Final Flush Is Coming For Orchids Paper Products

About: Orchids Paper Products Company (TIS), Includes: CLW, FHN, JPM, STI
by: ASB Capital

Losing money and customers while piling on debt, Orchids has been insolvent for most of the year.

Pressure on banks to foreclose will only build as interest rates move higher.

There is no fundamental reason for recent higher share prices. I think a wipe-out is coming.

Orchids Paper Products is insolvent, and the company's worthless stock has been bandied about for several months at prices from $2.00-$4.00/share. This charade should come to an end any day now, and I believe that Orchids stock will trade back towards zero in the very near future.

We covered Orchids in three previous articles over the summer, which showed how the company was losing money and what the dramatic actions of its lenders meant. Three months later, the company has used up all the time granted to it in a subsequent set of extensions expiring in September and October. Even though the stock price has moved as high as over $4.00 per share, the situation is as bad as it was back then. With Orchids' Third Quarter earnings coming up, we see no room for improvement and expect the coming 10Q to show the company remains insolvent with higher debt and accumulated losses.

1. Background

Orchids Paper Products makes store brand toilet paper for large customers such as Sam's Club and Dollar General. The company has been losing money for two years, and through that time it borrowed money to build a new facility that doesn't appear to have enough demand to support it. In April, the company disclosed that it had stopped making payments on its substantial indebtedness and was being forced to sell itself by its banks.

2. Second Quarter Earnings

Orchids' Quarterly Report for the Second Quarter filed on Thursday, August 9 was a disaster. Even though the company had disclosed for a year that it was unlikely to be able to repay its debt, this quarterly report was the first filing to mention a risk for foreclosure (p. 32), and also disclosed that a customer representing 23% of Orchids sales was leaving.

The company's operating results were terrible. Orchids reported $45,858,000 million dollars in sales, but a cost of sales of $45,263,000 for a gross profit of only $595,000 - for gross margins of only 1.3%! The company claims that start-up costs associated with the new facility were $789,0000. Even if we took that number at face-value (it hasn't been audited) and granted it back to them, that would result in a pro forma gross margin of $1,384,000. Pro forma for start-up costs, this gross margin of 3% would still be worse than the margins in the second quarter of 2017, when the company ran at 3.9% gross margin rate and still lost money. Whether the culprit was rising costs or inefficient processes or a lack of pricing power, even running a brand new facility, Orchids' margins are not sufficient.

Putting aside the fact that no manufacturing company could hope to cover its Selling, General and Administrative expense on margins this thin, Orchids interest expense for the same quarter was $4,530,000 - which is to say that (even after just granting Orchids that everything it calls a start-up cost was really only a start-up cost) they racked up three times as much in interest as they took in for gross margins.

Interest expense will be even higher for Orchids for the quarter ending September 30. At the end of the first quarter, Orchids owed $172 million in "Short-term notes payable." (Note that Orchids has had to classify its loans which were not supposed to come due until 2022 as "current obligations" for more than a year because they cannot meet debt covenant obligations.) At the end of the second quarter, indebtedness stood at $183 million. Note 7 to the Second Quarter report says that the company's weighted average interest rate was 9.85%. For the third quarter, Orchids will have started off owing a higher amount, and the company's variable interest rates will have increased by as much as one quarter of a percent. I estimate that lenders will have advanced at least $1 million per month to fund ongoing losses, making total debt (not counting uncollectable interest) at least $185 million at an interest rate of 10.1%; I estimate Orchids will have accrued at least $4.67 million in interest for the quarter.

"Accrued" is the right word to use here, because another thing the company reported is that they entered into another amendment to the credit agreement deferring interest and principal payments until October 31. This company is so broke that:

- in March they got taken down a peg from Quarterly to Monthly Payments, and

- in April they stopped paying back their loans altogether (see Amendment 8, Exhibit "A.")

- in August the lenders don't even expect them to try to make payments for three months at a time!

Now that all the cards had been dealt, it should be clear to all that Orchids is insolvent, and the equity is worthless. Then came the bizarre events of August 13.

3. Conference Call Day - August 13

The company's conference call of Monday, August 13 was disappointing and provided no basis on which to support the share price. First, a description of operating results was given by the company's CFO - their third CFO within two years. Then, the CEO started talking.

One striking thing that he discussed was the usefulness of the firm's QRT technology in the new Barnwell facility. The industry standard is called TAD. Equipment manufacturer Valmet has developed QRT in an attempt to create a low energy process that can produce a broad range of products, see this at QRT may or may not be a superior technology and may or may not produce toilet paper of equal quality to TAD, but the fact remains that $150 million was spent building a new facility with a process that appears yet to find customers. The fact that, to our knowledge, no other producer has built or replaced an existing facility in North America with QRT at a time of significant expansions suggests that other producers have found flaw in it, which would bring Orchids' decision-making into question by comparison.

The second big issue was talking about what he called the company's "transaction process." This is quite a gentle way of beating around the bush to describe the steps required of Orchids under the April Loan Amendment 8. As required by that amendment, after failing to make its April loan payment, Orchids' lenders forced the company to put itself up for sale immediately, hire a "Chief Strategic Officer" on one day's notice and receive offers in less than two months. This process was originally supposed to produce a signed letter of intent on June 30 and signed Purchase-and-Sale Agreement on July 31. As of the August 13 conference call date, the CEO claimed that "interested parties" were taking more time for due diligence. In light of the fact that Orchids and its lenders have been actively marketing these facilities since April, we believe that the "interested parties" language was designed to avoid claiming that a potential purchaser was involved. That is to say that even though their lenders made them to announce to the world that the company was being forced to sell itself in April, as of August they had no bids, and didn't think they'd see one until October. That's twice as long as the lenders gave them in the first place.

The conference call featured only question, and that was from an analyst at Craig Hallum. Craig Hallum is a firm that continues to list Orchids on its "Alpha Select List" to this day despite six months of bank defaults (see screen capture):

The analyst asked the CEO how the company thought its assets should be valued, and the answer he gave was to refer to the price-per-ton of two facilities sold in 2015. Three year old-comps are not appropriate in general and for a sense of scale as to how much can change in that time, just consider the fact that Orchids stock went for more than $20 share all of that year.

The fact of the matter is that the CEO's comps were ridiculous for a number of reasons. First, those sales were made for profitable assets, whereas Orchids current facilities lose money. Second, in the intervening three years, the cost structure in the industry has declined precipitously. In 2015, even Orchids had substantial profits. Third, as detailed in investor presentations by Orchids' competitor Clearwater Paper, 900,000 tons of capacity are due to have come online in this segment between 2016 and 2019 (page 47). Further attention to the chart shows that 900,000 is a *net* number and at least four facilities have been closed. I firmly believe that Orchids' Pryor plant (which makes up the bulk of its total tonnage) is the next one to be shut down. Overcapacity means that all participants make less, and the way you solve it is by shutting down the weakest competitor - not dividing the value of the market equally among all of them. All-in-all, I believe that the CEO's statements were so far off the mark as to be intentionally misleading.

4. And then what happened?

What happened next was a dramatic short squeeze that would have been more noteworthy if the stakes weren't so small. Though we wouldn't know this for another week, one fund bought 7% of all of the shares outstanding as Orchids stock price dipped below $1.00 per share. The investor filed a "13G" form one week later, which required him to certify that he had no plans for the company and was not involved in discussing strategy with management. That is to say, he confirmed that he was not an activist.

Now that this investor had taken up a number of shares that would have been more volume of stock than traded in a typical week, one can only presume that algorithms and day-traders sensed something was going on. Over the last almost three months, Orchids share price has levitated from under a dollar the Friday before the conference call to over $2.36 the day of the call and as high as over $4.00 on several occasions. The run-up in price was aided by a shockingly high cost to borrow the stock of over 200%.

That pressure seemed to abate through last week when shares fell under $1.50 and borrow costs approached 60% - high, but not unheard of.

Since that conference call, the company has only shared any news once. In the middle of September, they announced that the deadlines they missed to sell the company had been extended all the way until.... the end of September. And that extension expired over a month ago.

5. Next up - a winding, but certain path to "0"

It's been more than six months now since Orchids stopped paying back its debt, strategic control was taken over by the company's lenders, and they've held themselves out as insolvent and in need of a buyer. During that time, they've racked up more and more debt at higher interest rates. The old facility at Pryor, OK continues to depreciate. The new facility may or may not find customers, but low margins and excess capacity in an overbuilt sector make it appear unlikely to earn an economic return, and of the largest Orchids customers one has already walked away.

A number of people have suggested to me that there may be value at Orchids to a "strategic" buyer. It's entirely possible that someone will come in and buy the assets for "strategic" reasons (ie, for reasons that matter to someone already in the paper business rather than a financial speculator), but that still won't provide any value for the equity. Let's say you wanted to buy a house and you asked the owner what the price was. If he said, "I'll sell it to you for a dollar, but you have to pay my whole mortgage - which is in default," would you rather buy the house from him for a dollar subject to the entire mortgage, or ask the bank how much they would take in a short-sale or foreclosure? To assign value to the equity, you're insisting that the new buyer would take prefer to take the old mortgage.

So why would the lenders keep this up? It appears to me that the lenders (JP Morgan Chase (JPM) , SunTrust (STI) and First Tennessee (FHN)) prefer to support the business with millions of dollars in additional loan advances even though they know they won't get the entire amount back because the alternative for them is worse. That is to say that if they forced the business into foreclosure or bankruptcy today and stopped running the company, instead of an ongoing business with real, but unprofitable customers, they'd just have two piles of steel that used to be a business with customers, which will be EVEN LESS valuable than they are now. The lenders appear to be stuck funding a money-losing operation until they can get someone to take it off their hands.

"But maybe this will go on for a long time?" you ask. Over the last several years in a zero-interest rate environment, there was little or no cost to the bank "extend-and-pretend" non-performing loans. Today, that's not the case anymore. Extending and pretending a non-performing loan means the bank can't take its loan assets back and make a new, performing loan. This opportunity cost gets higher and higher as interest rates rise. In effect, the lenders are paying their depositors to borrow money so they can turn around and loan money to Orchids, but not making any money on the loan itself. Moreover, the fact that they are not collecting interest and they have to make new advances (ie, loan even more money) make this a major problem for the banks involved.

"But you said all this back in August, and the company still isn't done!" one might object. OK, but in the intervening three months, Orchids assets are even more run down and its debt just grows higher and higher.

6. Conclusion

In conclusion, there's no question in my mind that Orchids Paper Products equity is worthless and the stock will work its way down from here. (There are a lot of bankrupt stocks that trade above $0.00, so I'm not sticking around for the last 25 cents.) Hopefully you won't be the last algo or day trader holding the bag when the news of an insolvency proceeding hits!

Disclosure: I am/we are short TIS. 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.