Company Background

Core Molding Technologies (AMEX:CMT) is a manufacturing business that focuses on reinforced plastics – a type of plastic that is combined with a reinforcing fiber (like glass or carbon) and then molded into shape.

CMT makes sheet molding compound (SMC), a major input into compression molded products, and therefore controls the production process through its five facilities in the U.S. and Mexico.

These facilities encompass over 1M square feet of manufacturing space, making the company one of the four largest compounders and molders of reinforced plastics.

Reinforced plastics are used in the transportation, construction, marine, and industrial markets, but the primary use is for trucking – sales to the trucking industry made up 91% of CMT’s sales in 2011.

CMT was formed in 1996 for the express purpose of purchasing the Columbus Plastics unit from Navistar (a major truck company), a relationship which continues to this day – Navistar remains a major shareholder and accounts for 44% of sales.

Investment Thesis

#1) Highest recorded age of trucking fleet, combined with new orders still at or below replacement rate, point towards continued revenue growth for CMT

In 2010, the average age of the U.S. trucking fleet was 6.7 years, the highest in history, and industry experts are projecting a gradual decline in fleet age due to an increase in new truck orders:

This growth is driven by the fact that such an old fleet cannot be maintained because of exponentially increasing maintenance costs as trucks get older:

This dynamic is reflected by the run-up in truck orders since the 2009 lows, but the industry is barely at replacement rate and far below previous peaks in the trucking cycle:

March and April truck order numbers came in below expectations, but according the ACT Research, a leading market research firm, expectations remain bullish for 2012 (with truck orders forecasted at 299,000 annual units, or ~25k per month), along with expected strong demand into 2013 and 2014:

“our expectations for the cycle peak in 2013 are shallower with stronger demand now stretching through 2014.”

This is backed by the strong upward trend in truck builds: 

This bullish industry outlook should provide ample runway for revenue growth at CMT for at least the next two years.

#2) Investments in manufacturing and capacity expansion have raised capex significantly above maintenance levels, whereas normalizing these numbers showcases CMT’s strong free cash flow generation

Average FCFE over the past ten years was $3.8mm, a FCF yield of 6.6% based on a market cap of $57.3mm.

However, this average number is skewed by several major expansion projects which have doubled average capex over the past four years:

– 2009: CMT opened a 476k sq. ft. manufacturing plant in Matamoros, Mexico, transitioning from a formerly leased space. A $20.2mm project, the new facility increased floor space in the region by 43%.

– 2010: the company announced a major expansion of the Mexico facility in order to handle increased order flow and new product launches. The project is expected to cost $14.5mm, with $6.3mm spent so far in 2011.

– 2011: CMT leased a new 62k sq. ft. facility in Warsaw, Kentucky for its Core Specialty Composites division, which was created to produce parts for customers outside of the trucking industry. The company spent $1.2mm on leasehold improvements for this new facility, and management expects that the Kentucky facility will be fully operational by mid-2012.

Here’s the a breakdown in capital expenditures in chart form: 

Of the $51.5mm in total capex spend over the last ten years, $27.7mm was spent specifically on growth/expansion projects.

After subtracting out these growth investments, average maintenance capex is only $2.4mm (which also happens to more closely resemble average D&A of $3mm).

Using average maintenance capex, a normalized FCF number is around $6.5mm, for an adjusted FCF yield of 11.3%.

#3) Capacity gains plus efficiency improvements have transitioned CMT from below-average to above-average business since the previous upswing in trucking cycle

By a variety of metrics, CMT is operating more efficiently now than ever before in its history, especially at this stage of the trucking cycle.

Since 2003, ROE has averaged 17.48%, compared to an average of 8.99% in the previous seven years. Looking at similar time periods, average ROIC has increased from 5.8% from ’97-’03 to 11.8% for ’04-’11, as showcased in the graph below: 

Another illustration would be a DuPont breakdown – 2011 results are similar to 2004, another good year for CMT and at a similar point in the trucking cycle: 

The ROE decomposition clearly shows an improving ROA, driven largely by higher profit margins. It also shows the decrease in leverage – while total debt is nearly identical in 2004 and 2011, CMT is paying a much lower interest rate.

Asset turnover is down slightly, but that is to be expected. In 2001-2004, the company had no major expansion projects and capex was low.

However, CMT has invested heavily in new assets over the past several years – as those assets come online and become fully operational, turnover should increase and operational leverage will kick in, boosting returns even further.

#4) Investments in high-end machinery (i.e. plastic presses > 2000 tons) provide a competitve advantage, and should help CMT maintain higher average margins through the next cycle

According to the company’s SEC filings, CMT

“possesses a significant portion of the large platen, high tonnage molding capacity in the industry.”

These large presses weigh over 2,000 tons, and are used for the largest molding projects. As of December 31, 2011, the company owned 18 large presses, with 2 more planned for purchase in 2012.

At this size range, even a 10+ year old used press sells for $500k or more, so a competitor would be looking at investments in the tens of millions of dollars in order to compete with CMT for the larger press jobs.

The the chart below shows the increase in machine-hour rates for a range of plastic molding machine sizes:

Presses greater than 2,000 tons command a 4x-7x price premium over smaller machines.

This shift towards larger, higher value machines could help explain the uptick in CMT’s margins – average gross margins are running roughly 200 basis points above the previous cycle, and the 2011 GM of 20.8% was the highest since 1997.

An increasing gross margin does indicate some pricing power for CMT, and investments in these higher-end machines point towards a structural – not temporary – shift to higher margin business.

Management

Management is well-paid, but has a solid long-term track record – Over the past 10 years, CMT has grown book value per share at 15.5% annually.

The C-suite executives have demonstrated tremendous loyalty to the company, as all joined shortly after inception and have been with the company for 13-15 years. Insiders hold 11.6% of shares outstanding.

Two other well-respected value-oriented investment firms, GAMCO and Rutabaga Capital, own 14.1% and 9.5% of shares respectively. Navistar retains a 9.2% ownership stake, even after CMT bought back and retired 3.6mm shares from Navistar in 2007.

In addition to some stock options and restricted units, the company also leverages a profit sharing plan as part of its compensation. The plan kicks in after achieving an 8% hurdle rate on a ratio of EBT / Adjusted Average Total Assets, and is capped at 20% of EBT – the ratio produces result similar to ROIC.

While the 8% hurdle rate might be a bit low, the plan is much more reasonable than many other compensation schemes out there.

Risks

While there are risks with the company executing on its expansion projects, or gauging the exact stage of the trucking cycle, the most critical risk is customer concentration.

PACCAR and Navistar, two of the largest class 8 trucking companies, make up 80% of CMT’s sales. Put simply, losing either customer would be a major setback.

Here is a breakdown of CMT’s sales to its two largest customers: 

PACCAR is becoming an increasingly important part of CMT’s business, and now makes up 36% of sales versus 44% for Navistar.

Despite the customer concentration, CMT has a long relationship with both of its major customers:

Navistar

CMT has been associated with Navistar since 1996, as the company’s founding purpose was to acquire the Plastics division from Navistar. CMT also signed a comprehensive supply agreement with Navistar in June 2008, which was renewed in Jan. 2010.

Under the agreement, CMT

“continues to be the primary supplier of Navistar’s original equipment and service requirements for fiberglass reinforced parts, as long as the Company remains competitive in cost, quality and delivery.”

The agreement is up for renewal in October 2013, but the non-renewal risk is mitigated by several factors:

1. Navistar remains a significant investor and shareholder of the company, holding 9.2% of shares outstanding. The current Chairman of the board (and former CEO of CMT), was a VP of Navistar from 1992-1998 and presumably retains some key relationships there. In addition, another board member, Thomas Cellitti, is Navistar’s SVP of Reliability & Quality, and has been on CMT’s board since 2000.
2. As part of the amended supply agreement, CMT moved production from its Ohio facilities to its Mexico plant in order to more effectively supply Navistar’s Mexican operations. This was a costly move, and CMT has invested millions more in expanding the Mexican facility.

It’s unlikely that management would take such drastic steps unless they were reasonable assured that a supply deal would be re-signed.

PACCAR

While CMT has no formal relationship, PACCAR has been a named customer going back to at least 2005. In addition, recent sales results show a positive growth trend lending credence to the assumption that CMT is becoming a more important supplier.

In 2011, sales to PACCAR were up 97%, achieving a record of $51.4mm. This was $11.1mm, or 28%, greater than the previous high set in 2007.

Health of Navistar / PACCAR

Of the two, PACCAR seems to be the better-run company, but both enjoy a healthy percentage of the overall truck market in North America.

Both customers are expected to grow at a healthy clip over the next 2 years: 

These revenue growth expectations are backed by increasing backlog as of the end of 2011. 

Navistar’s backlog of 32,000 units was the highest since 2006 while PACCAR’s 3-month backlog of $2.6B was just shy of the record of $2.7B in 2006.

Both companies were bullish in their latest disclosures and conference calls:

Navistar Analyst Day – Feb 2012

“We’re saying right now that our 2012 industry forecast is, give or take, a 15% increase over 2011. But we believe that 2013 and ’14 will again have increased volumes from an industry standpoint”

“We think that there’s an opportunity to grow our market share by about 10%. So we’re — we’ve — we finished the year around 21%”

PACCAR Q4 Conference Call – April 2012

“U.S. and Canadian industry retail sales are estimated to improve this year to a range of 210,000 to 240,000 units, up from 197,000 last year. This is being driven by ongoing replacement of the aging truck fleet and some economic growth”

“I think people are just — they’re buying what they need. They certainly recognize the very tangible benefits of having a new truck versus a truck that’s 5, 6, 7, 8 years old. That can be measured in thousands of dollars per year.”

Other Customers

While CMT is heavily dependent on Navistar and PACCAR, sales to other customers (primarily other major truck manufactures) increased 57% to $18.3mm in 2011.

This is an encouraging sign, and there appears to be further runway to diversify based on results from prior years (for example, sales outside of the big 2 were $45mm in 2006).

In addition, the Kentucky operation was created in order to further diversify outside of the core business segments, lessening the concentration risk.

Valuation

CMT does not have a useful public comp in North America, so instead a comparison can be done based on the company’s historical averages: 

A normal P/B multiple of 1.4x would yield a share price of $10.46 (40% upside), while an average EV/EBITDA multiple of 6x would yield a share price of $16.12 (105% upside).

At TTM 5.3x P/E, the current valuations is overly pessimistic, and represents a state more similar to an industry on a cyclical downswing – a stage of the trucking cycle that is unlikely given:

(1) the size and increasing nature of order backlogs (both at CMT and its major customer)

(2) the extreme age of the current trucking fleet

(3) double digit growth forecasted by industry expert and confirmed by major truck manufacturers

(4) an order rate still below the truck replacement rate and well below past peaks in cycle

Catalysts

• Record year-end backlog leads to another huge revenue year – Backlog of $15.2mm at year-end 2011 is a record number, and 29% higher than previous record of $11.8mm in 2005. By comparison, the 2005 backlog translated into 2006 revenue of $162mm, a mark which should be surpassed in 2012. Q1 2012 sales were up 53%, confirming this trend.

• Additional manufacturing capacity comes online in 2012, boosting revenue growth even further – The Kentucky plant alone is expected to contribute $5-8mm in incremental annual revenue once it becomes operational in 2012

• Additional product sales cover larger investment in fixed costs and capacity, and operational leverage boosts income – Net PP&E is over 50% of total assets, so the business is inherently leveraged, and volume increases will translate to an even greater jump in EPS

• Multiple expansion boosts stock price as strong results confirm that trucking market cyclical upswing continues

Conclusion

Purchasing CMT is an opportunity to pick up a well-run company at a 10%+ normalized FCF yield and a discount to long-term valuation multiples at an attractive point in the trucking cycle.

In the Q1 2012 earnings report, revenue growth materialized as expected, but margins were hurt by “production inefficiencies and startup costs.”

Based on the long-term track record, management has proven the ability to deal with these operational hiccups and the recent sell-off presents an attractive entry point – the company should report strong bottom-line results for FY2012 as operational leverage improves.

Disclosure

Long CMT

I’m excited to announce that my stock pitch was selected as a semi-finalist in the Ira Sohn Investment Contest.

Four pitches were selected as finalists, with the winner having the chance to give a 10 minute presentation in front of 2000+ people at the Ira Sohn Conference – in front of legendary investors like David Einhorn, Bill Ackman, Joel Greenblatt, Michael Price, and many more.

Obviously, this was a tremendous opportunity for any aspiring investor. Unfortunately, I did not make the finals, but still received a free ticket to attend the event. It was a great experience, as it was the first time I’ve had the chance to hear actual presentations from many of these investors.

Even more importantly, the event is for a great cause, as the conference has raised millions of dollars for pediatric cancer research.

Without further ado, my investment thesis for ABH, a deep value contrarian idea.

Note: The stock is down another ~10% since I put together the analysis, which makes the valuation even more compelling. I think the second quarter might be rough, but believe the company will start showing improvement in the second half of the year. I have a small starter position for now, as the stock price could certainly get worse before it gets better.

Company Intro

AbitibiBowater Inc. (changing its name to Resolute Forest Products, Ticker: ABH) was formed by the 2007 merger of U.S-based Bowater with the Quebec-based paper and pulp company Abitibi Consolidated. After the merger, the combined entity was the third largest paper and pulp company in North America and the eighth largest in the world.

A debt burden of $6b combined with the economic crisis forced the company to declare Chapter 11 bankruptcy in April 2009.

ABH received financing from Fairfax Financial during the bankruptcy, and emerged in December 2010 with restructured operations, a new management team, and the stock price around $21/share. The stock peaked near $30/share in February 2011, before starting to slide, and is now down 40% over the past year.

Fairfax purchased more shares after the emergence, and continues to hold 18% of the company. Of the top 10 institutional holders, position sizes were increased by +9.5m net new shares over the past two quarters.

Segment Breakdown

Newsprint now makes up 39% of sales and 36% of EBITDA, down substantially from 2008 when newsprint was almost 50% of sales and 45% of EBITDA.

The Fibrek acquisition gives the company more exposure to market pulp, which was the only segment to show industry-wide shipment growth in 2011 (up 3.5%, with a 30% increase in China).

(Note: Fairfax is also a significant shareholder in Fibrek. Fibrek decided to take the ABH bid despite a higher offer from Mercer…potential synergies to boost overall value of their combined stake?)

Investment Thesis

#1) With the recent sell-off, the market is pricing ABH as a distressed equity despite improving operations and continued evidence of execution of management’s turnaround plan –

ABH now trades at an EV/EBITDA of 3.3x (or 5.4x EV/EBITDA after adjusting for the underfunded pension) and P/TangBV of 0.4x.

This compares to an industry average EV/EBITDA and P/TangBV of 7.2x and 1.2x respectively.

With dramatically improved operations, ABH doesn’t deserve such a large discount, as management has executed on its restructuring plan while substantially reducing the annual carrying cost of running the business.

SG&A expenses were cut during the restructuring and continue to fall, as the line item has decreased from $330mm in 2008 to $158mm in 2011 – the company is approaching its target SG&A expenses of $20/ton (~$140mm).

These results have shown progress on the turnaround plan, as the company reported an operating profit of $261mm in 2011, the first annual profit since 2006.

#2) Dramatic restructuring efforts have substantially reduced ABH’s debt burden while allowing the closing of excess capacity and removal of outdated assets –

The bankruptcy proceedings reduced total debt from $6.8B in 2007 to only $900m. By selling non-core assets, management has taken steps to reduce debt even further, which has fallen to $620mm as of March 31, 2012 (corresponding to an annual interest expense of just $60-$65mm, down from almost $600mm prior to the reorg).

The company has also aggressively shut down excess capacity and old mills:

The revised product breakdown reduces the company’s dependence on newsprint (which continues to decline) while maintaining exposure to market pulp (a long-term growth story).

PP&E has been reduced from $5.7b in 2007 to $2.5b in 2011, with the majority of remaining mills operating in strategic locations close to port access, allowing ABH to take advantage of the export market.

The business does throw off a ton of cash flow, and with the new operating structure, this cash is finally available for something other than interest payments.

#3) ABH’s maintenance capex is far below depreciation –

This capex/depreciation spread helps boost FCF, with a current FCF yield to EV of 12% even after including substantial pension liabilities.

While the newsprint business remains the largest segment by total capacity and profits, management has recognized that newsprint is in a state of decline (especially in North America). Management has responded by slashing reinvestment – essentially, the business is being milked for cash flow, a situation enabled by ABH’s leading position in the global newsprint market.

Maintenance capex is forecasted at only 55-65% of D&A, or roughly $120-$150mm per year. This favorable depreciation/capex spread of $80-$100mm per year juices FCF, and should be sustainable as further capacity reductions continue.

This equates to a 12% FCF yield, and normalized FCF yield is much higher (see Valuation and Catalyst sections).

Bear View

Bears will say that, despite the restructuring, ABH remains in a commodity business with the wrong set of assets (namely major capacity in newsprint), old mills, and a tough labor environment. All of these are true but seem overblown as major factors, especially given the stock’s current valuation:

Risk #1) Newsprint, ABH’s largest business segment, is in a state of long-term decline –

Agreed! Here’s the data on newsprint volumes over the past five years:

After the large drop in 2009, the downward trend has at least stabilized, but newsprint is a business that isn’t going to return.

Counter:

The market (including ABH) has responded to these declines by cutting capacity at an even faster rate, leading to stable pricing (post-’09) – ABH’s newsprint segment remains solidly profitable despite declining demand.

Newsprint prices stabilized around $640/ton in 2011, and analysts are estimating prices increasing to $655/ton and $665/ton in 2012 and 2013 respectively, driven by the ONP/newsprint relationship in Asia (see Catalyst section for more detail).

According to ABH’s CEO in the Q4 conference call (emphasis mine):

“So with the continuous decline in newsprint demand in North America, there is less ONP, less recovered paper that is going to be available, so I think that it’s going to push that cost up, and because of the virgin fiber advantage, I think that this market is only going to continue to be open to us… I would not underestimate the potential to also sell in this market because of the advantage of the location of our mills”

A $25/ton increase in newsprint would raise ABH’s EBITDA by $67m annually.

Risk #2) The mills and other fixed assets are old –

True, but much of the oldest and most unproductive assets were sold off or closed down during the restructuring. The total number of paper machines was reduced 50% from 62 to 31.

Counter:

On the NA newsprint cost curve (how cost competitive each mill is with current equipment), 10 out of 12 ABH mills are in the 50th percentile or above, with 7 in the top 9 spots.

The reality is that the paper machines haven’t changed much in 150 years and are at low risk for obsolescence or major technological change – even old mills can get the job done.

Risk #3) ABH faces a tough labor environment in Canada with large pension liabilities –

True…but manageable. ABH’s balance sheet shows an underfunded pension of $1.5B, and the company warned that this funding level could increase after the next actuarial report in June.

Counter:

The company negotiated a deal with the Canadian provinces for pension relief that essentially capped the cash pension contribution over the next ten years, in exchange for certain covenants such as dividend restrictions, capex funding requirements in Quebec/Ontario, and further lump sum payments if capacity is shutdown in Quebec.

This agreement takes a big chunk out of the actual cash outlays and balance sheet liability.

Despite the restrictions, management has been able to downsize the employee base, with a reduction of 7,600 workers (-42%) so far. The negotiated pension plan reduces annual commitments from $300mm/yr to ~$100mm/yr – the estimated net pension liability with these caps is closer to $800m.

Valuation

Outside of its P/E multiple (ABH is still affected by non-operating/one-off charges post-bankruptcy), ABH is cheaper than the industry by 50% or more despite having comparable margins and a lower debt load.

On $456mm of current run-rate EBITDA, an EV/EBITDA multiple of 6x (a slight discount to peers considering post-bankruptcy uncertainties) would yield a per share value of $17.42, or 44% upside from current prices.

Normalized EBITDA is likely closer to $590mm:

A 6x multiple on $586mm run-rate would yield a per share value of $22.50 (86% upside). This translates into normalized FCF of around $385mm, for a FCF yield to EV of 16%.

This EBITDA run-rate does not take into account any upside in the wood product segment (due to improvements in NA housing starts), or further synergies and margin improvement on the pulp segment after the Fibrek acquisition (see Catalyst section).

These factors could increase normalized EBITDA to $650mm+, raising the FCF yield to almost 20%.

Catalysts

#1) Improving EPS after one-item items fall away –

In FY 2011, ABH reported $46mm ($32mm after-tax) in asset impairment and closure costs as the company shut down old mills, in addition to $47mm ($34mm after-tax) in costs related to post-emergence legal expenses.

In Q2, both of these costs have fallen dramatically, and the new run-rate points to a $0.37 EPS improvement, boosting EPS to $0.89 – this translates into a P/E of 13.6x – much closer to the industry.

Add another estimated $0.10 per share from Fibrek (and more with additional synergies), and normalized EPS tops $1.00.

#2) Fibrek acquisition boosts exposure to market pulp, a growing market with potential pricing improvements –

After a hard fought battle, ABH won the bidding for Fibrek (TSX:FBK), another Canadian paper & pulp company, which increases ABH’s capacity in market pulp by roughly 76%. (bid was $70mm in cash, payoff of $115m in debt, plus  ~3m shares).

On the pricing side, NBSK pulp prices have risen from $870/ton to near $900 in May, and analysts are forecasting future increases to $965/ton by FY2013.

Each $25/ton price increase generates an additional $26mm in EBITDA for ABH – with the addition of Fibrek, prices in the $950/ton range would mean an additional $120-$140mm in annual EBITDA for ABH.

#3) Upside in Wood Products due to (slow) recovery in housing starts –

With the severe downturn in housing, ABH’s wood products division has operated at a loss for several years. In 2006, the wood products segment generated EBITDA of over $80mm compared to TTM EBITDA of only $7mm.

Recent numbers show modest improvements in U.S. housing starts, up 18% YoY. With the number of new homes still far below replacement value, the market will eventually recover, driving lumber prices up and the Wood Products segment back to profitability.

Even a normalized EBITDA of $40-50mm would add another $200-300m to ABH’s value (~$2.50/share).

#4) Newsprint industry dynamics are misunderstood, and will lead to sustainable pricing and demand –

ABH relies on virgin fiber for its newsprint (via access to timber from the Canadian government) while China & India – where the growth is – have little virgin fiber of their own and therefore rely on recycled newsprint (ONP).

Historically, newsprint was in such large supply that ONP-based mills were much cheaper. But with such a steep drop-off in newsprint volumes, ONP prices have steadily increased, shifting the cost curve towards NA mills – 45% of ABH’s newsprint shipments were outside of the U.S., with 14% to Asia alone.

This creates a cycle:

growth in Asia – > greater demand for ONP – > but less newsprint supply – > higher newsprint prices

In addition, the industry is seeing further capacity reductions and bankruptcies. Since October, over 8% NA newsprint supply has been shut down, and both the #4 and #5 producers have filed for bankruptcy.

These dynamics will continue to stabilize (if not increase) pricing for newsprint going forward, counter to market expectations.

Disclosure

Long ABH