FOUNDER, CHAIRMAN AND CEO OF FORTRESS Paper, a specialty paper company based in Vancouver, Canada, Chadwick Wasilenkoff considers himself a contrarian investor. Before launching Fortress in August 2006, Wasilenkoff bought a series of out-of-favor assets and sold them at a tidy profit; they included South American gold mines, properties in the natural-gas-rich Barnett Shale in Texas, a copper deposit in British Columbia and a uranium company with assets in Saskatchewan and Nunavut, Canada.
Wasilenkoff then led a group of investors that bought a paper mill in Landquart, Switzerland, that produces security paper and a Dresden, Germany, mill that makes nonwoven wallpaper. With these assets in hand, Wasilenkoff took Fortress public in July 2007 through a C$46 million ($46.3 million) equity offering, even though forestry had had a devastating couple of decades characterized by what he calls “huge erosion of capital and a near-total loss of investor confidence.” The C$105 million loan Fortress needed to finance the acquisition and conversion of a key production mill in Thurso, Quebec, at the end of 2011 came from the provincial government because no bank would touch the request. The company has gone back to the government to finance development of a second mill in Quebec.
That environment hardly sounds promising for Fortress. Wasilenkoff, 40, is the first to admit that newsprint is going away, the paper telephone directory is doomed, and the future of books, in his view, at least, is online. So what’s the upside in paper? Nonwoven wallpaper and security paper — chiefly, banknotes — along with Fortress’s other major product, dissolving pulp (the feed product for rayon) defy characterization as commodities, although they were tarred as such along with less profitable paper when the CEO created Fortress.
Nonetheless, two of the company’s product lines face serious challenges. To be sure, rayon is fast replacing cotton in clothing, especially among Chinese manufacturers. But because rayon is tied to cotton’s price, which took off a few years ago, leading to a big increase in pulp supply, Fortress now finds itself with intense competition for dissolving-pulp sales, which account for 36 percent of its total 2011 revenue of C$309 million. Now the company is offering clothing makers volume discounts in hopes that it can drive higher-cost competitors out of business. Meanwhile, production has suffered in recent months because the Thurso plant was shut down for maintenance and then struck by lightning after starting back up.
Fortress also faces a major obstacle in security paper sales, which account for 17 percent of revenue. The value of the Swiss franc has soared against the euro, in which the company’s main competitors’ costs are based. Some help has come from the Swiss central bank, which imposed a ceiling of 1.20 to the euro on the currency’s value in late 2011, and from European Central Bank efforts to support the euro. The moves have stabilized Fortress’s margins in this business, but at a much lower level.
All this has shown in the company’s financial results: It reported a net loss of C$18.9 million in the third quarter of 2012, compared with income of C$12.5 million in the previous quarter and a loss of C$7.2 million in the year-earlier period. Not surprisingly, its shares, listed on the Toronto Stock Exchange, were trading on December 5 at C$7.20, down 82 percent from their 52-week high of C$40.12.
Even a contrarian can’t enjoy results like that. Institutional Investor Executive Editor Ronald Fink interviewed Wasilenkoff recently to find out how he expects to turn them around.
Institutional Investor: Let’s start with Europe. Tell us about your security paper operation there.
Wasilenkoff: When I bought the mill in Landquart, they had 3,000 products coming off of it. They were trying to make photocopy paper, trying to compete against million-ton machines in South America. So we were losing a ton of money on that machine but also a ton of money on a small banknote machine. So we upgraded the banknote machine and at the same time made a major investment of C$50 million to rebuild the commodity machine to a triple-width banknote machine. It’s now the widest, fastest state-of-the-art banknote machine.
Where does the strength of the Swiss franc leave you?
We’ve achieved about a tenfold increase in banknote capacity but gone from 20 percent-plus profit margins to a current range of a little less than 10 percent all the way to break-even, because with the erosion of confidence in the euro zone, everyone flooded into the Swiss franc for safety. At one point, the increase in its value was 50 percent. It’s been stabilized now, but it’s still at 35 percent. About 80 percent of our costs are in Swiss francs. Most of our competition is euro-based, so all their costs are now in undervalued or depreciated euros. When we’re bidding on international tenders around the world, their cost structure is 35 percent better than ours on labor, on insurance. It’s devastated our ability to compete on a global basis.
To what extent will your new product, Durasafe, help?
Our low-end banknotes go for C$10,000 a ton. Our midrange banknote, which would have the same amount of security as the euro, the Canadian dollar, the U.S. dollar — you’re looking at C$20,000 to C$25,000 a ton. The Swiss franc is more like C$35,000 to C$40,000 a ton. And our new paper, Durasafe, is C$65,000-plus a ton.
Durasafe is an eight-year project now. It’s getting close to C$20 million of R&D. We take two thin sheets of banknote paper, and just before we bond them together, we cut holes in each side and put polymer in the middle so it bonds together. The polymer infiltrates the paper, so there’s no glue or laminating. Ink is not going to fall off, you cannot break this apart, you can put security features inside, and wherever you cut windows on both sides, you end up with a transparent window. So it eliminates the color photocopier and scanners and things like that, and it adds significantly more security. Also, having this polymer core will triple the life of the banknote, which makes it very cost-effective for a national bank.
Unfortunately, it takes multiple years to convince risk-averse national banks to adopt new technologies.
You don’t have these problems in your German operations. How are they performing?
People are reluctant to buy traditional wallpaper because they fast-forward and say, “I never want to take this off the wall,” even when it’s full of tears and holes, because that requires steaming. But nonwoven wallpaper is strippable when dry and comes off in one pull. So worldwide demand for the product is growing at a rate of 15 to 20 percent a year, faster than originally anticipated.
What are you doing to take advantage of that?
Every August we have our annual ten-day maintenance shutdown. During every one of these shutdowns, we have implemented capacity increases. We are now at 60,000 tons per year. And we have just committed to go to 70,000 over the next 18 months.
Your real emphasis is on dissolving pulp. Why?
When we looked at this business about six years ago, I fell in love with it. Dissolving pulp is a chemically modified product, so it’s perfectly designed to replicate cotton, only with double the absorbency and the dryability. It dyes better, and it holds those dyes better. We break it down to the cellular level and make these strands any shape, size, strength or characteristic. Cotton has impurities, so for the spinners and weavers, rayon improves their runability.
Meanwhile, the population is growing and moving into cities, reducing arable land and putting pressure on food prices. That’s going to drag down cotton. And cotton is going to face more-extreme challenges because it is the most aggressive user of water, the most aggressive user of herbicide, fertilizer and pesticide, and all the prices of those are increasing.
Yet people moving up in income want cotton. Around a third, maybe as much as 40 percent, of the global textile industry is cotton. It’s breathable, it’s airable. Regions like hot, humid India, Bangladesh, Indonesia, southern China, which represent just about half the world’s population and are seeing big increases in disposable income , want these dry, breathable types of fabrics.
Where does Fortress come in?
While dissolving pulp typically trades at a premium to cotton, our cost structure is dramatically lower. Pulp comes from trees, which don’t require any watering or fertilizer. Cotton is very, very volatile, so companies that make T-shirts and underwear and things like that experience a lot of volatility in their results trying to predict cotton futures and what’s going to happen to the weather in Texas or Bangladesh. Whereas trees just grow. Our cost structure is very stable and consistent.
But your results have been problematic.
Pricing is poor, so we’ve actually presold all of our product into, depending on our production level, the first half of January, maybe all of January.
It sounds like you’re trying to make it up on volume.
Exactly. We’re still going to be able to make a profit. It was a challenging couple of months through the summer with issues surrounding the shutdown. We took the mill down for over a week to fix all the problems. But we’ve been operating for the last three weeks [through early November] at 96 percent of capacity.
Why is pulp’s price poor when cotton’s is rising?
Eight or nine years ago, pulp mills could swing back and forth between dissolving and regular pulp, so nothing could get too far out of line. When cotton took off in late 2010 and early 2011, every mill that could produce dissolving pulp did, because the profit margin was so spectacular. And a whole bunch of announcements for new mills were made. Since then about half of them have canceled, and the majority of those that went forward are in China, where wood chips have to be imported. The cost to get it to China is C$700 per ton. We’re going to be delivering a finished product at between C$700 and C$750. Their variable costs, between wood and all the chemicals, are about C$1,000 a ton, and their total all-in production is C$1,100 to C$1,200 a ton. So they have no cost savings from being in a low-cost manufacturing environment in China. The supply increase puts an effective ceiling for a couple of years on prices. But prices are really not sustainable below C$1,000, even though they’re C$905 today, because 40 percent of our industry is operating at a loss.
We had a bad quarter. With all those shutdown problems, the mill was not optimized. But our costs are now coming in line as we start to operate more consistently.
You’ve said analysts don’t understand this very well. What’s the reason for that?
Some of the analysts are using much, much higher [cost] numbers. It’s shocking to get two analysts from two Canadian banks, one with a C$7 target on the stock and one with a C$27 target. One of them gets it, and the other one has not dug deep enough to understand the variable cost analysis. But they don’t like to change their minds, because they lose credibility.
What are you doing about that?
I’m getting out and talking with investors, to let them know that there are some misconceptions out in the market.
