Skip to content

A small, new position: AbitibiBowater

September 27, 2011

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:

Negatives

  • 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.

Positives:

  • 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.

Operating Results

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.

Advertisements
3 Comments
  1. I don’t know if new management team should be a positive. It depends entirely on the quality of the manager, and sometimes it can suffer from reversion to the mean. Or if you think that management skill follows Pareto’s law (or the 80/20 rule), then there is a very high chance that the new management will be subpar.

    Companies like Seahawk drilling (the CEO came from Hercules Offshore with a terrible track record) and Idearc have had new CEOs who couldn’t save a sinking ship. We’ll see what happens to Premier Exhibitions with the new management, though I think that the previous management were better at operations.

    2- Paulson apparently sold his stake in this company? He has also been in the press recently as his hedge fund got burned on SinoForest.

    3- I don’t understand the fan following for Fairfax/Watsa. Fairfax may have been technically insolvent back in the day… arguably this company is very risky. The returns don’t look that great compared to other investors like John Malone (LCAPA/LINTA/LSTZA), Robert Cudney (CVE:NFD.A), Warren Buffet, etc. especially given the level of risk.

    4- I haven’t read the 10-K and I don’t really know this industry so I have no idea what this company should be worth. I don’t see a one foot hurdle here. I wish you the best of luck.

    • Glenn,

      Thanks for the comments. All good points.

      You’re right that new management is not necessarily a positive sign, but there is nothing I like to see less than a company that was put into Chapter 11 because of overindebtedness being led out by the same management team. I’ll have to go and dig a bit deeper into the background of Richard Garneau.

      Yahoo lists Paulson as a 5% owner as of 6/30/11, and I don’t see any schedule 4’s submitted after that, so I would guess, unless I’m missing something, that his fund is still an owner of about 5 million shares. My point was that he, or another large owner, may decide to sell some or all of a position for liquidity reasons rather than because they don’t like company fundamentals. This is a real risk (or opportunity).

      As to Fairfax, well, if you don’t think that compounding BV by 25% annually for 25 years is an accomplishment, then we’re not on the same page. Almost being insolvent is kind of the inverse of almost winning the lottery; it either does or doesn’t happen. But perhaps that’s a separate issue. I still think the Fairfax results make Hamblin Watsa a superstar investor. I will say that the investments they make are not always easy to understand and may have some machinations that you and I can’t duplicate. And I’ll be the first to add that like all investors, they too are destined to make mistakes. That’s why we all have to do our own homework. And yeah, I like Malone (my ASCMA position earlier in the year), but I just don’t see a lot of hidden value in the Liberty companies at the moment (doesn’t mean there isn’t… I just don’t see it).

      Finally, to your point about the one foot hurdle. I totally agree. That’s why this is a small, tracking position for me. Enough to keep me following company events closely. Skin in the game, that sort of thing. I see the major upside in ABH as well as the major downside and am trying to figure out how I eliminate the risk of falling over the edge.

      Jay

  2. Hmm I guess I spoke too fast about Watsa. I made a judgement based on its share price based on where the Google Finance data starts.

    2- Regarding Paulson, it was based on this *erroneous* article:
    http://seekingalpha.com/article/292171-john-paulson-completely-exited-these-7-stocks-last-quarter

    Here is the 13F filed August 15 2011:
    http://sec.gov/Archives/edgar/data/1035674/000103567411000003/0001035674-11-000003.txt

    3- Abitibi definitely has the “ick” factor that Michael Burry talks about. Everybody knows that newspapers are in decline (some of the public ones have gone bankrupt), this is coming out of bankruptcy, etc.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: