Switching Costs Keep Rayonier Compelling for the Long Term

Acetate tow is a very profitable business for Rayonier. Demand is recession-resistant, and high switching costs based on taste make for sticky customer relationships. However, long-term growth prospects for the business are limited. Global cigarette demand growth is likely to be less than 1% annually. Other CS applications are enjoying stronger growth, but the market as a whole is growing a modest 2%-3%.

Though Rayonier reported a predictably awful 2014, and 2015 pricing is likely to be slightly worse than we thought, costs are shaping up better than we expected, prompting a modest increase to our 2015 EBITDA forecast. Our long-term profit outlook, predicated on an end to recent destocking and a return to modest Chinese demand growth, is essentially unchanged. Our $36 fair value estimate and economic moat rating of narrow are also intact.

Market conditions remained difficult in the fourth quarter amid ample supply and tepid demand. Full-year sales dropped to $958 million from $1.0 billion on an 8% decline in cellulose specialties, or CS, prices. CS volumes fell to 479,000 tons from 486,000 due to shipment timing. While end-market demand appears to have shrunk, Rayonier has been able to gain share with its customers. Pro forma EBITDA, excluding nonrecurring environmental, separation, and legal costs, dropped to $267 million from $369 million.

Management expects 2015 to be worse, guiding to EBITDA of $200 million-$220 million. Prices are expected to fall 7%-8%, equal to the drop experienced in 2014 and greater than the 5% drop we had incorporated into our valuation. Flattish Chinese cigarette filter purchasing in the context of loose supply conditions is the main driver of declining prices. Rayonier expects CS sales volumes commensurate with 2014 levels (480,000 tons) and suggested it might sell 195,000 tons of commodity grade product. Management's outlook for 2015 costs, however, is more favorable than we had previously anticipated thanks to cost deflation, normalized plant uptime, and cost-cutting initiatives. As a consequence, we're slightly raising our own EBITDA forecast to $210 million from $198 million despite the pricing disappointment. We expect the recent cyclical downswing to abate in 2016 as inventory destocking runs its course.

In 2016 and beyond, with inventory levels normalized, we expect demand growth to allow Rayonier to place an incremental 25,000 tons of cellulose specialties into the market annually. Rayonier books far fatter profits on CS volumes than the commodity-grade tonnage it is forced to sell amid tepid demand conditions, so the mix shift should allow Rayonier's EBITDA growth to comfortably outpace global CS demand growth. Because this profit growth has already been paid for with the commodity-to-CS conversion project, free cash flows should grow faster than EBITDA in the years to come.

Our Fair Value Estimate Is $36 per Share Our fair value estimate is $36 per share. Cellulose specialties prices are the most important assumption in our model. After growing roughly 8% annually from 2003 to a peak of $1,913 per ton in 2013, prices fell 8% in 2014 and are set to dip another 7%-8% in 2015. We think an end to the recent inventory destocking phase of the cycle will see prices grow in line with general inflation in 2016 and beyond.

Following the Jessup CS conversion completed in 2013, Rayonier now has a 675,000-ton combined CS capacity at its two mills, Fernandina and Jessup, up from a 485,000-ton CS capacity before the conversion project. We do not expect full operating capacity to be reached anytime soon. Though management has indicated that it aims to fully place the new volume by 2018, we think it will take into the next decade. By 2019, we expect Rayonier's CS volumes to reach 580,000 tons. Commodity-grade cellulose volume is expected to decline from an expected 195,000 tons in 2015 to 95,000 tons over the same interval.

We discount free cash flows generated over our five-year explicit forecast horizon using an 8.4% weighted average cost of capital. We value free cash flows generated beyond 2019 using a multiple of 8.8 times EBITDA. This multiple reflects low systematic risk to cash flows partly offset by limited long-term organic growth prospects. We assign a high uncertainty rating to our fair value estimate.

Switching Costs Lead to Narrow Moat Switching costs related to acetate tow, Rayonier's most important product, underpin the company's narrow economic moat. Acetate tow used in cigarette filters accounts for an infinitesimal share of the total cost of manufacturing a cigarette. Still, the chemical companies that buy from Rayonier and sell to cigarette companies might be tempted to switch suppliers in a bid to save money.

The reason they don't is because some smokers can tell the difference. Professional "tasters" at tobacco companies are consistently able to differentiate Rayonier's acetate tow from that of other producers. For a chemical company, switching acetate tow suppliers would risk sums of money that far exceed the savings that might plausibly be gained.

We estimate adjusted returns on invested capital at an average of 24% from 2011 to 2013. We expect this measure of profitability to trough at in the low teens in 2014 and 2015, reflecting lower prices and slack CS capacity. Once pricing pressure abates and new capacity is fully utilized in 2018-19, we project adjusted returns on invested capital rising to the high teens.

Room for Improvement in Capital Allocation While we credit the current management team of Rayonier Advanced Materials with the value-accretive decision to separate Rayonier into two more-focused enterprises, Rayonier and Rayonier Advanced Materials, credibility and capital allocation have been concerns.

Revelations that Rayonier had been overharvesting in the Pacific Northwest during Rayonier Advanced Materials CEO Paul Boynton's time at the helm without the knowledge of the board calls into question his oversight abilities and transparency. The 19% overstatement of Pacific Northwest merchantable inventory in the 2013 10-K, since corrected by Rayonier's new management, is especially worrisome to the extent it was not the first time a management decision (or oversight) obscured what had been going on in the Pacific Northwest. In 2006, the company lowered the age at which it deems a tree merchantable (inflating inventories). In 2011, the company commingled Pacific Northwest with New York timberland for inventory reporting purposes, which also obscured insight.

We think management's initial capital-allocation goals as a newly independent company, which prioritized acquisitions over dividends, were misaligned with the company's opportunity set. To us, Rayonier Advanced Materials has all the markings of a cash-cow business and a big dividend payer: low capital reinvestment needs, low organic growth opportunities, and attractive operating margins. The painfully low share price would make buybacks especially attractive, in our view. Heading into 2015, management has de-emphasized acquisitions. However, it's unclear whether this recalibration of priorities is a function of difficult times for the business or a shift in underlying capital allocation philosophy.