Description
Pope and Talbot (POP)
We believe that Pope and Talbot (POP) represents an excellent risk/reward with an immediate catalyst and a solid chance of a double from here. Since the end of Q3, a sizable cash inflow stemming from the settlement of an industry-wide trade dispute has led to a doubling of book value, but the stock price has trended down and it now trades at about 50% of book. The market seems to be focused on the company’s former financial distress and has ignored the cash inflow which will show up when the Q4 balance sheet is reported.
Our conviction stems from the following:
· The pulp market is very tight right now and, while it looks to be at a peak in U.S. dollars, is actually only a bit above mid-cycle when viewed in the more relevant Canadian dollars. A significant price increase for January, 2007 was just announced by leading competitor Mercer International and additional price increases are possible.
· Lumber prices appear to have bottomed as high-cost sawmills have been taking downtime.
· Management is using its sizable cash refund from the Softwood Lumber Agreement to reduced debt by as much as 30% and should ultimately be able to refinance at lower rates.
· The Canadian dollar has quietly started to fall
The average price/book of North American lumber and pulp companies is about 1.2 times. Given the capacity that has come out of the pulp market and the capacity that appears to be coming out of the lumber market, over time POP should earn its cost of capital through the cycle. At a minimum POP should trade at book value, or over $10/share (which would equate to slightly over 5x mid-cycle EBITDA of $83MM).
POP operates two businesses: Lumber and Pulp (specifically NBSK pulp). Though its headquarters are in the U.S., most of POP’s assets are located in British Columbia, Canada. A few other companies that produce either one or both of these products have been posted on VIC over the last several months, and I highly recommend reading those write-ups as a good way to get up-to-speed on the key industry dynamics (Mercer International posted by samba834 and Canfor by tickles879). Here are the highlights for both products:
Pulp: There are two primary varieties of pulp: hardwood and softwood. POP makes the major sub-type of softwood pulp, NBSK (Northern Bleached Softwood Kraft). Pulp is priced in US dollars, but production costs across the industry are typically incurred in Canadian dollars or Euros (most mills are in Canada and Europe). Over the last few years, both Canadian dollar and energy inflation raised the cost of pulp production and led to significant capacity closures in Canada (~20% of Canadian capacity has closed). In 2006, rising demand and falling supply has led to a rapid price increase for NBSK and additional pricing upside is certainly possible given current inventory levels (very low), operating rates (at 100%), and continued demand growth. On the supply side, there is almost no new capacity being built anywhere in the world and there is a multi-year lead time to build a new mill. Extensive cap ex requirements from years of underinvestment will likely keep most of the high cost mills that were shuttered from reopening even if there are additional price increases.
Hardwood pulp capacity is growing in South America and there is some debate about the ability of pulp customers to substitute hardwood for softwood (prices have historically been tightly coupled). Most industry contacts that we’ve spoken with say that there is some substitution risk, but that it is minimal - at least over the medium term. Why? NBSK’s primary use is to give paper strength. The inherently shorter fibers of hardwood pulp lack this critical attribute. Additionally, paper making machines are “finicky” and susceptible to costly downtime when pulp proportions are changed.
Wood chips (fiber), a by-product of the lumber-making process, are the primary raw-material input for pulp. Falling lumber production is now leading to an increase in wood chip prices.
Lumber: Lumber prices have fallen hard as both the primary demand driver (residential construction) and a much smaller secondary demand driver (hurricane damage repair) are down substantially. Very low pricing will likely persist until there is a meaningful rebound in housing starts (perhaps one to two years), but recent sawmill shutdowns appear to have put a floor on pricing.
Until very recently, Canada and the U.S. were battling over the import of softwood lumber from Canada to the U.S. The U.S. claimed that Canadian lumber companies were effectively subsidized by the Canadian government to the detriment of the U.S. lumber industry. For years the U.S. collected a tariff on Canadian lumber imports. In August a settlement was reached between Canada and the U.S. The settlement included two major components: 1) a refund of 80% of past duties collected by the U.S. back to the lumber companies, plus interest; and 2) a new regime, by region in Canada, to either collect an export tax or impose a quota on future lumber exports to the U.S. Lumber companies in B.C. will pay the export tax which is a sliding scale based on average monthly lumber prices (the scale is from a 15% tax rate when lumber prices are low to a 0% tax when lumber prices are high). In a low-lumber price environment, this new scale means that B.C. lumber companies will pay a higher export tax rate to Canada than they were paying to the U.S. earlier in 2006. However, historical lumber prices imply that that the average tax rate will be decently lower than what the U.S. had been collecting (granted, naively applying the new tax regime to historical pricing is likely to be misleading given new quotas, etc).
Company-specific discussion:
|
Capitalization |
|
|
Stock price |
5.20 |
|
Shares |
16.2 |
|
Mkt. cap |
84.2 |
|
Debt |
388.8 |
|
Enterprise value |
473.0 |
|
Lumber refund net of cash taxes |
(118.7) |
|
Adjusted enterprise value |
354.3 |
|
Book value |
|
|
Q3-06 BV ($MM) |
84.2 |
|
+ Lumber refund |
118.7 |
|
+ Reversal of U.S. NOL allowance (est.) |
15.0 |
|
- Pension underfunding (SFAS 158) (est.) |
(50.0) |
|
Q4-06 BV before operating results ($MM) |
167.9 |
|
Q4-06 BV per share |
10.36 |
POP operates 3 pulp mills with a combined capacity of 830K tons, or about 3.5% of world NBSK capacity. Two of these mills are in the second quartile of the cost curve, but probably towards the lower end. The third mill is higher cost. POP operates 5 sawmills with a combined capacity of 1bn fbm, or about 1.5% of North American capacity. The lumber sawmills are at the high end of the second quartile of the cost curve (i.e., large and low cost)
POP got into financial distress as a result of the rise of the Canadian dollar and the use of debt to acquire a large sawmill. Management says that a 1 cent change in the Canadian to US dollar exchange rate results in pre-tax costs $6.4MM ($0.39/share, pre tax). Needless to say, the $0.25 rise of the Canadian dollar since 2002 has been painful. EBITDA was negative in the second half of 2005, but a recovery in pulp and a lowering of the US lumber duty rate has led to 3 consecutive quarters of both positive and increasing EBITDA. Q3-06 EBITDA was $11.7MM ($20.2MM from Pulp, -$4.3MM from lumber, and -$4.2MM corporate).
POP ended Q3 with a book value of $84.2MM, or $5.17/share. In November, POP received a pre-tax $127.5MM refund stemming from the new Softwood Lumber Agreement between the U.S. and Canada. Taxes will only be about $8.8MM, so the net effect of the refund will be to increase BV by about $7.33/share. A change in Pension accounting will be a partial offset.
Valuation:
We estimate that mid-cycle EBITDA to be about $83MM as detailed in the following table:
|
Pulp |
|
|
Trough EBITDA/ton |
(2.1) |
|
Peak EBITDA/ton |
163.0 |
|
Mid-cycle EBITDA/ton |
80.5 |
|
|
|
|
Capacity (tons) |
820 |
|
Mid-cycle operating rate |
96.5% |
|
Operating capacity (tons) |
791 |
|
|
|
|
Mid-cycle pulp EBITDA ($MM) |
64 |
|
|
|
|
Lumber |
|
|
Trough EBITDA/fbm (pre export tax) (est.) |
(25) |
|
Peak EBITDA/fbm (pre export tax) |
133 |
|
Mid-cycle EBITDA/fbm |
54 |
|
|
|
|
Total capacity (fbm) |
1,030 |
|
Mid cycle operating rate |
90% |
|
|
|
|
Average price/fbm |
363 |
|
Average export tax rate (% of price) |
5.6% |
|
% of production subject to export tax |
80% |
|
|
|
|
Mid-cycle EBITDA before export tax ($MM) |
50.2 |
|
Export tax ($MM) |
(15.1) |
|
Mid-cycle lumber EBITDA, net of export tax |
35.1 |
|
|
|
|
Consolidated |
|
|
Corporate SG&A |
(16.0) |
|
Total EBITDA |
82.8 |
|
Interest (prior to possible refinancing) |
(31.0) |
|
Cap-Ex ($25-$30MM for next several years) |
(27.0) |
|
FCF (pre tax) |
24.77 |
|
FCF/share (pre tax) |
1.53 |
POP’s Pulp EBITDA/ton last hit a peak in 2000 (prior to the acquisition of the Mackenzie, BC mill) and last reached a trough in Q4-05. On the Lumber side, POP’s EBITDA/fbm (pre lumber duty) last reached a peak in 2004 (prior to the acquisition of the very low cost Fort St. James, BC mill). We estimate that Q4-06 will be the trough lumber EBITDA number and estimate a loss of -$25/fmb. Applying the new lumber export tax formula to historical monthly prices for the last 12 years, it appears that the export tax rate would have averaged 5.6%. As only 80% of POP’s lumber is subject to the export tax (that is, lumber produced in Canada and shipped to the U.S.), the average annual duty looks to be around $15MM assuming a 90% operating rate. Management says that corporate SG&A cash costs should be about $16MM/year. According to management, cap Ex for the next several years should be $25-30MM. Assuming that the full after tax refund goes to repay debt, interest would drop to ~$31MM/year. The company may have closer to $37MM in interest in 2007 if they choose to keep a portion of the refund as cash to build liquidity. Putting all this together results in EBITDA – Interest – Cap Ex of about $25MM, or $1.50 share.
Another way to think about valuation is to look at asset sales. The most recent North American sawmill asset sale was West Fraser Timber’s purchase of 13 southern yellow-pine sawmills with 1.8bn feet of capacity from International Paper for $325MM ($180/fbm). These sawmills are certainly not perfect equivalents to POP’s sawmills, but are reasonably close. This sale implies an estimated $186MM value for POP’s sawmills. Backing this value out of POP’s $354MM adjusted EV suggests an estimated value of $180MM for the pulp business. Ascribing 1/3 of corporate SG&A ($5MM) to lumber implies that the pulp business is trading at 2.6x Q3-06 annualized EBITDA ($81MM Pulp EBITDA less $11MM SG&A). This appears to be significantly cheaper than pure-play pulp companies Mercer International and Canfor Pulp Income Fund (which are trading at around 6.0x and 4.0x Q3-06, respectively). Other recent sawmill sales have been sold for $200/fbm, implying an even cheaper valuation of POP’s pulp assets.
Risks
The company has been in financial distress and has a ‘going concern’ opinion from its auditors. Clearly a lot can go wrong in an economically sensitive company with a significant amount of operating and financial leverage that’s in an industry that has struggled over time to earn its cost of capital. Debt remains high and covenants could be breeched.
Lumber EBITDA in Q4 and early 2007 will likely be below Q3’s already negative levels (at this point mills are operating at curtailment costs).
Fiber costs for pulp, the largest input cost, have been rising as lumber production falls (POP does have a partial natural hedge here from its own lumber operations. Fiber is typically a sawmill byproduct but mills are currently running to produce fiber as the primary product).
Catalyst
Catalysts
• Continued decline of Canadian dollar
• Additional pulp price increases
• Removal of ‘going concern’ opinion
• Stabilizing lumber market
• Lumber duty refund reflected on Q4-06 balance sheet