When I last wrote about Orchids Paper Products (NYSEMKT:TIS) in October, I expressed a lot of respect and admiration for this well-run paper products company, but thought the valuation was a bit steep. I'm not going to claim that I got that part right; the shares rose another 20% or so from where I wrote and it was only a sharp three-day drop in Orchids' stock that brought it back down again. I still do not believe that these shares are all that cheap, but it's hard not to like a company with a credible growth plan and a solid dividend.
Continuing To Outgrow A Fast-Growing Market
I don't have much to complain about when it comes to Orchids Paper's growth performance. When the company last reported (early February), revenue was up 28% as converted product sales rose 33%. Gross margin improved almost a point, and EBITDA rose 24%. Strip out costs tied to a CEO transition and the growth rate goes up above 30%.
Private label paper product sales continue to outgrow the market as customers look to save money and stores look to improve their own margins. Euromonitor has previously reported that private label toilet paper sales have outgrown the overall category by 3x since 2007, and Private Label Buyer magazine reported 10% growth in 2013. To outgrow a growing market is certainly a feather in Orchids' cap.
Why The Big Decline?
The elephant in the room with this stock is a three-day decline in mid-to-late March that saw the shares plunge almost 20%. Some have tried to pin this on an attention-seeking headline from a law firm fishing for clients on the basis of "potential breaches of fiduciary duty" tied to a new stock incentive plan that would allocate shares amounting to nearly 10% of the current shares outstanding when combining the 2014 Incentive Plan with a prior allocation of potential shares to new CEO Jeffrey Schoen.
I don't buy it. Those plans vest over time and are tied to fairly specific performance metrics that should also result in a higher stock price if/when they are achieved. Likewise, I don't think anybody takes press releases like these from law firms seriously anymore.
More importantly, this is a thinly-traded stock with an average daily volume of around 70,000 shares. If a large investor (an institution) wants or needs to sell in a large block in a hurry, they are going to get a lousy price.
Moving On Up
Orchids isn't close to challenging the share of Procter & Gamble (NYSE:PG), Kimberly-Clark (NYSE:KMB), or Georgia-Pacific, and that's not the model the company is pursuing. Orchids isn't trying to be the next Charmin or the next Bounty. Instead the company is pursuing a model at least a little more akin to Perrigo's (NASDAQ:PRGO). Perrigo specializes in private label OTC medical products (like allergy medications) and has roughly two-thirds share across that market, leveraging strong distribution and customization capabilities to be a partner of choice for many store chains.
Now, I'm not saying Orchids is going to get two-thirds of the store brand market for toilet paper and paper towels. But what I am saying is that there is a large potential runway of product offerings and business expansion here.
Orchids is underway with an expansion of its towel and tissue capacity and is continuing to move further up into the mid-tier/premium market. From barely no part of the business at all in 2010, these products are now close to 40% of the company's revenue. Remember, too, that this is a primarily regional operator that focuses on a 500-mile radius around Pryor, OK as its target market. As the company deepens its relationship with major customers like Dollar General (NYSE:DG), Family Dollar (NYSE:FDO), and Wal-Mart (NYSE:WMT), I can see that supporting decisions down the line to buy or build facilities to extend that target geographical market.
A Profitable Paper Company, But Still A Paper Company
My biggest issue with Orchids Paper's valuation is that it takes some fairly aggressive assumptions about just how profitable a paper company can be. Using a wide swath of comparables -- including paper products companies like Kimberly-Clark and Clearwater Paper (NYSE:CLW), as well as specialty companies like Glatfelter (NYSE:GLT) and Neenah (NYSE:NP) - very few paper companies ever post double-digit FCF margins, so Orchids is already in pretty exclusive company. I do also expect a certain amount of "yo-yo'ing" in the numbers as particular projects like the towel/tissue capacity expansion can have a big near-term impact on cash flows and a more gradual impact on costs that capacity goes into use.
If I assume 7% long-term revenue growth and a long-term FCF margin of 14%, that leads to a 14% free cash flow growth rate. My required rate of return (discount rate) here is more than 10% as although the company has a good recent ROIC record, it's a relatively short one and the stock is quite illiquid. All of that results in a fair value in the high $20s.
The Bottom Line
Using an EV/EBITDA approach leads to a somewhat higher target, as an 8x multiple on 2014 EBITDA leads to a $30 target. While the three-year expected EBITDA growth rate is in the high teens (arguing for a higher multiple), it's just not very often that you see a company in this kind of business get that sort of multiple.
Some readers aren't going to care about what's normal for a paper company, arguing instead that "growth is growth" and that Orchids Paper Products has a lot of that right now. It's certainly true that you don't find all that many companies with strong EBITDA growth, a 4%-plus dividend, and substantial opportunities for long-term growth/expansion. I still lean bullish on this name, though it does take some extra effort to get comfortable with the valuation.
Disclosure: I 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.