Letter via Snyder Brown Capital, LP (see full disclaimer in PDF at end of article)

Snyder Brown Capital, LP (the “partnership”) returned 4.40%, net of fees and expenses, in the second quarter of 2014. Below is an interesting debt analysis followed by the fulll letter.

Current Investments: Convertible debentures of Fortress Paper

In order to give our limited partners greater insight into our investment process, in each of our quarterly letters we will discuss one or more of our current investments. Our largest current investment is in the 6.5% convertible debentures of Fortress Paper Ltd. (TSE:FTP) (OTCMKTS:FTPLF), which come due in December of 2016. In general, we do not believe fixed income securities offer value in the current environment. However, these Canadian-issued debentures are a unique situation.

Trading at 67% of par, these unsecured debentures offer a 25% annualized yield to maturity. This level of return on a fixed income investment usually signals significant distress at the issuer and substantial doubt in the market that the company will be able to pay off the principal amount at maturity.

An investor who came across these debentures might look up the financials of Fortress Paper and they would not be surprised to find a money-losing company that carries a substantial amount of secured debt on its balance sheet. Seeing that this company, which manufactures banknotes in Switzerland and specialty wood pulp in Canada, appears to be destined for a painful restructuring, most investors would not spend any additional time analyzing this investment. So what do we see here that others don’t?

Delving into the corporate structure of Fortress Paper Ltd. (TSE:FTP) (OTCMKTS:FTPLF), it turns out that all of the secured debt is held at the Canadian pulp subsidiary, which is also the division responsible for the losses on the income statement. Importantly, this debt is actually non-recourse to the parent company. In effect, Fortress Paper can “turn in the keys” and walk away from the entire pulp subsidiary and associated debt secured by the pulp assets. This would leave only the valuable banknote printing business, a reasonable debt-load, and enough cash on hand to pay off these debentures in full. From this perspective, an investment in these debentures carries almost no risk.

Of course, we don’t have a monopoly on the ability to read through company filings and we must compete with many intelligent analysts. This means that for our thesis to be correct – that this investment actually carries very little risk and we will be paid all of the interest payments and the full principal amount owed to us – we would expect there to be some other reason that no one else has discovered this opportunity.

In fact, there are three reasons why intelligent analysts have not already bid up the price of these debentures to a level at which we would no longer find them attractive. First, at only C$35 million in total face value, this is a tiny issue by fixed income standards that on many days does not even trade. Because of this, the vast majority of professional investors are simply managing too much money to “waste their time” looking at an investment like this. Second, these debentures are not registered for sale to private investors in the United States, so only institutional investors (like Snyder Brown Capital, LP) can purchase them in the US. Third, management has specifically stated that they have no current intention to shut down the money losing and debt-laden pulp subsidiary.

Because most sophisticated investors cannot purchase these debentures even if they did bother to read the filings, almost no one is paying attention to what management will do versus what they say about the money-losing pulp division. As it turns out, the debt securing this facility was provided by a Canadian government entity as a means of stimulating local employment. Examination of past actions by this government entity shows that in the current situation, it is likely to relax the terms of this debt and potentially provide additional financing to modernize this mill so that it will become profitable. Because this division likely has a bright future in a few years and the Canadian government is potentially willing to fund any operating losses in the meantime, management has a large incentive to paint a picture of overall financial distress (no open market repurchases of stock or debentures despite an authorization and cash on hand) and to talk about keeping this mill open as a priority.

See full Fortress Paper Convertible Debentures: Valuation Analysis in pdf format here.