I’m always excited to discuss recent equity purchases, but this recent buy is particularly special for me. I’ve never invested in a company like this before, so it’s equal parts exciting and scary all at the same time. We’ll see how I do with this investment over time, as I publicly disclose all of my purchases and sales.
I telegraphed this transaction, as I already revealed my watch list earlier in the month. General Electric Company (GE) was my top stock pick for the month, and I already purchased shares on the 10th. Looking down the list, I decided to stay true to what I wrote about and invest in the company that was listed just below GE. As always, I put my money where my mouth is.
I purchased 60 shares of Orchids Paper Products Company (TIS) on 3/21/14 for $27.29 per share.
Orchids Paper Products Company is an integrated manufacturer of private label tissue products. These products include paper napkins, bathroom tissue, and paper towels. They produce bulk tissue paper, known as parent rolls. They convert these parent rolls into finished products. These products are primarily marketed and distributed through discount stores under customers’ private labels, or to a lesser extent Orchids’s own brand names, such as Colortex, Velvet, Linen Soft, and Big Mopper. These products are sold exclusively to retailers serving the at-home market.
Orchids is not the typical company I invest in. This is a speculative play for me, but I feel comfortable investing here as my six-figure portfolio is now chock-full of high quality blue chip companies. The risk/reward relationship with TIS is certainly more aggressive than the investments I usually target, but I think the potential is great enough for me to take a chance here. Furthermore, the high yield on shares makes the stretch a bit more palatable.
This is a very young company. It went public in July 2005, so historical operational records are rather short. Furthermore, they spent time and capital in 2009 and 2010 expanding operations, which resulted in increased capital expenditures. The company also issued additional shares in 2009, which diluted the float but resulted in additional capital to grow the business. The net proceeds of $14.8 million of the follow-up offering were used to finance a $27 million expansion project. After the share issuance and expansion project, the company initiated a dividend in 2011 to return more cash to shareholders. The company continues to invest in its ability to serve customers and provide dynamic products, and at the end of 2013 announced a project to replace two paper machines and an upgrade to the converting line. While this will come at a price tag of $30.4 million, it’s expected to add approximately $6 million to $8 million in annual EBITDA due to increased capacity (57,000 tons to 70,000 tons) and reduced production costs.
The company owns and operates a paper mill, converting facility, and finished goods warehouse in Pryor, Oklahoma. The paper mill consists of two facilities totaling 162,000 square feet and a 23,000 square foot paper warehouse. The mill generally operates 24 hours per day, 362 days per year. Three days per year are set aside for scheduled maintenance. The converting facility, at 300,000 square feet, converts parent rolls into finished product. Typically, parent roll manufacturing capability exceeds conversion requirements, and as such the company sells some of this unused parent roll into the open market. The company does plan on adding another high-speed, flexible converting line in 2014. The finished goods warehouse was built in 2010, and is 245,000 square feet. Its capacity allows it to hold approximately 600,000 cases of finished product.
From 2010 to 2013 revenue is up from $92.504 million to $116.374 million. This is a compound annual growth rate of 7.96% over this time frame. EPS is up from $0.76 to $1.67 during this same period, which amounts to a CAGR of 30.01%. Pretty solid growth here. While it’s incredibly difficult to get a handle on what kind of growth an investor should expect for the future, consider this: Most of Orchids’s products are distributed within a 900-mile radius of their headquarters in Oklahoma. And of this, most of their sales are concentrated within 500 miles. And this is an area of the country that is not nearly as densely populated as the rest of the country. That leaves a lot of growth potential still out there for this small company. Right now, Orchids concentrates on this small area because they’re one of the few competitors in this area of the country, which gives it certain advantages like lower freight costs. However, in the future they’ll likely have to tap into larger markets for growth.
The company has four primary retail customer relationships. Their four largest customers accounted for 81% of their converted product sales in 2013. Dollar General Corp. (DG) is their largest customer, at approximately 52% of converted product sales. Family Dollar Stores, Inc. (FDO) is second largest at approximately 11%. HEB became their third largest customer in 2013, and now accounts for approximately 9% of converted product sales. Finally, Wal-Mart Stores, Inc. (WMT) accounts for approximately 9% of converted product sales. Orchids supplies their private label products to over half of its customers’ distribution centers within their cost-effective shipping area. Obviously, another great area for future growth is further retailer relationships, while still maintaining strength within the networks the company already has built.
Orchids also likes to point out that they’ve been growing mid/premium tier products as a % of total cases shipped. Orchids maintains flexibility and diversity within their paper product offerings, and with key investments over the last few years they’ve been able to broaden their product base. They offer premium products through higher quality paper, improved embossing, enhanced graphics, and increased packaging configurations. Shipments of mid/premium tier products as a percentage of total cases shipped increased from 6.8% in 2011 to 37.9% in 2013. This will be an ongoing key area for revenue growth.
Now, let’s get to the nitty-gritty. Shares in TIS contracted by over 18% over the last two trading days of last week. Whoa. What happened here?
Well, it was announced that a securities firm out of New York, Faruqi & Faruqi, LLP, is investigating TIS for potential breaches of fiduciary duty by its board of directors. This investigation comes on the heels of a proxy vote initiated by management on the matter of stock options and grants. Basically, management is holding a special shareholders meeting on April 9, 2014 to discuss certain matters, most prominent of which is the vote to approve a a stock option plan of 400,000 shares to newly appointed CEO and President Jeffrey S. Schoen, as well as a 2014 Stock Incentive Plan, which reserves an additional 400,000 shares of common stock to be issued under the plan, which would depend on certain financial performance metrics pursuant to the plan. Note that this isn’t the first large stock incentive plan for Orchids, with the last such plan being titled the “2005 Plan”. That plan eventually allocated 1,097,500 shares.
Let me state first that I’m not a fan of this compensation plan. While executive compensation is often a prickly subject between shareholders and management, this particular proposal is a bit more egregious because of the rather small size of the company. As of December 31, 2013, Orchids had 8,066,809 shares outstanding. That means the 800,000 shares in question would dilute shareholders’ equity by approximately 10% if all shares are allocated.
However, as was mentioned above the stock took a 18%+ hit in two days on news that was already outstanding. That means there is a 8%+ spread between the potential dilution and the reaction by the emotional Mr. Market. He’s fickle, isn’t he? In addition, half of the shares in question are open to be purchased by Mr. Schoen, which is not set in stone – and would be available depending on certain share price metrics. And this compensation, if passed, would be offered over the course of years as vesting occurs. Furthermore, the vote hasn’t even passed yet.
Okay, with that said let’s get back to the company.
Dividend growth, which is one area of particular concern for me as a dividend growth investor, has been outstanding, if only for the last few years because of a short history. The company initiated a dividend in 2011, as was previously mentioned. The first dividend was $0.10 quarterly per share. The dividend is now $0.35 quarterly per share. This is a CAGR of 64.32% from 2011 to 2013. Now, I don’t expect this kind of growth in the dividend to continue indefinitely. The payout ratio right now is 80.8%, which is quite high, especially for such a young and small company. This is probably where one of the biggest risks in the investment lie, as future dividend growth will be generated by growth in earnings. Any hit to earnings could cause the dividend to be reduced. However, as it stands with current payout, the yield on shares here is fantastic. After the recent hit to the share price, the entry yield on my purchase is 5.13%.
The balance sheet remains well-managed, with a long-term debt/equity ratio of 16.5%. The interest coverage ratio is very high at over 50.
I like TIS here. I think the company has a lot of growth ahead of it. As consumers continue to feel the squeeze of the economy years after the Great Recession first hit, products that represent great value remain in demand. And the company has a lot of growth avenues with which to take. They can expand their sales area, as they primarily operate in a small and sparsely-populated area of the United States. They can also expand their customer base, catering to a wider swath of retail centers. In addition, the company continues to grow its mid/premium tier products. With a market cap of $223 million, the growth potential is outstanding. The company had a record quarter of sales for 4Q 2013, and the new investments in assets should provide solid ROI looking out over the long term.
However, special risks present themselves with such a small company. Their headquarters is situated in an area of the country that is prone to natural disasters like tornadoes. If one of their large customers cuts back on orders, this can have a material effect on the company’s ability to generate increasing revenue and earnings. Competition always remains a key risk, although I think TIS is somewhat insulated due to the value of their products and the area of the country they operate in. As a very small company, interest rate risk is very present, and the company cites a 100 basis point increase in interest rates would result in a pre-tax $146,000 increase to their annual interest expense. They are also exposed to input cost fluctuations, specifically relating to the price of fiber. One last risk is the high capital expenditures the company expects for 2014 and 2015 as a result of aforementioned investments.
Shares in TIS are trading for a P/E ratio of 16.67 right now. That’s a rather attractive valuation considering the growth potential of this company. With high growth, low valuation, and a high yield this is a value stock, growth stock, and a high-yielding stock all built into one. It’s rather unique.
I valued shares using a Dividend Discount Model analysis with a 10% discount rate and a 6% long-term growth rate. I used a rather low growth rate as a margin of safety considering the unique risks with this business. Using this model I see a fair value on shares at $37.10 right now, which implies a heavy margin of safety, especially considering the low growth rate I used. If the company is able to grow to its potential, and grow the dividend in kind, then shares are considerably undervalued here. However, even though I think the valuation is great here, I likely will not average down like I usually would if the stock continues to fall from here. This is due to the rather small size of the company and inherent risks there. As such, it’ll remain a small position for me.
This purchase adds $84.00 to my annual dividend income based on the current quarterly payout of $0.35 per share.
My portfolio now holds 46 positions. This is an increase since the last update, as this was a new investment for me.
I usually like to include analyst opinions on the valuation of a stock, but no major outlets follow this stock. So I have nothing to include with this report.
I’ll update my Freedom Fund in early April to reflect my recent addition.
Full Disclosure: Long TIS, WMT, GE
What are your thoughts on TIS? Too small of a company with too many risks? Outstanding opportunity?
Thanks for reading.
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