Description

In my opinion, there is a high probability that, within the next year or so, the price of containerboard will rise sharply in reaction to a secular shortage of the raw materials used to produce containerboard, which are (1) virgin unbleached wood pulp and (2) recycled old containerboard (or “OCC”). The situation is as follows. In 2000, about 27% of the fiber used worldwide to manufacture containerboard was virgin fiber (pulp made from trees) and the remaining 73 or so % was OCC. Since then, the capacity to manufacture virgin unbleached pulp has remained roughly flat, while the demand for containerboard, driven by rapid economic growth in China and in other developing countries, has grown by more than 10% in spite of the recession in the early 2000’s. As a result of this 10+% growth, currently only about 20% of the fiber used to manufacture containerboard is virgin unbleached pulp, while about 80% is OCC. Based on my knowledge of the paper industry (I have been on the Board of a paper company for about twenty-five years), virgin fiber can only be recycled about 5 times (on average) before the fibers become too damaged and too short to manufacture boxes of sufficient strength (they are damaged and shortened when they are “beat” to make recycled pulp). Therefore, the theoretical limiting ratio for virgin pulp-to-recycled OCC is 1-5 – which is were the industry is now. Looking ahead, the demand for containerboard is projected to grow at a 3+% annual rate, driven by the developing world and by increased demand for boxes to ship goods ordered over the Internet (for example, if you order books from Amazon, they are shipped in boxes made from containerboard). Of importance, all the increased capacity to produce containerboard is coming from plants that use OCC as their raw material. Much of this new capacity is coming from China (7 new recycle mills with a combined capacity of 1.8 million tons) and Europe (9 new recycle mills with a combined capacity of close to 1.6 million tons) (note – these capacities compare with total present world capacity of about 100 million tons). There are no plans (that I know of) for new virgin capacity – and such new capacity announcements are likely to be modest because new virgin mills are expensive, need a large resource of inexpensive pine trees (which are located in few parts of the world), and need to comply with strict environmental standards. Thus, it is logical that OCC soon will become in short supply and that its price will rise sharply – driving up the price of containerboard.

Just to have some numbers to work with. In recent periods, OCC prices have averaged roughly $80 per ton. In previous temporary periods of shortage, OCC prices have risen sharply to over $200 per ton. I would not be surprised if (1) OCC prices increase to over $200 over the next year or so; (2) if OCC prices then remain high because of the lack of new virgin pulp capacity; and (3), because it takes about 1.2 tons of OCC to produce a ton containerboard, if containerboard prices increase by more than $144 per ton.

Smurfit-Stone is the containerboard company most leveraged to virgin containerboard (it is the largest producer of containerboard in North America). I view Smurfit-Stone as a publicly traded LBO. The company was formed over the past decade through a series of acquisitions that left the company highly leveraged (the company has about $4.6 billion of balance sheet debt plus some off the balance sheet obligations). While the debt gives the shares an element of risk (although most of the debt has a long maturity), the company has about 8.5 million tons of board capacity, of which the equivalent of 6.4 million tons is produced by virgin fiber (and the rest by recycled) – and thus the company is highly leveraged operationally and will be a major beneficiary of rising prices. We will assume that board prices increase by $144 per ton, but that only the 6.4 million virgin tons benefit from this increase (because the recycled tonnages’ costs would increase to the extent of the price increase). Thus we would look for a $920 million increase in Smurfit-Stone’s pre-tax profits ($144 per ton on 6.4 million tons), or $570 million after taxes (at a 38% annual rate), or $2.25 per share on 255 million shares outstanding. Smurfit-Stone reported a modest recurring loss last year, but costs last year were unusually high and the company has recently reduced its costs by permanently closing 700,000 tons of high cost capacity. My guess is that, if the OCC market develops as we expect, Smurfit-Stone’s EPS could reach the $2.50 per share level – and remain at this level for an extend period of time because it would take many years to build new virgin pulp capacity. At 8X earnings, Smurfit-Stone would then be worth about $20 per share, or more than 60% above its recent price. I note that the shares sold as high as $18 earlier this year and as high as $20 last year.

Another approach is to value the company based on the estimated value of its assets. New virgin containerboard mills cost at least $1,250 per annual ton of capacity. We believe that virgin containerboard mills will be in good demand (because of the shortage of virgin fiber) and that Smurfit-Stone’s containerboard mills are worth at least 60% of their replacement value, or $6,375 million. In addition, the company owns 193 converting (box) plants that, at $15 per plant, would be worth a total of $2,900 million. Also, the company has about 500,000 tons of market pulp capacity that we value at $600 per ton, or $300 million, and an OCC collection business that we value at $300+ million. Other assets include $450 million of working capital and $50 million of timberlands. Adding all of these asset up, one comes to $10,375 million. Against these assets are $4,630 million of net debt and $700 million of net miscellaneous other liabilities. Thus, our appraised net asset value is $5,045 million, or close to $20 per share on the 255 million shares outstanding.

Catalyst

The price of oil, copper, and several other commodities have benefited from accelerated demand from China and other developing countries. While paper prices have not spurted to date, we believe that the price of containerboard soon will rise sharply due to shortages of recycled fiber (OCC), the raw material used to produce about 80% of the world’s board production. Smurfit-Stone should be a major beneficiary of such a shortage – and I believe that the company’s earnings and share price will rise sharply once the shortage occurs.