Tredegar (TG) is easily overlooked, given its less-than sexy business model. It only has one analyst following the stock and the lack of understanding of the company's business keeps many investors out of the stock. Over the last three years, the company has seen a wide array of swings to the upside, followed by moves to the downside. Yet, the real story is that it has underperformed the S&P 500 by some 13 percentage points, despite a period of improving fundamentals.
Quick overview
Before getting into why the stock is an underperforming, let's first try to wrap our minds around exactly what Tredegar does. The company is a plastic films and aluminum extrusions manufacturer headquartered in Virginia with locations in North America, Europe, Asia and Latin America. Its film business makes plastic films, elastics and laminate materials primarily for personal and household care products and surface protection and packaging applications. As far as aluminum goes, they produce soft-alloy aluminum extrusions primarily for building and construction, distribution, transportation, electrical, consumer durables and machinery and equipment markets.
It can be difficult to get your arms around the two businesses. As a quick run down, let's see just what film products means. The term, by itself is cryptic, and doesn't properly outline the market opportunity. Also worth noting is that film products make up nearly 70% of sales. For film products, Procter & Gamble is the company's largest customer, with sales of $264 million to P&G in 2012. That's nearly 30% of total sales.
The key use for film products is personal care, which includes feminine hygiene products, baby diapers and adult incontinence products. Personal care accounts for around 40% of Tredegar's sales. Other notable uses for films include specialized polyester films for packaging applications, for heat resistance, barrier protection and strength. The key end uses are food packaging and industrial applications. At the end of 2012, these specialized polyester films made up 16% of sales.
The film products segment also gives Tredegar exposure to the fast growing tablet and smartphone market thanks to surface protection films. These films are used in protecting components of flat panel displays used in smartphones and tablets during the manufacturing process. These surface protection films made up just under 10% of revenues as of 2012.
Slow and steady doesn't always win the race
Tredegar has been a consistent performer when it comes to generating revenues (at least over the last few years), but, as mentioned, this has failed to convert to a higher stock price. From 2010 to 2013, the company optimized operations and refocused the company, which includes broadening its film products offerings, and closing unprofitable plants in the aluminum business.
The company has paid out 55 cents in dividends over the last three years, but it's current dividend yield is a mere 1%. Investors need more. This includes value investor Mario Gabelli and his GAMCO Investors, as well as the Gottwald brothers.
GAMCO and the Gottwald brothers go 'activist'
Gabelli's stake in Tredegar goes as far back as 2008. He now owns over 14% via GAMCO, Gabelli Funds, and Teton Advisors. Meanwhile, the Gottwald brothers have also gone activist. Together, the family owns over 23% of the company. They are pushing the company for "strategic alternatives."
GAMCO CEO Mario Gabelli, dubbed "Super Mario" by the media, reminds us a lot of famed investor Peter Lynch, both in his investing mentality and appearance. However, one of the greatest things about Mario is that he looks for a "pending catalyst to bring that value to the surface. He advises that this catalyst can take many forms. Examples would be a company or industry specific event, such as a change in management, a spinoff, regulatory changes or industry consolidation." We believe his firm has gone activist at Tredegar because there is an upcoming event that will unlock shareholder value.
In its October letter to management, GAMCO notes that it "believes that the enlargement of the threshold for the poison pill from 15% to 25% would underscore your company's focus and sensitivity to shareholder values."
All this is leading up to a proxy fight. The Gottwald's wrote a letter to the Board earlier this year, noting that "using the terms of a poison pill to disqualify individuals who own shares seems to us to be unwise as a matter of corporate governance and contradictory to the long standing precept that poison pills are not to be used to prevent shareholders from choosing a corporation's directors..."
John Gottwald and William Gottwald, Vice Chairman of the Board, together own around 15% of Tredegar, with their father, Floyd Gottwald, owning the other 8%. John Gottwald was Tredegar's first CEO, starting in 1989 and serving until 2001. He again became CEO in 2006 when he replaced retiring CEO Norman Scher. His latest tenure ended in 2010. Since then, the company's stock has grossly underperformed, despite the 'initiatives' the company has implemented..
Tredegar said it implemented initiatives in 2010 focused on accelerating profit growth. The company said the strategy "has delivered results" with 2012 net sales growing 35 percent and earnings per share from ongoing operations growing 40 percent compared with 2009. Yet, as mentioned, this has failed to translate into share price improvement.
So what gives with the stock underperformance? First, although revenues and earnings have rebounded to pre-2010 levels, a number of things are awry. ROA, ROE and FCF-to-net income are all lower as of the TTM, compared to 2009, and its balance sheet is more levered.
John Gottwald seems to know something about a solid stock price. For the three years prior to 2010 (during his tenure as CEO), the company outperformed the S&P by some 25 percentage points.
Build the topline and the rest will follow
We see topline growth being easily achieved with the help of a rise in demand from personal care products, which comes as the middle class expands and new users, namely more adults, come to market.
The rapid increase in 65-plus individuals will lead to increased demand for adult diapers
As well, other personal care products should see increased demand as incomes rise in emerging and developing markets. Take the largest country in the world for example, China. An increase in their middle class, with more disposable income, has the opportunity to really move the needle when it comes to feminine hygiene and diaper products.
The middle class as a percent of total China households is rapidly rising
Source: Thomson Reuters
If we go to the other side of the film business, the increasing demand for various electronics should further help drive demand.
Smartphones continue to drive the global mobile device market growth
Finally, Tredegar film products are also used in packaging. A transition from cardboard and metal to plastic packaging is a big positive for Tredegar. Now, there's also the aluminium side of the business, which should also see some demand increase due to a continued recovery in construction and vehicle production. Furthermore, aluminum is highly effective when it comes to helping meet new fuel economy standards.
What should be done?
The company has two very different business units. These are two very different companies, both of which might be best served as individual companies. At this stage, all options are on the table, from a spinoff to a merger or sale. However, there is a level of intertwined-ness with the manufacturing processes, where the company likely has various cost synergies.
We think one of the biggest initiatives that Gabelli and the Gottwald's will be pushing for will be a revamp of operations, to help get margins back up to historical levels. In the base case, we think margins will expand as the film business grows its portion of company revenues over the interim (more on this later). Thus, any margin improvement that the activists can extract would only gas pedal our earnings expectations.
Just how cheap is the stock?
The stock has a PEG right at 1, with a forward p/e that comes in at 21x. Meanwhile its EV/EBITDA is around 8.6x. The one Wall Street analyst expects Tredegar to grow EPS at a 21% over the next five years, which is nearly double the industry average. Yet, the stock trades in line with the industry at 21x earnings. This one analyst also has a hold rating and a $25 price target on the stock. Their 2014 EPS estimate is $1.21, which has been reduced from $1.34 a month ago.
Prior to the financial crisis Tredegar was a 30x earnings stock. Admittedly, in the current state, the stock doesn't deserve a 30x multiple. However, revenue is expected to rebound to near decade highs, and that in and of itself will drive EPS higher. 2014E sales are estimated to be $990 million, which is not unreasonable, considering the stock has generated some $970 million in sales over the TTM and generated $1.1 billion in 2006.
As mentioned, we believe the market dynamics are in our favor. The faster growth of the films business will, ipso facto, increase the operating margin. The operating margin for aluminum is around 4.5%, while film products has an operating margin of 12%. As a result, we believe margins could be over 10% in 2014, ultimately putting its net margin to over 4%. Thus, we see 2014 EPS coming in close to $1.24, which puts its forward p/e at around 20x.
Meanwhile, FCF could hit $2 per share, which puts its FCF-to-net income at 1.6x, which is still well below historical conversion rates. In any case, at 2014E FCFPS of $2, that's a free cash flow yield of 8%. Very enticing, where the 30-year T-bond is at 3.9%.
Bottom line
The businesses of Tredegar are very different, but very much integrated. Separating out the two might prove more difficult than many investors believe. Yet, there's a very good chance that Gabelli and the Gottwalds already know this. We believe that implementing some key margin improving initiatives will go a long way in driving earnings higher.
The top line growth will come by the way of various market tailwinds, including the rapidly rising age of individuals in developed markets, and the rise of the middle class in developing markets. As well, Tredegar has exposure to the construction markets, which should continue its post real estate bubble burst rebound. All in all, we believe the justified multiple is around 25x, coupled with the 2014E EPS of $1.24, suggesting 24% upside in just over a year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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