Description

Executive Summary

• Mercer International (“MERC”) is a $1.7B TEV US-listed company with two primary segments: 1) Pulp and 2) Solid Wood
• We believe MERC’s stock and bonds offer asymmetric risk/reward given recent developments in the softwood pulp industry
• As todd1123 pointed out in his excellent writeup on RYAM one year ago, cost-driven supply closures can be a significant positive catalyst in this “dirty dawg” sector
• Following a structural upward shift in the cash cost curve after the Russia-Ukraine war, there have been a significant amount of supply curtailments (e.g. 10% of global softwood supply in Finland alone this month), which indicates that current price levels represent a trough and are set to improve
• We believe the opportunity exists due to poor recent results, limited research coverage of this small cap, and concerns over MERC’s high financial leverage
• At current trading levels, the stock creates the business at approximately 4x EV/midcycle EBITDA and 20% unlevered midcycle FCF yield
• We believe the stock offers 2.5x-3x MOIC to a price target based on ~6x midcycle EBITDA and ~15% unlevered FCF yield
• We believe the 2029 bonds offer 15% one-year total return potential assuming they re-rate from +600bps to +400bps (approx 100 bps wide of the US HY index)

Business Description

• Pulp Segment
  • MERC's Pulp segment is one of the world’s largest producers of Northern Bleached Softwood Kraft ("NBSK") with 2.1 million tons of capacity
  • Operates four modern NBSK pulp mills
    • Stendal, Germany – 740k tons NBSK
    • Rosenthal, Germany – 360k tons NBSK
    • Celgar, Canada – 520k tons NBSK
    • Peace River, Canada – 475k tons NBSK or NBHK
  • Pulp being a commodity, MERC has no pricing power - price is typically set by the highest cost marginal producer
  • The two biggest components of the industry's cost structure are: 1) fibre, 2) energy
  • MERC has two big competitive advantages on the cost side:
    • Germany is one of the few regions in the northern hemisphere where fibre availability is not an issue 
    • MERC's mills are modern and generate surplus energy which is sold on the open market
  • Key end markets are: i) tissue, ii) fluff, iii) packaging, iv) printing & writing, and iv) other specialty grades
  • Segment EBITDA peaked at $453mm ($236/ton) in 2022 and troughed at $66mm in 2023 ($34/ton)
  • We believe pulp prices have troughed and cash flows from this segment are set to inflect higher 
• Solid Wood Segment
  • MERC's Solid Wood segment is the largest producer of mass timber in the US (37% est. market share)
  • This segment is also highly cyclical, with the key end market being construction
  • Segment EBITDA peaked at $122mm in 2021 (zero-interest rate fueled housing boom) and troughed at -$30mm in 2023
  • It is worth noting that due to growth capex and acquisitions in the past two years, the earnings power of this segment has nearly doubled
  • We don't believe a rebound in Solid Wood cash flows is necessary for MERC stock and bonds to work
  • However, it is worth noting that MERC investors benefit from an interesting 'call option' on US housing market recovery, potentially as soon as next year as we have entered the interest rate cutting cycle 
  • In any event, the Solid Wood segment only represents about 20-25% of TEV, and we will focus the rest of the writeup on Pulp  

Industry Description

• Global fibre consumption is approx. 400 MT per year, of which approx. 45% comes from virgin fibre wood pulp (the balance from waste paper and other non-wood fibres) 
• Of this amount, approx 60% is produced in integrated facilities (i.e. pulp mill co-located at paper mill), while approx 40% is 'market pulp', i.e. independent pulp mills whose output is sold on the open market
• Within 'market pulp', there are two main grades: i) hardwood, and ii) softwood:

• Softwood tends to be used for higher value applications, such as heavy-duty corrugated containerboard, and commands a $100+/ton premium:

• Worldwide demand for market pulp has been growing at approximately 2% p.a. but there have been significant mix shifts within this sector over the past two decades
• Printing & writing demand has dropped from 61% in 2003 to 19% by 2023 and continues to be in structural decline
• Tissue (including fluff, which is used in incontinence products) has grown from 17% of demand in 2003 to 55% by 2023
• Packaging and other specialty grades have increased from 22% to 26% over the same time period
• NBSK demand is driven by the following macro trends              
  • + Strong demand from Emerging Markets: EM now makes up 53% of global demand, China alone being 30% of total (all of Western Europe is 22%)
  • + Increase in demand for packaging
  • -  Decline in global demand for graphic printing
  • -  General decline in demand for paper in North America, Western Europe, and Japan

Investment Thesis

• Discount to intrinsic value
  • MERC stock is currently pricing in trough valuation for the Pulp segment and little to no value for the Wood Products segment.
  • Our framework for valuation here is an EV/EBITDA and FCF-based approach.
  • Our low case assumes $750/t of capacity, which is what we estimate fourth quartile assets have traded for (based on discussions with industry experts). 
  • Replacement cost is a bit of an academic exercise here, since no new softwood plants are being built; however, we believe that in today's environment it would likely cost over $2k/ton to build a new plant, putting the valuation range in our sensitivity below at 1/3 to 1/2 of replacement cost:

• Structural pressure on fiber prices leading to increased earnings power for MERC
  • Following Russia’s invasion of Ukraine in early 2022, there has been a sharp upward spike in fiber prices as a significant amount of softwood supply was removed from the market.
  • See below from the National Resources Institute of Finland:

• This dynamic has also pressured prices in Canada, leading to structurally higher costs across the supply curve
• CMPC recently put out a slide showing the BSKP cash cost curve up around $700/MT, which is $150/MT higher than prior cycles:

• • However, even that does not tell the full story, as we have seen significant supply curtailments this month in Finland (e.g. Metsa's Joutseno mill and UPM's Kaukas and Kymi mills) despite Finland appearing to be on the border of 2nd quartile in the chart above at just over $600/MT
  • NBSK prices are around $750/MT yet these mills are sitll taking downtime; clearly the real cost curve is even higher than industry research publications would suggest.
  • The main implication of all this is that prices need to be higher for the industry to function properly.
  • With MERC's advantaged position in both fibre and energy, the company is poised to generate $200+mm of EBITDA in a 2024 market environment where numerous other competitors are being forced to shut down. We think 2025 can potentially approach midcycle levels of $300+mm EBITDA.   

• High-quality, strategic investor
  • Currently, affiliates of Atlas Holdings own just under 10% of MERC stock.
  • Atlas Holdings was founded in 2002 by two entrepreneurs with the purchase of a small paper mill in rural Indiana. Over 20+ years, their approach has been to buy underperforming assets in sectors where they have specific expertise, including pulp & paper, and improve performance through active management by their network of operating partners. Atlas is currently investing its fourth private equity fund which has $1.4 billion of dry powder remaining.
  • Atlas has been an active acquirer of pulp assets, having recently purchased two Canadian mills from West Fraser Timber in April 2024 and the Thunder Bay (Ontario) mill from Resolute Forest Products in August 2023.
  • The last time Atlas got involved in a publicly listed pulp & paper company with a similar % stake was in 2021 when Atlas made a takeover offer for Verso Paper for $20/share. At that point, Atlas affiliates already owned 9.1% of the shares of Verso. The company was ultimately acquired in 2022 by Billerud Aktiebolag for $27/share.
  • Atlas’ track record in the sector and recent purchases of pulp mills makes their presence in MERC stock a positive signal.

• Insider buying
  • Three executives, including the CEO and CFO, and two directors, were actively buying stock earlier this month. Note that MERC's blackout period for insider buying begins 2 weeks before quarter end. It is bullish to see five insiders buying prior to blackout period.

Key Risks

• Substitution risk: softwood > hardwood
  • While NBSK appears to be on the verge of inflecting positively due to supply closures that are set to push industry utilization ratios over 90% according to industry experts, NBHK has been going the other way due to supply additions which have yet to be absorbed
  • While softwood has separate use cases vis-a-vis hardwood, the prices of these two commodities tend to be highly correlated
  • The biggest mitigant is that utilization rates are expected to increase again for NBHK in 2025 and beyond due to continued demand growth (tissue and packaging) 
• Overspending on capex
  • The company has levered up to buy Solid Wood assets and expand production capacity, which appears poorly timed given the cyclical downturn in those end markets
  • The biggest mitigant here is that the company has publicly committed to deleveraging, which limits their ability to go on an acquisition spree
• Cyclical downturn
  • We believe the stock has been under pressure due to the current oversupply in NBHK (even if NBSK is more insulated)
  • Any 'hard landing' recession which dampens demand for NBSK could push out the timeframe of a cyclical recovery
• Debt capital markets dependency
  • MERC is highly levered and will not generate enough FCF to pay off its debt without continued access to the refinancing markets:
  • Mitigant #1: YTD 2024 US High Yield bond issuance is $255 billion, up 82% vs. prior year. Following the FOMC’s 50 bp interest rate cut earlier this month, September 2024 has been the best month of the year at $42 billion of issuance MTD. The window is currently open.
  • Mitigant #2: Other “dirty dawgs” have successfully refinanced this month, such as LD Celulose ($650 million at 8%) and Cerdia ($900 million at 9.375%).

Catalyst

• Earnings Inflection
  • Following its Q2 2024 earnings, MERC sold off as results underwhelmed. However, we believe Q2 will mark the low print of the year at $30 million of EBITDA, as the company took a significant amount of downtime for maintenance that will not recur in coming quarters.
  • Furthermore, the company printed quite weak numbers in 2H 2023 ($59 million of EBITDA in total), setting a low bar for y-o-y comps. Based on the maintenance schedule and where NBSK prices have been thus far in Q3, we believe the company has a good chance of doubling that EBITDA in 2H 2024, putting full year EBITDA north of $200 million.
  • We expect the company’s leverage to tick down from 8.7x LTM closer to 6x by the end of the year as EBITDA grows and the company generates FCF.
  • Looking ahead to 2025, we expect further EBITDA growth, as NBSK prices are likely to be supported by recent supply closures and solid wood products volumes benefit from a pickup in construction activity due to interest rate cuts. The 2025 consensus EBITDA estimate of $275 million looks achievable, which will bring leverage below 5x.
• Refinancing 2026 Bonds
  • MERC has $300 million of 5.5% senior unsecured bonds due in January 2026. This near-dated bond maturity is likely weighing on the share price. We believe it’s a matter of when, not if, this refinancing gets done, which should act as a positive catalyst for the stock since it extends their runway.
  • We expect MERC to take advantage of favorable debt capital markets and refinance this bond in Q4 2024. These bonds are currently quoted at 98c, indicating that the bond market is relatively comfortable that they will be refinanced without any problems.
  • The company is focused on keeping an unsecured debt structure to preserve flexibility. Given where the 2029 bonds are trading, that likely means a 10+% coupon on any new bond. However, the company has excess cash, and it would not be surprising for them to only refinance $200 million in a new bond, using excess cash to pay down the balance, thereby minimizing the increase in interest expense.
• M&A
  • The pulp & paper sector has seen a significant amount of M&A recently:
    • Smurift Kappa buying WestRock for USD 21B TEV
    • IP buying DS Smith (beating out Mondi) for GBP 8.5B TEV
    • Mondi acquiring the Hinton pulp mill from West Fraser
    • Atlas acquiring pulp mills from West Fraser and Resolute
  • The presence of one large shareholder (Peter Kellogg and affiliates at 34%) simplifies any path to a deal.
  • Furthermore, Atlas’ involvement likely increases the probability that something happens (they are typically not passive shareholders, as witnessed in the Verso case study).
  • Note that the companys 2029 bonds have strong Change of Control covenants which would give bondholders the right to put back to the company at 101c (+20% vs. current price of 84c).