Description

Mercer International offers the opportunity to own three of the highest quality market pulp mills in the world during a period of industry rationalization at a valuation of ~5x normalized free cash flow. Mercer owns and operates market pulp and paper assets in Southern Germany and Canada. The company’s three pulp mills were purchased at a significant discount to replication cost, due to very favorable financing agreements with the German government and a bankruptcy sale of the Canadian asset. While northern bleached softwood kraft (NBSK) pulp pricing has been at trough levels for a period of time now, there are several reasons to believe that pricing should improve in the near-term and that Mercer is significantly undervalued. First, as Mercer has almost tripled in size over the past year, the company is neither well understood by the market nor is it given credit for its fully scaled and implemented business prospects. More importantly, capacity reduction announcements are finally being made by Mercer’s less efficient competitors, many of whom have cash production costs above current pulp price levels. With 5% of total world-wide NBSK capacity already announced to be shut down and with no major NBSK capacity additions scheduled over the next few years, the industry should realize significant price improvements. Mercer trades at a very attractive valuation – we believe that in a downside case the company is approximately cash flow breakeven assuming trough pulp pricing for the next twelve months, but is valued at a 20% free cash yield when viewed on normalized pricing over the past few cycles.

Business Summary:
Mercer owns three state-of-the-art pulp plants that produce more than 1.3 billion tonnes/year of a high quality pulp referred to as NBSK which is used primarily in coated and uncoated papers (printing paper, wallpaper, annual reports, junk mail), tissue and diapers. Two of its mills are located in Germany and the third mill is located in British Columbia, Canada. The company also owns two specialty paper mills in Germany; these are non-core to the business.

Mercer’s two plants in southeast Germany are highly efficient mills that have a combined capacity of approximately 860,000 metric tons of market pulp and are located within abundant forest regions. The Rosenthal mill began kraft pulp operations in 1999 and is currently producing roughly 310,000 metric tons of pulp a year. Rosenthal is located on the Saale river and produces pulp for sale primarily to specialty customers in Germany, Italy and the newly opening economies in Eastern Europe. The Stendal mill (64% owned by Mercer), located on the Elbe river, began operations in 4Q04 and should produce more than 550,000 metric tons of market pulp at full capacity. The mill was running ahead of plan at 90%+ utilization rates this past summer and management has been very pleased with the success of the ramp-up to date. In fact, they intend to install two additional digesters shortly that will add 10% of additional production capacity to the mill. In conversations with major pulp buyers, we have learned that they are very impressed with the quality of the Stendal pulp, with many buyers now commencing negotiations for long-term supply contracts (most pulp was purchased on the spot market with trial discounts during 2005).

Both Rosenthal and Stendal have a very strong fiber base, and Mercer is the largest purchaser of wood chips and pulp logs in Germany. As fiber generally represents 40-50% of a pulp-maker’s cost structure, Mercer has a considerable cost advantage both with the quality and quantity of its fiber supply. Rosenthal’s fiber mix is approximately 85% spruce / 15% pine and Stendal’s is 65% pine / 35% spruce. Since Mercer owns the only two softwood kraft mills in the country, they have considerable negotiating leverage vis-à-vis their chip suppliers, and most supply arrangements have modest annual price increases but are not tied to NBSK pulp price levels. Rosenthal’s cash production costs are considered best-in-breed among the NBSK mills, and management believes that Stendal should be even lower than Rosenthal once it reaches full capacity.

Mercer acquired its third pulp mill, Celgar, in early 2005 for US$210 million, or approximately 30% of replacement cost. The mill is located in British Columbia, Canada and has production capacity of at least 430,000 metric tons that is sold into the North American and Asian markets. Although Celgar began operating in 1993 (after a significant modernization capex spend), it had been operated by a trustee in bankruptcy since 1998 and was unable to negotiate long-term supply contracts while being in receivership. Since the mill was essentially managed by accountants for many years, it was not a model of efficiency. Mercer management has replaced many senior members of the operating team, put in place several upgrade projects that should expand production and improve pulp quality, and is building out a sales team to target more world-wide supply agreements with large paper producers. Mercer believes they can expand Celgar’s production by 10% over the next two years and improve the cost structure of the mill dramatically in the short-term (Celgar was at 360 euros/mt in 2004, management believes they can achieve the 320 euro/mt level during 2006). Importantly, the legacy Celgar mill sold product into the market at roughly 5% discounts relative to their British Columbia competition. We believe that having a higher quality operating team and more focused sales effort should enable Mercer to achieve parity level pricing with its competition.

Pulp Mill Capacity
Celgar 430,000 mts
Rosenthal 310,000 mts
Stendal (64% owned) 552,000 mts

Industry Overview:
NBSK pulp is made from a specific species of northern softwood that adds strength to a wide range of paper products and is considered to be of premium grade because of its strength characteristic. The NBSK market is dominated by Canada and Europe (primarily Scandinavia), which produce approximately 70% of world volume. Total NBSK supply is approaching 12.5 billion metric tons per year, so Mercer represents 10% of the market. The NBSK sector has very little capacity coming on-stream over the next few years, largely due to the high capital costs and fiber supply constraints. Supply is expected to grow 1-2% per year over the next few years, mostly due to capacity creep at existing operations.

Almost all users of market pulp (printing papers, coated and uncoated magazine papers) utilize a mix of softwood and hardwood grades to optimize production and product qualities. Hardwood species have shorter fibers that decrease strength and provide for bulk and opacity. Most of the new pulp capacity is coming from lower cost hardwood locations in South America (primarily Chile and Brazil) and Indonesia, where forest plantations exhibit dramatically higher growth rates. However, pulp produced in these areas does not have the strength characteristics of NBSK. In many of our conversations with pulp buyers, they articulate that substitution risk for NBSK is low as the strength characteristics of softwood fibers are irreplaceable (buyers need to maintain the strength of the sheet to ensure that it doesn’t rip on the paper production line) and most machines are already running at their peak hardwood mix.

NBSK pulp demand has grown at 3% on average over the past 10 years, and most industry experts believe that demand should outpace capacity growth over the next few years. Furthermore, should most of the recently announced capacity reductions actually be executed, we should see a dramatic improvement in the supply/demand picture over the intermediate term for NBSK.

While it has been a long time in coming, many less efficient pulp producers have recently announced capacity reductions that should throw the supply/demand balance in the favor of the pulp-makers. In general, the world’s oldest and most inefficient mills are located in Eastern Canada. These mills have high energy costs, are poorly located for transportation purposes, have dramatic limitations on their supply of wood chips, and have been hurt by the strong Canadian dollar. Their cash production costs per metric tonne can run into the high 400s (euros). In recent months, the following NBSK line shutdowns have been announced as these mills have been burning significant cash. These closures should be finalized by the end of the 1st quarter of 2006.

Bowater Thunder Bay mill – 210,000 mt
UPM Mirimachi mill – 240,000 mt (was closed for most of 2005)
Weyerhauser Price Albert mill – 130,000 mt (seeking a buyer, to close otherwise)
West Forest Squamish mill – 275,000 mt
Total Announced – 645,000 mt (7% of NBSK supply)

Additionally, there are several mills that are currently either temporarily idled or speculated to be shut down in the near future. These are listed below. All in, more than 10% of current industry production could be shut down in the next six months, and with no major NBSK additions coming to the market in the near-term, dramatic pricing leverage should follow.

Domtar Lebel-sur-Quevillon mill – 210,000 mt
New Skeena Prince Rupert mill – 350,000 mt
Tembec Smooth Rock Falls mill – 200,000 mt
Tembec Marathon mill – 180,000 mt

Investment Thesis:
We believe that an investment in Mercer represents an inexpensive way to invest in a pulp business with high quality assets, an improving industry structure, and minimal financial risks due to sponsorship from the German government.

• Asset Quality – Mercer’s plants have an average age of less than 5 years (versus worldwide average of 20 years) and are significantly more efficient than the majority of pulp mills worldwide. Significant cash savings result from having efficient plants (primarily energy savings and low capex requirements) which allows the company to outperform particularly in trough periods, when older plants cannot spend necessary maintenance capex and often face environmental safety standard issues.

Rosenthal’s cash production costs hover around 300 euros/mt which is lowest in the industry. Although Stendal is still ramping production and working through required engineering tests, the company believes that its cash costs should match or better Rosenthal’s longer-term. These figures compare to industry averages at comparable quality mills in the 350-450 euros/mt level, with several eastern Canadian mills running at around 500 euros/mt. While most mills have approximately 10% of their production costs associated with energy, Mercer’s German mills are energy self-sufficient and actually sell some excess electrical power to the regional power grid. Additionally, as Rosenthal and Stendal are the only two NBSK pulp mills in Germany, they have a major transportation cost advantage relative to imported pulp.

• Favorable financing arrangements – In order to stimulate job growth in eastern Germany, Mercer received generous financing terms for their two German mills from the government. For the Stendal asset, Mercer paid only 10% of the 1bn euro capital cost in equity. The government awarded grants for 30% of the cost and guaranteed 80% of the remaining debt, allowing the company to finance itself at low interest rates (5-6%) and with favorable amortization schedules (15 years). In Rosenthal’s case, approximately 30% of the 1999 spend was also financed through government grants. These exceptional financing terms have allowed Mercer to build high quality assets that otherwise might not have such attractive economics.

• Asset Value – Threat of new entrants is negligible as replication costs for a new world class pulp mill would likely be around US$1 billion and it would take several years to reach full production levels; suffice it to say, at current NBSK price levels investing in a new mill would not be a wise economic decision. A quick and dirty analysis of the replacement value of Mercer’s pulp assets implies significant upside to equity holders.

Invt Invt Discount Asset Value
Year Amt (euro) Applied Euro US $
Rosenthal 1999 360 25% 270 $329
Stendal 2004 1,000 0% 1,000 1,220
Celgar 1993 550 50% 275 336
1,910 1,545 $1,885

Less: Net Debt 705 860
Equity Value 840 $1,025
Per Share Value 19 $23


• European Industry Structure – Mercer’s German mills (Rosenthal and Stendal) are the only market kraft pulp producers in Germany, which is the leading import market for kraft pulp in Western Europe (Western Europe accounts for 40% of total NBSK pulp demand). Mercer therefore has a material transportation cost advantage compared to North American and Scandinavian pulp producers. Additionally, since eastern Germany is primarily an importer of goods, most trucks that deliver goods into that portion of the country do not have goods to haul out of the region so Mercer is able to obtain relatively low freight rates on average. Finally, given Mercer’s eastern German locations, the company is ideally situated to capitalize on the eastward growth of the European Union.

• Macro Supply / Demand Imbalance – As previously discussed, there is very little confirmed softwood kraft capacity coming to the market. According to NLK Associates, a pulp and paper consulting firm, softwood capacity should grow by only 1.5% per year over the next several years, compared to worldwide demand growth estimates of 2.5% (and perhaps twice this rate in Eastern Europe and China). Furthermore, most of the demand growth for softwood will be for the reinforcing grades of NBSK, while most of the capacity growth will come from new mills in Chile and debottlenecking in Russia. This new capacity will produce a lower quality pulp (shorter fibers, less reinforcing) which is not a good substitute for high grade NBSK.

Valuation and Financial Projections:
At $8/share, Mercer is trading at 5x normalized EBITDA and offers a 20% FCF yield. Our normalized valuation presumes NBSK pricing rises to the mid-500 euro level (which is equal to the 10 year average price). Note that although US pricing is currently at historical norms, the appreciation of the euro/US$ rate has driven euro based pricing levels significantly below normalized levels.

NBSK Pricing (per metric ton)
2000 2001 2002 2003 2004 2005E Avg
US$ / mt $668 $524 $490 $546 $616 $609 $576
Euro / mt 726 582 519 483 497 486 $549
Euro spot 0.92 0.90 0.95 1.13 1.24 1.25 1.06

For valuation purposes, we have stated figures in euros as the company publishes its financials in that currency. Additionally, we have ascribed no value to the non-core paper business which is operating at break-even levels and may eventually be sold for a nominal sum. The equity market capitalization assumes conversion of a convertible that is slightly in the money, and the financial metrics ascribe only Mercer’s proportional ownership position in the Stendal mill.

Share Price (US$) $8.18
Share Price (euros) 6.70
Shares 44.2
Market Cap 296
Net Debt 705
Enterprise Value 1,001

2006E Pulp EBITDA 217
2007E Pulp EBITDA 235

06 EBITDA Multiple 4.6x
07 EBITDA Multiple 4.3x

2006E FCF / Share 1.33
Implied Yield 20%


Since Mercer is a highly levered business in a commodity market, it is important to examine the option value of the three pulp mills. In a trough scenario, the pulp business would be slightly FCF negative after amortization requirements in 2006 and 2007, but Mercer has a current unrestricted cash balance of 90 million euros so we believe it would have ample liquidity. We believe that the company should be able to survive a trough and could return more than 2x our investment under mid- and peak-cycle scenarios, based on previous cycle pricing. Several recent events give us increased comfort that pricing is moving in the right direction: (a) capacity removal announcements as previously discussed, (b) pulp inventory levels remain quite low as we approach the spring buying season, and (c) major NBSK players including Weyerhauser have announced price hikes beginning February 1 which appear to be gaining buyer acceptance.

Investment Risks:
• Market Growth - While the pulp and paper market has grown at 3% for the past 40 years, secular growth rates in paper have been flat for the past few years which will likely continue (or get worse) due to displacement by the internet and electronic data storage. However, near-term paper pricing trends looks favorable as industry-wide capacity has been taken down. Additionally, the coated paper business, which requires a high portion of NBSK pulp input, has a new lightweight coated product and tissue product that are demonstrating strong growth.

• Execution – the Stendal plant is still ramping up production and there are many execution risks associated with the asset. Industry contacts suggest that the Stendal operating manager is outstanding, and the production and cost control performance of the mill to date give us much comfort with this risk element.

• Mercer’s operating results are subject to volatile currency and commodity price shifts. Since pulp pricing is stated in US$ while the majority of Mercer’s costs are in local currency (euros and C$), the appreciation of those two currencies relative to the US$ has constrained the company’s profitability. Mercer has reduced some of its exposure to currency price changes by entering into currency derivatives to swap all of its long-term bank indebtedness from Euros to US$.

• Substitution – There is a large amount of capacity coming onstream in the eucalyptus market (primarily Brazilian and Chilean hardwood species) in the next five years. As the spread between softwood and eucalyptus pulp prices has increased, customers may be tempted to substitute inputs.

Catalyst

Industry capacity removal
Improved NBSK pricing
Successful execution of Stendal mill ramp-up and Celgar efficiency improvements