RFP - make that 10%+ FCF while biz transitions from PaperCo to WoodCo

Long RFP, ideal entry <= $14 / share for at least 2:1 risk-reward w/ upside.

Unchallenging multiple @ 2-turn discount vs. peers w/ lowest leverage, mix shift should drive stability & better cost pass-through, and Canadian-US trade dynamics w/ supply constraint drives blue-sky strategic value.

Situational Overview:

Resolute Forest Products (RFP, $1.6 Bn Mkt cap, $1.9 Bn EV) is one of the several Canadian lumber/ newsprint companies operating wood product, pulp, and paper mills in Quebec and Southern United States. Once known as AbitibiBowater, RFP had a rich history of consolidation (Abitibi + Bowater in 2007), leverage ($6 Bn+ in net Debt & 10-20x+ Net Debt / EBITDA), distress (Chapter 11 in April 2009), and complexity in a sector of secular decline. However, since it emerged from bankruptcy in Dec 2010 with Fairfax backing (which currently owns 31% stake), a new management team, and $7 Bn less debt, the story has dramatically simplified as RFP aggressively slashed newsprint and commercial paper capacity (~50% from 2008 peak) and took out as much as ~$900 mm of annual fixed cost. The focus going forward is to run the newsprint + paper segments for cash, while building out pulp and wood products for the brighter growth profile (as evident by the CapEx plan for FY14 where 40% flows to pulp and 30% to wood products)

Potential Source of Mispricing:

·         As per 1Q14 13F filing, Top 5 holders control 61% of the company. Limited ADV of ~$5 mm / day.

·         Lack of big-firm coverage, too small for analysts to focus on, and caught most wrong-footed in 2011-12 when newsprint & paper pricing + margin assumptions were too high.

·         Still perceived as a sleepy paper company w/ problematic end-market (rightfully so) & lack of catalyst.

Thesis:

• Assuming status quo, RFP valuation is unchallenging @ ~5x EV/EBITDA: Assuming RFP can maintain the $4.5 Bn topline and 8.5-9% EBITDA margin, it is set to generate ~$380-400 mm of EBITDA and will reap a ~4.7-5x EV/EBITDA (ex-pension) while having the lowest leverage profile (~0.8x Net debt / EBITDA), vs. the 6-8x paper & pulp comparables on the FY14-15 basis w/ ~2.5-3x average leverage. Even re-rating to median valuation of 6x in 2011 would reap RFP shareholders 25-30% upside, and de-rating to its trough T12m low of 3.75x (back in early 2012) will only net one 25% downside to ~$12.50 / share. In a similar token, with the guided $150-160 mm maintenance CapEx, a $400 mm EBITDA will translate to ~$175 mm of FCF, or ~11% levered FCF yield (this # approaches ~17% if RFP drops to $12.50 / shr). While RFP has some pension issues to attend to, as long as the overall numbers do not deteriorate, it is difficult to imagine a much more depressed multiple unless we have a full melt-down, and even in that case, the unlevered balance sheet should give management ample room to buy back stock. Mgmt already did so @ ~$12 ave. price back between May – Dec 2012, which somewhat suggests where the top 5 holder & mgmt considers “cheap”.
• Migration to diversity upstream lowers cost & dampens volatility: The ~2-5% annual decline in newsprint + specialty papers and RFP’s strategic initiative to build out its wood pulp & wood products franchise should surprise no one. But the internal sourcing (60% of Canada Virgin Fiber already internally sourced, vs 40% 1-2 yrs ago) is a prudent step to lower COGS, decrease earnings volatility, and combat timber inflation given the low incremental CapEx and the close proximity of the plants. While no sawmills are currently installed in southern US, it would not surprise me that RFP eventually installs timber capacity in the region around Calhoun. I expect the pulp + wood mix to hit 45-50% of sales and 50-60% of EBITDA with dampened earnings volatility and lowered cost base. Assuming continuous deterioration of newsprint and specialty paper EBITDA margin towards 5-7%, and pulp + wood eventually reaping industry level 11-14% EBITDA margins, this mix shift should bridge us to north of $400 mm EBITDA by FY15. Management has no intension of breaking up the company (and quite frankly non-synergistic to do so), but a WoodCo - PaperCo SOTP with WoodCo at high multiples can easily imply upside (or get PaperCo “for free”, so to speak)
•  RFP may be strategically advantaged to capture idiosyncratic imbalances: In Western Canada, in particular British Columbia, there had been a Mountain Pine Beetle epidemic since 2001. The epidemic has now killed an estimated 710 million cubic meters of commercially valuable pine timber — 53% of all such pine in the province—and is projected to reach 767 mm by 2017 (As per B.C. Ministry of Forest). This number equates to ~26 years of B.C., or 13.5 years of Canada annual production. The downed woody debris is expected to lose >50% of its density by year 3-4 and the epidemic really began hitting the dense, mill-heavy areas in 2010-2011. In other words, by 2014-15, the production in this region is likely to remain hampered w/  higher cost curve due to (a) less trees, (b) higher logging cost given sparser trees, and (c) lower quality and yield due to rot. At the interim, the Quebec government w/ 90% control of forests in the province, have reduced the harvest limit by ~30% between 2004 and 2013 and is unlikely to bring it back. Given that these 2 regions collectively account for 70% of Canada’s lumber production, the supply dynamics in Canada is likely to be constrained into the latter half of the decade with the east-side (Quebec) rights and mills potentially more valuable than the west. Add such a flat supply dynamics to timber export to China growing at 10%+ YoY (already 20%+ of Canadian production), export to the rest of the world not tapering off (another 20% of production), and the export to USA ramping as homebuilding improves, RFP is holding an asset base  in Quebec and Southern uniquely levered to (a) immunity to the pandemic, (b) export improvement at the ports of Quebec, (c) both regions being targeted for further growth by acquisition given the constraint in the B.C. Interior, and (d) margin maintenance, if not expansion, thanks to its vertically integrated model as the potential rise of timber cost base flushes through. If this scenario plays out as expected, RFP’s wood and pulp products will be in for a few very good years.

Risk , mitigating factors, and other

·         Circulation of US newspapers approached @ 70-year low and continue secular decline?  We are unlikely to see irrational competition given top 5 players control ~80% of NA capacity (and who in the right mind would enter the newsprint industry now?) Assume Price / mt to $~550 (2009 trough level), shipment to ~2.4 mil mt, and EBITDA margin @ 5.5% (unprecedented except for 2009-2010)), RFP Newsprint should still be able to generate 30-40 mm in FCF and this already is our base case. ONP prices should be higher, competitors in serious distress (and potentially drive consolidation), and the 11 facilities @ ~2.7 mm mt capacity should have at least some salvage value to PE firms (I assume ~$200 mm  @ 5.5% EBITDA margin w/ $500 / mt). See liquidation analysis attached.

·         ~$1.2Bn Pension Liability?: In the last 5 years, RFP actually has been closing the funding gap by ~$240 mm per annum (excluding actuarial adjustment), the only problem is that discount rate at the interim expanded by 240 bp and left the gap and effectively blew the gap back out $600 mm in total. With interest rate as low as it is and Prem Watsa advising the fund, I find it hard-pressed to expect another blow-out. In fact, if RFP executes its historical performance by another 2 years and discount rate expands by 100 bp, to ~6%, the pension plan only be left with ~$200 mm of funding gap all from the OPEB side. We may be able to hit the 0 threshold within 2 years, and RFP will not no longer need to contribute $100-150mm+ every year, essentially freeing up 50%+ of OCF for other purposes. Also, can RFP can withdraw at surplus?

·         What if Pulp and wood don’t work out? Indeed a risk, you have to buy into the thesis where the feedstock (timber) will be supply-constrained, and RFP has a unique advantage to pass-through pricing. I also assume that they can at least run the operation by 2 years and fill the gap of the pension fund. In which case the liquidation value gets one to perhaps 45% downside. But look at how conservatively they are levered! If the stock price ever gets down to sub $10, any buy-backs will be very, very accretive.

·         Catalysts: No hard catalyst as of now, but any recovery in US housing, popularization of the timber constraint thesis stated above, potential merger talk, further acquisition in the distressed newsprint industry, recognition of virgin fiber’s importance to the newsprint process as industry-wide inventory falls, and rise of interest rates.

·         What will make you have second thoughts?: If the integrated company cannot exhibit a higher and more stable margin profile. If Timber prices were to drop materially as the taunted recovery never materializes. If the company switches course and take up leverage significantly.

·         Additional due-diligence questions: Verification of industry cost curves, distress level at newsprint competitors, industry expert opinion on timber prices, virgin pulp importance, ROIC of a sawmill, actual management competence, employee satisfaction, product quality, and competitors’ view of strategic value.

Comp Sheet: Note that the worst TTM EV/EBITDA for RFP is 4x.

Liquidation SOTP: I get to $8-12 / share in the worst case, assuming they can postpone liquidation until pension gap is almost fully closed. Also note that mgmt bot back stock at around $12.