Most investors cringe and run when they learn that the company they've invested in is abruptly changing course.
That explains why Fortress Paper shares were bruised last Friday, after the company announced that it was buying a pulp mill from a bankrupt operator in Quebec.
Fortress is a smart little company that literally makes money. To be precise, the company makes bank notes for Switzerland and euros for 10 countries. It also makes passport and other security papers. Plus it makes high-end wallpaper. It's been a great little investment, returning more than 100 per cent since it started trading less than three years ago and 300 per cent since it bottomed in the market crash a year ago.
At first glance, the pulp purchase looks like a change of strategy. While Fortress is technically in the paper business, it's nowhere near pulp on the food chain. No one wants pulp, which explains how the mill ended up in bankruptcy protection.
But this is not a change of strategy. It fits in very well with how Fortress has made such gains for investors, and analysts have figured it out, which is why the stock was up so much yesterday. If it works out - and CEO Chadwick Wasilenkoff told me yesterday that he thinks this is the best deal he's ever done - the stock has lots of room to rise.
While it's true that pulp demand is in decline as we consume less paper, demand for rayon is climbing briskly. Rayon is a substitute for cotton, and according to the U.S. Department of Agriculture, cotton production is dropping, down by about a sixth in the past four years. The economics don't make sense for farmers who can make more by growing food or ethanol feed stocks.
Demand for cotton, meanwhile, is growing. But there isn't enough of it, so demand for rayon is climbing at about 7 per cent a year, according to Fortress.
What does that have to do with a pulp mill in poor old Thurso, Quebec? With a healthy investment, the mill can be converted to produce what's called "dissolving pulp," which is what they use to make rayon among other things. And that's what Mr. Wasilenkoff intends to do.
Fortress is paying all of $3-million for the mill. It has to invest $153-million to convert the plant - $91-million for the actual conversion and another $62-million to build co-generation, which produces electricity. Once up and running, the refurbished plant will, analysts figure, be a cash cow.
Why? Well, since there's a shortage of production capacity out there, dissolving pulp is changing hands for $1,500 a tonne - that compares nicely to the $800 a tonne the mill's pulp product fetches now.
What's more, Mr. Wasilenkoff arranged for attractive and cheap government financing for much of the acquisition. Fortress is putting up equity of only $15-million in total. The risk to shareholders is limited.
The analysts whose reports I looked at show, on average, a doubling of earnings before interest, taxes, depreciation and amortization over the next two or three years. The new price targets are twice as high as the stock price today, which may seem ambitious and may even be ambitious but isn't ridiculous.
Meanwhile, Fortress's other divisions - wallpaper and security paper - also show promise. The wallpaper mill is one of the lowest-cost mills in the world, and Fortress has about half of the global market share of coated and uncoated non-woven wallpaper.
And the banknote business is also stable with room to grow, although Fortress needs to make investments to modernize the works. Fortress's EBITDA grew 125 per cent from 2006 to 2009.
The truth is that this deal fits in perfectly with what Mr. Wasilenkoff has been doing all along: being a contrarian, buying cheap, seeing opportunities others overlook, allocating capital intelligently and being patient - the sorts of things only CEOs who own a lot of stock (23 per cent in this case) do.
Asked what is most challenging about his job, Mr. Wasilenkoff says "the stock price. We think it's lower than it should be and that's frustrating."
While small companies bear risks that bigger ones don't, like concentrated customer sales, I think he's right. The stock does look cheap, especially given that he's demonstrated an ability to make money for not only central banks but investors as well.
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