Distressed Debt Case Study: ABH / Bowater

Every few months, I try to post a recent idea from the Distressed Debt Investors Club to give readers and potential applicants a sense of the quality of ideas on the site. With that I give you a recent submission by "shoreboy" on Bowater. Enjoy!

Synopsis

We recommend an investment in the AbitibiBowater “Bowater side” unsecured bonds at a price of 30.5, or 2.9x-3.4x run-rate EBITDA (depending on the outcome BOW Finco double dip dispute) offering near term upside in excess of 50% at an important turning point in the cycle. More importantly, we believe downside is supported by low financial leverage and extremely high free-cash flow generation (worst case scenario FCF yield of 15% assuming downside EBITDA of $500mm and a complete loss to the Bow Finco double dip).

Investment Write - Up

Recommendation:

Dramatically Restructured Operations: ABH significantly transformed its business while in bankruptcy, closing high cost mills, shifting focus to more attractive paper grades, and slashing operating costs. As an example, ABH closed in excess of 900k tons of newsprint capacity (representing 20% of ABH’s capacity and in excess of 10% of North American capacity) since January 2010. We anticipate only 35% of future EBITDA will be generated from Newsprint, with the other 65% coming from coated paper, specialty paper, pulp, and wood products. Additionally, the company reduced fixed costs by $900mm and will benefit from an agreement with the union upon confirmation of the plan of reorganization, which will further reduce COGS & SG&A by $95mm.

Overly Pessimistic Outlook for Newsprint & Under appreciated Sustainable Export Story: As a result of the secular decline in North American newsprint demand accompanied by the step-function loss of demand experienced during the financial crisis, much of the North American newsprint industry found itself in financial distress over the past couple of years. The industry responded by dramatically reducing North American capacity by in excess of 25% since 2009. This reduction of capacity has caused a spillover effect which has increased the cash costs for newsprint manufacturers outside of North America and thus, shifted the cost curve in favor of the North American producers (who are currently the low cost producers in the world). This dynamic stems from North American producer’s outsized reliance on virgin wood fiber as its key raw material, relative to Asian and European producers who rely much more heavily on recycled newspaper (ONP – old newsprint). Historically, ONP was in plentiful supply and thus, its cheap cost accompanied by a production process that was less energy intensive allowed ONP mills to produce newsprint on the lower end of the global cost curve. As a result, almost all of the European and Asian mills built over the past two decades have been ONP based and most do not have the equipment or the wood supply to produce newsprint using virgin wood fiber. ;This has come back to bite them, as ONP can only be recycled 4 times before the fibers breakdown and Asian producers must source ONP in North America (which they then have to ship back to Asia) because of its high virgin fiber content. Due to the rapid decline in North American production of newsprint, unsurprisingly recycled newsprint has become increasingly tight (and is expected to remain tight) – driving up the cost for ONP to in excess of $100 per ton relative to $50 two years ago. Additionally, the current low cost of natural gas in North America has reduced the energy cost advantage of the ONP production process.

As a result, North American producers currently have ~$150 cash cost per ton advantage over Asian producers. Meanwhile, European producers would not be competitive until the Euro was sub $1.20, a situation which seems less likely every day. All of the aforementioned factors have created a huge export story (ABH is currently exporting over 50% of its production and is turning down export orders) allowing North American producers to operate at 100% utilization ratios and thus, creating pricing momentum. Despite the continued secular decline in North American newsprint demand (which is expected to continue to decline at 5-6% per year), the rest of the world is actually growing - Asian demand is expected to increase in excess of 500k tons per year through 2014 (more than offsetting the decline in North American demand, as the base of North American demand is already extremely low) as literacy rates increase in emerging markets. Therefore, we expect ABH will maintain their ability to generate meaningful cash flow from newsprint operations into the foreseeable future, as it exports more of its production into the Asia and Latin America.

Near-term Upside in Coated & Super-Calendar Paper: ABH has in excess of 1mm tons of capacity of coated paper and super-calendar paper, representing in excess of 15% of North American production. Due to a dramatic reduction in capacity and inventories, accompanied by a second half recovery in magazine and catalog circulation, coated paper manufacturers have recently announced $100 per ton of price increases. Despite these price increases, we believe there is room for additional price increases, as prices remain near historic lows on a real basis. Additionally, the US ITC ruled on Friday that domestic coated paper makers are being harmed by low-cost imports from Indonesia and China. This was the last of 4 decisions that was necessary for tariffs to be imposed on imports and is expected to keep the Chinese out of the domestic market for the next 5-years, which should further support price stability.

Pulp – A long-term Secular Story: The recent run-up in pulp prices in 2010 to in excess of $1,000 highlights the long-term story for pulp, as consumption per-capita increases in the developed world, as more and more people in emerging market use tissues, toilet-paper, diapers, etc. and and areas of North America are the only place in the world that produce long-fiber NBSK pulp. While many of the industry forecasters expect short-term pulp prices to decline, recent industry pulp data has indicated a more gradual decline, as demand in China continues to support pricing. Regardless, current prices are in excess of the plan assumptions.

Option on Wood Products & Upside from Monetization of Other Ancillary Assets: I currently ascribe no value to the wood products division as well as a number of other ancillary assets, including timberlands and closed mills (which they have been selling to scrap steel companies for $15-20mm). While the wood products division is currently generating virtually no EBITDA, it has generated as high as $100mm of EBITDA in the past and I believe normalized EBITDA for this business is $75mm. Assuming 5x, this business could be worth $375mm alone (7.5 bond points, or 25% upside from today’s price).

Business Overview/Paper Grade Exposure:

• Newsprint: 3.3mm tons of capacity representing 9% of worldwide capacity and 37% of North American capacity
• Coated papers: 658k tons of capacity representing 15% of North American capacity
• Specialty papers: 1.8mm tons of capacity representing 36% of North American capacity (note: roughly 1/3 of this capacity is supercalendar capacity, which trades like coated, 1/3 trades like uncoated, and 1/3 trades like newsprint)
• Market pulp: 1.1mm tons representing 7% of North American capacity
• Wood products: the company operates 18 sawmills in Canada that produce construction grade lumber sold in North America.

Simplistic EBITDA Projections:

Key EBITDA Sensitivities

-/+ $25 newsprint = -/+ 80mm of EBITDA

-/+ $25 CPP = -/+ 55mm of EBITDA

-/+ $25 Pulp = -/+ 26mm of EBITDA

+/- .01 C$/US$ = -/+ 18mm of EBITDA

+ / - 10% natural gas = -/+ 11mm of EBITDA

Other Investment Considerations:

Bowater Finco Double Dip: The outcome of this inter-creditor dispute remains unknown, and appears to be trending in favor of the Finco. However, based on current prices on the Abitbi-side, the market is currently ascribing now value to the option associated with this claim. Said differently, the market is implying 100% probability the Finco wins. While I don’t have any special view towards the outcome of this case, assuming a 50/50 chance (or a settlement that splits the value down the middle), the bonds should be at 33.5 (3 points higher, or approximately 10%)

ACH Sale: ABH is in the regulatory process of selling its Canadian Power Assets. The assets have $239mm of debt associated with them, which is non-recourse. We expect the assets will be sold for in excess of $400mm ($200mm of equity value) by Q1 2011. The proceeds will be used to pay off the debt at ACH as well as pay off up to $100mm of the 850mm exit debt.

Pension: The company has an underfunded pension of ~$400mm (as indicated Plan Projections on the POR balance sheet), most of which resides in Canada. The company is in the process of finalizing a deal with the governments of Quebec and Ontario that will limit the cash contribution of the pension catch-up payments to $50mm annually. As a result, I add $424mm underfunded pension (the NPV of $50mm per year) to my gross debt.

NOL’s: ABH has retained significant NOL’s and we do not expect them to be a significant tax payer for an extensive period of time.

Emergence, Listing, & Technicals: We expect the judge will confirm the plan within the next two weeks and likely will not rule on the Finco double dip (expect a 17% holdback). We do not expect this company will experience a technical sell-off post-emergence (ala Lyondell & Smurfit). The investor base is strong and the stock will be tightly held – large holders include Avenue, Paulson, and Fairfax. Additionally, the company will be immediately listed (day 1) on the NYSE and will have a secondary listing on the TSX (Toronto Stock Exchange). Furthermore, we believe there is a possibility ABH will experience a strong technical bid from Canadian Pension Plans, who typically hold substantial positions in Canadian Companies that trade on the TSX, and may be flush with cash assuming the Potash deal goes through.

Upside/Downside Cases (click to enlarge)