Xerium Technologies (NYSE:XRM) has completed a full business transition over the last years. The intensive CapEx for the Chinese machine clothing plant, the re-alignment with market trends, and improved operating efficiency have created a more stable company with a vastly superior growth outlook. The thorn in the side and pebble in the shoe has been an inefficient and risky capital structure. With approximately 5x net-debt-to-EBITDA, the company has been unavailable to most risk-conscious investors.
Xerium has entered the phase where FCF will be rapidly deployed to reduce debt, but the management team, with high inside ownership, seems intent on releasing value sooner. On the 19th of March, Xerium released a filing titled: “Xerium Technologies Announces Review of Strategic Alternatives to Maximize Shareholder Value” which includes below paragraph:
“[...] announced today that its Board of Directors has initiated a review of strategic alternatives to maximize shareholder value. Alternatives could include a sale of the Company or of its divisions and selected assets in separate transactions, a strategic merger, a Reverse Morris Trust transaction, or other business combination. The Company has engaged TN Capital Advisors LLC (“True North”) as financial advisor and Latham & Watkins LLP as legal advisor to assist in the process. [...]”
Xerium Technologies is a decent business with recurring demand, cyclical but growing end-markets, and a strong margin profile. The company produces $100 million in adj. EBITDA per year and has maintenance CapEx of approximately $15 million and expected taxes of ~$5 million.
Unfortunately, the company has $480 million of 2021 notes outstanding and ~$50 million in minor debt. The notes pay 9.5% and therefore result in a $45.6 million interest charge. The total interest charge for 2017 was $52 million. Furthermore, the debt implies existential risk and detracts materially from any equity valuation.
The risk from the debt has resulted in XRM trading at 6x EBITDA, but the business is stable and recurring enough to support an 8x EBITDA multiple. The competitive position is especially strong post-transformation and XRM inhibits a moderately attractive segment of the paper-production value chain. All-in-all, the business is at least moderately attractive and warrants a fair multiple.
A proper EV/EBITDA multiple would rely on debt being repaid year over year or a debt refinancing. Furthermore, there is strong existential risk in a potential recession as financing opportunities dissipate.
An acquirer would have none of the existential risk and refinance at much lower rates. Refinancing the $500 million at 5% would yield $48 million in FCF (post tax-considerations), or roughly a 50% yield on the current market cap. Refinancing $300 million at 5% would imply $56 million in FCF or an 18.6% ROE.
What Can Shareholders Expect?
The private-equity space has seen attractive EV multiples over the last 2 years, but a conservative estimate for a business the quality of Xerium would be an 8x EV/EBITDA multiple.
It is, however, unlikely that any acquirer would pay such a price given the negotiating leverage afforded due to the capital structure. If XRM was debt-free, a 9-10x EBITDA multiple could be expected given optimistic assumptions. Given current circumstances, a 7x EV/EBITDA multiple would not be out of the question. The adjusted EBITDA for 2017 was $100 million ($98 million including option expense). A 7x multiple would result in a $700 million enterprise valuation. Removing debt of $504 million, the equity stub is worth $196 million.
There are currently 16,367,743 shares outstanding at a price of $6.74 for a total market cap of $110 million. The theoretical estimate leaves upside of 78%. The 78% is not expected, but shows that an acquirer has plenty of room to offer a 30-50% premium to equity and profit adequately.
In summary, there are no reasons shareholders should not expect a 30-50% premium in an acquisition.
What If Nothing Happens?
If nothing happens, three scenarios can play out. Either the business does wonderfully and the macro is great (the bull case). The business can continue as expected with a reasonable macro-backdrop (the base case). XRM can also face a tumultuous, recession-like market environment for several years (the bear case).
We will not entertain the bull case.
The base case is that the company continues to produce $100 million in EBITDA, pays $50 million in interest, $15 million in CapEx, and $5 million in taxes. The balance is spent on debt extinguishment. It would be reasonable to assume LSD organic growth. The balance would be roughly $30 million. The company would extinguish ~$25 million in debt per year which would accrue to the equity stub. There would probably be growth in the equity valuation slightly above enterprise valuation predictions given the de-risking of the company. In short, the company stock would appreciate, ceteris paribus, $30 million per year.
The bear case is a recession that lasts for 3 years and makes Xerium unable to refinance. The company is forced to dilute equity holders heavily. That implies downside is at least 50%. The scenario is unlikely, but should be considered carefully.
When Will The Event Happen?
There is a slight indication in the Xerium 424b3 regarding the timing of a corporate event. In the bond prospectus at page 42, there are several important corporate limitations regarding debt extinguishment:
“The Notes will not be redeemable at Xerium’s option prior to August 15, 2018. Xerium is not, however, prohibited from acquiring the Notes by means other than a redemption, whether pursuant to a tender offer, open market purchase or otherwise, so long as the acquisition does not violate the terms of the Indenture.”
In short, the company can make open-market purchases of debt, but low liquidity and informed owners make said possibility potentially expensive. There are several paragraphs regarding pre-August bond redemption:
"At any time prior to August 15, 2018, Xerium may on any one or more occasions redeem up to 35% of the aggregate principal amount of Notes issued under the Indenture at a redemption price of 109.500% of the principal amount, plus accrued and unpaid interest to the redemption date [...] with the net cash proceeds of a sale of Capital Stock [...] of Xerium; provided that:
at least 65% of the aggregate principal amount of Notes originally issued under the Indenture (calculated after giving effect to the original issuance of any additional notes) (excluding Notes held by Xerium and its Subsidiaries) remains outstanding immediately after the occurrence of such redemption; and
(2) the redemption occurs within 90 days of the date of the closing of such sale of Equity Interests.”
In short, the company can sell stock and purchase up to 35% of the aggregate principal amount of notes with a material debt extinguishment fee. The importance is that the company could technically pursue dilutive corporate events and enhance value through other avenues. The 424B3 further states:
“At any time prior to August 15, 2018, Xerium may on any one or more occasions redeem all or a part of the Notes, upon not less than 30 nor more than 60 days’ notice to holders (with a copy to the trustee), at a redemption price equal to 100% of the principal amount of the Notes redeemed, plus the Applicable Premium as of, plus accrued and unpaid interest to the date of redemption, subject to the rights of holders of Notes on the relevant record date to receive interest on the relevant interest payment date.”
Xerium can therefore redeem all notes pre-August for “the applicable premium” in debt extinguishment. The “applicable premium” is outlined on page 71 of the prospectus:
The document states that the present value of the bond using a discount rate equal to the treasury rate + 50 bps. According to my rudimentary calculation, that implies an approximate premium of ~25%. In short, untenable. The debt extinguishment post-August is vastly superior:
The $480 million can be redeemed at a 4.75% premium ($502 million in aggregate). It seems likely that the corporate event will be structured to occur in late August given the bond circumstances.
In case of being acquired, an expected 30-50% premium can be obtained within 150 days for a three-digit CAGR. Given the economic rationale, motivated management team, and current market position, I believe that being acquired is extremely likely. Given my unfamiliarity with potential acquirers (mid-space private equity like the operators who acquired Meridian Waste assets, other industry players) and their current capacity, a margin of conservatism should be included. A 50% estimate of the acquisition happening is what I would personally model.
In a base case, the equity will be appreciate 30%, but with considerable risk. The base case is not as much a fixed probability as it is a "time-weighted" bomb. In essence, it is a 30% yield bond that could "randomly" default without recovery values. Over a 1-year period, I estimate that the risk of recession is no greater than 25%. The inverted yield curve and market price action might prove me wrong in my estimates. As a result, I place a 25% probability of a 30% one-year return occurring.
In a bear case, losses could result in bankruptcy. As previously outlined, I use a 25% conservative estimate for a recession.
Based on conservative estimates (in my opinion) and reinvestment rates (acquisition case), the expected value is between 10-20% above current prices with an inherent margin of safety in the conservative use of estimates.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XRM 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.