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One of the unsolved mysteries of stock analysis is how to learn about stocks in the first place. Some investors hear about stocks at cocktail parties ("Tesla is going to be 10x in 3 years") and rush to buy the stock. Other investors carefully read buy-side analyst reports. And some investors just follow a gut feeling (I know a portfolio manager who regularly visits a fortune teller.)
I argue that one of the best methods to understand a stock is by reading the risk Factors section of the 10-K report. This section of the annual report describes much more than risks - it provides a snapshot of the company and its industry. In short, the section details that keep management up at night.
In this meditation, I will share what can be gleaned from the Risk Factors section of Orchids Paper Company, a company I invested in a few weeks ago.
On page 10 of the 2017 annual report, management wrote "We have significant indebtedness, which subjects us to restrictive covenants relating to the operation of our business." Management expected $22.9 million in total debt payments for 2018. And for a company that reports on an adjusted EBITDA of about $15 million, that is a hefty debt burden. A closer look at the income statement reveals that while in 2016, the interest expense was $1.7 million, debt services mushroomed by over twofold, to about $5 million in 2017.
The cost of debt in numbers: Orchid paid a weighted interest rate of 2.6% in 2016. But in 2017 it paid a weighted interest rate of 7.3%. And as of the second quarter of this year, the rate on its debt crept up to over 9%.
Why the rising cost of debt? Risk number 12 in the Risk Factors section explains: Orchids is paying its debt based on variable payments. That is, the debt service fluctuates according to the level of the interest rate environment, specifically, the 30-day LIBOR index, an interest rate index that is almost twice as high compared to a year ago. (The 30-day LIBOR is now 2.06%, compared to 1.23% twelve months ago.)
Rising debt costs is an important issue for the common stock investor, and this section of the annual report immediately cuts to the chase.
"A substantial percentage of our net sales is attributable to three large customers," noted management, "any or all of which may decrease or cease purchases at any time." Listed as risk number 4 out of a list of 15 risks, the risk explains that between Dollar General, Wallmart and Family Dollar, about 67% of 2017 sales occurred.
To illustrate how sensitive capital markets are to this risk, I will remind current shareholders, yours truly is included in that camp, that Orchid's share price declined from about $4 to 80 cents a few weeks ago because management disclosed that a major customer would terminate its relationship with Orchid in 2019.
In Let my People Go Surfing, Yvon Chouinard boasted that Patagonia worked with one manufacturer in Japan. And because of the single concentration to one supplier, many of his peers regarded him to be mad. David Tran, founder of Sriracha, followed the same practice and relied on just one producer of hot peppers.
But what works for one-of-a-kind companies, such as Patagonia or Huy Fong Foods (the company behind the hot chili sauce), is inapplicable to the rest of us. Most businesses are better having an ample number of customers, a group of heterogenous suppliers and a host of manufacturing facilities in case one is out of commission. Orchid, selling a commodity product, cannot afford the customer concentration and the risk section, again, lets us quickly understand that.
To operate a paper mill requires constant work. And in Risk Factor number 7, management disclosed that "Our operations require substantial capital, and we may not have adequate capital resources to provide for all of our cash requirements." When I purchased the stock of TIS, I entirely ignored this risk factor. But you should not. Especially as we saw in prior paragraphs that most of the operating cash flow is expected to go to service the debt.
Between 2013 and 2017, the average capital expenditure was $48 million each year. If we want to go back even further, for the decade between 2008 and 2017, the average capital expenditure was $30 million. Compare that to the average EBITDA of $22 million for the past five years, or $20 million for the average EBITDA over the past decade.
And capital expenditure is a real expense for Orchid. And more worrisome, given the amount of variable debt, Orchid's ability to continue to pay for the expense is questionable.
I learned from Guy Spier how important it is to understand a company's cost structure. In The Education of Value Investor, he wrote, "It is critical to discern whether a business is overly exposed to parts of the value chain that it can't control." Returning to the business of running a paper miller, Orchid has two dominant costs of good items. The first item is energy cost and the second is solid bleached sulfate paper, also known as SBS paper.
The cost of both are rising. And rising costs are lethal when a company sells a commodity product as it is practically impossible to pass through the rising costs to the customer.
According to the Securities and Exchange Commission (SEC), the risk factors section in the 10-K includes information about the most significant risks that apply to a company. My purpose in this meditation was to argue that the risk section is much more than that. The risk factors section should be looked at as an index to story of the company.