fluff pulp to specialty fibers. Although increased competition may stunt prices, it is unlikely that prices will continually fall to match the consistently increased volume demanded.

Buckeye Technologies passes all the major tests of a strong investment. It is in a strong position in an industry with strong fundamentals. It has proven its strength against its competitors and ability to consistently improve efficiency, and signs indicate to a continuation of this trend. While the threat of lowered prices in the industry is troublesome, it is likely that Buckeye will still be able to profit. The company is undervalued on a relative, historical and absolute basis, indicating that the market is pricing in extreme pessimism of the stock. The current price of Buckeye Technologies represents a strong buy at this point.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BKI-OLD over 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.