Xerium's Fair Value?

| About: Xerium Technologies, (XRM)

I wrote about Xerium Technologies (XRM) as a potential long back on December 5, 2012 when the stock was trading at about $3. Since then XRM released its Q4 results, which were largely in line with what I projected in my write up, but more importantly, management projected a very optimistic picture for the environment for XRM's various paper machinery products. Refer back to my original article for more about XRM's business and my projections as they related to XRM's 2012 performance.

In the past week, XRM stock has exploded, moving up from roughly the mid $5s to over $8 on incredibly high volume. This was due to XRM providing preliminary Q1 2013 figures of $140MM in sales and $29MM in Adjusted EBITDA. In Q1 2012, sales were $134MM so this is a nice jump in top line. Further, XRM under its previous and current CEOs has undertaken an impressive operational improvement program, which has greatly reduced operating costs and improved working capital management. What this means is that when sales bottom out and grow - and management indicated that was happening on the Q4 2012 call - the overall profitability could be tremendous.

The stock price action seems to be suggestive of this. In fact, in my original 2013 estimate I projected XRM would generate a bit over $100MM of EBITDA but that due to operational improvements would delever. As of XRM's latest release it is very possible that the company generates $120MM-$130MM of EBITDA based on current progress. What should also be noted is that XRM products could enter into other paper markets such as consumer/disposable paper products, thereby expanding its overall business opportunity.

XRM's stock performance is reflective of the upside available to financially and operationally lever businesses with improving fundamentals. Aside from any technical considerations with XRM's stock and its explosive move of late, I think XRM could very well be worth $20. At $8/share, XRM's enterprise value (EV) is $522MM and is valued at about 4.0x 2013 estimated EBITDA based on Q1 results. Keep in mind that XRM is a global company and this growth comes in the face of challenged European and Asian markets so the notion that its performance completely falls off could be unrealistic. In addition, XRM's topline for 2013 is just in line with Q1 2011; it's the fact that the topline at this level can be impressively leveraged into $29MM of EBITDA due to the company's operational improvements that's drawn attention.

I would argue that XRM's fundamental outlook, 20%+ EBITDA growth in 2013, and further de-risking of its balance sheet would warrant multiple expansion. Applying a 5.5x EV/EBITDA multiple to an estimated $125MM of EBITDA for 2013 gets to $19/share or about 140% above current prices. That's before accounting for any debt reduction, which will likely occur in 2013 and be accretive to equity values. A $20/share price is also only about 7.5x XRM's cyclical low 2012 EBITDA. Historically, cyclical companies would be valued at very high multiples as their operations bottom because the fixed costs of the business are a significant drag on profitability when the topline is weak. In XRM's case, its valuation multiples even when experiencing trough performance were reasonable.

My suggested valuation range for XRM is not very aggressive considering XRM's main peer, Albany International (NYSE:AIN) is valued at 7.3x EV/LTM EBITDA. In addition, as XRM's fundamentals improve and its balance sheet delevers, one could argue for multiple expansion, or for XRM's valuation gap from AIN to compress.

A $20/share price is also consistent with XRM's cash flow profile. The company's cash outflows for 2012 should be $30MM in cash interest expense ($33MM including non cash deferred financing costs), $30MM in CapEx or possibly lower as CapEx in 2012 was $25MM, and Pension expense of $10MM. Against $125MM of EBITDA, XRM's cash flow would be about $55MM. The one tricky part is what its cash tax basis would be given XRM has accrued NOLs across various countries so the ability to utilize those NOLs could be challenging or tricky. But let's assume XRM is a full cash tax payer. XRM's cash taxes in this scenario would be about $19MM, which would leave free cash flow at $36MM.

Most investors consider 10x free cash flow very cheap because you've accounted for every cash outflow. At this valuation, XRM would be valued at $25/share. I expect XRM's FCF to be higher than $36MM because that is under the assumption of the company not utilizing its NOLs, but even under my draconian cash tax assumption, XRM's FCF/share is $2+ for 2013, meaning the stock at $8 is valued at 4.0x FCF, not 4.0x GAAP earnings, 4.0x hard, tangible cash flow, or flat out extremely cheap. One could lower the FCF multiple to account for the cyclical aspect of XRM's business but then should also use a more realistic FCF figure which accounts for XRM's NOLs, thus providing a significant boost to FCF.

My projected share price estimate is also consistent with what XRM's reorganization partners likely had in mind when issuing warrants during the 2010 restructuring. Those warrants expire on May 25, 2014 and can be exercised at $19.55 per share. Technical considerations are warranted given XRM's recent run up but I think the stock has significantly more upside from here. XRM's pace of orders and results could also be a positive indicator for other paper related names such as Verso Paper (NYSE:VRS). Presumably if paper producers have been purchasing XRM products, it could be due to stability in paper production markets. This could portend paper price hikes due to stabilizing demand and/or better than anticipated operating performance.

Disclosure: I am long XRM, VRS. 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.

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