The markets, and shares of Fortress Paper, have been extremely volatile since our initial comment on the Company.  Investors have fled to safety and have abandoned small-cap, under-followed, deep-value securities.  However, we are confident in the Fortress Paper story and recent results have confirmed our investment thesis, despite the present market price of Fortress.

Fortress Paper has now reported three quarters of financial and operating results as a public entity.  On the surface, the numbers appear volatile, so we feel the need to provide some colour to the results.  In November, Fortress reported third quarter revenue of $34.1 million while earning only $0.02 per share.  This compares to revenue of $35.4 million and earnings of $0.17 per share in the second quarter of 2007.  These results may have caught the market by surprise since they appeared to weaken sequentially.  However, this temporary dip in earnings should have been anticipated.  Management had been clear that downtime would be taken in the quarter in order to perform scheduled maintenance and upgrade the mills to increase higher margin capacity using the IPO proceeds.  Consequently, the results rebounded strongly in the fourth quarter of the year, with sales of $37.5 million and earnings of $0.22 per share.  For the year, Fortress reported impressive results, with sales of $145.3 million, EBITDA of $13.6 million and net income of $0.76 per share.

At the current price of approximately $7.50 per share and a total market capitalization of approximately $75 million, the shares are cheap.  The discount to replacement value of the Landqart and Dresden mills, we believe, is excessive for a Company that is both cash flow positive and earning money.  Trading at only 5.5 times EBITDA and below 10 times earnings, the market has placed forestry sector multiples on this Company.  However, we suggest that it is more appropriate to use a high tech security multiple instead.  Fortress operates in a highly specialized industry, with impressive research and development capabilities related to the development of the latest and most advanced anti-counterfeiting features.  Should a multiple re-rating occur and/or the Company is discovered by the market, we believe that the shares could trade in a range between $10 and $12 per share in the context of a 12 to 18 month period.

May 23, 2008

After reporting a soft Q3/07, followed by a vastly improved Q4/07, Fortress Paper reported earnings for Q1/08 that blew away all expectations. The Company reported basic earnings per share of $0.41, or net income of $4.2 million. Earnings were almost double the Q4/07 results and approximately fourfold greater than the prior year’s comparable period. Sales in Q1/08 were $49.8 million compared to $37.5 million in Q4/07 and $38.3 million in Q1/07. To explain the growth, management pointed to capacity increases at both mills (using the proceeds from the IPO) and a shift towards more non-woven wallpaper base at the Dresden mill. In addition to revenue growth, Fortress was able to expand margins in the quarter, as newer, more efficient equipment led to higher productivity. The EBITDA margin expanded to 13.3% or $6.6 million compared to 11.3% in Q4/07 and 7.4% in Q1/07. The net margin reached 8.4% versus 6.1% the previous quarter and 2.9% in the comparable period a year ago. Needless to say, we were very pleased with these results.

In addition to the excellent quarter, the Company recently released a second bit of good news. Fortress Paper redeemed its $7.5 million convertible note, held by Mercer International as part of the original purchase agreement. The Company paid $8,176,674, which represented the full principal amount of the note plus interest accrued up to August 1, 2009, and 105,000 common shares. The note had a yield of prime plus 2% and was convertible at a price of $8.00 per share. The strong financial results and the rising share price made the transaction feasible with minimal dilution to existing shareholders. A cleaner balance sheet should allow opportunistic acquisitions and accretive growth to continue in the near to medium term.

August 22, 2008

The volatility in today’s markets, driven by fear and greed, can easily be seen in the share price behaviour of Fortress Paper.  After going public at $8.00 last year, the stock rallied quickly above $10.00, declined to $5.30 in March, rebounded to $11.98 in June and now trades just under $10.00 per share.  Considering that this Company is relatively insensitive to the North American economies, now is a good time to reexamine the fundamentals.

Firstly, the name “Fortress Paper” is a misnomer.  We believe that the word “paper” conjurers up negative connotations of cyclical commodities, small profit margins and a weak return on capital.  However, Fortress is a high-technology company that prints international currencies such as the Swiss Franc and the Euro.  The Company uses proprietary technology to incorporate features such as embedded watermarks, chemical taggants, security threads and even clear polymer windows in their products.  Fortress also produces passports, visas, share certificates and identification cards that incorporate features such as holographic foil, radio frequency chips, antennas and machine-readable digital nanotechnology.  These components allow for instantaneous verification of important documents.  The market seems to have missed this key aspect of the Company’s products which, we believe, warrants a premium valuation.

Secondly, the Company’s financial performance has been excellent amid the general market malaise.  On August 11, Fortress Paper reported results for the second quarter and first half of 2008.  Sales grew to $49.1 million in the second quarter, an increase of 39% from sales of $35.4 million in 2007.  Net income reached $3.4 million in the most recent quarter, double the net income earned during the comparable period in 2007.  For the first half of 2008 compared to 2007, revenue grew to $98.9 million from $73.7 million and net income increased to $7.6 million from $2.8 million.  On a per share basis, year over year comparisons are meaningless due to the dramatically different share counts pre and post IPO.  However, in the first six months of 2008 Fortress Paper has earned a total of $0.74 per share.  Book value is $6.58 per share, which is well below the replacement value of the Company’s assets.

At the current share price, Fortress Paper trades at 7.8 times 2008 consensus earnings expectations, 3.8 times 2008 consensus EBITDA expectations and 1.5 times book value.  This multiple of book value is actually less relevant given the significantly higher replacement value of the assets and a premium 20% forecasted ROE.  Value investors are not often presented with an opportunity to buy a high-quality Company at such deeply discounted multiples.

Finally, our thesis on Fortress Paper has always been relatively simple.  Demand for currencies with advanced anti-counterfeiting measures is growing.  The wall paper division, as strange as it may sound, generates excellent cash flow.  The replacement value of the assets could be in the $375 to $425 million range, though admittedly we don’t expect to realize this full amount.  However, even if the shares traded at a 50% discount to replacement value, the current share price offers an excellent potential return.  Remember this story isn’t a commodity cyclical; it is a growth stock with market leading technology and deserves a relatively higher multiple.  We recommend investors focus on the long-term fundamentals and ignore the volatility, the pessimism and the dour headlines.  It is our opinion that solid businesses, with clean balance sheets and astute management should succeed in the long run.

October 24, 2008

With Fortress Paper currently trading at $6.00 per share, it’s time to recap the volatility and insanity that is characteristic of this stock market.  The Company went public at $8.00 last year and the stock rallied quickly above $10.00 within the first month of trading.  The shares then declined to a low of $5.30 in March of this year before rebounding to $11.98 in June.  Recently, the shares declined to a low of $4.80 on October 10th before a small bounce that reached $6.00 today.

Considering the stable nature of the Company’s operations, let’s examine what an investor can buy for a $6.00 per share investment in Fortress Paper.  First, the Company has $3.40 per share of cash on the balance sheet.  Net of long-term debt the Company has approximately $1.00 per share of cash.  You also get a stake in the Company’s two mills, the Landqart Mill and the Dresden Mill, which includes printing presses, a water treatment plant and a hydroelectric facility.  The tangible book value of the assets is currently stated as $6.58 per share but, as we have discussed in the past at great length, we believe that the replacement value is several times higher.  With solid assets and net cash on the balance sheet, we are amazed that investors would panic and sell shares below book value.

Our final thoughts revolve around the earnings power of the Company’s assets.  If they can’t generate decent earnings or cash flow, then our thesis must somehow be incorrect.  However, in the first half of 2008, Fortress earned $0.71 per share and generated $12.8 million of EBITDA.  To be frank, these results are excellent given the current economic environment.  On an annualized basis, the stock now trades at 4.2 times earnings and has an enterprise value to EBITDA multiple of less than two.  The assets are sound, the earnings and cash flow are solid and the stock appears to be extraordinarily cheap.

Despite the share price volatility that we have discussed previously, Fortress Paper remains one of our Value Favourites. The Company has just released operating and financial results for the fourth quarter and fiscal year 2008. Annual sales grew from $145.3 million to $189.0 million, an increase of 30%. EBITDA almost doubled, advancing from $13.6 million to $25.0 million. Similarly, net income jumped from $5.3 million or $0.76 per share to $12.7 million or $1.24 per year in fiscal 2008.

Examining the performance of the Company at the mill level yields some interesting tidbits. First, the IPO proceeds that were deployed to boost capacity and efficiency at Dresden seem to have been well spent. Sales increased 29% to $105.6 million, while operating income more than doubled to $20.0 million. In fact, the operating margin at Dresden improved from 12% to 19% over the course of the year as more non-woven wallpaper base was produced. Conversely the Lanqart Mill has yet to benefit from upgrades to its machines. However, management pointed out that PM2 (Paper Machine 2) is now running at full capacity and should demonstrate improvements throughout the year. Although sales at Lanqart increased 30%, operating income increased just 12% to $4.0 million. We will monitor the margins at Lanqart closely to ensure that the expected operating efficiencies result in a tangible improvement in financial performance.

We believe that the market is only valuing the Company at approximately 4 times earnings and 2 times EBITDA for one key reason. Since the IPO, management has talked about making an acquisition to add bank note production capacity but have been unsuccessful thus far. Currently, bank note production is sold out and management has actually been politely turning down orders. Of particular importance, Fortress Paper has a clean balance sheet with $26.2 million of cash against $30.6 million of debt. With a net debt figure of $4.4 million, this provides Fortress with excellent opportunities. Should Fortress complete an accretive acquisition, we believe that the market would respond quite positively.

August 14, 2009

Fortress Paper has just released results for the second quarter of fiscal 2009.  Although revenue was up slightly to $49.6 million from $49.1 million in 2008, earnings were weaker.  Reported net income in the second quarter of 2009 was $1.9 million or $0.19 per share compared to $3.4 million or $0.35 per share in the second quarter of 2008.  The current quarter was negatively impacted by a $0.8 million foreign exchange loss and an unusually high tax rate.  Conversely, results in 2008 were unusually strong due to a future income tax recovery of $1.1 million offset by a foreign exchange loss of only $0.2 million.  Adjusting for the FX loss and unusual tax rate, results for the most recent quarter were better than analyst’s expectations.

EBITDA (earnings before interest, taxes, depreciation and amortization) was $5.7 million or 11.5% of sales compared to $6.2 million or 12.6% of sales in the comparable quarter a year ago.  Management clarified this drop by saying, “The decrease in EBITDA relative to the prior year comparative period was primarily due to the difficult environment for specialty papers at the Landqart mill which was a direct result of the global economic slowdown.  The market for security papers, which includes bank notes, passport paper and other high security papers, continues to show strength and our order book for wallpaper base has recovered to healthy levels.”  The Company is actively looking at various cost cutting initiatives to mitigate the effects of the economic downturn.

November 13, 2009

After reporting a relatively lackluster second quarter due to the global economic slowdown’s impact on the sale of specialty papers, Fortress Paper is now firmly back on track.  In the third quarter of 2009, the Company reported sales of $51.0 million compared to $43.7 million in the third quarter of 2008 and $49.6 million in the second quarter of 2009.  EBITDA was $7.0 million in Q3/09 compared to $6.2 million last year and $5.7 million in Q2/09.  Net income was $3.5 million or $0.34 per share compared to $2.3 million or $0.22 per share a year ago and $1.9 million or $0.19 per share in the prior quarter.  Given the depth of the economic downturn, it is actually pretty unusual to find a company that is demonstrating both year over year and sequential revenue and earnings growth.

Examining the results more closely, the Landqart mill reported sales of $24.0 million compared to $20.9 million a year ago.  Operating income improved to $1.8 million from $1.2 million in the comparable period.  The results reflect strength in the security paper segment and more banknote sales than in prior quarters.  At the Dresden mill, demand for wallpaper base has reached the highest level since the start of the economic downturn.  The division’s revenue increased to $27.0 million compared to $24.7 million and operating income was relatively stable at $4.7 million compared to $4.9 million in the third quarter of 2008.  The small dip in operating income at Dresden could be explained by some product mix changes.  All told, we were quite impressed by the performance of both of the operating divisions.

Finally, we would like to discuss a potential, near-term corporate development that could act as a catalyst for the shares.  Once a financing package to fund the conversion of PM1 to a banknote printing machine is put into place, we believe that the market would become more willing to put a high-tech or growth multiple on the stock for two key reasons.  First, banknote printing, entailing the in-house and patented development of advanced security features, is a relatively unique and high margin business.  Second, management has already suggested that demand is robust.  They have actually turned away some Euro orders in order to accommodate other central banks.  This ensures the maximum number of potential clients to fill Fortress’s additional capacity once the converted banknote machine is operational.

December 18, 2009

We have just met with management of Fortress Paper in our offices.  The discussion covered the Company’s solid third quarter results and several key corporate and operational developments.  Because the financial results have already been “priced-in” to the stock, in this Value Investigator update we wanted to report on the more forward-looking aspects of our conversation.  Hopefully, the market will respond positively as management delivers.

From our perspective, the most important near-term issue is the PM1 (Paper Machine 1) rebuild.   Remember that the conversion of the PM1 machine to a banknote machine will boost capacity of the high margin product from 2,500 tonnes to 10,000 tonnes per annum.  Management seemed certain that the financing arrangement would be announced shortly, perhaps even before the end of the year.  Essentially, the only remaining points of negotiation surround various covenants and conditions, which management wishes to minimize.  Obviously, they want to retain the maximum amount of financial flexibility in the event that opportunities arise in the future.  As per Company guidance, we expect that the PM1 banknote machine will be operational by January 2011.  In fact, management suggested that they have already started “pre-selling” some of this capacity, which is a testament to their confidence in the expansion.

Management also discussed their new “Durasafe” product, which has just become commercially available.  Essentially, they have developed a banknote that contains a transparent polymer window that is highly resistant to counterfeiting.  Although the Company has yet to receive any firm orders, several parties have examined the product, expressed interest and have begun pricing negotiations.  We believe that this innovation will command higher margins than traditional bank notes.

Finally, management discussed potential acquisitions.  We would not be surprised to see them acquire one or more related businesses within the next six to eighteen months.  Additional banknote capacity or technology related to embedded security features seemed to be the key areas of interest.  Thankfully, with management and insider’s large stake in Fortress Paper, we believe that they will be extremely patient and disciplined buyers.  All told, we came away very impressed with the Company’s positioning and outlook.

April 1, 2010

On March 18, Fortress Paper announced what we believe to be a transformative acquisition.  Fortress has signed an asset purchase agreement to acquire a northern bleached hardwood kraft (NBHK) pulp mill in Thurso, Quebec, known as the “Thurso Mill”.  The Company plans to convert this facility into a low cost, specialty cellulose (dissolving pulp) producer.  As part of the plan, Fortress intends to build a bio-mass cogeneration plant at the mill, which will produce electricity resulting in materially lower energy costs.  Importantly, Fortress has already put in place the financing required to fund the conversion of mill and build the cogeneration plant.

In addition to the $3 million purchase price, Fortress is expected to spend approximately $91 million to convert the Thurso Mill and $62 million to construct the 25 MW cogeneration plant.  The Company has arranged a loan in the amount of $102.4 million with Investissement Quebec with a term of ten years at a rate of 5.0% for the first five years.  Fortress has also issued an unsecured convertible debenture to a Quebec financial institution in the amount of $15 million, maturing in five years with an interest rate of 7% per annum.  The debenture will be convertible at the option of the financial institution any time after closing at a conversion price equal to the lesser of 145% of the trading price of the common shares and $20.00.  Further, the assets include $9.9 million of credits granted under the government’s Pulp and Paper Green Transformation Program.  Finally, Fortress intends to apply for approximately $15.2 million in credits under the Green Infrastructure Fund program, related to the cogeneration plant.  The remaining balance should be covered with existing working capital and internally generated cash flow.

Once the conversion is completed in mid-2011, the Thurso Mill is expected to have annual production capacity of more than 200,000 air dried metric tonnes of dissolving pulp.  The finished product is then used as the raw material to produce rayon, a natural fibre that is subsequently used to produce textiles.  With cotton supply falling, demand for rayon has been growing at approximately 10% in China and 7% worldwide over the past five years.  Clothing made from rayon is particularly well suited to the emerging economies since it “breathes” better, is soft yet strong, wears well and holds dyes better to produce brighter, more vibrant colours.

If all goes according to plan, the economics of the project are exceptional.  Currently priced at about US$1,500 per metric tonne, dissolving pulp is priced almost US$600 per metric tonne above NBHK pulp.  If we use a price that is more reflective of the five year average price, say US$900 per tonne, and use the forecasted cost structure post-conversion, the Thurso Mill project could generate approximately $60 million in EBITDA.  With Fortress Paper trading at five to six times enterprise value to EBITDA, the project could add $300 to $360 million of enterprise value within a few years.  Compare that to the pre-announcement enterprise value of approximately $135 million and the significance of the Thurso Mill acquisition is readily apparent.

Although shares of Fortress Paper have performed extremely well since the lows of the credit crisis, this acquisition could be the catalyst to take the shares “to the next level”.  As the news was disseminated and several positive analyst reports were released, the stock moved very quickly to $20 per share.  Although the stock has retreated slightly, we believe that investors will see higher prices as management delivers on its milestones while moving the project forward.

June 25, 2010

Management at Fortress Paper has been working diligently to make progress on the start-up and conversion of the newly acquired Thurso Mill.  Since our last update, several key milestones have been reached, including the official closing of the transaction.  We are extremely pleased with the steady stream of news from the Company, as it reinforces our confidence in the project.

Shortly after closing the deal, Fortress entered into an energy supply agreement with Hydro Quebec for the sale of power from the planned biomass-based cogeneration facility.  Under the agreement, the Company will build a facility and provide 18.8 megawatts of net power to Hydro Quebec over a 15 year term, with deliveries expected to commence in the fourth quarter of 2012.  The cogeneration facility will serve a dual role: it should improve the economics by lowering the net cost of power and it will build some goodwill with the government of Quebec by providing a source of “green” electricity.

With the restart of the Thurso Mill approaching, the next step required entering into a pulp purchase and sale agreement with International Forest Products Corporation (IFP).  Under the terms of the agreement, IFP will be the exclusive distributor for the sale of northern bleached hardwood kraft (NBHK) pulp produced over the life of the mill.  Production and sale of NBHK pulp commenced relatively quickly on May 28, 2010, which was ahead of schedule in order to take advantage of the strong NBHK pulp prices.  In fact, NBHK prices have rebounded from approximately US$600 per tonne in May 2009 and now trade between US$900 and US$1,000 per tonne.  The price strength was due to a recovery in demand, with inventories being drawn down just as an earthquake in Chile removed a significant amount of production capacity.

Although the near term cash flow from NBHK pulp production could be significant at current prices, we are carefully monitoring the steps toward the production of dissolving pulp, a higher value product. Importantly, Fortress announced the appointment of the key personnel who will be responsible for the conversion of the Thurso Mill.  Most notably, Peter Vinall was named President and Chief Executive Officer of Fortress Specialty Cellulose Incorporated.  Mr. Vinall has approximately 30 years of experience in the pulp and paper industry and has successfully led the conversion of an NBHK pulp mill to produce dissolving pulp.  His experience with specialty cellulose, and specifically dissolving pulp, will be invaluable to this division under the Fortress Paper banner.

Just a few days after the new management team joined Fortress Specialty Cellulose, they announced the signing of an equipment purchase agreement with Stora Enso, a Finnish forestry company, to acquire digesters, specialized process equipment and other ancillary equipment to be used in the mill conversion.  The total purchase price for the equipment, including delivery, was EURO 3 million (CAD$3.8 million), which was probably a pretty good deal.  Chad Wasilenkoff summed it up nicely, “This equipment has operated for only 12 years and we are confident of its quality and performance, which should result in a material reduction in our overall capital investment requirements for the conversion to dissolving pulp”.  In short, management is delivering nicely on its promises while keeping costs under control.