The DotCom bubble of 2000 and Financial Crisis of 2008 instilled me with a conservative mindset. However, I still craved excellent returns. I became increasingly fascinated with small cap corporations such as Verso. While looking at small cap corporations I found a problem, they were volatile. I quickly realized while P/E ratios are a great way to value a large cap it is terribly inconsistent for small cap companies. The smaller a company the more likely it is to be affected by small changes in demand. I needed a firm foundation and I delved deeply into the teachings of Benjamin Graham and early Warren Buffet. Graham taught me it is essential to have a margin of safety when investing in small cap companies.
I like Ben Grahams analogy that one should buy stocks the way you buy groceries not the way you buy perfume
Verso Corporation is a small cap North American producer of printing papers, specialty papers, and pulp. These are used to make various products such as magazines,brochures and tissue products, However it derives the majority of its revenue from its paper products.
The Paper industry is in a secular decline and has received a lot of pressure from international competitors spurring consolidation in North American corporations in order to compete. This consolidation, lean cost structure and increased short term demand has spurred a renaissance in the industry.
Verso is Undervalued
Although Verso has had a run of nearly 400% since June 2017, it is still below its P/B value! How did verso get to be so undervalued? Much of it may have to do with its debt consolidation after filing for bankruptcy in early 2016. It was even de-listed spurring a mass selloff. However, it was able to initiate a debt to equity swap which allowed it to decrease the debt that was squashing its returns. This instantly diluted shares but allowed for anyone purchasing the stock after the swap to be rewarded handsomely.
The debt equity swap was completed at the beginning of 2016 and Verso was again listed on the New York Stock exchange on July 20th 2016 at a price of $12.23. It was not all good news from there. Verso would drop below $4 before the trend reversal and quick increase to its current price of $14.47 as of this writing.
The drop below $4 is troubling and the downward volatility trend can be alarming. To instill confidence in this investment it is important to understand why the stock dropped to this level.
The sale of its subsidiary Verso Androscoggin Power LLC (VAP) caused a large influx of positive cash giving the company more liquidity moving into 2017. This created a false sense that Verso's worst days were behind it but it was not quite there yet. The industry conditions were unfavorable and Verso failed to meet targets for the next two quarters posting two negative quarters. This plunged the stock below 4 dollars per share. It was not until the announcement of the cost cutting strategy began that the stock began to show signs of resistance.
In March of 2017 Verso planned a move to Dayton Ohio in order to reduce administrative overhead. The cost of this move would be $2 million and partly contributed to its fall below $4 due to uncertainty and cost. However, Verso was able to receive a small loan of $500,000 from JobsOhio (not a typo its actually all one word) in order to support the move. Verso also received a tax incentive for the move described in the quote below.
The Ohio Tax Credit Authority voted in January on a six-year tax incentive worth $1.2 million for the company if it creates the jobs promised in the next three years. Verso will create $11.2 million in new payroll with 46 new full-time positions, and retain its existing 209 jobs and $18.5 million in payroll in the Dayton region. (Source)
Verso was not done yet it also planned to cut 55 million in overhead costs from it's mills. to achieve these cost savings Verso began machine conversion projects. This would help to reduce costs by creating less waste.
Material efficiency is part of sustainable development, and taking it into account is now more important than ever due to the growing scarcity of natural resources. Material efficiency covers the minimization of raw materials used in the production process, selection of the most economical raw materials possible, and the reduction and recycling of waste to minimize the amount of unutilized material. (Source)
Not only was the cost reduction strategy a success the industry conditions began to turn and allowed Verso to achieve a market cap of approximately $500 million today. With a P/B value of close to .7x it is undervalued. I believe that fair value is around $705 million. This is enough runway to make at least 50% in capital gains, not including future profit potential.
Profitable Quarter and favorable government conditions
The quick rise in the stock from $7 to north of $14 per share can mostly be attributed to its recent positive quarter. Verso has had its first profitable quarter in a very long time (I'm not counting its asset sale of a hydro electric plant back in winter of 2016). In September 2017 Verso posted an earnings per share of $2.15. While missing its guidance it was still a huge step into profitable territory sending the stock flying up 80% in just one month.
This has led to positive guidance from BWS financial indicating a strong buy and a price target of $20. With Verso sitting at a price of $14.49 as of this writing the stock is clearly a bargain. If Verso can keep up the positive earnings into the next quarter it has the potential to surpass its $20 price target. If Verso were to miss the damage would likely be limited due to its already low valuation and will have another shot the following quarter. There is definitely huge potential with limited downside.
While I believe Macro environment is much less important that company fundamentals it would be foolish to not admit the corporate tax cut moving into the new year had at least some impact on Verso. Small cap stocks in general have been rallying ever since the announced tax cut from the white house. This most likely will have a positive impact on all small caps moving into the new year.
Debt is being paid down
When looking at undervalued companies it is important to take debt into consideration. A company trading at below P/B needs to keep its costs tight and not burn cash. Debt levels should remain low or the company should have a clear plan outlined in order to service debt in the near future. Verso has done just that and is diligently focused on paying down its debt. It has a current ratio of 2.20 and a quick ratio of .80.
The current ratio formula is cash and cash equivalents divided by current debt. While the quick ratio is cash and accounts receivable divided by current liabilities. The quick ratio is a much more conservative view because it does not take inventory into consideration. While the quick ratio is slightly concerning Chris DiSantis, the CEO, is dedicated to reducing the current debt thereby increasing both ratios. He stated in the call transcript:
We’ve retired a substantial amount of debt. So, $60 million of term loan year-to-date has been retired through 10/31, and we are now in the best liquidity position that we have seen since our emergence. (Source)
At current levels Verso is in value territory, but if Verso continues to post profits every quarter it could easily surpass the $20.00 price target set by BWS and transition to growth stock. I recommend this stock as a buy and currently have a price target set for $24.00. I expect the profits from the next few quarters, Ohio tax incentive and the debt consolidation to push the P/B ratio up resulting in the higher price target. Of course there is no guarantee of continued profits so investors should continue to do their due diligence over the next few quarters.
Disclosure: I am/we are long 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.