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Veritiv: A Klarman Stock That Is Dirt Cheap


"For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are few assets so bad that they can't be a good investment when bought cheap enough." -Howard Marks (Trades, Portfolio)




I feel the same way as Marks about Veritiv Corp. (NYSE:VRTV), a busted initial pulic offering.

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Veritiv is a North American distributor of packaging material, facility solutions and paper products. It was created by combining International Paper's (NYSE:IP) distribution unit and Unisource, which is owned by Bain Capital and Georgia-Pacific. The purpose of combining was to lower costs and squeeze out synergies, while consolidating a mature market. The game plan was to do this by streamlining supply and distribution chains, combining warehouses and simplifying processes, which would result in lower costs and increased pricing power.

Seth Klarman (Trades, Portfolio)'s Baupost Group owns 22% of the outstanding shares and Bain Capital owns 17%. There is some comfort in being in the company of these astute investors, though, to date, this has been a losing investment.

By looking at Veritiv, I am trying to guess what the original premise of Baupost's investment was. I think Klarman may have reasoned that Veritiv, after it had consolidated operations, would be able to increase free cash flow, reduce working capital and deleverage the balance sheet.

The company is making good progress with these metrics.

Cash flow

This progress is reflected in the jump in operating and free cash flow. Free cash flow reflects changes in working capital, which can distort the metric, so I like to strip out changes to working capital and see what is happening. However, even "core free cash flow," in which I strip out changes to working capital, has also turned around.

Why is free cash flow important? In simple terms, it represents the amount of excess cash a company has generated, which can be used to return to shareholders (via dividends or share buybacks), reduce the comany's debt (see below) or invest in new opportunities for the business without hurting the existing operations; thus, it's considered "free." The green line in the diagram below depicts free cash flow.

Working Capital

Veritiv has a very high working capital as compared to its market cap. If the company can increase the efficiency of its working capital (i.e., reduce working capital to produce the same operating income), it can redeploy excess working capital to reduce leverage. It appears that it has started to make good progress in the last 12 months as the working capital has been reduced by approximately $400 million. In addition, the operating income and margins have started to recover over the past two months.

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Deleverage

Long-term debt has beed reduced by $262 million in the last 12 months. Debt reduction is a good sign. The less debt the company has, the lower its interest expenses and better its credit ratings.

The company's debt obligations were as follows:
(in USD millions) Sept.30, 2019
Asset-based lending facility $ 665.40
Commercial card program 0.40
Finance and capital leases 70.30
Total debt 736.10
Less: current portion of debt (9.90)
Long-term debt, net of current portion $ 726.20



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2019 guidance

For full-year 2019, the company is guiding for adjusted earnings before interest, taxes, depreciation and amortization of $150 million to $160 million. It is also projecting free cash flow of $170 million. These are great numbers given the depressed market capitalization.

Conclusion

With a market cap of only $300 million, the company is selling at a very reasonable 2 times Ebitda. In fact, Veritiv reduced working capital by $400 million in the last 12 months, which is more than the entire market cap. It used its free cash flow to reduce debt by $262 million.

With this low of a valuation, we can ignore a lot of problems, like a declining paper segment and high leverage. If the company can succeed in bringing its annual operating margin to 1% (its historical norm), the stock will zoom back into the mid-$30s. (The GuruFocus earnings power value for this stock is over $100 per share.) Currently, the company's average operating margin over the last year is 0.8%. A consistent operating margin of 1.5% or above will deliver a multi-bagger.

Disclosure: I am long Veritiv.

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This article first appeared on GuruFocus.