Prem Watsa is known as the Warren Buffett of the North. He made $2 billion for Fairfax Financial by betting against companies exposed to the housing bubble ahead of the financial crisis and has an enviable 30-year investment track record.
Watsa has nearly 12% of Fairfax's equity portfolio in Resolute Forest Products (NYSE:RFP) and owns over 30% of the company. Watsa is bullish on Resolute because its shares are very cheap relative to the cash flow that it generates. I'm inclined to be less bullish because I just don't think this is a very good business. Cheap? Yes. Able to generate high returns on capital over a long period of time? Not so much.
Business isn't exactly booming
Two of Resolute's main business lines are in obvious secular decline: newspapers and specialty papers. The Internet has delivered each of these businesses a crushing blow.
Newsprint demand is steadily declining, and the next generation of people aren't going to have any use for something they can't read on their smartphones.
Specialty papers -- including novels, magazine, direct mail, flyers and so forth -- is in no better shape: another declining business.
Resolute has three other business units in addition to these, though, and the plan is for those to grow and more than offset the declines in newspapers and speciality paper.
Market Pulp: Resolute's pulp is a renewable and biodegradable material and a key ingredient in making products we use every day. You'll find it in everything from tissues to paper towels, coffee filters, disposable diapers, and other absorbent products, as well as printing and writing papers.
Resolute produces approximately 1.7 million metric tons of market pulp (softwood pulp, hardwood pulp, and fluff pulp) at seven facilities in North America -- or 11% of total North American capacity. Resolute is the third largest pulp producer in North America.
Wood Products: This segment makes wood that is used in construction on walls, roofs, and floors. Resolute has 20 wood products facilities and is the No. 1 Canadian producer of wood products east of the Rockies.
Unit Tissue: The tissue segment is new, and the company hopes it will drive cash flow growth going forward. Moving into tissues would provide the business with clear demand for the long term -- unlike the declining paper markets.
Resolute is expanding into tissues on two fronts.
Resolute is building a $270 million state-of-the-art facility in Calhoun, Tennessee, where it will manufacture private-label tissue. It's expected to be fully operational in 2017. In November 2015, Resolute acquired Florida-based Atlas Paper Holdings, which is a manufacturer of tissue products.
The pulp and wood products units are pretty strong and provide solid cash flow for the company. The expansion into tissue is a big opportunity where Resolute should be able to exploit its vertically integrated model and the cost advantages that come with it to its advantage over tissue competitors (only one of which is vertically integrated).
How attractively valued are the shares today?
While Resolute's business may not throw off buckets of capital like Apple or Coca-Cola, it does look tempting relative to its market valuation.
At the recent share price of $5 per share, the market capitalization of the company is roughly $450 million. According to Prem Watsa's fellow value investor Francis Chou, a normal level of EBITDA (earnings before interest taxes and amortization) for Resolute would be $400 million.
That would mean Resolute is trading for barely more than one year worth of EBITDA. Add in Resolute's $570 million of debt, and its enterprise value of just over $1 billion also looks pretty small next to $400 million of EBITA annually.
The balance sheet with $570 million of net debt doesn't appear overly stretched against $400 million of EBITDA, either.
While Resolute's business is pretty boring and not likely to set the world on fire in terms of rate of growth, you can see why a value investor like Watsa would be interested.
What's an investor to do?
While Resolute is clearly very inexpensively valued relative to its cash-generating ability and has the blessing of Prem Watsa, I'd be inclined to take a pass. I'm much more inclined to get excited about a great business at a reasonable price than I am to be interested in a mediocre business at a fantastic price. I consider this a mediocre business because its growth prospects are virtually non-existent, two core business units are in decline and the tissue unit is completely unproven. There is also a considerable amount of capital required to run this business which makes generating high returns difficult.
When you buy a mediocre company at a cheap price, you might get one good stock price run to get that company up to fair value. When you buy a great company at a reasonable price, you can get 20 years of stock price runs as the company keeps growing at a high rate. Resolute can offer a one time return to a less cheap valuation, but it likely isn't going to grow its cash flow generation significantly in the coming decades with the headwinds that the business is facing.
Christopher Malcolm has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple and Coca-Cola. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.