Description

Note that above numbers accept EPS are in billions of JPY.

Background

Hokuetsu Kishu is a producer of paper and paper products in Japan. They also own a producer of pulp in Canada. In the paper business, Hokuetsu is really a pure play on writing and printing papers, unlike peers who have significant assets related to packaging. Roughly 90% of sales are towards various types of coated and uncoated papers. For the non pulp business > 85% of sales are to the domestic market. In 2015, Hokuetsu purchased a Canadian producer of hardwood pulp (Alpac). Interestingly the seller of the asset was Hokuetsu’s domestic competitor Oji (in conjunction with Mitsubishi), who viewed it as low quality at the top of the cycle. This business contributes approximately 20% of operating profit.

High-Level Thesis

The Japanese paper short thesis is predicated on the reasonably well understood decline in paper volumes due to the continued proliferation of digital technologies.Trailing five year paper demand has declined at a 2% CAGR for the past five years. This is better than what we have seen in the US and Europe where demand declines are more like 5% per annum. While there are some peculiarities to Japanese paper demand, Japanese paper demand declines have historically lagged those in the US and Europe. We believe 5% type declines are inevitable. Even without that, a 2+% decline in Japan is difficult to manage.

However, this does not mean shorting Japanese paper companies is always a good idea. They have been aggressive cost cutters and it is effectively a three player market. From time to time the industry is able to get ahead of volume declines by either raising prices (when international conditions are favorable) or cutting costs at a pace that offsets volume declines. Hokuetsu, for example, has had an average stock price since the end of 2014 of ¥704 versus today’s stock price ¥734. However, during this time the stock has moved roughly between ¥600 and ¥900, allowing you to variously make 33% or lose 50% during this time.

Why the opportunity exists?

We believe now is an appropriate time to shot Hokuetsu. There are two current Bull cases on the stock that we think can easily be dispelled. First, Japanese paper companies are currently working to push domestic prices higher and had some partial success in August 2017. Second, pulp prices have been very strong of late and Hokuetsu has more pulp exposure than in the past. We see both as explaining where the stock is today and why the opportunity exists.

Paper prices increases will stall out

The recent rise in paper prices have, in our estimation, been cost push. Japanese paper producers have no domestic pulp exposure but rather purchase wood chips from countries like Indonesia to produce pulp. As a result pricing can go up in a generalized inflationary environment. However, the conditions for price increases that could generate higher operating profit than in recent years are not present. We see two key drivers to the industry’s ability to raise prices and more than offset raw material cost increases. The first is low inventories in the channel and the second is low (by historical standards) differentials with international prices. Relatedly, we look at imports as a percentage of domestic demand, which has varied over time depending on the level of the Yen and pricing.

In terms of the first, the following chart shows the levels of imports coupled with import levels.

Presently inventories as a percentage of demand are at historical highs at over 9.5% of demand. This compares to historical levels of < 7.5%. At the same time, imports went to extreme levels in 2012 when the Yen was at very high levels but since that has already corrected and now they are at a more consistent 7-8% of demand (versus close to 12.5% at peak). If anything with the weak level of the Yen and high Japanese pricing versus what is being realized abroad (to be seen below) will now push imports higher (indeed they have ticked up slightly in recent months).

Pricing is still high in Japan relative to the rest of the world. The following shows the differential of uncoated paper prices between Europe and Japan relative to historical Japanese pricing.

Typically price differentials closer to €100-€120 have been associated with sustained pricing increases. Today the differential is > €200. As mentioned the recent increase has been driven by higher pulp prices pushing raw material costs up. In H1 FY 2018 end March 2018 operating profit was down 26% YoY.

Pulp is at a cyclical peak

Pulp has benefited from an unprecedented level of supply disruption in the past year. We see this as temporary and believe it will be in acute oversupply through 2020+. By our estimation pulp capacity utilization would ordinarily be 92-93%. But given temporary supply constraints present operating rates are close to 95%. However, we see new supply outpacing demand by and additional 1%+ per annum for the next four years driving operating rates to 86%. This is a level historically associated with pricing close to cash cost levels.

Even with recent pulp price increase Hokuetsu will not be able to grow operating income. (Pre-tax income will grow due to the reversal of foreign exchange losses from last year). And with lower price prices coupled with lower paper production volumes we see lower earnings into the future.

Risk/reward  

Hokuetsu has to raise prices to offset volume declines and what we see as impending pulp price declines. We believe from this fiscal year volume declines will bite as pricing stays stagnant. As such, EPS of approximately ¥54 this year will decline into the ¥30’s in the next year or two. At even 15x there is more than 30% downside. Earnings and the multiple can go much lower given leverage at > 1x net debt/EBITDA (with much of the cash held in various long-term securities of questionable quality). The stock can easily be down > 50%. We see near-term risk as 18-20x ¥50 in EPS (ex Fx gains) for 20-30% upside.

Catalyst

-Paper price increases in Japan will stall out

-Paper demand declines in Japan will accelerate from down 2%

-Global pulp prices will decline from cyclical highs