Value Library

The following is an excerpt from the ABC Perspective - January 2010 - Pg. 4-5

ABC Fund Value Favourites

Fortress Paper Limited

Fortress Paper (TSX: FTP) is an international producer of security and specialty papers and wallpaper base.  The Company’s Landqart Mill, in Switzerland, produces security papers, which includes paper currency, passports, visas, cheques, share certificates and lottery tickets.  The Landqart Mill has been the sole provider of banknote paper for the Swiss currency since 1979 and is one of only nine authorized suppliers of the Euro.  The Dresden Mill, in Germany, produces non-woven wallpaper base that is sold to Eastern Europe and the former Soviet Union. Although global demand for wallpaper is declining, these markets are experiencing growth, especially in the non-woven segment.

Fortress Paper became a TSX-listed Company on June 28, 2007, after purchasing assets from Mercer International.  Mercer, a European softwood and kraft pulp producer, divested the mills to focus on its pulp business.  A Canadian entrepreneur, Chad Wasilenkoff, reviewed the assets, conducted due diligence and negotiated the transaction.  Mr. Wasilenkoff then installed experienced European management, led by Dr. Alfonso Ciotola and Erich Sulser.

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.

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.  Overall, we were quite impressed by the performance of both of the operating divisions.

Subsequent to the release of Fortress’s solid results, the shares jumped almost 20% and currently trade at approximately $10.00.  This represents a relatively small premium to book value of $8.08, which is justifiable given the annualized return on average equity of 17.2% in the quarter.  On an earnings basis, the shares are valued at 9.2 times 2009 consensus earnings and only 7.4 times 2010 consensus earnings.  With the results public, we had the opportunity to meet with management in our offices.  The discussion covered the Company’s solid third quarter results and several key corporate and operational developments.

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.  The remaining points of negotiation surround various covenants and conditions, which management hopes to minimize.  As per Company guidance, we expect that PM1 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.

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 resistant to counterfeiting.  Although the Company has yet to receive any firm orders, several parties have examined the product, expressed interest and begun pricing negotiations.  We believe that this innovation will command higher margins than traditional bank notes.

The final topic of discussion surrounded 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’s and other insider’s large stake in Fortress Paper, we believe that they will be extremely patient and disciplined buyers.
 
Once the financing for the PM1 conversion is put into place and perhaps once an accretive acquisition is announced, we believe that the market will become more willing to put a high-tech or growth multiple on the stock.  Banknote printing, entailing the in-house and patented development of advanced security features, is a relatively unique and high margin business.  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 PM1 becomes operational. All told, we are very impressed with the Company’s positioning and outlook.

Onex Corporation

Onex Corporation (TSX: OCX), founded in 1984, is a publicly-traded private equity firm and alternative asset manager. The team of investment professionals has completed more than 260 acquisitions totaling approximately $43 billion.  Since inception, they have generated a 29% compounded annual internal rate of return using a value-oriented, active investment strategy. The Company’s team also manages approximately $7 billion of third-party capital, which generates management fee income and earns a carried interest.

The structure at Onex is relatively unique. Publicly traded and private investments are held at both the corporate level and within the Company’s funds alongside third party money. Current investments include public companies such as Celestica, Spirit Aerosystems, Emergency Medical Services, Skilled Healthcare and ResCare.  Private investments include Sitel, Center for Diagnostic Imaging, Carestream, the Warranty Group, Hawker Beechcraft, Tube City, Allison Transmission and Husky Injection Molding.  Notice the focus in the aerospace, healthcare, financial and industrial sectors.

Shares of Onex Corporation tend to strengthen when the Company monetizes one of its publicly-traded or privately-held investments.  It validates management’s successful track record and gives investors confidence in the private equity firm’s portfolio.  It also frees up capital that can then be redeployed into another potentially profitable investment.  Notably, there have been several recent and significant transactions.

On March 30, Onex announced that a syndicate of underwriters had agreed to a bought deal for the Company’s 12,956,885 trust units of Cineplex Galaxy Income Fund at a price of $14.25 per trust unit.  The timing of the issue was good, since going to the movies seems to be a relatively recession-resistant pastime.  Gross proceeds of approximately $184.6 million were essentially inline with our carrying value of the investment in our model, since we mark the position to market.  Importantly, because Onex had tax losses available to shelter the capital gains, the Company did not incur any taxes on the transaction. 

In August, Onex announced that it had sold part of its interest in Emergency Medical Services Corporation (NYSE: EMS).  Essentially, 9.2 million Class A shares were sold in a secondary offering at US$40 per share.  Of the offering, Onex sold approximately 3.5 million shares, which represents roughly 29% of the Company’s interest in EMS.  This transaction crystallized an amazing six fold increase for Onex.  Subsequently, OCX sold an additional three million shares of Emergency Medical Services Corp at US$48.31 for proceeds of US$151 million.  In terms of investment return, the trade was completed at approximately seven times cost.

On the buy side, Onex has made an intriguing investment in Tropicana Resort and Casino.  Tropicana had filed for Chapter 11 in May 2008 and Onex acquired more than US$200 million of the principal amount of the Company’s US$440 million term loan that is secured against the casino in Las Vegas.  The debt was acquired at a discount to par value and the plan of reorganization provides for the secured creditors to own 100% of the equity in the casino.  Since Tropicana is an older property it will require additional capital to upgrade the 34-acre site, with 1,850 hotel rooms, a 61,000 square foot casino, 5 restaurants and an 850 seat showroom.  However, given the economic downturn, now could be an excellent time to buy real assets on the cheap.

Valuing the stock is an exercise in sum of the parts analysis.  Using cash at the parent level, the value of publicly-traded investments at market and the value of other investments at book implies a value of almost $29.00 per share.  Using a 20% holdco discount gives a floor net asset value of approximately $23.00 per share.  To this figure, we have to add value for the management fees and earned carry on third party capital.  In the recent quarterly release, the Company reported that the current annualized rate of management fees on third-party capital is approximately US$80 million, which “more than offsets the Company’s operating costs”. After deducting operating expenses and applying the same multiple as comparables, we calculate an additional $6.00 in value.  Our combined net asset value for Onex therefore ranges between $29 with a 20% holdco discount and $35 per share assuming no holdco discount.

Currently trading at $24, about $5 below the Company’s net asset value (including the 20% holdco discount), we see good value in the stock.  Management apparently agrees, having purchased 1,788,281 shares under a normal course issuer bid that expired on April 13, 2009, at an average price of $26.70 per share.  The NCIB was renewed and for the ten months ended October 31, 2009 Onex repurchased 566,660 shares at an average cost of $22.49 per share.

The shares typically outperform when management either monetizes an asset or makes a new significant investment.  Since both have recently occurred and sentiment in the credit and equity markets continues to improve, we expect the stock to continue to perform well. Bottom line: the Onex team is a proven money maker and we are willing to run with them in the current market environment. With the stock valued at a discount to NAV, it suggests that patient investors will be rewarded over time as the Company deploys its ample cash reserves.

Irwin A. Michael, CFA