Rayonier Advanced Materials: Challenged Spin-Off From The Start, Looks To Bottom Out

| About: Rayonier Advanced (RYAM)

Summary

Shares of Rayonier Advanced Materials have been a real laggard following its spin-off in the summer of 2014.

Investors and management believed that the business was very stable, but competition entered the market, pressuring earnings by a huge degree.

Price and volume declines have been painful amidst a leveraged balance sheet, requiring the company to tap the capital markets in the summer of 2016.

With leverage not being a great concern right now, I believe that current earnings power at a low point in the cycle reveals appeal, certainly in case of a recovery.

Rayonier Advanced Materials (RYAM) is a producer of cellulose products. The company has only been around in its current form since the summer of 2014 when it was spun off from its former parent Rayonier (RYN). The parent company was left with the real estate and forest resource components.

While the spin-off looked very good on paper, Rayonier Advanced Materials has proved to be a real nightmare for investors as prices and volumes kept falling. These adverse changes in the market place took investors and management by surprise, as they though that the business would be more resilient.

This line of thought was based on the high barriers of entry, yet these barriers were less high than anticipated as competitors entered the market. The good news is that management made the right moves in response to these changing conditions by cutting costs and reducing leverage.

These efforts and recapitalization have pretty much solved most of the leverage concerns. At the same time, earnings power remains relatively strong in relation to the current valuation. Despite the bad track record of management, and uncertainties for the 2017 outlook, I think that shares might be worth a gamble in the long run.

Market Likes Spin-Offs, Just Not This One

The outperformance of spin-offs has been well documented. Part of this relates to the fact that many shareholders in the parent company do not like to own a piece of an often smaller business and are often willing/forced sellers. Another reason for outperformance has to do with the fact that management, which previously headed just one of often many divisions, now become CEOs and have better incentive packages.

While these rules apply for Rayonier Advanced Materials as well, the performance so far has been disappointing to say the least. Shares fell from $40 around the time of the spin-off in 2014 to lows of $6 late in 2015. By now shares have recovered to levels around the $15 mark.

What Is Rayonier Advanced Materials?

Rayonier produces cellulose specialty products. The company produces acetate, ethers, specialty fibers and absorbent materials which are used in everyday life. This includes your phone's screen, make-up, shampoo, breakfast, shaving products, toothpaste, sponges, computer screens, paint, among many other applications.

Around the time of the spin-off, Rayonier presented itself as a very unique company. It stressed diversification in terms of end markets, long-term supply contracts and low-cost of production. While the company is classified as a pulp company, it focused mainly on the cellulose specialty market. This market is just 1.5 MMT a year, versus 50 MMT for the commodity like pulp market. Around the time of the spin-off, roughly 80% of sales were derived from the cellulose specialty market, but that percentage has fallen ever since.

At this moment, Rayonier operates two plants. Its Jesup plant in Georgia has capacity of 330,000 MT in cellulose specialties and 245,000 MT of commodity capacity. The Fernandina Beach plant in Florida has 155,000 MT cellulose specialties capacity.

Market Leader Facing Troubles

Back in 2014, Rayonier claimed to have roughly half or even more of all the CS capacity in the world. The modest commodity capacity was often used to switch production in case CS demand was up or down, acting as some sort of buffer to keep utilization rates high.

Rayonier claimed that it was very hard for competitors to enter the CS market, citing high capital spending requirements and large R&D efforts, among others. That statement did not prove to be accurate as (foreign) competitors have entered the market in part aided by a strong dollar. This additional capacity has severely impacted the supply/demand balance which existed in 2014 and in the years before that as claimed by management back at the time.

The 2015 annual report showed the financial statements for the past five years which revealed the stable performance of the business. Between 2010 and 2014, revenues fluctuated between $900 million and $1.1 billion, with operating profits ranging from $200 to $350 million. EBITDA numbers came in $50-$100 million.

The company produced on average 450-500k metric tons of CS each year with prices ranging at $1,700-$1,900 per metric ton. Those premium prices were however no longer sustainable following the spin-off as this separation coincided with additional capacity supplying the market.

Trends Were Difficult From The Start

In early 2015 Rayonier posted its 2014 results as shares had already fallen to $20 at the time. Adverse mix, price and costs effects resulted in adjusted EBITDA falling to $267 million for the year, translating into a 3.3 times leverage ratio. Rayonier's Advanced former parent company has saddled the company with $880 million in net debt at the time.

Worse the company guided for a difficult year of 2015, in which adjusted EBITDA was expected to fall to $200-$220 million, despite a plan to save $40 million in costs that year.

To improve the balance in the CS market, the company made a huge announcement in July of 2015. It reconfigured 190k tons of CS capacity into commodity production capacity, cutting its own CS capacity by 28%. The move effectively cut the global production by 10-15% as well.

The decision was very painful as Rayonier spent $385 million to built this manufacturing capacity in a project which was finalized as recent as October of 2013. Including reconfiguration costs, management effectively threw out +$400 million within a two year time period, being a very costly mistake.

By early 2016 shares had fallen to just $7 despite the fact that 2015 adjusted EBITDA came in at $237 million, comfortably ahead of the guidance laid out at the start of the year. With net debt being reduced towards $765 million, leverage ratios were stable at 3.2 times.

Despite the real challenges, Rayonier was able to post net profits of $55 million that year, equivalent to $1.30 per share, as adjusted earnings hit $1.74 per share. At $7 per share, the earnings multiples arguably looked very appealing, yet Rayonier faced even greater volume and price challenges into 2016.

2016 Revisited

While the company ended 2015 on a relative solid note, the guidance for 2016 was not comforting at all. Rayonier expected prices to fall 6-7% at the start of 2016, with volumes being down another 4-5% compared to an already difficult 2015.

Based on these challenging conditions, management expected 2016 adjusted EBITDA to fall to just $175-$190 million. Not only did that guidance imply that leverage ratios would increase to +4 times, investors should not expect any profits either.

To deal with the situation management embarked on additional cost saving plans, allowing shares to recover to $12 in August. Investors were furthermore comforted by the fact that the company hiked the midpoint of the adjusted EBITDA guidance towards $200 million. With net debt having fallen to $637 million at the end of the second quarter, leverage ratios fell to 3.2 times.

Despite the leverage improvements, the company decided to issue roughly $170 million in convertible preferred stock last summer. This expensive 8% preferred stock will create dilution in 2019, when it will be converted into 11 to 13 million common shares. The issuance reduced net debt towards $463 million at the end of Q3. As the company simultaneously hiked the adjusted EBITDA guidance to $220 million, leverage ratios were reduced to just 2.1 times. Even better, the vast majority of this debt is only due in 2024.

Net earnings are seen around $69 million this year but have been in part inflated through debt extinguishment gains. If not for these extraordinary gains, earnings are expected to come in around $62 million. Including the 12 million shares to be converted in 2019, earnings power comes at in $1.15 per share.

2017 Remains Challenging

While 2016 was challenging already in terms of pricing and volumes, the company has already indicated that acetate pricing is seen down by 2% in 2017. The company furthermore indicates that there will be continued excess production capacity, as the strong dollar has created advantages for foreign competitors.

This pricing pressure will undoubtedly hurt results, yet cost savings are expected to "contribute" an additional $25 million versus 2016 and another $25 million in 2018. If volumes can be held relatively constant, that implies that costs savings might be able to make up for lower prices, resulting in flattish adjusted EBITDA and profit numbers. There is a big if in that statement, being the assumption of flattish volume trends.

The current earnings power of $1 per share or more is relatively solid at a low point in the cycle. Remember that earnings came in as high at $200 million in the good years, allowing for earnings per share of $3-$4 per share if this can be achieved again.

The current earnings power, potential earnings power at a good point in the cycle and reduced leverage concerns provide some comfort for investors. This is the case, even if today's operating environment remains very challenged.

Of course management has blown a lot of credibility with the $400 million being destroyed with the expansion of the Jesup plant and the sequential conversion into commodity capacity. On the other hand, management has focused on deleveraging the balance sheet and cutting costs since the spin-off, although it did come at the expense of dilution with the issuance of convertible stock.

Leverage is now no longer a major problem and I must say that management has been conservative in its EBITDA guidance in recent years. The company even cited increased financial flexibility as an advantage going forwards as I believe that many investors would like to see a prudent course of financial management going forwards.

All in all I am balancing between current earnings power of +$1 at a low point at the cycle when leverage is manageable and spectacular upside of 2010-2014 conditions return. For now the 2017 outlook is highly uncertain, although pricing and volume risks can (in part) be offset by additional cost savings. If volumes were to drop a lot and EBITDA would start falling again, Rayonier should still be able to deal with this following the increased financial flexibility.

While an investment is certainly volatile and visibility is low, I like the combination of a low valuation, manageable debt load, $1 earnings per share power at a poor point in the cycle, and potential for blow-out earnings if the situation might improve. Weighing it all together I contemplate to initiate a modest position at these levels.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RYAM 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.

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