The rear mirror is always clearer than the windshield

Orchid Paper's right side of the balance sheet

Published on:
September 22, 2018
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Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

"The room was small, airless and cramped. To make matters worse, somebody in our group was making the most dreadful silent farts. Fortunately, it was me, so I wasn't as bothered as the others," wrote Bill Bryson in The Road to Little Dribble.

I, too, am less upset when investing mistakes are the result of my own doing. Last week, while on a three-day vacation in Seattle, I saw that the common stock of Orchid Paper Company was trading at 80 cents a share. I happily bought 4,000 shares of Orchid in June at an average price of $4.67, a whopping loss of 83% on paper, I realized. Ouch.

As I wrote in Capital markets have reason, which reason does not know, I bought shares in Orchid because I thought the stock price was low. In the June 1 article, I argued that Mr Market penalized the stock price because management stopped paying dividends to shareholders and because of a turnover in management. That Orchid’s latest quarterly earnings fell short of Wall Street expectations did not help much,either.

I was not expecting to hear much of Orchid after I bought its shares. Founded in 1976, the company operates in the somewhat monotonous world of parent roll industry, which is to say it converts fabrics to the stuff we use when we sneeze or go to the restroom. Click this link to view a video about the parent roll conversion process.

The stock: Over the past decade the average earnings per share was $1.15, and between 2008 and 2017, the stock traded hands as high as $36 (in 2016) and as low as $2 (in 2015). On July 31 of this year, Orchid's stock traded at $5, but ten days later, the stock price dropped to a record low of 80 cents per share.

Mr Market feared that the company was heading to bankruptcy. In 2016, Orchid paid an interest rate of 2% on its long-term debt of $187 million. In 2017, Orchid paid an interest rate of 6% on its long-term debt of $205 million, and as of the second quarter of this year, the cost of debt was greater than 9%. Management had reclassified the debt from long-term obligation to payable within one year. Read: its lenders would like to be paid off by year’send.

So instead of finishing the wonderful page-turner spy novel by Alex Gerlis, The Best of Our Spies, I spent the entire flight back to San Diego reading more about Orchid Paper Company. I frenetically sifted through its most recent annual reports and call transcripts with analysts, thinking, perhaps, that the recent decline in stock price was an opportunity to buy more shares at a going-out-of-business price tag.

Orchid's valuation – the parent roll multiple

In the second quarter earnings call with analysts, when asked what is the value of the company, Jeff Schoen, boss of Orchid Paper, did no tprovide a clear answer. Yet he referred listeners on the call to two facts. The first fact was that SCA, a Swedish hygiene company, purchased Wausau Paper for $513 million in January 2016. And since Wausau Paper had the capacity to manufacture 214,000 ton of parent roll, this transaction represented an implied value of $2,400 per ton.

The second sale transaction was when Resolute Forest Product purchased Atlas Paper for $156 million in November 2015. With a 65,000 ton manufacturing capacity, this comparable sale showed a similar $2,400 implied valuation per ton.  

Schoen was implying that Orchid Paper, with the capability to manufacture 70,000 tons of paper rolls, has an implied valuation of $300 million. Remove the $214 million in liabilities on the company's books and you get an equity of $98 million or roughly $9 per share (Orchid had 10.68 million outstanding shares as of the second quarter of this year).

Orchid's valuation – the EBITDA multiple

When Warsaw was acquired, it reported an annualized EBITDA of $64 million. In the prior year, it reported on an EBITDA of $76 million.With a price tag of $513 million on what I estimated an EBITDA of $70 million, the EBITDA multiple was 7 times. Atlas EBITDA was $23 million when Resolute bought it. And on a purchase price of $156 million, the EBITDA multiple was roughly 7 times again. And if we assume that the EBITDA drives the acquisition price,then the current sullen mood of shareholders of Orchid is likely to remain.  

Orchid's adjusted EBITDA between 2012 and 2017 was as low as $15 million (in 2017) and as high as $33,419 (in 2016). I used the highest EBITDA amount to demonstrate that even on the unlikely optimistic scenario that Orchid will return to a higher EBITDA (expected EBITDAis mere $17 million for 2018), its EBITDA-based valuation will barely pay off current debt holders, and shareholders are unlikely to receive any capital back.  

The math: with an EBITDA multiple of 7 times on EBITDA of $33million, we get a valuation of $231 million. With total liabilities of $214 million, the common stock holder is expected to get just about nil back.  

Looking in the mirror

Buying Orchid was a mistake. When I bought the stock, I knew that the culprit for the rising cost of debt was not management taking on additional debt, but the variable payment nature of the debt itself. And in a rising interest environment, to purchase a stock whose debt is indexed to interest rates was foolish of me.

The second mistake was that I was not compensating enough for Orchid's customer concentration. Three customers composed 68% of the 2017 sales. And when management informed shareholders that a major customer has decided to no longer work with the company, Mr Market was infuriated.  

Epilogue

Whether Orchid can be sold for $9 per share remains uncertain.Management had said that it expects that, within a few quarters, it will be able to replace the one customer who announced departure. And, hypothetically, with improved EBITDA, management may tame its lenders, or at least renegotiate the debt from variable payments to fixed payments, which would further may be of boon to shareholders. In short, the optimistic common stock holder expects a double-digit stock price sometimes while the pessimistic one expects the return of capital to be nil.

More important is to take ownership of mistakes. To reflect on the decision-making process and to see whether errors in thought could have been avoided. In the case of Orchid, the relatively cheap stock price impaired my ability to think clearly about the company I was buying in. One thing is for sure: I will never look at a paper tissue the same way again.