A small, new position: AbitibiBowater
A week or so ago I added a small new position in AbitibiBowater (ABH) at around $16.75 a share. ABH is a NYSE listed forestry products (primarily pulp and paper) company with most of its operations in Canada. The company was formed in 2007 by the merger of the Abitibi and Bowater companies. The merged company went into bankruptcy two years later in 2009 due to its inability to service its high level of long-term debt and emerged last December substantially recapitalized. On emergence, the company had a book value of about $38/share (remember this represents ‘fresh start accounting value’, an estimate of true asset value at the time of exit from bankruptcy, not a historical cost number) and about $0.9 billion in long-term debt vs. pre-petition debt of $4.8 billion
I first became aware of ABH while reviewing the 2nd quarter 2011 equity portfolio of Fairfax Financial. I often troll through portfolios of investors I think of as outstanding value investors, and certainly Prem Watsa is one of those. As of the end of the second quarter ABH was Fairfax’s 2nd largest equity position, making up 13% of the portfolio. But what really jumped out at me was that Fairfax had been adding to its holdings in both the first and second quarters, increasing its initial position, acquired from the conversion of ABH debt, by about 30%. I was surprised because Fairfax had acquired the debt at cents on the dollar and the cost basis for those converted shares was probably significantly less than the market price during the first and second quarters. The stock relisted in December 2010 at around $21.75/share, then rose to around $30 in March before beginning a long retracement back down to $20 by the end of the second quarter. Since then, shares have collapsed with the market and are now trading at about $15. So the shares are now trading at about 40% of book value and at least 25% below any of Fairfax’s open market purchases. That was enough to pique my interest and get me to do a little more digging.
After reading through the 2010 10K, the latest 10Q and the last proxy statement I came away with a few first impressions and observations:
- One of ABH’s main products, newsprint, is in a secular decline,
- ABH is in a commodity business where pricing is subject to wide fluctuations according to demand and supply,
- Because of the cyclical nature of the business and the high level of operating leverage ABH needs a very conservative capital structure to reduce the possibility of future bankruptcy. To me this translates into an unlevered balance sheet. On emerging from chapter 11 the company still had $900 million in LT debt which was planned to be paid down through the sale of non-core assets over the 12 to 18 months plus a large underfunded pension liability. There is execution risk in both of these.
- The industry could potentially be heading into a period of consolidation which would put pressure on management to make acquisitions, and thus relever the balance sheet. Management will have to have exceptional capital allocation skills and discipline to avoid this.
- New management team – in Jan 2011 a new president and CEO was brought in with experience in the business,
- Management incentives – these need to be aligned with shareholders’ interests and there is some indication that these may have been structured effectively; up to 8.5% of the company’s shares have been reserved for long-term management incentives,
- Shareholders – there are several large shareholders with good capital allocation skills. These include Fairfax Financial (18%), Steelhead Partners (10%) and Paulson (5%) which can act as both a sounding board and a constraint, depending on what is needed.
One further observation concerns why the shares have fallen to such a degree over the past 5 months. One might venture that, with the potential for a double-dip recession, the market has become more aware of the operational risk inherent in the business and discounted the shares accordingly. However, I think there could be a second factor, one which makes the shares a bit more interesting. A number of shareholders acquired their shares through the conversion of debt, yet are not equity holders by definition, i.e. they are distressed debt investors and have no interest in holding the shares over the long-term. These shareholders may be liquidating even at today’s depressed prices because they have a significantly lower cost basis. This extra supply pressure could be part of the reason we have seen the shares fall so dramatically (50%) since April. In some sense these are ‘forced sellers’, just the kind of sellers I like to buy from. They are selling because of the category of investment not because the company has poor prospects. This is, of course, a double-edged sword as the selling could continue and drive the shares significantly lower (say if Paulson & Co. needed to liquidate its position to satisfy redemptions – see today’s NYT article), thus my small opening position.
What can we learn from the first 6 months of operation as a new business? Unfortunately not a lot, as the time frame is so short. Earnings for the first 6 months of 2011 were $0.94 a share. Now don’t annualize this and get all excited. Though certainly better than the prior year’s loss of almost $14 a share, almost 60% of the 2011 ‘earnings’ were income tax benefits. If you look at cash flow, which is perhaps a better barometer of performance, you will see that operating cash flow of $15 million is significantly less than the net income of $91 million. This is not usually a good sign. Where did the cash go? Well, $53 million wasn’t cash in the first place but the impact of a reduction of deferred income taxes. Then you need to add back $ 77 million, the difference between depreciation expense and asset investment, with the result that you $115 million in cash flow. This went to finance an increase in accounts receivable ($77 million) and pay down pension liabilities ($55 million) as well as the impact of currency translation. [Hmm. Sales increased 4.5% but accounts receivable 9.5%. We’ll need to keep an eye on that.] We can also see that the proceeds of the sale of the ACH limited partnership interest ($296 million) were used to pay down $269 million in long-term debt, so management is keeping its promise here.
What is my first look conclusion? Well, because of the operating leverage of the business, if management can get it just right and the pulp and paper market are somewhat stable, the company could make a boatload of money. These are big ‘ifs’, however.
So ABH is what I would consider a “long-shot play” (thus my small initial position). It is not an investment that should be held alone, but needs to be part of a strategy where a number of similar ‘long-shot’ positions with high potential upside are held simultaneously. Interestingly, I seem to recognize this kind of approach in the Fairfax equity portfolio, with, of course, a counterbalancing element, market hedges. In other words the strategy there seems to be, create a portfolio with significant potential upside (and downside) in each position while taking out the market risk. Several of these ‘bets’ may fail, but if one pays off, it will more than compensate for those that didn’t. Is this the right portfolio for a deflationary economy? I’ll leave you with that thought.