Description

Resolute Forest Products (RFP-US)

I believe Resolute Forest Products (RFP) is a compelling merger arb situation as the market appears to largely ignore/undervalue the contingent value right attached to this expected deal. 

My investment thesis summary: 

1. RFP is being acquired by Paper Excellence (Domtar) For $20.50. I would say the deal risk is low because: a) all cash deal, b) deal was announced early July so the acquirer is fully aware of capital markets deteriorating and still went ahead, c) shareholders will almost certainly approve the deal given Fairfax’s support and owning ~40% of the shares.

2. RFP had been paying lumber duties to ship lumber from Canada to the US, to the tune of $500 mln. As part of the deal, there will be a contingent value right (CVR) to pay out whatever may be recovered (when US and Canada come to a new lumber agreement, US typically refunds a % of duties collected). Based on the previous softwood lumber deal and actual transactions, I would give credit to 80% of this $500 mln number over however long it takes to resolve the dispute. Alternatively, we have seen rights to lumber duties sold for 40-55% of the amount on deposit.

3. The CVR is unique because many other CVR’s are dependent on the merged entity achieving a milestone (such as drug approval or mine production). In this case, there is no misalignment of interests (i.e. lets start the mine after the CVR expires to save money) because the lumber duty refund amount and timing is completely out of the hands of Paper Excellence.

4. Deal is expected to close by 2Q23 and being in a commodity business, there should not be material anti-trust issues.

5. If the deal breaks, fundamental support probably in the $15 range so downside/upside ~ $15/$25 and it seems the market is not correctly pricing this deal as it would imply 50/50 chance of it going through (which is way too low)

Background

RFP’s predecessor was essentially Abitibi Consolidated, a newsprint producer that did well in the 1980’s and suffered death by a thousand cuts since then, facing timber availability issues, energy and input cost inflation but most critically, unrelenting secular decline in newsprint demand (going digital). In one last attempt to survive, Abitibi merged with the other remaining significant newsprint producer, Bowater, creating Abitibi Bowater just prior to the great financial crisis. 

While the theory of matching supply with declining demand (by shutting mills or cutting production) to maintain margins seems to make sense, the combination of a deep recession and double digit newsprint demand declines were too much for Abitibi Bowater. As (I believe) a convertible debt holder, Fairfax ultimately became an equity holder of RFP as the entity came out of restructuring and renamed itself Resolute Forest Products. 

Perhaps with Fairfax’s oversight, RFP also shuffled its asset base over time, selling pulp and paper mills and acquiring saw mills and even bought back shares when RFP’s price was depressed and paid special dividends when the lumber price spike helped generate a lot of excess cash.

It appears coming off Paper Excellence’s 2021 $3 bln acquisition of Domtar (UFS), Paper Excellence continued its acquisition quest by making a bid for RFP.

Why Deal Risk is Low

With M&A, there is always the potential for deal risks that cannot be fully anticipated. In this case, I believe the deal risk should be low given it is a cash deal and Paper Excellence just completed a $3 bln acquisition and was still able to get committed financing for this deal.

Further, going through the proxy statement, it is very interesting that Paper Excellence increased its bid from the initial non binding proposal of $18 per share in Feb 2022, to $20.50 in early April. Then a non-binding “Party A” bid for just the paper assets came in early June. At this time, Fairfax wanted $25. On June 15, probably close to the S&P 500 low point this year, Barclays (representing Paper Excellence) mentioned they were deciding to counter or terminate the deal given due diligence issues but then makes best and final proposal of $20.50 + CVR based on any refunds on lumber duties on deposit (essentially a creative way to get to Fairfax’s $25). 

In terms of financing, a banking syndicate is willing to provide $1.5 bln debt financing, essentially covering the purchase price. I think this demonstrates the banks are very comfortable with this deal, especially when it was negotiated during a time the capital markets were quite volatile. 

Finally, shareholder approval is highly unlikely to be an issue as it looks like a simple majority is required and Fairfax is already ~40% and Chou Associates is ~4%. It appears Francis Chou and Prem Watsa are friends, or at least get along with each other - https://www.forbes.com/sites/jacobwolinsky/2021/04/29/francis-chou-wants-to-build-the-next-berkshire-hathaway/

In terms of regulatory approvals, RFP has to (mostly) get through HSR Act in the US and the Competition Act in Canada. My legal expertise here is limited but would highlight RFP and Domtar operate in a commodity business and there is limited geographic overlap in its asset base.

Details on CVR

Overview - Since the CVR depends on the refund of lumber duties RFP paid, it would be useful to provide a quick background on lumber duties. For reference, the CVR would be entitled to refunds on the $500 mln duties paid until June 30, 2022 – which in theory is $6.40 per share at 100%.

Softwood Lumber Dispute Background - For the past 4 decades, there has been a long running dispute between Canada and the US regarding the export of softwood lumber from Canada to the US. Canada is a large producer of softwood lumber and the US is its largest customer given its homebuilding needs. Canadian lumber producers are generally lower cost given their scale and expertise, while US lumber producers historically have been higher cost. Understandably, there is a material difference in timberland ownership between Canada and the US (lumber producers have to buy the trees (or right to harvest) to make lumber). In the US, most timberlands are privately owned so lumber producers are charged whatever the market could bear. In Canada, the government owns the majority of timberlands, leading the provincial government to establish a stumpage system to set rates (albeit based on market lumber prices and bids) for lumber producers to harvest trees. Because of this difference in pricing systems, US lumber producers (who are typically higher cost) historically lobbied the US Department of Commerce to take action against Canadian lumber imports.

Essentially, ever since the 1980’s, the lumber dispute pattern looked something like this:

1. US producers petition the US Department of Commerce to do something against lumber imports from Canada

2. US puts in a duty rate (technically anti-dumping (AD) and countervailing (CV)) anywhere from 10-25%

3. Canada appeals to the relevant trade body (i.e. NAFTA/WTO) and usually “wins”

4. US refunds most of these duties and enters into a softwood lumber agreement with Canada, usually where Canada voluntarily limits lumber exports either via an export tax or quotas (or a combination of both)

5. Softwood lumber agreement ends and we go back to step 1

The last round of lumber dispute resolution was:

1. April 2002, US DoC imposed combined duty rate of 27.22%

2. In 2006, it was agreed that 80% of duties would be repaid

3. The 2006 softwood lumber agreement came into effect, where Canadian regions could choose an export charge or quota

4. Softwood lumber agreement expires in 2015

5. In 2017, the US put in an average of 20% anti-subsidy tariffs on Canadian lumber imports

Based on the above, the key parameters are: a) took 4 years before Canadian producers got a duty refund, b) refund was 80%.

Actual Transactions in Lumber Duties – It is very interesting that other lumber producers have actually monetized lumber duties they paid – which is a very solid valuation tool that can be used for RFP’s CVR as these transactions should be representative of fair value:

1. In late 2019, Conifex sold its interest in duty refunds for $13.9 mln, 42.5% of CV and AD duty deposits:

2. In 2021, Interfor acquired Eacom Timber and explicitly accounted for CV and AD duty deposits in its purchase price at 55% (of the $150 mln paid)  

Given the passage of time between the Conifex and Interfor transactions, I would be more inclined to put fair value closer to 55% (or more) than 42.5% - meaning as more time passes, the closer we get to an eventual resolution and duty refund. Tying this back to RFP, 55% would be $275 mln or $3.5 a share (add that to the $20.50 cash consideration, we get pretty darn close to the $25 per share total consideration our friends at Fairfax was aiming for)

Why This Opportunity Exists?

It is not too hard to imagine why this RFP deal would at least be slightly mispriced. For instance:

1. CVR will not be tradeable or transferable, making it undesirable/unsuitable for many funds

2. CVR payout amount and timing is totally uncertain

3. Given the current M&A environment, there are “easier” ways to earn a generous spread on merger arb opportunities (maybe MSFT/ATVI?)

Fundamental Value if Deal Breaks

In assessing the downside and what RFP might trade at if the deal breaks, I looked at RFP 3 ways: 1) DCF, 2) picking a multiple on management’s forecast in the proxy, 3) triangulating a value based on the “Party A” unsolicited bid.

DCF, $15:

There are many variables to consider but in my model I generally assume lumber prices trail off but to a newer normal in the $500-$600/mfbm range due to structural changes in wood fibre availability in Western Canada and cost inflation. Given pulp and paper prices are still getting price increases through, I assume these prices stay elevated for 1-2 years before reverting to trend pricing/LT averages. With that I get a DCF value for RFP at ~$15.

Using Management Forecast in Proxy, $14:

In the proxy document, RFP provides the following projections:

Based on projections, I assume “normal” EBITDA generation is $275 mln. In reviewing the proxy document, I realize their financial advisor CIBCWM thought peers were trading currently at 1.1x-5.7x EBITDA. However, I think these are probably low multiples that largely reflect peak lumber prices. While not a precise science, I use a 6x EBITDA multiple to 2026E projection of $275 mln EBITDA. Also, I assume the cash generation between now and 2026 would negate the $1 bln pension liabilities. Hence, that gives me an equity value of ~$21 per share in 2026, discounted back 4 years at 10% gets us ~$14 per share. 

Using “Party A” Bid, $16:

Again in the proxy document, RFP mentions on June 3, 2022 they received an unsolicited non-binding bid from Party A for all operations except lumber and tissue for $0.9-$1.1 bln. Based on this, I made a bunch of assumptions to zero in on what the lumber assets are worth per share:

1. Lets assume RFP has zero net debt

2. Assume $600 mln used to fund pension liabilities

3. $400 mln leftover

4. Tissue operations at $0

For the lumber assets, I assume theoretical capacity of 2.4 bln bf and use a reasonable replacement cost estimate of $350/mfbm. With these assumptions, I get $16 per share:

My Understanding of the Odds

Broadly speaking, I think if RFP deal goes through, the upside (NPV basis or discounted otherwise) is $25 while the fundamental downside is ~$15. Therefore, I think it is as if the market is saying there is a 50/50 chance the RFP deal goes through, which I believe is incorrect, likely due to the existence of a non-tradeable CVR. 

Put another way, if I think the odds of the deal closing is at least 80%, the fair value of RFP should be $23, not $20 where it is trading right now – hence the opportunity. 

Disclaimers: Not investment advice, write-up subject to errors, do your own due diligence. Author not liable for losses/damages. Author may change positioning at any time or even trade against investment idea.

Catalyst

Deal closes

CVR pays out as US agrees to refund lumber duties collected