Tuesday, April 26, 2005 / GLOBE AND MAIL
In investing, numbers often lie. The numbers say that Tembec, one of the country's largest forest products companies, is among the cheapest stocks money can buy. With a market capitalization that's less than one-third of the company's $1.1-billion in net assets, how can you go wrong?
Don't be fooled. More than $500-million in shareholder wealth has been eviscerated since last summer, and if you watch what the bond market says, more pain lies ahead. Tembec's debt has been tumbling in recent weeks, an ominous sign. On Thursday, the company will report its second-quarter results, which management has already warned will be abysmal. It's rude to say it out loud, but in dark corners people are starting to wonder whether the company may be forced to consider bankruptcy protection.
The sad part is that many of Tembec's woes are not management's fault. Chief executive officer Frank Dottori couldn't have predicted the Canadian dollar would rise from 65 cents (U.S.) to the 80-cent range so quickly, crushing the company's profit margins. He couldn't help the fact that the Brazilians have built hyper-efficient new pulp mills that render Tembec's smaller mills uncompetitive. But it is also a case study for executives and investors on the dangers of foolhardy acquisitions.
Any analysis has to start with the balance sheet, which is rated R and should not be shown to small children or others who are easily frightened. Tembec started out in 1973 by buying and saving one doomed pulp mill in Temiscaming, Que., and steadily got bigger, partly by purchasing other doomed mills. Management bought small assets and tried to pay as little as possible, a strategy that has left it with 55 factories spread out over three continents.
There's nothing wrong with acquisitions as long as you're careful about how much debt you accumulate along the way -- especially in cyclical businesses, where you never know when the cycle is going to turn against you. But Mr. Dottori failed to heed this, with damaging consequences.
With $1.6-billion (Canadian) in long-term debt, Tembec's interest costs run to more than $30-million a quarter. It would be manageable except everything else has gone against them. Pulp prices have been good but not great, and since it's sold in U.S. dollars, price increases have been sabotaged by the rising Canadian dollar and euro. New mills in South America, Asia and Europe are adding millions of tonnes of new capacity and hurting prices.
To make matters worse, the Quebec government has proposed a 20-per-cent cut to the tree harvest in the province, exacerbating a shortage of fibre in Eastern Canada. In Ontario, power prices have gone up. You get the idea. Next week: a plague of locusts strikes. The bright side, if you can find one, is that Tembec doesn't have any huge debt repayments until 2009. But since it's not even covering its interest costs at the moment, a financial crunch could come sooner.
Having lost so much lately -- the stock is down 42 per cent this year -- a shareholder might be tempted to take comfort in the $2.4-billion in fixed assets on the balance sheet. But demand for high-cost pulp mills paying developed world wages is, shall we say, not robust. One forest industry insider, speaking on condition of anonymity, reckons the plants aren't worth half as much as it says on the books. Tembec's $1.1-billion book value is an illusion.
This is starting to dawn on bond investors, who have been marking down Tembec's debt in earnest. Yields on the company's 2009 bonds have jumped to more than 10 per cent, from the low 8-per-cent range at the start of the year, according to Bloomberg data. If the bond guys are getting nervous, you can bet there won't be much left for equity holders if Tembec renegotiates its debts. Is there a way out? If the loonie slides back to where it was two years ago, maybe. But a huge restructuring seems inevitable.
