Monday, August 1, 2016

Verso Corp: Bankruptcy Reorg, Cheap Valuation

Verso Corporation (VRS) is a paper producer, primarily of coated papers used in magazines, catalogs, direct mailings, and other commercial applications.  They operate 8 paper mills, most of which are in the upper midwest.  This is a business in secular decline, shrinking mid-single digits annually the past five years as all media shifts to digital formats.  Verso was created by Apollo Global in a $1.4B 2006 leveraged buyout of International Paper's coated paper business, shortly afterwards the industry began to decline and Verso was sub-scale and had too much debt to compete.

In January 2014, Verso announced they would attempt to fix the scale problem and agreed to purchase competitor NewPage for another $1.4B.  The deal was heavily scrutinized by the Department of Justice fearing a monopoly in the coated paper market, all while both businesses were struggling and needed the combination to cut an estimated $175MM in costs.  Eventually the combined company agreed to sell 2 paper mills to appease regulators for $74MM and the deal was completed, but not in time to save Verso which filed for bankruptcy this past January with $2.8B in debt.  In July, Verso emerged from bankruptcy eliminating $2.4B in debt leaving it with $371MM split between an asset-back line and a term loan.  The former Verso and NewPage creditors became the equity shareholders and the company resumed trading under the symbol VRS.

After a company emerges from bankruptcy, the new equity is often in the hands of disinterested owners, the former debt holders, and similar to a spinoff there's no IPO road show to get investors excited.  The dream scenario is when a good business over-leverages themselves and a temporary setback in their business pushes them into bankruptcy while the underlying business is solid with long term growth prospects.  That's not the case here with Verso, the paper business is a declining commodity industry with high fixed costs and a variable priced end product that also has to compete against foreign producers benefiting from the strong dollar and lower labor costs.  But a cheap price can overcome a lot of flaws and Verso's equity is priced very cheaply.

Verso's management provided financial projections out to 2020 as part of the bankruptcy process, here's a link to the entire docket but I found the disclosure statement filed 5/10/16 to be the most helpful.
Verso expects to earn $145MM in 2017, it's current market cap is $404MM, so it's trading at a forward multiple of under 3 times earnings.  But P/E is probably not the best measure for Verso, they have a significant pension liability at $565MM that needs to be funded.
Verso expects to generate approximately $70MM annually in free cash flow after making pension plan contributions which works out to a 17% free cash flow yield.

PJT Partners, a 2015 Blackrock spinoff, was Verso's financial advisor through the process and provided their own valuation analysis.
A $700MM market cap would equal $20.35 per share (75% higher than today's $11.50) and value Verso at ~5x earnings, 10% free cash flow yield, and about ~4.4x EBITDA before pension contributions.  Sounds like valuations for other declining industries like newspapers and terrestrial radio stations.  Cheap and very reasonable even for a terrible business like coated paper.

The company is currently searching for a new CEO who would presumably have freshly struck options at today's depressed prices and a mandate for change, they wouldn't be tied to any of the decisions of previous management and could accelerate a shift to more profitable and less commodity specialty papers.  The ill-fated NewPage acquisition had strategic merit, the industry needs to consolidate and take capacity out of the system, Verso just had the wrong balance sheet and not enough time to experience the cost synergies of the merger.  By eliminating $200+MM of interest payments and realizing $175MM in cost synergies, new Verso should be more agile and able to adjust their business to the industry's realities.

Verso isn't a business you want to hold long term, I view this as a Graham cigar butt trade, get one last puff to the upside and move on to another one.

Risks:
  • High fixed costs, variable input/outpost costs - Verso's input costs (timber, pulp, energy) are all highly variable and it's a price taker in their end coated paper markets, pair those dynamics with a high fixed cost expense base (expensive to maintain mills, unionized labor force) and a lot could go wrong.  A $25 change in pricing per ton would wipe out their entire annual EBITDA.
  • Paper industry is in secular decline - Demand for paper decline 10% from 2012 to 2015, expected to decline another 4% in 2016, and likely will continue to decline at a similar pace for the foreseeable future.
  • Verso hasn't been profitable since 2009 - I'm somewhat relying on management's financial projections and assuming they'll be able to come close to meeting those expectations which would be a significant turnaround from their results prior to bankruptcy.
  • Continued strong US dollar - many of Verso's competitors are foreign, a strong dollar makes Verso's paper less competitive both domestically and in overseas markets.
Disclosure: I own shares of VRS

48 comments:

  1. I looked at this briefly last week as well. Do you know who the largest creditors / post reorg equity holders are?

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    1. In their filings they state that no one owns more than 10% of the shares at the time it emerged from bankruptcy. Looking at some of the old creditors you have Oaktree, Invesco, some CLOs, typically creditors you'd expect.

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  2. How did you get $404 in market cap? There are 81.8 million shares at $11.75, that's about $963m.

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    1. That would certainly change things, but I believe you're looking at the old pre-bankruptcy share count, there are a little over 34 million shares outstanding post emergence.

      https://www.sec.gov/Archives/edgar/data/1421182/000119312516648965/d215736d8a12b.htm

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  3. don't they have some non-publishing paper grades in wisconsin and maine? those assets are locked in a low multiple business

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    1. Sorry - I don't fully follow, could you expand? Yes, they're trying to focus more on their specialty paper business (labels, flexible packaging, etc), and how low of a multiple is correct? Seems like it's too cheap now for an ongoing business regardless of paper grades. But I could be naive to the business, it's not an industry I know well. Thanks.

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  4. I think the main issue I have here is that all of the analysis is based off management estimates. How on Earth do you know management estimates are even close to realistic?

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    1. Hi - I agree somewhat, but if you look at the 2015 10-K the estimates don't seem that outlandish, they show sales dropping from $3.1B in 2015 to $2.9B in 2017, COGS comes down mostly in line with sales and the big differences are in interest expense (which makes sense) and depreciation which was accelerated in 2015 due to reducing capacity at a mill. They do state in their assumptions that they see demand flattening for paper in the next several years, that seems rosy, otherwise they seem to pass the eye test. Does anything in their projections particularly alarm you? Thanks for the comment.

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  5. Why the two classes of stock?

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    1. I don't know the exact reason, but they have the same voting and liquidation rights.

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  6. Featured your post on my blog (https://specialsituationinvesting.wordpress.com/). Very informative, thanks and cheers!

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    1. Thanks and I look forward to reading your future posts.

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  7. What gives you confidence in their ability to achieve 6%+ EBIT margins? It appears they have only achieved this level once in their lifetime. Other competitors seem to achieve *EBITDA* margins less than 5%. How do you explain the delta between history and these forward projections?

    Assuming their margin projections are accurate, what is the support for their sub-20% projected tax rate? Do they have any tax shelters carried over from Chapter 11?

    Thanks for your thoughts!

    - Michael

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    1. Which competitors are you looking at? Both Sappi and UPM have EBITDA margins well above 5% at first glance. I think part of their rosy projections is the cost synergies from the NewPage acquisition being fully recognized, they never had the scale to achieve to sustainable margins since the Apollo/IP deal. The other piece is their move to more profitable specialty paper segments versus the commodity coated paper market. Not a great answer if you're trying to build a model, but the scale and shift in strategy made me feel comfortable given the low multiple currently implied.

      They do have some NOLs that carry over from bankruptcy, but they're subject to annual limitations, my guess is that explains most of the lower tax rate.

      Thanks for the comment.

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  8. Don't mean to go offtopic but was curious what your thoughts were on the GRBK earnings and conference call. I'm not an expert but it seemed pretty bullish. While the upside is hard to predict, it sure seems as if the downside is pretty well protected with close to an unlevered balance sheet and a book value that is likely understated. As an aside, with everything that people like David Einhorn and Dan Loeb say and do making news, I find it pretty remarkable how under the radar this stock seems to be. Partnering with Einhorn and Loeb, especially after they fully bought into the secondary at higher prices, seems like a pretty intriguing risk-reward. Appreciate your thoughts and your wonderful blog.

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    1. Yeah it seems like they're starting to mature as a business finally, no one is going to give Brickman a public speaking award, but the business is starting to hit its stride operationally as they continue to grow and scale up. I think you sum up the case pretty well, it's trading near book value which should be understated, you have a long term oriented management, skilled capital allocators as cornerstone investors, and two hot housing markets that should continue to stay attractive. As for being under the radar, I think that's mostly because of the small market cap and smaller float, plus management blew their guidance badly out of the gate, probably turned off quite a few institutional investors. Thanks for reading and the kind words.

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  9. I agree with everything you say here except "But a cheap price can overcome a lot of flaws and Verso's equity is priced very cheaply."

    Sorry, that is absolutely incorrect IMO. You may still make good money here due to post-reorg dynamics and I hope that you do. But businesses in irreversible secular decline tend to attract, time and time again, deep value investors because they have a semblance of being inexpensive.

    What tends to happen typically is that earnings "catch down" to stock price rather than the other way around. PE funds usually buy these businesses in distress, squeeze every drop of blood that they can via fees, put lipstick on these pigs, and then float them out unsuspecting public via post-reorg option or an IPO to get the last % of return for their "trouble".

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    1. Good thoughtful comment, number of things to digest here.

      The paper business isn't one I want to be in for the long term, more interested in the post-reorg dynamics as you mention. Verso being a former private equity holding does make me worried. They do own most of their plants and a few non-core assets surprisingly, but that is a concern. But I can't argue with most of your points here, thanks again.

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    2. Realizing that this is imprecise and totally back of the envelope... but:

      They show in projections generating $2.9B in revenues in 2017. Looking at the quarterly figure just released, and taking into account that this is a shrinking business, I doubt if they can get anywhere near the $2.9B.

      Now, there is seasonality in the business due to xmas, holiday mailings (that we all love to get in the mail!!) and I looked at some seasonal numbers in past 10Ks. Based upon what I saw, I still cant see them coming even close to $2.9B in revenues in 2017.

      Moreover, they show some growth in out years which I find to be a wholly unrealistic assumption. I have been doing this for a very long time - in general, these projections are made conservatively to beat later on and get a boost for mgmt shares/options etc. Doesnt seem to be the case here.

      Did I miss something?

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    3. The results weren't confidence inspiring, and I may very well be wrong on this idea. But keep in mind these were pre-emergence results, customers probably pulled back some and they have some work to do to get those back, and there will be a lot of noise in the results for a few quarters. They still need to find a new CEO, keep moving towards specialty papers, and the cash flow is still somewhat there although I think they're just pushing off some capex to 2017 in order to soften the blow of a bad quarter. I need to learn to be more patient, probably should have given it more than a few weeks post emergence to trade, but not throwing in the towel just yet. Thanks.

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  10. I honestly don't mean to be mean and this one may work out yet but I suspect PJT and Apollo may have done the valuation work together on this one (wink wink..).

    As always, wish you best of luck!

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    1. Yeah no worries, I always appreciate your viewpoint. I've got egg on my face at the moment, but luckily I sized this one (mostly) appropriately.

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    2. I looked up the projections and notes to projections in the disclosure statement. I could not find breakdown of management's assumptions on price and volume, i.e. how they came up with revenue forecast. Was wondering if you might have come across this information elsewhere in the docket? thx.

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    3. I don't think they disclosed it. VRS did provide a year-over-year EBITDA bridge in their Q2 conference call, price took EBITDA down $35MM whereas volume took it down $12MM.

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    4. OK - thanks. It funny, right? We can see this stock moving down and then it makes you wonder, what is taking place? PR dynamics or fundamental issues that became evident during Q2 results? No one knows for sure and it may be a combo of the two. In any event, I can tell you this much - that post reorgs of 2001-2002 cycle were the last real deal. too many hedgies chasing the same crap has made everything efficient, perhaps over-efficient and we need this HF space to completely blow itself out of the water if we are to make real money in future.

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    5. I think it's a combination of the two, but you're right, it's hard to really tell and I should have shown more patience before buying. I wasn't actively investing in 2001-2002, started a couple years later but I bet you're right, the opportunity set as gotten smaller.

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  11. didn't they take significant market related downtime in 2H15 (~$35MM)? No downtime in 2H16 should help offset the price/vol impacts.

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    1. Good point, but I believe they did guide to some downtime in 2H16 at two of their mills that would impact P&L "$10-$12M unfavorable for remainder of the year", these seem more like regularly scheduled maintenance than one time items we should ignore?

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  12. The problem is that EBITDA margins have declined to mid single digits from almost teens in the last 2 years. And at the current run-rate, the EBITDA will not be sufficient to cover capex + interest + pension contributions. So Verso will be cash constrained unless the business picks up / they come up with huge restructuring measures (which come at a cost as well).

    Synergies won't help I dont think. At the Q3'15 results, they were saying that synergies on a run-rate basis were already running at close to 90%. I would guess that synergies are already fully reflected in the current results.

    Operationally, its hard to see what they can do in a fixed cost business where volumes are structurally declining.

    So the remaining lever is price. This has been hurting them due to strong USD. But I guess it could swing back the other way. Verso then effectively becomes a high beta call option on pricing improving.

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  13. This situation points out a big flaw in GAAP accounting. They changed the rules to account for unfunded pension liability in that now firms have to show it on the balance sheet (whereas in the past, it was in the footnotes).

    However, no impact on the income statement which doesn;t make any sense? Unfunded pension is nothing more than debt "in drag". Just as cost of debt flows through the income statement (interest expense), I see no reason why pension contribution shouldn't.

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    1. You make a good point, what's the counter argument? Why did FASB decide against it?

      As an aside, the CFO bought a decent chunk of stock last week. I'm still holding for now, it was a tiny position that's gotten a lot smaller.

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    2. Unfortunately I don't know the counter argument but common sense would tell you that pension should flow through inc stmt.

      I saw the CFO transaction - quite meaningful.

      Timing aside, this stock does have quite a few potential catalysts that may or may not be overwhelmed by business fundamentals. I imagine that whoever they hire as CEO will have every motivation to low ball numbers/ests. until his or her stock and options are in place. So that is something to think about...

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  14. they have been issuing press releases highlighting new non-printing/publishing products. would be helpful to understand the capacity/revenue/profit contribution from these markets!

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    1. I've noticed that too, most likely just trying to reshape their image, time will tell if they're actually able to reshape their business as well.

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  15. I Havent taken my eye off of this one... It will be interesting to see the owners list when 13Fs are all filed with the SEC.

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    1. I haven't either, still own a (now) small position in it. VRS could be a tax loss candidate for me soon, but definitely a lesson in showing more patience/caution as these companies emerge from bankruptcy.

      Surprised there's no CEO announcement yet, what to make of that? Could delay any kitchen sink type quarter as you mentioned earlier in the thread.

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  16. CEO is taking a while but not the end of the world - unless - all the distressed debt guys are out or sold out most of their stake.

    If they are still in (and we will know more when 13Fs are done filing) they will protect their stake and get a decent CEO. If out, this will be a rudderless ship unfortunately. If they were going to promote anyone from within, it would have been done by now.

    The stock has lost so much value already, how low is it gonna go seriously.

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  17. I imagine that you have bigger and better things to focus on but going back to Verso..

    I have come to the conclusion that management of this company are outright liars and manufactured misleading projections to push the bankruptcy through. This is most likely why the CEO is "retiring" .. it rarely happens this close after a Chapter 11 process that you see a CEO go without any replacement already in place.

    Also, how could things have deteriorated so fast? This is a oil or natural gas. Paper has been in the shitter for a while but pricing is not quite so volatile that these guys were taken by surprise.

    I am not sure if there are any lessons to be learned here - 100% of the time, we assume mgmt will not commit fraud. Sometimes shit just happens.

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  18. sorry, I meant not oil or natural gas co

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    1. I want to believe you're overreacting, but you're probably spot on, seems like every year I make one bad mistake, VRS was 2016's.

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    2. To close this loop, I sold this week at $5.40.

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    3. Wow! Definitely time to buy. Year end bond sellers and panic seller on a story no one here has caught on to given 100% of holders wanted out of this stock by the end of the year given they need 90+ to recover their bond losses. Time to buy = very soon.

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  19. MDC.

    Are you thinking what I am thinking about Verso vis a vis this import tax proposal and how it could impact Verso? Imports are killing this company...

    ;)

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    1. I would think the strong dollar more than cancels out an import tariff?

      Speaking of post re-org equities, have you looked at CNTE? I've had a couple people mention it to me recently and have been looking at this week. Much of the former assets of Alpha Natural Resources.

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    2. You are absolutely correct! and given the trajectory of interest rates, the dollar will get worse (stronger). really bad news for VRS

      i have not looked at CNTE thanks for pointing it out

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  20. Hi MDC.

    painful as it may be,you still watching VRS? I imagine that a strong Dollar will continue to whack its business. but as howard marks says, its not what you buy, its what you pay for what you buy that determines succes or failure in an investment...

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    1. I haven't been paying close attention but haven't deleted it from my watchlist, I agree with you on the strong dollar comment, but the Howard Marks comment? Does that mean you're considering a jump back in at these prices?

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    2. Not quite yet but i have feeling this could end up being worthwhile to keep on radar and look for an inflection point.

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