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Re: hweb2 post# 34

Thursday, 03/30/2017 11:20:05 AM

Thursday, March 30, 2017 11:20:05 AM

Post# of 164
Orchids Paper: Equity Holders Are About To Get 'Wiped'

Naturally, the writer has a short position. He wrote a scathing article with several alternative facts.

He claims the Barnwell plant ramp up is botched, whereas everything is happening as mgmt laid out a year ago.

He also claims they delayed a dividend which is patently false.

Another patently false statement is this:

In addition, Orchids' sales team failed to develop new demand for the Barnwell plant ahead of its completion at the same time its existing customers disappointed on expected orders.

As evidenced by this:

https://ir.orchidspaper.com/all-sec-filings#document-3530-0001144204-17-003432

Item 7.01. Regulation FD Disclosure.
As advised during the third-quarter earnings call, Orchids Paper Products Company (the “Company” or “Orchids”) has been actively engaged in several retailer private-label bid-processes. Now, in an effort to provide additional and useful information to its shareholders, Orchids is announcing that it has been awarded a significant amount of new business in the form of bid awards from new and existing customers (the “Award”), pursuant to which converted-product cases may be ordered via purchase order. Winning bids included both conventional and structured tissue products expected to be produced in Orchid’s new plant in Barnwell, SC as well as the Pryor, OK facility. The Company anticipates that purchase orders under the Award may ultimately represent approximately a 35% increase in the annualized sales volume of converted-product cases, based on customer forecasts and relative to third quarter 2016 actual sales volumes, with full implementation in the third quarter of 2017.

I may add again later today.


To see all of the charts and graphs, click here:

https://seekingalpha.com/article/4058655-orchids-paper-equity-holders-get-wiped

Top Idea
Mar. 29, 2017 5:00 AM ET

Summary

* Once a handsomely profitable regional tissue manufacturer, Orchids’ margin structure has been fundamentally impaired, yet its shares trade at an 86% premium to peers.

* Dividend hungry investors attracted by TIS’ headline yield are unwittingly holding a company that has levered up considerably just as each of its markets worsen.

* Profitability is collapsing as reduced volumes, price competition, and large-scale capacity additions drive negative operating leverage.

* Interest rates on debt recently spiked 40% in exchange for covenant relief, dividend was announced then “delayed," and Orchids continues to hemorrhage cash on an ill-timed, poorly executed growth plan.

* Management is flailing and we anticipate trouble in 1H17. Estimates are largely unachievable and we cannot forecast a scenario where the dividend is sustained, the pillar on which valuation stands.

Orchids ("Orchids", "TIS", or "the company") is a highly-levered producer of paper towels and toilet paper trading at 11.2x next year's EBITDA, a considerable premium to peers. The company had historically operated a single, handsomely profitable facility serving the US Midwest. A confluence of factors at this facility drove industry-leading margins and a premium valuation multiple.

Over the past few years, Orchids has taken several steps to expand its footprint, including levering up to build what we believe was an ill-timed, poorly executed greenfield facility in the Southeast just as six competitors announced expansions in that area. Orchids has serially missed analyst estimates, received a covenant waiver in exchange for a much higher interest rate, "delayed" its dividend, and botched execution on its new plant.

Moreover, for TIS to meet analyst expectations over the next several years, it must receive pricing well above levels achieved throughout its history at an EBITDA per unit also above any levels historically experienced. As Orchids' difficulties compound, we cannot mathematically forecast a scenario whereby Orchids does not have to cut its dividend, the last proverbial pillar upon which its current valuation stands.

Historically Profitable Single Facility

TIS had historically operated a single facility serving the US Midwest in Pryor, Oklahoma. The "Pryor facility" has a capacity of 83k tons annually and is unique for several reasons, allowing it to earn outsized margins in an industry that is otherwise highly commoditized. These factors include:

* 75% of shipments are picked up by customers, thereby reducing freight cost

* Tax credits due to its situation on former Native American land

* Low input costs given an exclusive supply agreement with nearby Dixie Pulp & Paper, low wage employment market, and cheap electricity.

Questionable Expansion Plan

In November 2013, Orchids' board of directors brought in a new CEO (Jeffrey Schoen) tasked with repeating the success of the Pryor facility in other US regions. In Schoen's own words:

My goal is to increase the value of Orchids to reflect a $50-$60 stock price, as I am incented to do so with market-based options. To accomplish that, Orchids has needed to expand its footprint. -Jeffrey Schoen, 2Q15 Earnings Call

In June of 2014, TIS announced an agreement with Fabrica. Fabrica is a large tissue manufacturer based in Mexicali, just south of the California/Mexico border. The Fabrica deal involved several elements:

* Asset purchase agreement: Orchids issued 412k shares of its stock ($12m) for a paper machine, two converting lines, Fabrica's customer list, and a non-compete.

* Supply agreement: Orchids paid $16m cash and 274k shares of its stock ($8m) in exchange for the right to purchase capacity from Fabrica at cost plus a markup.

* Equipment lease: Orchids charges Fabrica a rental fee based on the number of tons Fabrica ships to Orchids.

* Board representation: Mario Garcia, founder of Fabrica, was given a board seat on Orchids' board.

Fabrica agreed to supply a base of 19.8k tons with a two-year additional 7.7k ton option. Orchids would then market that tissue in the Southwest, thereby expanding its footprint to the left side of the country.

Further, in April 2015, Orchids announced the greenfield construction of a 32k ton facility in Barnwell, South Carolina ("Barnwell"). The project was expected to cost $120m, a whopping 53% of TIS' then current market value. To finance construction, Orchids raised $34.5m through the issuance of 1.5m shares and took on a term loan, initially expecting that debt would peak at $110m.

Analysts cheered Orchids' strategy. This time last year, analysts were projecting $60m of EBITDA in 2017. The analysts were ostensibly extrapolating the success of Pryor across the rest of the business, although as indicated earlier, there are several specific reasons why Pryor is uniquely profitable.

It appears, however, that each segment of Orchids' business (Southwest, Midwest, Southeast) has fallen under significant pressure.

Life Happened While Making Plans

Just as Orchids stretched its balance sheet to build Barnwell, negative trends developed in each of its respective markets.

Southwest - Supply Availability Drops

Orchids' supply agreement with Fabrica was for 19,800 base tons with a two-year option to purchase an additional 7,700 tons. As the Fabrica deal came up for renegotiation in June of 2016, the two parties failed to reach an agreement. What happened?

Fabrica is a large tissue manufacturer operating in a low-cost environment. When the optional tonnage came up for renegotiation, Fabrica wanted to extract pricing from Orchids to share in the significant margin they witnessed at Orchids. Orchids held firm and Fabrica walked away from the bargaining table. This had the impact of reducing available tons sourced from Fabrica by 28%. This had a pronounced impact on gross margin given that Fabrica is the largest tissue manufacturer in Mexico with scale and cost advantages, thus volumes purchased were at higher-than-average margins.

Moreover, Orchids had taken over a large account from Fabrica concurrent with the 2014 supply agreement. This customer, HEB Grocery Company, was immediately catapulted into a top customer for TIS, representing 15% of sales in 2015. As Fabrica shipments declined, HEB is no longer reported as key customer.

Midwest - Competition Intensifies

Orchids began to experience intensified competitive pressure from branded product manufacturers promoting products through price reductions, specifically Georgia-Pacific. This had the effect of shifting customer mix away from private label, which reduced Orchids' shipments of converted tissue and increased shipments of commodity tissue rolls that the company had manufactured. This reduction in tons shipped due to competition coupled with a reduction in tons purchased from Fabrica caused total tons to shrink by enough that Orchids opted to stop reporting quarterly tons shipped. We had to wait for the 10-K which revealed that 2H16 over 2H15 tons declined by more than 13%. For a "growth" business with a growth multiple, this is bad news.

Further, Orchids derives half of its revenue from just two customers, Family Dollar (14%) and Dollar General (36%). Both Family Dollar (Owned by DLTR) and Dollar General (NYSE:DG) have experienced steadily declining same store sales comps, also a bad harbinger for Orchids' "growth" trajectory.

Southeast - Intensified Competition Coupled with Botched Execution

As Barnwell was being built, competitors announced several hundred thousand tons of planned capacity expansion in Orchids' new southeast region.

* Clearwater announced 70k tons in Shelby, NC

* First quality announced 64k tons in Anderson, SC

* Resolute announced 66k tons in Calhoun, TN

* ST Tissue announced 45k tons in Franklin, VA

* Von Drehle added 30k tons in Natchez, MS

* Kruger is planning to expand in Memphis, TN

In addition, Orchids' sales team failed to develop new demand for the Barnwell plant ahead of its completion at the same time its existing customers disappointed on expected orders. Inventory days have grown by 39% as competition in the Midwest heats up, customer growth slows, and the sales team tries to drum up business for Barnwell in a market experiencing significant capacity increases.

This Ain't 2013: Orchids Now Has A High Degree of Operating AND Financial Leverage

In 2013, Orchids had $15.1m of debt and generated $18.4m of operating income. From 2013 to 2016, Orchids increased its debt by $124m, yet its operating income is higher by only $280k due to negative developments across its disparate markets. The recent 13% y-y reduction in 2H16 revenue drove a 34% reduction in gross margin per ton. This is obviously dangerous given the following two realities:

* Orchids is a price-taker operating a fixed cost business in an intensifying competitive environment.

* Orchids will likely exit 1Q17 at more than 5.5x leverage as measured by debt/EBITDA.

Whereas management originally projected total debt to peak at $110m, Orchids is already at $141m and will be higher after 1Q. Orchids' debt could peak at more than $150m, which is $40m higher than initially expected. A $40m delta would represent 18% of Orchids' market cap at announcement. How did management misjudge project cost by nearly a fifth of the value of the entire company? In any event, Orchids is already running into trouble under the weight of its massive debt. The company's original credit agreement contained a maximum 3.5x leverage covenant. When it was clear that Orchids was going to breach, its bank issued a waiver in exchange for a 40% higher interest rate (5.2% vs. 3.7% prior). Orchids' higher debt load multiplied by higher interest rates results in an incremental $5.5m of cash interest in 2017. ?Specifically, from the end of 2015 to the end of 2016, TIS' total debt has increased by 84% from $74m to $137m. Moreover, we project that TIS' total debt will peak at $177m if they only pay three dividends this year. TIS' higher average debt in 2017 multiplied by a higher interest rate results in $8.4m of total interest expense in 2017. This represents an incremental $5.5m of cash interest vs. $2.9m paid in 2016.

Management is in Flail-Mode

The competitive landscape is clearly evolving to the detriment of Orchids and CEO Jeffrey Schoen's tone on the 4Q16 earnings call was a poor attempt to hide this reality. During the call, Schoen points out that Orchids has two options as competition in the Southeast heats up:

* Sell commodity unconverted tissue rolls ("Parent Rolls") into the market

* Ship converted product from South Carolina to markets in the West

A key part of the Barnwell margin structure, however, is reduced freight! Moreover, a key reason for recent margin deterioration is a mix-shift toward commodity Parent Rolls from finished converted product. Thus, these two comments by themselves make it difficult to extrapolate the attractive margin structure from the Pryor facility to the Barnwell facility.

As Orchids' debt-load balloons and its market projections deteriorate, management is trying to soften the blow by promising future volumes. In conjunction with Orchids' amended credit agreement, management issued an 8-k stating Orchids has been "awarded" significant new business. Upon digging through the filing, we found that converted product cases may be ordered pursuant to these "awards." This language is obfuscated, misleading, and commensurate with management's over-promise/under-deliver style. In fact, Orchids has missed all estimated metrics by a wide margin for the last three quarters.

Forward Analyst Projections are Likely Unachievable
But what is the downside to the short thesis? What happens if Orchids is able to plow through the morass without permanent damage to the business? We turned our attention to the expectations currently baked into the stock using a simple exercise to test the feasibility of analyst assumptions going forward. Specifically, we took analyst revenue and EBITDA estimates and divided both by total tons of capacity in order to derive the implied unit economics. We compared the result to Orchids' historical experience. We found that in order to meet analyst projections, Orchids will have to generate considerably higher revenue and EBITDA per ton than the company has ever generated.

If we assume 134.3k tons of capacity (82.5k Pryor + 19.8k Fabrica + 32.0k Barnwell) and 90% utilization, we arrive at a reasonable figure of 120.9k tons of capacity per annum. Analysts are expecting $270m of revenue in 2019, implying an average price per ton of $2,234. TIS' ASP over the last six years however, has been $1,884. Thus, analyst projections are a considerable stretch as pricing competition heats up and competing capacity is added.

The same analysis applied to EBITDA yields a similar result. Analysts are expecting $57.4m of EBITDA in 2019. If we divide this into capacity of 120.9k tons, the result is $475 per ton. TIS has, however, historically generated average EBITDA of only $350 per ton. Moreover, analyst estimates are likely quite a stretch given that we think Barnwell will be less profitable than Pryor in addition to existential environmental margin pressures.

Dividend Cut is Likely Imminent

After six consecutive years of paying a stable/growing dividend, we cannot mathematically forecast a scenario in 2017 in which Orchids can sustain its dividend. Specifically, from the generous $27m of operating cash flow we project in 2017, which already includes incrementally higher interest expense, Orchids has considerable earmarked cash uses including additional capex to finish Barnwell, maintenance capex on existing facilities, and required principal payments.

Management has already effectively cut its dividend by delaying payment in order to comply with its interest coverage ratio. Not surprisingly, management has been quick to point out that Orchids is not bound by any policy requiring a dividend payment. It seems we're slowly being set up for the elimination of the dividend. The "delay" notwithstanding, news outlets such as Bloomberg and CapitalIQ continue to forecast a runrate dividend and implied yield which appears attractive at 5.5%. We believe this attractive headline yield has lured unsuspecting dividend-hungry investors unaware that the underlying business and end-markets are facing significant challenges.

What is the stock worth?

Orchids has historically been outwardly more expensive than its publicly traded direct competitors. The same remains true today. However, it's our opinion that this premium is no longer warranted as margins contract from historical levels and the equity is now highly levered. In short, the business has changed but the valuation has not. And, the valuation disparity is not a simple rounding error; Orchids' equity is 5 turns (86%) more expensive on an EV/EBITDA basis than its public peers.

We believe that as the company continues to hemorrhage cash, miss analyst estimates, and cut its dividend, shares will ultimately trade down to our DCF-based target price of $15.50, representing 40% downside from today's price. We also note that this implies an EBITDA multiple in line with peers.

Disclosure: I am/we are short TIS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.









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