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Orchids Paper: The Moat Is in Its Location

February 08, 2013 | About:
Listed in July 2005, Orchids Paper Products Company (TIS) is an integrated manufacturer of tissue products serving the private label consumer, or "at-home" tissue market. TIS produces a full line of tissue products, including paper towels, bathroom tissue and paper napkins, from its operations in northeast Oklahoma. Its core customer base consists of dollar stores and other discount retailers, and its products are sold primarily under customers’ private labels and, to a lesser extent, under TIS's brand names such as Colortex, My Size, Velvet, Big Mopper, Soft & Fluffy, Tackle, Nobel and Care.

Hedge Fund Insights

Cadence Capital Management, founded in 1988 with approximately $3.2 billion in assets under management, initiated a position in TIS in the fourth quarter of 2012, with a purchase of 48,420 shares. According to its website, Cadence claims to be a growth stock specialist, focused on identifying profitable, growing companies with attractive stock prices on a bottom-up basis

Valuation TIS currently trades at a trailing 12 months P/E of 17.5 and a trailing 12 months EV/EBITDA of 8.0. Its current P/E valuations are at a 24% premium to its five-year average P/E of 14.1. TIS achieved a trailing 12 months ROE of 13.4% and a five-year average ROE of 13.8%.

TIS PE-ROE Comparison1360305469333.png

TIS has an excellent profitability and cash flow generation track record. It was profitable and operating cash flow positive in every single year since its listing in 2005 and delivered positive free cash flow in four out of the last five years. Except for 2009, gross margins for TIS have stayed within a narrow range of between 14% and 17%. Management has grown revenue and net income by a 10-year CAGR 6.7% and 13.1%, respectively. On Feb. 6, 2013, TIS reported year-end 2012 financial results, with full-year net sales of $100.8 million, marking the first time TIS has achieved more than $100 million in net sales.

TIS Earnings-Cash Flow Comparison

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TIS Profit Margins Analysis

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Financial and Business RisksTIS has a relatively strong balance sheet with a low gross debt-to-equity ratio of 21% and a net gearing of 10%. This is further supported an interest coverage of 8.5x. The strong build-up of cash from positive free cash flow generation and net proceeds of approximately $14.8 million from a follow-on offering of 862,500 shares of common stock, have kept TIS in either a strong net cash or low net debt financial position.

TIS Cash-Debt-Market Capitalization Comparison1360306246632.png

TIS has off-balance sheet liability exposure through a fixed price contract to purchase 60% to 70% of its natural gas requirements, or 334,000 to approximately 380,000 MMBTUs per year, through December 2014. If it is unable to purchase the contracted amounts and the market price at that time is less than the contracted price, it would be obligated to reimburse an amount equal to the difference between the contracted amount and the amount actually purchased multiplied by the difference between the contract price and the current spot price.

TIS faces significant customer concentration risk. Its three largest customers, Dollar General, Family Dollar and Walmart accounted for approximately 42%, 15% and 15% of its converted product revenue in 2011.

Like any other commodity product company, TIS is susceptible to increases in costs of its raw materials. TIS primarily uses pre-consumer solid bleached sulfate paper, or SBS paper, to produce parent rolls. Any sharp increase in the cost of SBS paper could require TIS to purchase alternate fiber grades at increased costs, and reconfigure its pulping plant to process other available forms of recycled fiber or other sources of paper fiber.

Business Quality and Capital Allocation

TIS is one of the few tissue paper manufacturers located in the south central U.S., which puts it at proximity to key customers in a geographic areas with strong population growth. TIS typically has lower freight costs to its customers’ distribution centers located in its target regions covering Texas, Oklahoma, Kansas, Missouri, Arkansas, Nebraska and Iowa. According to the U.S. Census Bureau’s 2010 census, TIS' targeted region includes approximately 13.4% of the U.S. population, and had a population growth rate that is approximately 5% higher than the national average growth rate for the 10 years ended in 2010. Management believes that Georgia-Pacific’s Muskogee, Okla., plant, Cascades’ Memphis, Tenn., plant, Pacific Paper’s Memphis, Tenn., plant, and Clearwater Paper Corporation’s Oklahoma City, Okla., plant are the only competitors’ plants in Oklahoma and the immediate surrounding area.

TIS was among the first manufacturers to adopt a strategic focus on supplying value retailers with quality private label tissue products and this has resulted in TIS building strong long-term relationships with leading value retailers. Its five largest customers have been with TIS for five years or more and aggregate finished product shipments to these customers have increased approximately 32% during the last five years. The dollar stores channel of the discount retailer market has shown resilience and even growth in previous economic down-cycles and is benefiting from a shift in consumer spending from traditional retail stores to discount retailers. According to a 2011 article from San Diego Union-Tribune, currently six out of ten shoppers shop in dollar stores each quarter. TIS is targeting to capture a share of the growing mid-tier market at these retailers with its new converting equipment and new product development efforts.

TIS' focus on at-home private label tissue products has enabled it to maintain revenue growth in uncertain times. Tissue demand is divided between the away-from-home and at-home markets and TIS sells its products exclusively to retailers serving the at-home market, which is not materially seasonal. Furthermore, private label tissue has been gaining market share at the expense of national brands. According to data from Resource Information Systems Inc., the private label tissue segment grew 5.9% over the last seven years, while branded tissue sales grew 2.1% over the same period.

On Feb. 22, 2011, TIS announced the initiation of a quarterly cash dividend policy and it currently sports a trailing 12 months dividend yield of 3.6%. TIS increased its most recent quarterly dividend from $0.20 per share to $0.25 per share.

ConclusionFreight costs represent a material portion of end product costs and geographical location is a key competitive advantage in the tissue market, given estimates by TIS' management that it is generally economically feasible to ship within an approximate 900-mile radius of the production site. TIS does possess a moat in the northeast Oklahoma by virtue of its geographic location. In recent years, TIS's competitors have added plants in its focused 500-mile sales area. In 2009, Pacific Paper added a new converting plant in Memphis, Tenn. In 2010, Clearwater Paper Corporation, via its acquisition of Cellu Tissue, started production from a new converting plant in Oklahoma City, Okla.

DisclosureThe author does not have a position in any of the stocks mentioned.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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