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Fortress Paper, at last!

July 19, 2012

In general I’m a balance sheet investor. I try to invest in out-of-favor companies with lots of liquid assets and a low stock price relative to book value. Net-nets with positive cash flow are obviously the best but have been pretty hard to find in the past few years. I tend to steer clear of companies with lots of cash generation promise and not much in the way of assets. I also stay away from commodity businesses, especially those that require a large investment in assets (like automobile production and airlines) that are not liquid. So why would I even look at a company like Fortress Paper? It’s in a commodity industry, pulp and paper, it requires lots of capital investment and the assets required are highly illiquid. It should be just the wrong type of investment for me, but I’ve been reading about it in the Corner of Berkshire and Fairfax forum where a couple of members follow the company closely and I’ve become interested. What’s intriguing to me is that management has purchased assets at a deep discount to replacement cost and then has upgraded or repurposed them. On reading this, the first thing that came to mind was that the company could potentially be one of the, or ‘the’, low-cost producer, and in a highly operationally leveraged business like this there could be some outsized profits. But the proof has to be in the pudding and right now Fortress Paper is in its 4th quarter of losses. Given the way it has grown over the past 6 years and the CEO’s statements I would have to characterize the company as still in the early stages of its growth phase. Thus it may take some time for the business thesis to pan out, if it does at all. In the meantime investors have been fleeing the stock for the past year, sending its shares down over 50%.

I started accumulating shares, as always, too early; I began purchasing in May at the CDN $24 level and now the shares are down around $16. The shares trade on the Toronto Stock Exchange but there are also rather illiquid ADSs that trade on the US over-the-counter market. I’ve opted for the latter so as I don’t, at the moment, have access to trade on the TSX.

First let’s look at the company’s history then I’ll follow on with my investment thesis.

Fortress Paper was formed by Chad Wasilenkoff in 2006 for the purpose of purchasing two mills that Mercer International wanted to divest, the Dresden Mill, producing non-woven wallpaper, and the Landqart Mill, producing security and banknote paper. Since the acquisition, Fortress has invested considerable capital to increase the output at each of these mills, as well as well as adding additional assets, the Thurso Mill (dissolving pulp) in April 2010, certain assets relating to banknote security from the Bank of Canada in January 2011 and the LSQ Mill (dissolving pulp) in a deal consummated in June of this year. The Company now operates in three subsectors of the pulp and paper industry, non-woven wallpaper, security paper (for banknotes, passports et al.) and specialty cellulose (dissolving pulp). Management has stated that they feel dissolving pulp is the future of the company and has recently said that they intend to purchase additional mills to convert to DP production and possibly spin off or sell the non-DP assets. Between 2007 and the end of  2010, when only the Dresden and Landqart mills were operating, the company operated with positive net income and cash flow. Since then, however, cash flow has turned negative.

Initial acquisition of the Dresden and Landqart Mills

The purchase of the Dresden Mill and the Landqart Mill in the Fall of 2006 was made for an aggregate of $15 million, $7.5 million in face value of preferred shares plus a convertible note for $7.5 million. The company was then capitalized by the issuance of 2.75 million common shares shortly thereafter; 2 million were sold in a private placement at $4.00 per share (Wasilenkoff purchased 446k shares) with the remaining 750k granted to Wasilenkoff as incentive. The proceeds of the private placement, $8 million, were used to repurchase the preferred shares from Mercer and provide $500k in working capital for the company. Subsequently, in early 2007, there were two, additional private placements at $4.00 which raised an aggregate of $1.7 million (453.5k shares).

2007 IPO

In June 2007, the company raised $46 million in an IPO, selling 5.75 million shares at $8 a share. In recognition for bringing the company public Wasilenkoff was granted 1 million shares.

2007-2009 Sources and Uses of Funds

During the period 2007-9 the company generated about $36 million in operating cash flow, raised $42 million in equity capital and increased long-term debt by $6 million. The funds were used to purchase plant and equipment ($41 million), repurchase Mercer’s original convertible note ($8 million) and pay down operating loans of $4 million and capital leases of $2 million. This left the company with about $33 million in cash at year end 2009.

2010 Secondary Offering and the upgrade of the Landqart facility

In July 2010 the company completed a secondary offering of 1.9 million shares at $23.50. Proceeds of $45 million, along with a secured loan of $22 million on the Dresden facility and a factoring agreement at Dresden for $12 million, were used to rebuild one of the paper machines (PM1) at the Landqart facility. The upgrade was designed to increase the facility’s ability to produce banknote specialty paper by a factor of 4, to 10,000 tons/year, and was completed in January 2011.

2010 Purchase of Thurso Mill

In April 2010 management completed the purchase of the Thurso Mill in Quebec (subsequently renamed the Fortress Specialty Mill) for $1.2 million. In conjunction with the purchase, the company entered into a $102 million project financing and issued a $15 million convertible debenture to raise the funds needed to convert the mill to dissolving pulp. Production of pulp was continued until the Fall of 2010 when the company began an overhaul of the mill to transform it into a dissolving pulp facility. The $15 million debenture was converted into 750k of common shares in January 2011.

2011 Purchase of Optical Security Assets

In January 2011 Fortress Purchased certain assets from the Bank of Canada related to optically variable security material for the security threads contained in Canadian banknotes and various international currency denominations for a price of $750k.

2011 Secondary Offering

In February 2011 the company completed its second secondary offering of 1.1 million shares at $47.50 a share, raising $50 million

2012 Purchase of the LSQ Mill

In January 2012 the Company signed an agreement to purchase of the LSQ Mill from Domtar with the intent to convert the mill to dissolving pulp. The purchase price agreed on was $1 plus a commitment of up to $10 million in environmental remediation payments over 5 years. Conversion will be financed by 10 year loan of $134 million from the province of Quebec at 5% interest rate (with 715k warrants) and $25 million 7% 5 year convertible debenture from a Quebec financial institution. The conversion is expected to be complete in late 2013.

Operating losses at Landqart beginning in the 3rd quarter of 2011, slower-than-anticipated conversion of Thurso and an increase in capital required for the conversion created a potential liquidity issue for the company in the first half of 2012. In response the share price declined precipitously as it appeared another secondary equity offering might be needed and, given the price, would be very dilutive. Management, however, responded by placing $60 million of 7% convertible debentures (conversion price of $31/share) in late June so the liquidity issue has been addressed and dilution has been kept to a minimum. Nevertheless, the stock price remains in the doldrums until it can be shown that the operating losses have been stemmed.

For a detailed understanding of the businesses in which Fortress operates and the impact of changing trends in the pulp & paper industry I suggest you read the most recent annual report which can be viewed through SEDAR.

The economics of the company are a bit difficult to get your hands around because of its rapid pace of acquisitions and growth.

At the end of 2011 the company had $103 million in current liabilities, $138 million in LT debt $21 million in other LT obligations and $232 million in shareholder equity. There were 14.3 million shares outstanding with an additional 826k potential shares for convertible debt and management compensation (options, RSU, etc.).

In the first quarter of 2012 the company had a net loss of $10.5 million. Losses at Landqart and Thurso (FSM) more than offset the profit at Dresden. Landqart was operating at less than 50% capacity due to a major banknote order received in 2011 and then delayed in December just prior to production. The order was reinstated in June but any positive financial impact will not be felt until the 3rd quarter. The Thurso mill was finally brought to production in mid-March, so ramp-up to full production efficiency should have taken place in the 2nd quarter, with improvement to the bottom line to be seen in 2Q financials.

In millions except per share

1Q 2012
Total Corp Dresden Landqart FSM
Revenue $61.4 $37.7 $13.3 $10.4
Expense $63.2 $2.5 $28.3 $18.5 $13.9
EBITDA ($1.8) ($2.5) $9.4 ($5.2) ($3.5)
  margin % 25% -39% -34%
equity comp ($0.4)
D&A ($4.0)
Interest ($4.8)
Taxes ($0.7)
FX $1.2
Profit/(loss) ($10.5)
per share ($0.73)
LT Debt 188.6

The consensus forecast for the 2nd quarter (for whatever it’s worth.. and I don’t think much) is a loss of about $3 million. The shares are currently being punished because of the growing losses and management’s earlier optimistic statements regarding Landqart and Thurso that did not prove out. Any overperformance vs. expectations in the second or third quarters should bring some reprieve to shareholders in the form of a higher share price.

So what should the financials look like in the third quarter of this year if the Landqart and Thurso problems have been worked out? I would hope to see all three operating mills contributing to the bottom line. Dresden, hopefully, will continue its great performance with close to 100% operating efficiency and 25-30% margins. Landqart with the reinstated order should be running at between 80-100% of capacity and have a better product mix, thus increasing its revenue per ton closer to $20k. And Thurso should be at 90-100% operating capacity, and despite the current softness in the DP market, will be getting over $1,000 per ton. Excluding the LSQ purchase the financials might look something like this with earnings per share around $.50.

In millions except per share

3Q 2012
Total Corp Dresden Landqart FSM
Revenue $125.0 $40.0 $35.0 $50.0
Expense $105.5 $2.5 $30.0 $29.0 $44.0
EBITDA $19.5 ($2.5) $10.0 $6.0 $6.0
  margin % 25% 17% 12%
equity comp ($0.4)
D&A ($4.0)
Interest ($6.0)
Taxes ($1.5)
FX $0.0
Profit/(loss) $7.6
per share $0.54
LT Debt $248.6

The investment thesis is that Fortress hit a glitch (Landqart and Thurso) last year, this will be (or has already been) remedied and that investors will flock back to the stock once the current and future cash flows become apparent. The forward-looking thesis is that the current slackness in DP demand will end, that prices will rise again to the $1,500 range and that fully operational Thurso and LSQ mills will provide significant cash flow.

Of course, the risks are not small, both from a micro and macro perspective. Landqart may not be on the mend, despite the significant capital expenditures to date, Thurso may have continuing operational problems and LSQ may see the same kind of significant cost overruns that we saw at Thurso (a 30% overage in the capex conversion costs). On the macro side, DP prices may remain depressed, though this should be compensated for by high cost producers lowering production, and/or DP demand growth in the long run may not be as high as projected if Asian economies do not resume their expansion.

This investment is not for the faint of heart. It could take several years for the investment thesis to pan out and there could be other glitches in the meantime, driving the share price lower. Shares are currently trading significantly below my average cost already. Do your own due diligence on this one.

  1. I think that there may be serious red flags here that makes Fortress a poor long.
    #1- They have a long history of negative free cash flow. By default, I would assume that the future will resemble the past.

    #2- They are a serial issuer of capital. This is not a bad idea if the shares are overvalued… but why buy overvalued shares in the first place?
    Issuing capital all the time will negatively affect long term returns as size is an anchor and paying commissions to brokers/underwriters is a huge expense.

    #3- “Management, however, responded by placing $60 million of 7% convertible debentures (conversion price of $31/share) in late June so the liquidity issue has been addressed and dilution has been kept to a minimum.”
    –> The reason why companies are ok with issuing convertible debt is because it’s a way of selling shares at a high price. If these debentures are exchanged for shares then they will basically be selling shares when they are overvalued. But even if that isn’t happening, the interest + value of the call option sold suggests a very high cost of funds. And they are not outrunning the cost of their debt (at least 7%). Right now they aren’t even doing better than a 0% return on their assets when it needs to be well above 7%.

    #4- They may be too aggressive in capitalizing expenses, though I haven’t read their financials. Capitalizing expenses too aggressively (this is what Worldcom did) will inflate reported profits and book value.
    Their capex far exceeds reported D&A… this is a huge red flag.

    Personally I think that things will end badly for shareholders (as in bankruptcy and bondholders taking over). This may be several years out though and I am not shorting this stock.

    • Basically all your points can be summed up as “investment outflow >> operating cash flow”. Of course that has to be the case with the company acquiring / converting 2 new plants and upgrading (significantly expanding) their existing 2 plants over the past 5 years.

      Look at their most successful plant, Dresden. They acquired it (along with Landqart) for $15M, yet D threw out $9.4M EBITDA last QUARTER alone. This speaks to their capital allocation success. For landqart, they will be turning around with the new large currency order.

    • csdraneChris permalink

      #1 – FTP is cash flow negative because Landqart has been burning cash and because they are converting idled mills. The first part of this would be easily solved by selling Landqart. Thurso will be fully operational soon enough, followed by LSQ. Your statement is only true if you believe that management will fail to convert the mills or if they will be uneconomical to operate.

      #2 – “They are a serial issuer of capital. This is not a bad idea if the shares are overvalued.” >> Agreed

      “But why buy overvalued shares in the first place?” >> That’s not a question for FTP, it’s a question for the investors who bought overvalued shares. I think the fact that the CEO owns a large part of the company goes along way here.

      #3 – You’re really just rewording your first point here. 7% to convert idled pulp mills is a good rate, and the financing is recourse only to the dissolving pulp operations. Further the convert price is way above the current market price. Your comment about not even earning a 0% ROA is amusing: the financing was to convert idled pulp mills to dissolving pulp. The conversion isn’t complete; you need to look at pro forma earnings.

      #4 – “Their capex far exceeds reported D&A… this is a huge red flag.” Capex is high for good reason: mill conversions, cogen construction, expansion of capacity at Landqart (rightly or wrongly), etc. You need some more basis here to say that management is improperly capitalizing expenses.

      IMO the market is in “show me” mode. Your views are in line with the market’s. The debentures FWIW are trading nearly at par. Your comments #1 and #3, to me, are just extrapolating the present to the future, which you can’t do in this situation. Would love to hear your thoughts if you have more to say.

      • Hmm I don’t have any insight to add. I’ll also point out that I have never read their financials and do not understand this industry. You should do your own due diligence because I know I haven’t.

  2. For a cheap paper / saw mill, just look into RFP (the post bankruptcy Abitibi Bowater). decent balance sheet, trades well below book and some value guys are into this stock. i do think that the paper business is just such a bad business that it is a value trap as well, but RFP does not have the rollup and pot. Accounting issues that I see with Fortress.

  3. Peter Hartline permalink

    This investment has been a complete disaster.

  4. Yes, no doubt it has. However, if you are a real investor and believe that the investment hypothesis is still intact, this is a great time to average down. The Dresden Mill keeps humming along and churning out cash. Alone, it’s worth about 2x the current market cap. The company has sufficient liquidity to complete the Thurso transition due to the timely placement of the convertible issue, so if you think they can turn around Landqart and the DP market will eventually improve, you can now get shares at only 40% more than the original investors did. I think its a bargain, and the nauseous feeling in the pit of my stomach seems to corroborate this. I picked up some more shares yesterday and today just over $7.00.

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