The other day, I spent an hour talking to the management team of Aldabra 2 Acquisition Corp. (AMEX: AII ) . Aldabra is a special purpose acquisition vehicle, which is an entity that essentially gives managers a blank check to find and acquire promising businesses, subject to final shareholder approval. Aldabra is in the process of acquiring the packaging and paper units of privately held Boise Cascade. Following the purchase, Aldabra will rename itself Boise Paper.
Over the course of our conversation, Aldabra's management team outlined its bullish thesis on the paper industry. Here are some of the high points.
Consolidation and discipline
Paper manufacturing is one of those laughably bad industries. Stocks like International Paper (NYSE: IP ) and Weyerhaeuser (NYSE: WY ) have gone nowhere for over a decade. It's hard to imagine investing in paper.
Yet a lot of really bad industries turned 180 degrees once consolidation and discipline took hold. The steel and can manufacturing industries are two examples of industries that went from down in the dumps to shareholder's delight. Once top players like Arcelor Mittal (NYSE: MT ) and Crown Holdings (NYSE: CCK ) consolidated smaller players, they helped lead the rest of the market with regards to pricing and returns on capital.
Could paper be the next "turnaround" industry? Aldabra certainly thinks so. One statistic management touted was that 10 years ago, the uncoated free sheet paper market was a free-for-all, with between 10 and 14 major paper producers slugging it out. Today, International Paper, Domtar (NYSE: UFS ) -- which acquired Weyerhauser's paper unit -- and Boise Paper together control 70% of the market.
Good things also happen to industries when supply becomes extremely constrained. For instance, consider crude oil refining. It costs a lot of money and takes a really long time to build an oil refinery. At the moment, oil refining capacity has become extremely scarce, and it's going to take a very long time to fix that imbalance. That has led to fat profit margins and soaring stock prices for companies like Valero (NYSE: VLO ) and Tesoro.
Aldabra notes that there hasn't been a new mill built in the last 12 years. Even if one could get the zoning, regulatory, and environmental clearances to build a mill, it would almost be economic suicide to do so. Boise's Louisiana mill is more than 2,000 acres, and houses machines 200-300 feet in length.
Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. In the not-too-distant-future, Aldabra believes, this will lead to supply constraints, allowing the paper companies to earn healthy returns on capital.
A couple other drivers provide tailwinds for the U.S. paper industry. The weakening dollar helps U.S. manufacturers by making it more expensive to import foreign goods. Aldabra's managers also noted that unlike the U.S. auto manufacturing industry, paper makers don't have to worry about legacy issues like pensions, health care, or environmental headaches.
The weakening dollar, Asia's huge appetite for commodities and pulp, and rising shipping costs have also led to an unprecedented situation in which it's actually more expensive to import paper products from Europe and Asia than to manufacture them in the United States. Currently, it costs about 10%-20% more to import uncoated free sheet paper, which previously accounted for around 10%-15% of total supply, than to manufacture it domestically.
All of these factors have led Aldabra to foresee a very bullish future for its pending acquisition. In SEC filings, Aldabra estimates that based on current paper prices, which have already risen substantially, it should generate $336 million in 2008 EBITDA, up from roughly $250 million in 2007. After cutting away estimated capital expenditures from a recent program Boise completed -- along with interest expenses and cash taxes -- management believes Boise Paper will generate $115 million, or $1.34 per share, of free cash flow, which would be a nearly 14% FCF yield on the current share price.
All it takes is one glance at a steel or oil refining stock chart for me to get the motivation to do some deeper digging into the paper industry. The factors above could make the public paper players big winners over the next couple years, so I think it would be very wise to take a much closer look at industry players.