Resolute Forest Products (RFP)
I haven’t really posted in-depth about my Resolute Forest Products position, but I think it’s time to look at the company again as the stock is up about 15% over the last 2 weeks. The company first came to my attention in 2011 when I noticed that it was a substantial holding of Fairfax Financial. After a cursory review of the company’s financials I noted that it was trading at about 40% of book value which really piqued my interest; I’m a sucker for companies trading below book value! And, of course, I’m always attracted to shares in a company that has just emerged from bankruptcy, especially situations where bondholders are given a majority of the post-bankruptcy equity; we know from Joel Greenblatt that bondholders are often uninterested in holding their post-bankruptcy equity, and that their primary interest is not always price. (It’s the “Just get rid of it!” phenomenon). I’m always ready to buy when the sellers don’t care about price!
Resolute Forest Products (then known as Abitibi-Bowater) emerged from bankruptcy toward the end of 2010. Fairfax, being a large bondholder (purchased, I believe, while the company was in bankruptcy), owned a substantial chunk of the equity when it emerged, about 26%. It still owns those shares today. On emergence from bankruptcy shares were initially quoted around $22, then, in the subsequent 2 months, rose to around $30 before beginning a long, slow decline. The share price bottomed in August of 2012 at around $9, bounced up in the subsequent two months then tested the lows (this time around $10.50) in November before beginning an uptrend. In the past 10 days on no real news the shares have popped 15%+.
Resolute Forest Products produces paper, newsprint and magazine paper (about 80%) and some lumber related products (20%) as well as earning returns on its cogeneration facilities. 2012 operations produced a small loss compared to income in the $200 million range during 2011. Much of last year’s loss has to do with impairment costs due to closures and restructurings. The question is, are we through with all the impairments and has the market for paper hardened up? Well, I don’t know. I had hoped that restructurings had been completed during bankruptcy. Obviously that’s not the case, or the market for paper and pulp has changed, requiring a change in strategy and more restructurings. The company produces commodities, and future prices of these commodities, like every commodity, can’t be predicted with any accuracy. AT ALL! Right, so why would a commodity producer be an interesting investment? In this case, bankruptcy has allowed reduction of debt to a reasonable level, as well as the usual asset write-downs. Hopefully this means we purchased shares in a company when its market cap was significantly below replacement cost. RFP, like FTP, is in a highly cyclical, capital-intensive business. When a company is a low-cost producer it, theoretically, has a competitive advantage. If you can buy a low-cost producer with low/no debt at a price below replacement cost you really should find yourself with a ‘moat’, even in a commodity business.
As usual I began purchasing RFP shares too soon. My first purchase was in August 2011 at around $17 a share, my second was in January 2012 at around $15 and my third in April at around $14. But that wasn’t the real mistake. My real mistake was to stop buying as the price fell, especially as it dropped through $10. Now with the price back up to about $17, I’ve made a ‘round trip’ on my first share purchases and am only up a bit on my overall position. Had I kept buying as the shares dropped below $10, I could be ahead 10%, 20% or 30%! It’s definitely hard to have that discipline, though, unless you are have a conviction of the company’s intrinsic value (well, of course, you should have some idea of the company’s value if you are buying shares in the first place).
The real question is, what is the company worth? The quick answer is that I don’t know as I haven’t calculated an ‘intrinsic value’ for RFP, at least not one I’m willing to share with everyone. But even if you don’t have a conviction ‘intrinsic value’ you should have some idea whether the shares are a good value. (It’s the old adage that you can tell whether a person is fat by looking at them; you don’t need to know their exact weight!) So, along these lines, let’s look at some measures of relative valuation. According to Yahoo Finance, RFP’s closest ‘competitor’ is Weyerhauser (WY).
2012 operating results
$ in millions unless otherwise indicated
|Share price ($)||$17.04||$30.85|
Revenues at WY are 1.6x those at RFP, and EBITDA margins are almost twice as high (16% vs 9%). Perhaps RFP can improve, but let’s assume not. Now let’s look at the relative valuations. WY has a market cap about 10x that of RFP. That multiple doesn’t seem justified given the relative size of revenue, even considering WY’s superior EBITDA margins. In effect, RFP is trading at only 15% of WY on a per revenue dollar basis, and even if we adjust for the difference in EBITDA margins, RFP is trading at a valuation of 27% of WY. What gives? Why should RFP trade at such a lower relative valuation? Is WY riskier (i.e. more leveraged)? Not at all. WY has 5x as much leverage as RFP. Perhaps it has to do with product mix. This I can’t really speak to as I have little industry expertise. Perhaps the issue is the continuing restructuring charges that RFP seems to incur. I can see that investors might be a bit spooked by this, as the company went into bankruptcy due to its high level of debt (which I might attribute to poor management), and the continuing restructuring charges might be construed as further management ineptitude. So it looks to me like the shares are currently priced for continuing poor operational performance. That leaves upside in my book. I only want to be invested in companies where investors have a negative view, as any change in investor sentiment can be transformed into significant share price increases, as opposed to situations where operational expectations are high and negative surprises can translate into significant capital losses.
So, from this back-of-the-envelope comparison, can I determine what the company is worth? Not really. I do know, however, that Mister Market is expecting RFP to continue to perform worse than its closest peer. This presents significant upside potential for RFP investors were to the company to perform only as well as its closest competitor, or even if operations are only half as efficient as its nearest competitor. Furthermore, RFP seems well positioned for a market decline with its relative low-level of debt.
You see, I’m avoiding any DCF valuation because I simply don’t feel that projecting paper, pulp and lumber prices will serve me well. I would rather invest in a commodity business where I know the company is a low-cost producer as, I believe, in the long run the company will best its competitors and eventually produce a market beating return.
Another key factor I am always interested in as an investor is management incentive. Unfortunately at RFP management owns less than 1% of outstanding shares. Such low share ownership is often a reason to stay away from investing in companies. In this case, however, there are countervailing factors. As noted above, Fairfax Financial owns 26% of RFP. Furthermore there are two other major hedge fund owners, Steelhead Partners with 14% and Donald Smith & Co with 10%. I put all of these owners in the ‘value’ camp, which means that around 50% of the company’s ownership in rather stable hands. Aboveall, however, it means that there will be effective oversight in matters of capital allocation, extremely useful in a cyclical, capital-intensive business like this.
Overall RFP is a small position for me which, at this point, I don’t intend increasing. However, I believe that with patience (and I’ve already had a good deal), I think the company can show significant profitability. It’s currently a hold in my book.