Xerium Technologies (XRM) is a heavily levered micro-cap supplier of consumables used in paper manufacturing. Barely followed, it is hardly the kind of name that institutional investors find comfortable to own during difficult times, but with prospects improving for the paper industry that is improving the prospects of deleveraging and the stock trading around 6-7 times EV/trailing EBITDA, the name is worth watching.
As covered in my recent report on another major paper industry player - KapStone Paper & Packaging (NYSE:KS), the health of the paper industry has improved significantly over the past few quarters and the broader industry is in a much better shape to withstand any type of cyclical headwinds. Xerium is entering the seasonally strong period and the first phase of the capital-intensive repositioning program is mostly complete, the initial positive impact of which is visible in the sequential improvement in revenue and EBITDA growth, a trend that may gain pace over the coming months. The stock sentiment should get a boost as the improving free cash flow starts flowing down to the levered balance sheet, which is probably the biggest holdout for most investors right now.
Let the benefits flow from the repositioning program
The business model is pretty attractive, thanks to the recurring nature of revenues and market share that is largely concentrated among a few players. Please read my previous note for a detailed look at the background of the business.
The Roll Covers and Services segment, almost 60% of the total pie now and growing at 10-15%, has started to respond to the repositioning programs undertaken, which included stepping up efforts to introduce new products, plant upgrades, implementing a Lean Six Sigma program at all 30 plants globally to cut waste as well as improve lead times and field testing more than a dozen new products to push growth in targeted new areas, which is a major step 2-4 quarters before the introduction of a new product.
As the initiatives implemented gain traction, maintaining the current doubt-digit type of growth in the rolls segment should not be a tall order, especially given the recent introduction of new rolls cover product families and removal of all service limitations, be it related to the size or the type of services required.
Machine Clothing segment may be soft right now, with revenue declining by 6% during the previous quarter, but much of it is due to the product mix shifts underway and considering repositioning projects for the machine clothing products were started after the rolls cover products, the business should start to show some improvement by early next year.
Debt, a big overhang, but improvement in free cash flow offers a ray of hope
Anytime you have net debt close to 5 times adjusted EBITDA, the Long thesis largely boils down to the company's ability to deleverage the balance sheet, which will eventually flow down to more value for the shareholders and considering the improving EBITDA and free cash flows, the business does offers a lot to cheer.
Source: Xerium Tech.
After the sequential EBITDA and free cash flow improvement seen during the previous quarter, expected $110-130 million of adjusted EBITDA and free cash flow of $25-30 million looks easily achievable, if not conservative. In the meantime, much of the elevated spending on capital expenditure is behind, while full benefits from cost reduction programs and easing effects of product mix should help improve the profitability going forward.
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