Value Play: Rayonier Advanced Materials (NYSE: RYAM)

Back in October when I recommended the spinoff Vishay Precision Group (VPG), I discussed the many benefits of investing in spin-off companies. I’ve found another spinoff that I am even more excited about!

Rayonier Advanced Materials (RYAM), the world’s leading producer of high-value specialty cellulose fibers engineered from wood pulp, was spun off from timberland company Rayonier (RYN) on June 27, 2014 and began trading on June 30^th.  The manufacturing process for specialty cellulose (slide nos. 15-16)  is extremely complex and RYAM has proprietary cellulose chemistry expertise and manufacturing process knowledge developed over 85 years. How wood pulp is converted into cellulose fibers is described as follows:

Specialty cellulose is a sophisticated niche business

Specialty cellulose manufacturing is essentially a refinement of the wood pulping process – a highly sophisticated refinement. Wood chips are cooked with an ammonium sulfite liquor to produce pulp, extracting lignin and other components of wood fiber. The remaining specialty cellulose is screened, bleached, washed, dried and packaged for customers.

The industry has steep barriers to entry, including high capital costs and proprietary production processes. A select few companies manufacture most of the world’s specialty cellulose – and demand is rising. Customers generally use specialty cellulose to make high-quality branded products.

Technical expertise is a must, particularly in terms of the chemistry. 

Rayonier Advanced Materials’ cellulose products have a combined annual production capacity of approximately 675,000 metric tons and are sold globally to companies for use in various industrial applications and to produce products such as cigarette filters, foods, pharmaceuticals, textiles and electronics. Approximately 58% of performance fibers sales are cigarette filters (page 22) and 58% of total sales are exported to customers in Asia and Europe (page 18).

Rayonier Advanced Materials Product Segments

Source: Company 10-Q

The company doesn’t break out profit margins for each product segment, but based on sales prices and an investor presentation (slide no. 23), “cellulose specialties” (CS) offers the best profit margins. CS products can be sold for 2.5 times the price per metric ton of either of the other two segments. Consequently, it is good news that RYAM gets 89% of its sales from its highest-margin cellulose specialties segment.

Rayonier’s CEO Paul Boynton jumped ship from RYN and moved over to lead the RYAM spinoff and five Rayonier directors also moved over (including lead director C. David Brown II). The parent company’s CEO can do whatever he wants, so it’s a good sign for the spinoff when the CEO decides he’ll have more fun and success leaving the parent for the spinoff. As one analyst explained, RYAM is a much more profitable company, with a return on invested capital (ROIC) of 29% compared to RYN’s meager 6.4% ROIC. In addition, RYAM is a larger company than RYN, as an investor presentation outlines (slide no. 7):

Rayonier Spin-Off Diagram

RYAM’s one weak spot compared to RYN is its higher debt ratio (3.0 vs. 1.7) and worse credit rating, but a debt-to-EBITDA ratio only becomes problematic at 5.0 or higher. Furthermore, the company’s cash-flow generating power is strong and stable, making interest coverage very manageable at 4.2 times net income based on last nine months (page 20). Fortunately, the weighted average interest rate on the company’s debt is only 3.75% (slide no. 28) and more than 95% of the principal amount of debt does not become due until sometime after 2018 (page 16).

The company is financed entirely with debt as its book value per share is slightly negative – i.e., there is no shareholder equity. Investors are skeptical of high-debt companies, with RYAM no exception. The short interest-to-float ratio is high at 21.3%, but I’m betting that short sellers are wrong to doubt RYAM.

High debt levels are only worrisome if a company’s annual cash flow is unstable and cyclical. RYAM’s cash flow is extremely stable despite the fact that it operates in the basic-materials/chemicals industry, which is traditionally thought of as cyclical. As reliable and consistent cash flows pour in year after year, the company will be able to pay down debt and generate shareholder equity. Reasons for RYAM’s cash-flow stability include:

• Undisputed market leader in specialty cellulose, with annual sales and capacity two times larger than its next largest competitor.(slides 13,14, 22).

• Specialty cellulose manufacturing has high barriers to entry thanks to the technical expertise needed that is “technologically difficult to replicate” and the capital-intensive nature of the manufacturing process. RYAM says that it knows of only one new entrant in the specialty cellulose market over the past 10 years (page 59).

• 55% global market share in cellulose acetate tow, which is used for cigarette filters (82%) and TV screens (18%). Not all cellulose acetate tow tastes the same, and most smokers prefer RYAM’s cigarette filters to any other, making the costs involved in switching to another acetate tow manufacturer virtually unbearable for any cigarette manufacturer to even contemplate.

• Five largest customers account for 70% of total sales, but these customers are incredibly loyal. Average length of client relationship for top-10 customers is 38 years, with range between 24 and 82 years. (page 59).

• Cigarette filters account for a majority of the company’s total sales and cigarettes are addictive and recession-proof. Other recession-resistant products RYAM’s customers manufacture with cellulose fibers are consumer-defensive things such as LCD TVs, drugs, food, and tires that people will spend money on regardless of the economy’s strength. This customer resiliency was demonstrated during the 2008-09 financial crisis and global recession, when RYAM’s sales increased by 5%, net income increased 12%, and adjusted EBITDA increased 18%. (page 60)

Despite the economic insensitivity of RYAM’s products, the company’s sales and profits in 2014 are down significantly, which can be blamed on temporary industry-wide oversupply (page 24) that has resulted in unit sales prices dropping 7% in 2014 (page 19):

Markets for the Company’s cellulose specialties are currently over supplied and demand in certain end-use markets has slowed. The over supply is a result of production capacity expansions and competitors who produce both cellulose specialties and commodity viscose shifting production into more cellulose specialties.

Part of the current oversupply has been caused by RYAM itself, but I believe the decision was the correct one and will turn out to be a smart move over the long term. In 2011, RYAM began a capital project, the Cellulose Specialties Expansion (“CSE”), to convert a manufacturing line for commodity absorbent materials into a line capable of producing cellulose specialties. The CSE was completed in 2013 at a total cost of $385 million and added approximately 190,000 metric tons of cellulose specialties capacity, bringing total cellulose specialties capacity to about 675,000 metric tons. Production of cellulose specialties is expected to gradually increase to capacity by 2018. (page F-6). As one Morningstar analyst explains:

Investors should not view the CS expansion as a strategic failure. The ample spare capacity Rayonier now controls is likely to deter both would-be entrants or existing players looking to expand. Had Rayonier not expanded, the competition would have, resulting in an end to the heady prices of recent years one way or another.

The oversupply problem is short term because of ever-increasing demand for cellulose fibers. RYAM projects that the global demand for cellulose specialties will grow approximately 45,000 to 50,000 metric tons a year as customers’ product needs continue to expand. As demand for cellulose specialties grows and RYAM’s production capacity increases by 190,000 metric tons by 2018, RYAM anticipates an increase in total sales and operating income.(pages 67-68). The turnaround in pricing may already have started, as RYAM expects unit prices and volumes of cellulose specialties to rise in the just-completed fourth quarter, along with a decline in production costs. (page 24). Fourth-quarter earnings will be reported pre-market on Wednesday January 28^th.

The best time to buy a stock is when business conditions are depressed and valuations are low. Now is that time for Rayonier Advanced Materials. The Enterprise Value-to-EBITDA ratio (my favorite valuation measure) is cheap at only 6.9 times and the price-to-earnings ratio is only 9 times last year’s pro-forma earnings per share of $2.48. The stock even pays a modest annual dividend of $0.28 per share, which equals a 1.3% yield.

Rayonier Advanced Materials  is a buy up to $28; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for Rayonier Advanced Materials, Roadrunner is selling:

• United Therapeutics (UTHR)

United Therapeutics has been one of the biggest winners in Roadrunner history, so I am hesitant to sell, but I also want to lock in profits before increased competition takes hold in the market for pulmonary arterial hypertension (PAH) drugs.  Competing PAH drugs from Actelion and Bayer have been on the market for over a year, but the December 23rd announcement from Actelion concerning its U.S. new drug application for Uptravi could be the real game changer because Uptravi is an oral PAH drug that could be more effective than United Therapeutics’ oral PAH drug Orenitram.

Insider selling has picked up, including from CEO Martin Rothblatt. One of the reasons that I recommended the stock in the first place was that Ms. Rothblatt was buying aggressively. Now that she is selling aggressively, I must take note.

United Therapeutics is (reluctantly) being sold from the Value Portfolio.

Momentum Buy:

China Biologic Products (Nasdaq: CBPO)

China Biologic Products is one of the largest non-state-owned fully integrated plasma-based biopharmaceutical companies in China. It develops human albumin and immunoglobulin products. Valuation is expensive, but it’s amateur hour in the Chinese stock market and we’ll ride the momentum as long as it lasts.

• Price gain between 12 months ago and 3 months ago = 149.1% (100th percentile)
• Price gain over the past 2 months = -2.9%
• Price gain over the past month = -0.03%
• Roadrunner Momentum Rating: 149.1 – (-2.9) – (3*-0.03) = 152.06

China Biologic Products is a buy up to $79; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• AerCap Holdings (AER)
  
  The collapse in oil prices makes jet fuel much more affordable for airlines and reduces the disincentive to continue operating older, less fuel-efficient planes that they already own. Since aircraft leasing companies thrive in times when airlines are willing to pay the higher short-term cost of leasing the most modern, fuel-efficient planes because the fuel-cost savings are greater than the lease cost, the near-term future of AerCap may not be rosy.