SFK’s improving fundamentals will produce an FCF yield in excess of 20% in 2007 (based on recent market value). The strong FCF should drive further increases in the already respectable monthly cash distribution. With good management, efficient operations, and tangible book value in excess of market price, SFK offers solid downside protection and upside potential.

Why this opportunity? SFK’s financials have yet to reflect the recent improvement in market conditions and a shrewd recent acquisition. In addition, a number of pro forma adjustments are required to determine book value, units outstanding, and FCF per unit. Finally, cash distributions were increased only recently and remain below SFK’s prospective ability to return cash.

 

 

 

SFK offers a compelling capital appreciation and income opportunity with low downside risk:

 

 

SFK Pulp Fund (Toronto Stock Exchange: SFK.UN) owns and operates three North American mills that produce pulp, a key input into paper production. SFK is organized as a Canadian flow-through entity known as an unincorporated open-ended trust or income fund. As with other such trusts, shareholders in SFK are referred to as “unitholders,” and dividends are “distributions.”

 

NBSK pulp operations (the original SFK business). SFK has produced premium-quality northern bleached softwood kraft (NBSK) pulp in Saint-Felicien, Quebec for almost three decades. Production capacity is 375,000 tonnes per year. SFK Pulp Fund was organized as an income trust in 2002 to acquire the Saint-Felicien pulp mill from paper and wood products maker Abitibi-Consolidated (Toronto Stock Exchange: A.TO) for $628 million.SFK financed the majority of the purchase by issuing units at $10 each. In 2004, SFK raised additional capital at $8 per unit. Those two capital raises are largely responsible for the enviable position of prospective SFK investors, who today can purchase SFK units below book value of $6.48 per unit.

 

RBK pulp operations (the recently acquired business). SFK acquired two U.S.-based recycled bleached kraft (RBK) pulp mills for $194 million in cash (including working capital infusion and deal expenses) on October 31, 2006. The mills have an annual production capacity of 360,000 tonnes. SFK acquired the mills amid depressed industry conditions, paying significantly less than the $462 million spent to build the mills between 1994 and 1996 (the mills are in good condition, with maintenance capex of only $4 million). It appears SFK was able to strike this favorable deal because the target mills were teetering on bankruptcy due to massive financial leverage and therefore needed to be restructured. SFK obtained ownership of the RBK mills by repaying their US$400 million in debt at a fraction of face value. The mills generated positive operating income during difficult industry conditions in 2005 and 2006 but were unprofitable due to the interest expense payable on US$400 million in debt. While SFK borrowed money to finance a portion of the $194 million purchase price, it did not assume any of the mills’ legacy debt. Fortunately for SFK unitholders, SFK closed the acquisition before pulp prices began their recent rally. The mills, which are located in Fairmont, West Virginia and Menominee, Michigan, produce low-cost, high-quality air-dried RBK market pulp. They are the only mills of their kind in North America and two of only three such mills worldwide.

 

Basic business model is simple, but underlying economics are more complicated. Pulp production is a capital-intensive business with a straightforward business model: To become a pulp producer, you need to build a mill that processes wood fibre or wastepaper and turns those inputs into pulp. The cost of the input commodity accounts for roughly one-half or more of operating costs. Other costs include labor, chemicals, maintenance of the mill, and energy. To be successful, you need to locate your mill close to a reliable supply of fibre or wastepaper and railway and/or sea transportation. You need to strike long-term deals with suppliers and customers and make your mill as efficient as possible. Operating profit is commonly disaggregated as follows: (sales price per tonne of pulp net of delivery costs minus cost of input commodity per tonne minus other production costs per tonne) multiplied by tonnes of pulp produced. The economics driving these variables are quite complicated and are a reason for industry cyclicality and mispricing of pulp stocks by investors. For example, the sales price per tonne depends on the geographic region of delivery, the type of fibre used in pulp production, general economic conditions, and other factors. The cost of wood fibre depends on the demand for wood, government restrictions on the harvesting of forests, and even such natural disturbances as pine beetle infestations that can lead to excessive cutting in order to stop their spread, therefore producing an abundant (and cheap) supply of the input commodity.

 

 

The difficult conditions that prevailed in the pulp industry during 2005 and much of 2006 produced industry consolidation and led to a number of mill closings, setting the stage for a recovery in pricing. Efficient operators such as SFK tend to benefit following tough times because the marginal players are squeezed out or acquired at favorable prices.

 

NBSK pulp prices have recovered recently, rising from an average of US$600 per tonne in 2005 to an average of US$681 per tonne in 2006 (for NBSK pulp delivered to Northern Europe). On a quarterly basis, the market price per tonne has progressed as follows:

 

 

Despite the recent increase in the market price of pulp, prices remain below historical highs reached as far back as 1989 (>US$800) and 1995 (US$975). Unlike many other commodities, pulp has yet to break out of its decades-long historical range and enter new territory. Like other commodities, however, pulp has recently benefited from strong Chinese demand. It remains to be seen how the evolving industry dynamics will affect the market price of pulp going forward.

 

Recent industry reports suggest that some NBSK pulp producers have been pushing for an incremental US$20 per tonne price hike to be introduced in March 2007. For the purpose of forecasting SFK’s operating results, however, I have assumed that NBSK pulp prices will increase by only 4% over the two-year period from Q1 2007 to Q4 2008. My market price estimates for Q4 2008 match the prices announced by Pope & Talbot (NYSE: POP) on February 26, 2007 and slated to go into effect as early as April 1, 2007.

 

I have made a similar 4% growth assumption for RBK pulp prices, which have also risen recently. While different types of pulp trade in different price ranges (e.g., NBSK pulp prices exceed RBK pulp prices), prices are correlated due to substitution effects associated with excessive deviations in pricing.

 

 

While it would be unwise to believe that a commodity producer could ever build an enduring moat, several factors suggest that SFK does enjoy a favorable position in a competitive industry:

 

Transportation advantages. SFK’s facilities are located close to its source of raw materials, and it has fast access to the North American railway network and a deepwater port on the Saguenay River for the delivery of pulp.

Industry-leading efficiency. SFK has obsessively implemented improvement programs at its Saint-Felicien mill. Productivity, as measured by tonnes of pulp produced per day, has increased steadily and has recently set a new record.

Well-incentivized and able management. Management has made SFK one of the most efficient operators in the pulp industry. In addition, it had the foresight to acquire two mills amid depressed conditions at well below their replacement value. Compensation is reasonable and variable, with cash bonuses tied to short- and long-term performance goals. Senior executives are required to spend an average of 20% of their annual salary on the purchase of SFK units.

Significant and defensible market share. NBSK pulp: The Saint-Felicien mill produces high-quality pulp that generally sells at a premium to the market price of pulp. NBSK is made from northern softwood, which adds resistance to paper and is preferred by the publishing industry. As the wood fibre from northern softwood is available almost exclusively in Canada, Scandinavia and Russia, there is little threat from low-cost Asian producers. In fact, Canada accounts for roughly one-half of worldwide NBSK pulp production capacity. RBK pulp:SFK’s U.S. mills produce recycled pulp and enjoy 45% market share in North America. Such high share implies that SFK does have some input into RBK pulp pricing, as it would be exceedingly difficult to satisfy demand if SFK’s capacity were taken offline.

Savings and growth opportunities from recent acquisition. The recent acquisition of two recycled pulp mills is poised to make SFK an even tougher competitor. Management estimates it will be able to eliminate $6.5 million in operating costs (see Business Acquisition Report filed on January 12, 2007). Moreover, recycled pulp represents a growth segment within the pulp industry, as environmentally conscious paper use continues to gain traction.

 

 

 

To facilitate a valuation analysis of SFK, the following tables present pro forma calculations of units outstanding, book value, market value, and enterprise value. Also included are tables showing selected historical and projected operating data.

 

 

The following table shows pro forma market value and enterprise value. The calculation does not take into account FCF generated or distributions paid since September 30, 2006.

 

 

The following table shows pro forma book value. The calculation does not take into account FCF generated or distributions paid since September 30, 2006. The calculation also excludes adjustments for the Fairmont and Menominee mill assets, as such assets were acquired at approximately book value (see Business Acquisition Report filed on January 12, 2007).

 

 

Selected historical operating data (1995-2001) for the NBSK pulp operations (Saint-Felicien):

 

 

Note: SFK defines distributable cash as all cash received, less amounts spent on (1) the repurchase of units; (2) interest payments; (3) debt principal repayments; (4) ongoing operations, including working capital requirements; (5) tax-related payments; and (6) capital expenditures.

 

Selected historical and projected operating data (2002-2008E) for the NBSK pulp operations (Saint-Felicien) and the recently purchased RBK pulp operations (Fairmont, Menominee mills):

 

 

 

SFK temporarily suspended distributions in Q1 2006 due to depressed pulp market conditions. Distributions have since been reinstated. Most recently, on February 19, SFK announced an increase in the monthly distribution from $0.03 to $0.05 per unit. The new distribution level implies an annualized yield of 11%.

 

Based on an estimate of $1.18 in distributable cash per unit in 2007 and $1.28 in 2008, I expect management to increase the monthly distribution again this year – in one or more steps – to a range of $0.08-$0.10 per month. The next increase will likely be driven by one or more of the following factors: (1) growing FCF contribution from the Fairmont and Menominee mills; (2) better visibility into the cost of wood fibre at the Saint-Felicien mill; and (3) continued stability or increases in the market price of pulp.

 

 

While it makes sense for investors to strongly prefer businesses with high returns on capital, a high ROC is not always required for a great investment. In the case of SFK, we have a moderate-ROC business that distributes the vast majority of FCF instead of reinvesting it in the business. This creates the compelling dynamic that SFK can theoretically provide a return into perpetuity that closely approximates the FCF yield at which the investment is initially purchased. Of course, unlike an investment in a high-ROC business, a purchase of SFK – assuming that the unit price increases after such purchase – carries the reinvestment risk associated with finding high-ROI opportunities for the cash received each month.

 

For illustrative purposes, the following table shows the positive effect of a high payout on an investor’s IRR for a modest-ROC business that trades at a high FCF yield. I assume a 20% forward FCF yield and a 10% ROC throughout the observation period. The five-year period shown could be extended into perpetuity without altering the IRR.

 

 

SFK has adopted a policy of distributing virtually all free cash flow (“distributable cash,” as calculated by SFK). The payout is subject to a few conditions, most notably the maintenance of a cash reserve of $20 million in order to meet ongoing liquidity needs.

 

 

A Quebec government measure has disrupted SFK’s fibre supply. Wood fibre is the biggest input into the operations of the Saint-Felicien mill, accounting for more than 50% of the cost of NBSK pulp production. SFK has benefited since 2002 from a 20-year fibre supply agreement with former parent Abitibi. However, the Quebec government reduced by 20% the volume of wood that can be harvested on public land for the period April 2005 through March 2008 (and perhaps beyond). This measure has reduced the volume of wood fibre that Abitibi is required to provide under the supply agreement, forcing the Saint-Felicien mill to seek additional fibre suppliers and to renegotiate the price of fibre with Abitibi. SFK believes it has secured sufficient fibre supply through mid-2008 (and probably beyond). However, the fibre pricing under the Abitibi agreement is still to be agreed upon, creating a source of uncertainty. While the outcome may indeed be higher fibre prices for the Saint-Felicien mill, a powerful argument can be made that fibre input prices for the Saint-Felicien mill are likely to decrease over time. The argument is based on the fact that wood fibre cost is inflated in Eastern Canada because of the 20% harvesting reduction in Quebec, while fibre cost is artificially low in Western Canada due to excessive harvesting in order to stop the spread of a major pine beetle infestation. Despite the large divergence in input costs between Eastern and Western Canada, SFK has maintained margins that compare favorably even to Western Canadian peers (thanks to lean operations). Meanwhile, the divergence in input prices has favored the startup of new mills in the West and the closing of marginal mills in the East. These dynamics may result in input prices in Western and Eastern Canada ultimately adjusting upward and downward, respectively. Such a development would create incremental upside for SFK. (Note: The Fairmont and Menominee mills use wastepaper instead of wood fibre as their primary input. There are no wastepaper supply constraints of note at this time.)

 

SFK operates in a cyclical industry. The end markets for pulp are cyclical, resulting in alternating periods of undercapacity and overcapacity. Depending on market conditions, marginal mills start up or shut down. As an industry leader, SFK has experienced somewhat less cyclicality than the nature of its business may suggest. A large end market for SFK’s pulp is publishing, which tends to be a less cyclical segment of the pulp and paper customer base. SFK’s annual EBITDA margin has stayed at 12% or higher throughout the period for which data is available. As the following table shows, SFK’s margin was most depressed in 2005, with significant room on the upside as market conditions improve.

 

                             1995  1996  1997  1998  1999  2000  2001  2002  2003  2004  2005  2006E

EBITDA margin    56%   28%   33%   34%   34%   46%   26%   23%   18%   23%   12%   17%

Preferential tax treatment to end on January 1, 2011. In late 2006 the Canadian Minister of Finance proposed changes to the taxation of so-called “specified investment flow-through” (SIFT) trusts, of which SFK is one. The likely result is that SFK’s flow-through treatment will end on January 1, 2011. SFK will thereafter be taxed as a Canadian corporation, resulting in a likely effective tax rate of 31.5% (as stated on page 25 of SFK’s prospectus dated January 24, 2007). SFK’s economics with regard to taxation therefore appear analogous to a corporation that has sufficient net operating loss carryforwards (NOLs) to offset earnings for the next four years.

 

SFK has high customer concentration. The Saint-Felicien mill sells 75% of pulp (by value) to its five largest customers, while the Fairmont and Menominee mills derive 64% of sales from their five largest customers. A major reduction in the demand from a top customer would likely have some negative impact on SFK. However, as SFK produces a commodity product, it is probable the company would find alternative customers within a reasonable time period.

 

SFK employs unionized labor. The Saint-Felicien mill has collective bargaining agreements with production and maintenance employees (valid through April 2009) and laboratory technicians (valid through April 2010). Other SFK employees, including the workers at the Fairmont and Menominee mills, are not unionized.

 

 

 

 

This is not a solicitation to buy or sell stocks. Please do your own independent analysis before buying or selling SFK (or any other stock). We have a long position in SFK at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on our SFK buying or selling activities.