Description

MERC equity trades like a deeply-distressed credit, but the reality is that the business (i) is rapidly turning a corner (pulp prices are up >46% since the mid-2009 trough levels), (ii) has a powerful / yet hidden annuity stream of >$25mm EBITDA that should kick in later this year (harnessing energy production from its Celgar, BC mill) and (iii) given the mis-perception around the company's health, the equity trades for a ~48% leveraged FCF yield based on "normalized" leveraged FCF of 55mm (details further below) on ~115mm mkt cap. 

As a follow-up to samba834's write-up from January 2006 (price at the time of the long equity recommendation was ~$8.20 / share and peaked at $13.68 / share in early 2007), I am recommending a long equity position in Mercer International (MERC) at ~$3.35 / share which presents a compelling near-term risk / reward proposition, with total return potential of >100 - 200% over the next 6 - 12 months (based on probability tree matrix further below).  As you recall, MERC is one of the premier / global pulp operators with three mills and total capacity of ~1.5mm tons (two mills located in Germany and one in Canada).  While Samba834's write-up provides good background information on MERC's three mills (upshot being best-in-class), there are a couple notable updates: (i) capacity is up >160k tons since 2006: MERC's three mills currently have >1.45mm tons of pulp capacity versus ~1.29mm in 2007 - so arguably more normalized earnings power on the core pulp biz, (ii) cost structure has improved since 2007: in particular, MERC's Celgar, BC mill has significantly improved (note this is 495k tons of capacity that was earnings power neutral when MERC acquired it in 2005 and EBITDA negative in 2009 given the pricing environment ... but should provide a decent earnings power stream moving forward), (iii) energy earnings stream is just hitting stride: in particular, Celgar, BC mill will be generating >$25mm of contractual EBITDA per annum from energy generation which should incrementally help change around the earnings and perceived risk profile of this biz (cushions volatility and ultimately should lead to multiple expansion).

In many ways, MERC equity is very similar to the core ACAS equity thesis.  MERC equity trades like a deeply-distressed credit (which was definetly the case in early / mid-2009 when the biz was facing a steep fall-off in its business - NBSK prices fell from peak of $910 in mid-2008 to $580 in less than 11 months ... and company was in ongoing negotiations with its convertible security lenders in the 2H 09 to push out the maturity schedule - a perfect recipe for disaster vis-à-vis MERC equity).  Notably, however, the deeply distressed scenario (from mid-2009) has recently reversed itself quite dramatically: (i) pulp prices have rebounded from the $580 lows and are currently set to be at $850 and should result in significant upside to earnings power in 10E - 11E (but more importantly, should give investors more confidence around "mid-cycle" EBITDA), (ii) MERC equity trades for an overly-generous >48% leveraged FCF yield on a "normalized" EBITDA basis (and that factors in ~65mm of interest expense), (iii) the business profile has significantly been enhanced since 2007 - in addition to further efficiencies and additional capacity, energy production out of its Celgar, BC mill should be >25mm of EBITDA per annum- this earnings stream should help stabilize the volatility of its underlying pulp operations), (iv) pending convertible maturity has effectively (likely finalized in next couple wks) pushed out to the maturity until 2012 providing the business with more-than-adequate 2.5+ yr  runway (while the revised convertible notes are "dilutive" given the new strike price is $3.30 / share, I've factored in the additional ~13mm shares on an "as converted" basis in the cap table below ... and I believe giving he business a long runway more-than-adequately made up for the dilution). 

Overall, I think MERC equity offers asymmetric risk / reward and should ultimately trade for >$7 / share (I think a reasonable "upside" case gets to >$10 / share - which compares to current $3.35 / share).  Re: downside protection, I think MERC equity is relatively well protected by: (i) replacement value (Celgar cost 850mm CAD to build in 1999 and MERC acquired in 2005 for USD 210mm under unique circumstances but has subsequently spent a significant amt on improvements, Rosenthal mill cost over 360mm euros and Stendal plant would arguably cost >700mm euro to build given >635k of capacity) and (ii) strategic interest (couple China paper companies) would likely be interested in this business to feed their consumption needs. 

Re: upside catalysts, they include: (i) further clarity around FCF dynamic, stability of energy earnings stream and recognition that the company has a more-than-adequate runway / 2.5+ years to get back to "normalized" EBITDA, (ii) improved technicals (i.e. currently an orphan equity that should transition into the hands of more stable / value investors), (iii) less negativity around China falling off a cliff re: pulp needs (i.e. note that there is ongoing concern around the sustainability of pulp prices largely driven by the China risk).  On the final pt, while difficult to get a pulse on China's inventory levels, recent trade rags (RISI articles pasted at bottom) have been surprisingly upbeat re: China's ongoing / sustainable appetite for pulp.  This has further been supported by the extremely low inventory situation amongst producers (which is supportive of price increases to date and further increases).   My personal view is that the US and Europe can effectively help offset any pull-back in China's appetite (given early signs of re-stocking / pick-up in demand on coated / tissue and other pulp end-mkts).  Putting aside the n-term risk around China (which could create trading volatility), I think the longer-term (6 - 12+ mths) story around MERC equity is very attractive given their industry position, improved capital structure (incremental 1x EBITDA multiple expansion from current levels equates to >$3 / share of value or >100%).

VALUATION:

As noted in the graph below, MERC currently trades for ~4.8x "mid-cycle" EBITDA of euro 175mm (or around 100 - 105 / ton * 1.45mm tons of capacity + 25mm from energy production).  To help frame my "normalized" EBITDA assumption for the pulp operations, peak EBITDA / ton was around 115 - 120 in 2006 so I've assumed a discount to this peak number (arguably, the operating effecencies should enhance the EBITDA / ton metric ... every 5 / ton equates to approx 7.5mm of additional EBITDA).  On a leveraged FCF basis, MERC should generate >55mm per annum of FCF (or ~48% FCF yield based on ~116mm euro mkt cap).  Assuming a more "normalized" FCF yield of 7.5% - 12.5% (once perception changes around this NOT being a deeply distressed company), this implies a FV / share of 6.50 - 18.50/ share (low end based on 12.5% FCF yield and FCF of 40mm and high-end based on 7.5% FCF yield and 70mm of FCF)

UPSIDE / DOWNSIDE:

UPSIDE: assuming 10% FCF yield on Euro 55mm / USD 80mm of FCF equates to a share price of ~$16 / share (vs current of $3.35 / share or approx 350%+ upside) ... more likely scenario is ascribing a 7.5x EBITDA multiple (driven by higher multiple on energy production and lower on more cylical pulp) which gets to a $11.50 - $12 / share FV

BASE: assuming 15% FCF yield on Euro 55mm / USD 80mm of FCF equates to a share price of ~$10.75 / share (vs current of $3.35 / share or approx >200% upside) ... more likely scenario is ascribing a 6.5x EBITDA multiple which gets to a $8 - $8.50 / share FV

DOWNSIDE: assuming 15% FCF yield on Euro 55mm / USD 80mm of FCF equates to a share price of ~$8 / share (vs current of $3.35 / share or approx >125% upside) ... more likely scenario is taking a punitive 5.5x EBITDA multiple which gets to $4.50 - $5.00 / share FV

WHY THE DISCOUNT:

Three primary reasons: (i) technicals (pending negotiations w/ convertible noteholders has created an "orphan" equity ... BUT this is changing given the agreement / push-out in the convert maturity); (ii) pulp prices plummeted in late 2008 / early 2009 causing most of the analyst community to re-assess the hyper-cyclicality of this industry (my view is that MERC will cushion the cyclicality moving forward given its energy earnings stream will be >25mm of EBITDA); and (iii) mgmt has a lack-luster reputation (great operators BUT not necessarily the most effective value maximizers).  While frustrating on all three fronts (and may deserve a discount), these "uncertainties" have ultimately created the opportunity to buy a premier biz with significant earnings power that has asymmetric risk / reward (downside is arguably supported by "replacement" value - China would arguably want to get their hands on these three mills to feed their paper consumption needs).

RISKS:

EARNINGS POWER: Core earnings power comes in lower than I anticipate

CHINA RISK: China pulls back on pulp consumption and causes a spasm in pulp prices (as noted above, I view this more as a technical / headline risk - BUT so far to date, China has continued to have a large / growing appetite for pulp)

MGMT: Mgmt gets in the way of what is arguably a nice / 2.5+ yr runway w/ an acquisition or large capex program (I don't envision this occurring, just note the mgmt risk)

CATALYSTS:

NEAR-TERM (1 - 3 mths): Street recognizes that equity trades at an effective >45% leveraged FCF yield based on "normalized" EBITDA of 175mm

NEAR-TERM (1 - 3 mths): Street recognizes the earnings power stream is cushioned by a >25mm energy annuity stream from its Celgar mill (arguably deserves a premium multiple which creates even further downside protection around the core / pulp operations)

NEAR-TERM (1 - 3 mths): Orphan equity (largely given ongoing negotations w/ converts) SHIFTS to more of a "pure-play" way to articulate a view on pulp (which is largely driven by China demand + US / Europe underlying demand) + energy production

LONGER-TERM (3 - 6 mths): Mgmt regains credibility (q4 09 / q1 10 results were an early / encouraging indicator of moving the right direction in re-gaining trust

LONG-TERM (3 - 12 mths): Street recognizes the underlying earnings power of the biz model and applies a "market" multiple and FCF yield to the biz

Pulp purchasing frenzy resumes in China, prices up across Asia

SINGAPORE, Jan. 11, 2010 (PPI Asia) - Chinese pulp purchasers look to be going on a new buying spree.

Strong demand has helped push up prices for all pulp grades for January shipments in the Chinese market. Bleached softwood kraft (BSK) has climbed $20/tonne and bleached hardwood kraft (BHK) pulp is up $30/tonne. Unbleached softwood kraft (USK) pulp has risen $10/tonne.

Big volume buyers, including Sun Paper, APP China, Shandong Chenming Paper Holdings and Hengan Paper, have continued to build up inventory, snapping up any available tonnage.

Chinese traders have also picked up volumes to replenish their depleted stocks. They had been reluctant to stockpile over the months preceding December, believing it to be too risky as prices seemed too high.

Most reckoned at the time that as pulp had grown expensive and some companies had halted purchases, prices were nearing their peak. But suppliers did not agree, and continued to push for hikes.

Chinese traders, which sell stock mostly to small and medium-sized mills across the country, changed their minds about price trends after orders from their customers flooded in and their volumes could not meet the demand.

And they were caught by surprise when one of the largest Chinese paper and board producers, Shandong Chenming, came to knock on their doors seeking tonnage. Major buyers like Shandong Chenming usually purchase directly from overseas suppliers, but that sourcing seems to be falling short at the moment.

As a result, resale prices have firmed up. BSK levels have climbed RMB 300/tonne to RMB 5,400-5,700/tonne, equivalent to $669-707/tonne (after VAT and logistics costs). BHK, which has been in short supply, is selling at RMB 5,300-5,600/tonne, up RMB 200/tonne.

The robust pulp demand has been shored up by rising paper and board prices in the Chinese market in the fourth quarter of last year.

Other factors besides demand are bolstering prices.

The currencies of the major pulp exporting countries are still appreciating against the greenback. Market pulp is sold in US dollars in Asia, and its weakening means less profit for pulp producers after converting it back to their local currencies, unless levels go up.

And supplies of market pulp to China are limited. This is due both to output curtailments by North American and European producers who are still dealing with an uncertain economic outlook, and to a reduction in vessel space availability from the Americas to Asia.

Suppliers are now looking at seeking further hikes this month, of $20/tonne for BSK and $20-30/tonne for BHK. The plans have not been announced yet, but sellers are confident that they can be pushed through.

Contract levels climb: Elsewhere in Asia, contract prices have been settled for December deliveries. Radiata pine and USK climbed $10/tonne, while BHK is up $10-40/tonne.

Regular buyers are worried about the likely prospect that the buying frenzy in China will drive up levels across the region.

Several Canadian suppliers have told their agents in Asia about plans to seek hikes of $20/tonne for northern BSK for January shipments. And some Brazilian manufacturers are also seeking increases of $20-30/tonne for eucalyptus pulp.

The new round of price talks between sellers and buyers has just kicked off
and is expected to conclude by the end of this month.

Cheap spot offers are out of the market. Spot tonnage of both BSK and BHK is readily available, but buyers have pay at the same level as contract prices to get volumes.

Several South Korean mills have bought some BHK spot tonnage to build up stock, in the belief that prices will go up later.

Pulp price hikes unveiled for China despite growing resistance

INGAPORE, Dec. 21, 2009 (PPI Asia) - A few suppliers have pulled back the curtain on price increases for market pulp in China for January deliveries, unfazed by increasing resistance from Chinese buyers.

Mercer International and Canfor have tabled rises of $20-30/tonne for northern bleached softwood kraft (NBSK), while Fibria and Suzano are pushing for hikes of $30/tonne for bleached eucalyptus kraft pulp. Other producers are expected to follow suit.

The moves may set the scene for a price surge elsewhere in Asia early next year, even though buyers believe the market is nearing the peak.

Pulp prices in China are steady for now, following minor increases of $10/tonne for several long fiber grades and $20/tonne for some bleached hardwood kraft (BHK) pulps in early December.

Pulp producers and Chinese agents are confident the planned price hikes can be pushed through, saying large paper and board mills in China are still buying big quantities of pulp to build inventory. They could be the only purchasers left in the market, though.

Small and medium-sized plants have stopped buying, because pulp has grown too expensive, whilst paper and board prices in China have stagnated, leaving them no chance to pass on the extra costs.

These smaller players cannot afford to stock up. They are just buying small quantities in the pulp resale market from local traders to cover their immediate production needs. Still, many such mills have been forced to take downtime.

Meanwhile, traders are reluctant to stockpile, believing it too risky in the current climate with prices so high.

Traders' diminishing stores have led to less availability of pulp in the resale market. But demand is on the wane, too. Prices for bleached softwood kraft (BSK) pulp, sold to domestic plants, have thus stayed at RMB 5,100-5,400/tonne, equivalent to $632-669/tonne (after VAT and logistics costs).

Some annual contracts inked: To secure long-term supplies and obtain discounts, several of the largest Chinese mills have signed annual contracts for 2010, mainly with South American suppliers.

While traders buy most of the BSK imported to China, suppliers prefer to sell bleached hardwood kraft pulp directly to paper and board producers there.

The papermakers that have signed the annual contracts will be entitled to monthly discounts of 2-4%, with a handful of the big-volume buyers getting 5%.

Contracts for 2010 are still under negotiation in other Asian countries. The Chinese deals may give sellers an edge in the talks.

Most of their non-Chinese customers had discounts of up to 6% this year, with big-volume South Korean purchasers getting as much as 10%.

Suppliers are now seeking to apply the same discount terms seen in China to other Asian markets. But South Korean mills, the market leaders in Asia, are trying to bargain for discounts of 5-7%. The haggling continues.

Prices set to climb elsewhere: Outside China, suppliers are looking to raise prices for several pulp grades by $10-40/tonne in the rest of Asia, for December shipments. The hikes are expected to go through when deals are settled later this month.

Sellers are pushing for increases of $10/tonne for radiata pine and unbleached softwood kraft pulp. Some are aiming to raise prices for BEK by $20-40/tonne, playing catch-up with competitors who managed to obtain BEK hikes earlier.

Prices for NBSK and bleached chemi-thermomechanical pulp (BCTMP) are steady, though. NBSK is readily available due to dwindling purchases in China. Buyers have regarded BCTMP as too expensive for a few months now and thus reduced purchase volumes. Suppliers aim to boost sales by leaving prices be.

The tight supply of BHK seen in recent months seems to have eased. Buyers say spot volumes are increasingly available at the same prices as contract pulp. Availability of BHK spot tonnage was restricted just a month ago, and it was therefore more expensive than contract pulp.

Paper and board mills in South Korea also reported they have been able to buy more volumes from their regular suppliers. That must come as a welcome relief. Just a month ago they were struggling with insufficient BHK inventories and were forced to pay top whack just to get hold of some small amounts of spot tonnage.

Catalyst

NEAR-TERM (1 - 3 mths): Street recognizes that equity trades at an effective >45% leveraged FCF yield based on "normalized" EBITDA of 175mm

NEAR-TERM (1 - 3 mths): Street recognizes the earnings power stream is cushioned by a >25mm energy annuity stream from its Celgar mill (arguably deserves a premium multiple which creates even further downside protection around the core / pulp operations)

NEAR-TERM (1 - 3 mths): Orphan equity (largely given ongoing negotations w/ converts) SHIFTS to more of a "pure-play" way to articulate a view on pulp (which is largely driven by China demand + US / Europe underlying demand) + energy production

LONGER-TERM (3 - 6 mths): Mgmt regains credibility (q4 09 / q1 10 results were an early / encouraging indicator of moving the right direction in re-gaining trust

LONG-TERM (3 - 12 mths): Street recognizes the underlying earnings power of the biz model and applies a "market" multiple and FCF yield to the biz