Description

Paperworks 9.5% Senior Notes due August 2019 is an attractive risk/reward that pays a ~12.5% current yield and ultimately has a ~40%+ all-in return profile over the next 12-months. Paperworks is a cycle-bet with a security that is top of capital structure, has an August 2019 maturity (hammer that likely results in a sale over the next 12-months), has more than adequate liquidity and appropriately compensates w/ ~12.5% CY as we wait for cycle normalization + significant recent evidence supporting 2H 2017E improvements makes timely. The business operates 1) with relatively stable and attractive end-market demand (folding cartons largely into grocery end-mkt), 2) is performing at cycle-bottom conditions (inputs went up $80 / ton over past 6-mths and output pricing went down by -$70/ton so squeezed on both sides), 3) competes against disciplined oligopolistic peers (WestRock, Graphic Packaging and Paperworks control >90% of the CRB supply) and 4) heightened evidence of improvements with the recent closure of Paperworks’ Phily mill resulting in industry operating rates >95% and pricing power ($50 / ton implemented in Feb / March and 2^nd increase of $40 - $50 / ton working its way through the system) + significant optionality around OCC / input coming down as there was a 3-standard deviation move higher over the past 6-months.

At the current price of ~77, creating Paperworks from $0 - $235MM or ~4.7x mid-cycle EBITDA and ~5.7x EBITDA – capex (assumes $180 / ton of profitability versus GPK and WRK that generate $250 - $300/ton on their comparable business units). Moreover, there is a high likelihood of a sale of the business as Paperworks has 5 attractive converting plants (over the past 5-years, there has been a land grab to vertically integrate) and a strategic customer base (P&G is a marquee customer) and would likely be willing to pay up given significant synergies (historically, players such as Caraustar have successfully generated high single digit as % of sales synergies … applying that to Paperworks’ >$400MM of sales = $30 – $40MM of synergies). Ultimately, assuming a 101 take-out in 12-months, the all-in return profile is approximately 40% and the downside is limited as the security is top of the capital structure, has more than enough liquidity and creates the business for less than 4.75x mid-cycle EBITDA (versus comparables that trade >8.5x). Additionally, my mid-cycle estimate is relatively conservative as it assumes margins revert back to historical levels but a strong argument could be made for higher margins moving forward given current industry operating rates >95% versus historical in the low-90s.

Biz Snapshot: Paperworks is the 3rd largest recycled paperboard (CRB) operator controlling ~11% of the industry (~280k pro forma for recent closure of their Phily mill). The business has been owned by Sun Capital since 2008. Given recent actions around selling non-core business (sheeting operations sold in December 2016 for ~$68MM) and closing real estate (Phily mill closed last week and real estate sale likely results in >$20MM of net proceeds), Sun Capital appears to be tipping their hand on the ultimate goal of selling the existing 2 mills and 5 converting facilities ahead of the August 2019 maturity

Cap Structure: Straight-forward capital structure: $360MM of Snr Secured Notes trading in the ~77 context.

Factoring in cash and real estate, net debt is $325MM (face) and at ~77 price, creating the biz for ~$235MM

Key characteristics of the biz: 1) relatively stable end-mkt demand, 2) rational oligopoly on supply and 3) very tight S/D dynamic currently with operating rates >95%

-        Demand: Folding cartons mostly for grocery end-mkt (cereals, snacks, beauty products, etc). End mkts have historically been stable with small growth but more recently small declines given shift in consumer preferences to healthier items. Overall should be very stable demand through the cycle  

-        Supply: Rational oligopoly w/ 3 players controlling ~90% of the industry

-        Resulting utilization = pxing power: Papwrks closed >5% of capacity earlier this yr putting industry op rates >95 percent, level where pxing power. Industry has already implemented a $50 / ton increase and is in the process of pushing for a $40 - $50 / ton 2^nd increase

Why the opportunity: in 2016, S/D was imbalanced and the industry lost pricing power resulting in -$70/ton declines. Additionally, inputs (mainly OCC) temporarily spiked higher (3-standard deviation event peaking in March 2017 at $175 / ton) squeezing margins. The market has over-reacted to this temporary margin squeeze and is applying a punitive multiple to trough earnings power

Divergence: Paperworks closed capacity making S/D tight and industry has already established a $50 / ton increase and is focused on a 2^nd $50 / ton increase … in the meantime, input costs are in the early stages of coming down. This ultimately will drive margins toward mid-cycle levels (if not higher) in the 2H of 2017E and creating Paperworks for an attractive sub-6x EBITDA-capex multiple on relatively conservative estimate of mid-cycle

Valuation: Paperboard companies have historically transacted at 8x plus EBITDA multiples (WRK and GPK both trade >8.5x 17E EBITDA). To be fully covered through the 9.5% Senior Note, need to believe in mid-cycle EBITDA of $50MM and ~6.5x EBITDA multiple. Additionally, given Paperworks’ owner (Sun Capital) has been involved in the business for some time + the biz faces a 2019 maturity, there is a heightened chance of a sale of the business over the next 12-months. Re: M&A, there should be significant synergy value given scale benefits around procurement, freight, and mill / converting facility integration + >$40MM of SG&A at Paperworks = likely argue for at least $30mm of synergies so a strategic could theoretically pay >$400MM and get a 15 - 20% cash-on-cash return (>$70MM of post-synergized profits / $400MM)

Base / Upside / Downside:  See recovery analysis below. On the downside, difficult to see a scenario in which the recovery value is not >80% and collecting 9.5% coupon per annum in the interim. More likely scenario is that this is par paper given 1) cycle recovery on standalone basis or 2) strategic buy-out

Risks:

Economic weakness – mitigant is that demand is mostly tied to grocery volumes which is steady

Execution risk – mgmt is closing Phily mill but mitigant is that this is relatively straight-forward procedure and customer specs should limit any risk of customer attrition

Input inflation stays higher for longer – difficult to forecast OCC, but mitigants are that 3-standard deviation move to $175 / ton as of March is unusual (statistics would argue for n-term normalization) and price increases (first CRB increase of $50/ton implemented and 2^nd increase of $40 - $50/ton in process of being implemented) will offset cost inflation 

Catalyst

2H 2017 - 2018 performance (cycle bet); Possible sale of biz