Markets & Finance

Glatfelter's Paper Discount

By Stuart Benway, CFA on November 13, 2006

The company has added two major businesses this year, which we believe it acquired at very attractive prices (one acquisition is still subject to regulatory review). In our view, these purchases will expand Glatfelter's production capacity, reduce its per-unit manufacturing costs, widen its geographic presence, expand its market share, and provide opportunities for operating synergies.

In our opinion, Glatfelter shares are underappreciated on Wall Street, as the stock's valuation is well below that of the S&P 500, despite what we see as above-average near-term growth potential. Investors seem to be concerned about the somewhat slow progress on acquisition integration, but we continue to project significant profit improvement in 2007. Glatfelter carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

History of Profitability

Glatfelter is one of the world's leading manufacturers of specialty papers and engineered paper products. Many of its items are targeted at relatively small, niche markets with a limited number of suppliers.

The company serves customers in a variety of sectors, including book publishing, envelope and converting, food and beverage, pressure-sensitive, digital imaging, composite laminates, and other highly technical markets. Glatfelter's papers are used for tea bags, coffee filters, textbooks, metallized labels for beer bottles, postage stamps, adhesive tape, playing cards, and laminate flooring, among many other uses. Net sales in the U.S. accounted for 69% of total sales in 2005, Germany for 25%, and other countries the remainder.

Although Glatfelter has exhibited a moderately cyclical pattern of sales, earnings, and cash flow over the past decade, we believe it has shown more stability than many of its peers, and it has remained profitable over the entire period, which we view as impressive.

Since 1996, the company's sales have advanced at a compound annual growth rate (CAGR) of less than 1%, but sales in 2005 were down 18% from their peak in 2000. Over the same time frame, the paper-products subindustry has produced sales growth of 4.2%. Net income of $39 million in 2005 was down from $56 million in 2004 and $60 million in 1996. This compares to net income growth of 8.5% for Glatfelter's peer group over the past 10 years.

Niche Focus

Gross margins at Glatfelter averaged 26.6% from 1996 through 2005, vs. 22.8% for the paper-products group as a whole. Operating margins for the company averaged 9.1% in the past decade, a better performance than the 7.9% average for its peer group over the same period. We look for margins at Glatfelter to remain above the industry average over the next three to five years due to the company's focus on niche markets and specialty products. We also expect earnings to reach a higher level than at any time in the past decade due to the recent acquisitions.

In an effort to avoid the sharp cyclical swings in earnings that affect many of the major paper producers, Glatfelter has adopted a strategy that focuses on aggressively reducing costs and continually adjusting its product portfolio in order to increase the company's focus on higher-value, niche products and to better tailor its product offerings to customers' frequently changing requirements. One element of this approach is to capitalize on the company's leadership position in several categories and optimize its product portfolio with the goal of accelerating growth, improving margins, and generating better financial returns.

In 2005, about 75% of Glatfelter's total sales were derived from what the company considers to be higher-value, niche products. Over the next several years, management intends to increase the company's concentration of these types of products by driving growth in sales of trade book papers, uncoated specialty products, long fiber and overlay products, and other specialty categories.

Bagging It

The long fiber and overlay papers business unit will be an important focus for the company, in our view. Glatfelter is one of the leading producers of tea-bag and coffee-filter papers in the world, and we view this segment as having promising growth characteristics as certain markets move toward tea bags vs. loose tea leaves.

Cost reduction is another key focus at Glatfelter, as it has reduced its work force and implemented improved supply chain management processes in North America over the past two years. The company is putting a similar program in place in Europe, which it expects to reduce costs by about $8 million annually by 2008.

Another approach that the company has adopted is to divest most of its timberlands. Glatfelter has identified 40,000 acres of higher and better use properties and 20,000 acres of timberland that it plans to sell over the next three to five years. Although the company estimates that this program is likely to lead to an increase in fiber costs of 3 to 6 cents per share annually, the $150 million to $200 million in proceeds that the sale is expected to generate will likely far outweigh the increased costs.

Although Glatfelter has had a more stable earnings history than many of its paper and forest-products peers, its revenue and earnings have lacked a growth impetus, in our opinion, in part due to capacity constraints. We think this situation has changed as a result of the major acquisitions that the company has made this year.

Delayed Synergies

In April, 2006, Glatfelter completed the acquisition of the carbonless and specialty paper business of New Page Corp. for $80 million. We believe this was an attractive price for a business that had sales of $440 million in 2005 and production capacity of 440,000 tons of paper. Glatfelter paid less for these assets than the $87 million of working capital that was acquired.

Part of the reason for the low price, in our view, is that the carbonless paper market is in decline and is likely to continue to shrink. However, the company has said that this is the lowest-cost carbonless paper facility in North America and has the second-leading market share. Glatfelter plans to manage the expected downturn in the category by shifting production over time to other specialty grades where growth potential is much higher and margins are wider. It has also closed one of its primary paper making facilities in Neenah, Wis., and transferred production to the acquired facilities in Chillicothe, Ohio, where it expects production costs to be much lower.

Glatfelter originally said that this new business would add 10 to 15 cents to EPS in 2006, but it recently stated that the synergies related to this move are taking a little longer than originally expected. Nevertheless, it has maintained its forecast that this acquisition will contribute about 50 cents to EPS in 2007.

Rising Prices

In March, Glatfelter announced plans to purchase J.R. Crompton's Lydney mill in Britain for $65 million. This facility produces nonwoven products such as tea and coffee-filter papers, clean-room wipes, and double-sided adhesive tape substrates and had sales in 2005 of $75 million. By our analysis, the deal expands the company's geographic presence in Britain, Asia, and the Americas. Full integration of this unit is subject to European regulatory review, and it's currently being operated as a stand-alone unit. Once approval of the deal is received, we expect Glatfelter to realize significant operating synergies.

We expect the company's increased growth profile and potential for margin improvement to be positive factors for the stock. We're also encouraged by the recent trend of higher prices for paper. With no major paper capacity likely to be added for at least the next two years, we think a favorable pricing environment will persist for the next 12 to 18 months.

In our view, the quality of Glatfelter's earnings is affected somewhat by the company's substantially overfunded pension plan. We estimate that for 2006, about half of the company's 60 cents of estimated operating EPS will be derived from earnings on the pension plan. Our S&P Core Earnings estimate is 31 cents a share. As the expected contribution from recent acquisitions grows, the impact of pension earnings should decline.

In 2007, our S&P Core EPS forecast is 98 cents, compared to an operating EPS projection of $1.30. We note, however, that the strong condition of the pension program results in more cash flow available for other corporate purposes, such as debt reduction and capital expenditures.

Pros and Cons

As our operating EPS estimates detailed above indicate, we look for strong earnings comparisons in 2007, as both revenues and margins expand. We believe the integration risk at Glatfelter merits a modest discount to its peer group. Applying a forward p-e ratio of 15.7 times to our 2007 EPS estimate, we derive a value of $20. Our discounted cash-flow model indicates intrinsic value for the stock of $22. Combining these two measures, we derive a 12-month target price of $21.

In our opinion, Glatfelter's corporate-governance polices are very well aligned with shareholders' interests. By our analysis, the company ranks high relative to other companies in the Materials group and also scores well compared to companies in the S&P MidCap 400.

Factors that we consider favorable include: Only one inside director and no affiliated outsiders serve on the board of directors; the compensation committee is composed solely of independent outside directors; the company doesn't have a poison pill in place; and all directors with more than one year of service own stock in the company.

On the negative side, however, the company has a classified board of directors and the positions of chairman and CEO are combined.

Riding the Cycles

Risks to our recommendation and target price include difficulties integrating recent acquisitions, a weaker-than-projected recovery in demand and pricing for paper, renewed escalation in energy and raw material costs, and lower prices for land sales than is currently anticipated.

Glatfelter operates in a moderately cyclical segment of the paper industry that has relatively high capital requirements and commodity cost inputs. We see these factors being partially offset by the company's history of consistent profitability and diverse offering of products and geographic exposure. We also consider it to be a small market capitalization issue, and its debt levels have risen due to the recent acquisitions.