The shares of specialty paper company Glatfelter (NYSE:GLT) have done all right this year, but the stock remains virtually unknown and unfollowed. Although a company that makes specialty papers and fibers used in products like K-cups and hygiene products isn't going to be an explosive growth story, Glatfelter is the sort of company that can slowly build value over time.
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Strong Leverage Boosting Results
Glatfelter admittedly had a quiet second quarter from a revenue perspective. Revenue fell 3%, as reported, due in large part to adverse currency moves. Adjust out the foreign exchange impact and revenue was flat, as a 2% reduction in shipments offset higher prices.
The company's largest segment, specialty papers, saw revenue decline 1% on a nearly 3% decline in volume - a decline influenced in part by maintenance outages. In both composite fibers and airlaid materials, reported revenue declined by mid-single-digit percentages, as currency moves offset volume and price improvements - net of forex, revenue was up slightly in each segment.
Glatfelter may have had less to work with from a revenue standpoint, but the company did more with it. Gross margin improved more than a full point, while reported operating income nearly tripled. Even after stripping out a sizable gain related to asset disposition, operating income still rose 73% and the company handily beat estimates (all three of them).
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The Need for Ongoing Investment Leverage
If Glatfelter is going to work as a stock, the company needs to stabilize its free cash flow generation and build its return on capital. Keep in mind that 2009 and 2010 look a little better than they actually were, as the company saw the benefit of various credits and underspent on capital investment. Nevertheless, this is the sort of company where even a modest improvement in free cash flow conversion (even just half a percentage point) can lead to significant free cash flow growth and a higher fair value.
If the company can continue to innovate and sell prospective customers on its products, the future looks good. While losing patent protection on K-cups is trouble for Green Mountain Coffee Roasters (Nasdaq:GMCR), it could prove to be a good thing for Glatfelter if more competition (and, presumably, lower prices) spurs even more consumer demand. Likewise, if companies like Teavana (NYSE:TEA) and Peet's (Nasdaq:PEET) can turn Americans from soda drinkers to tea drinkers, the sales potential for those bags and filters ought to be meaningful as Glatfelter already has about 70% share.
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Get Bigger, or Maybe Go Away?
The specialty paper market doesn't really capture headlines or airtime, so investors may not realize that Glatfelter has a lot of expansion potential. In the auto industry, for example, there are applications in areas like filters, labels and adhesives, while the company could also expand its food and beverage operations in directions like casings and wrappings. There are also many potential applications in the housing industry - from products like acoustic ceiling panels to insulating materials, to papers and fibers used in laminates.
At the same time, Glatfelter could find itself as an appealing option for a company that wants to grow its addressable end markets. I don't necessarily see a company like International Paper (NYSE:IP) taking the plunge, but a company like Ahlstrom or Georgia Pacific may feel differently, particularly with Glatfelter's sizable share of the U.S. coffee/tea market. Perhaps even Buckeye Technologies (NYSE:BKI) could be interested, though the size of such a deal would make it more of a merger than a buyout.
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The Bottom Line
I have no doubt that many readers will take a quick look at Glatfelter and promptly dismiss it. It's true that returns on capital aren't great, the end-market growth is modest and the company is exposed to difficult-to-control input costs. However, I think that it's important to also remember how the company has repositioned itself over time to take advantage of higher-margin, more differentiated product opportunities.
Even modest low-to-mid single-digit free cash flow growth is sufficient to make this stock worth a look today. Given management's demonstrated ability to drive better operating leverage and a wealth of new potential market opportunities, Glatfelter is an under-appreciated small cap that could do well for patient shareholders.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.