Description

Summary investment rationale

We think SKG represents a compelling long opportunity with 40 to 80% upside, currently trading at 22% forward free cash flow yield.

We think investors are focused on short term earning volatility associated with rising input costs missing the longer term earning power of the company. We strongly believe that SKD, as market leader in Europe, will be able to continue raising its prices as it has done in the past and will continue implementing its cost cutting plan which is going to contribute materially to the bottom line. We believe SKG to be a high quality business with desirable attributes not appreciated by the market.

Moreover, we believe that in 2011 SKG's leverage, which has kept many investors away from the stock, will fall below 3x EV / EBITDA allowing the Board to reintroduce a dividend in 2012.

About the company

Smurfit Kappa Group (SKG) is a European largest corrugated packaging player with an important position in the growing Latin American market (18% of sales).

Smurfit Kappa Group is the result of the merger between Jefferson Smurfit Group (JSG) and Kappa Group that took place in 2005. Prior to the merger, JSG was acquired by PE Madison Dearborn Partners in 2002. Kappa Group was itself a roll-up of various European packaging producers owned by CVC and Cinven that sponsored an MBO in 1998. The newly merged group (SKG) went through a restructuring and rationalisation programme in 2006 and subsequently floated in March 2007. Madison Dearborn Partner, Cinven and CVC remained shareholders following the IPO, which was priced at €17.50. Today, Madison Dearborn retains c. 16% and Cinven, CVC and some members of the Smurfit family retain another 18% together in a feeder investment vehicle.

Business Overview

SKG is an integrated producer of corrugated paper. Integrated player means that it produces its own carton board to produce the final product, i.e. carton boxes.  Revenues are primarily driven by corrugated boxes prices. There are many corrugators in Europe and the market is very fragmented with the top 5 producers representing only 50% of the market. One of the reasons for the fragmentation is that radius of delivery is maximum 200km: it doesn't help to have a massive corrugated plant if you can't serve your customer in a timely manner. Barriers to entry to this end market are relatively small since a corrugating machine is not that expensive. The real barrier to entry is rather the size of the operation on a European basis and its ability to service Pan-European customers as well as the degree of integration.

In Europe, the vast majority of paper that goes in the production of carton boxes is recycled paper. Europe is "long" recycled paper, i.e. it recycles more than it needs. Additional surplus of recycled paper is usually shipped to China, as China is short recycled paper. Carton board derived from recycled paper is called Testliner, and it's the key component for what are commonly referred to as "brown boxes". Unlike corrugated paper, Testliner production requires very large machinery and very large up-front investments. Non-integrated players need to buy Testliner in the market to produce brown boxes. These small players are typically squeezed between large customers (The Unilever and Kraft of this world) and price-taker position on the supply side. When raw material prices rise, these players struggle to pass on their increase input costs to customers and get squeezed.

The other paper grade that goes into the production of boxes is Kraftliner. US investors will be more familiar with this grade being the most common one in the US. Kraftliner is typically higher quality paper, white coloured and comes from virgin pulp. It is difficult to distinguish between profitability in terms Testliner and Kraftliner based boxes as in many cases a box contains some of both. Kraftliner are typically more expensive (€100-200 per tonne premium) and are harder to get in Europe since Europe is short Kraftliner.

SKG is very well positioned in the industry being almost entirely vertically integrated. In fact, SKG is net seller of Kraftliner for 500k tonnes out of a production of 1.5m tonnes. This is a positive element to the story because Kraftliner is structurally in shortage in Europe and this gives additional downside protection / flexibility to SKG. Conversely, SKG is short 530k tonnes out of a total production of c. 3m tonnes. Again, in the long term this is a good thing because Testliner is structurally over-supplied in Europe

SKG ultimately makes money by selling the ultimate product, i.e. corrugated packaging. Its clients are typically food and beverage companies (60%), consumer products and others (industrial, agricultural products) that require packaging solutions. It is important to note that price of containerboard (kraftliner or testliner) is almost irrelevant to SKG's profitability (except for the half a million tonne of Testliner/Kraftliner they buy/sell respectively in the market). What drives profitability is the ultimate price they contract with their customers on the revenue side and input costs, which we'll see below.

Margin volatility and earning quality

Many investors are typically spooked by the apparent volatility in margins because of input costs volatility. Our key contention is that margins are much more stable than people are led to believe and input cost volatility tend to be managed in the short term:

• 1. First of all, SKG's prices are much more stable than any of its competitors. Whilst a corrugated box is in itself is a commodity, SKG offers much more than that to its clients. For example, SKG has teams of people sitting in their customer's plants permanently (Unilever, Inbev etc.) to design their packaging (In Store marketing and In Store logistics solutions). They are much more than simple commodity provider. Because of this, they typically receive premium prices for their boxes. Equally important, SKG has in place long term flexible contracts. 56% of their contracts are negotiated and 35% are auto indexed. Only 9% of their contracts are fixed. This means that when input costs go up, they can automatically, or semi-automatically, increase prices. This happens with one to 2 quarters delay but investors tend to worry about that single quarter when they get squeezed. Q1 2011 was one of these quarters when higher input costs weren't immediately passed on to customers. Company had a profit warning because of this in May 2011.
• 2. Since SKG is an integrated paper, the key cost drivers are containerboard input costs, i.e. raw materials (46%), energy (16%, logistics (11%) and other costs. Raw material is basically recycled paper. Recycled paper (usually referred to as OCC, or old corrugated paper) is currently trading at approximately €162/t. This used to be €50-60 per tonne up in H1 2009. In 2010 alone it almost doubled. SKG has a competitive advantage in that has a total "grip" of 80%. Grip means direct or indirect control over raw material via own depots, direct contracts with retailer and waste managers. Nobody in Europe has this level of grip, which means that input cost volatility is much lower for SKG than for other players. In turn, this means that SKG can better absorb price shocks than its peers and doesn't need to continuously adjust their prices to their customers. Customers value this and it's one of the reasons why SKG is gaining market share with large customers. For example, sales to Pan European customers are up 17.5% in last 2 years. SKG is by far European's largest user of recovered paper and the 2^nd worldwide after Nine Dragons in China. This is a key competitive advantage of SKG

Business quality

We believe SKG to be a high quality business for the following reasons:

• 1. Size matters - SKG is the largest corrugator in Europe. Second player SCA has less than half of SKG's market share. Size is important for a number of reasons:
  • a. Large customers like Unilever want their packaging to look all the same and they want to deal with a single supplier for every country. SKG is the only truly European player
  • b. Whilst corrugating plants are typically small, containerboard plants are very big and require economies of scale to be profitable
  • c. Logistics and transport represent c. 11% of input costs. SKG has an efficient network of over 100 corrugators in Europe to maximise efficiency
  • d. Size allows SKG to have a "grip" on raw material, as explained above, that nobody in the industry has
• 2. High barriers to entry - whilst in theory it is easy to build a corrugated plant, it wouldn't be profitable today for a non-integrated player because of high input costs. To be integrated, you'd have to build a testliner and a kraftliner plant, something that hasn't happened in Europe in years and requires massive capex. At current input costs and corrugated prices, it wouldn't be profitable for someone to invest in such a project, especially given the uncertainty on input costs (new entrant would be exposed to market price volatility in recycled paper given lack of "grip") and end prices (given lack of relationship with large customers, new entrant would be just a price taker on corrugated boxes)
• 3. Resilient cash flows - This is a company that has consistently generated predictable EBITDA margins and strong cash generation for the past 15 years. 2006 was the only year in SKG's recent history of negative cash flow and this was very much to do with the integration of JSG and Kappa following the 2005 merger. In terms of EBITDA margin, in the last 15 years it was always between 12% and 15%, so we can think about mid-cycle margin at 13.5%
• 4. Growing business - whilst the paper industry is in secular and structural decline in Europe, the paper packaging industry is growing in line with economic activity. Moreover, SKG is particularly exposed to fast growing consumer branded business. SKG is winning contracts with large multinationals like Heinz, Kraft, Pernod Ricard and Pepsico that are increasingly concentrating their packaging operations with SKG. For example, SKG's business with Pepsico increased by 140% between 2006 and 2010

Management quality

We believe management is an important element of the value creation story. Gary McGann has been CEO of the group since 2002 when he was appointed CEO of JSG. COO Tony Smurfit, member of the Smurfit family and a large shareholder, was CEO of Smurfit Europe and became COO of the merged group in 2005. Management is very focused on return on capital employed and shareholder value creation. They are used to run a leveraged capital structure to enhance shareholder value. At IPO, they announced a leverage target of 3 to 4x Net Debt / EBITDA. Given market conditions and 2008-09 crisis, management decided to change its range to 2.5 to 3.5x Net Debt / EBITDA target. Management target remains 10% Return on Capital Employed through the cycle. This would imply a return on equity of 15-20% assuming 7-8% in cost of debt.

Management uses different levers to deliver high ROIC, not only financial leverage. Cost cutting is an absolute priority for SKG. In 2008 management undertook a cost take-out programme that delivered €306m of cost cuts to date, equalling almost 5% of sales. New 2011-12 programme assumes further €150m of savings. Some of these additional savings are going to flow to the bottom line of the P&L. CEO stated that as results of these measures, along with other benefit from better "grip" on raw material procurement and commercial effort, SKG should earn 1 to 1.5% higher margins throughout the cycle than in the past. This would imply a mid-range EBITDA margin of 14-15% once these cost cutting measures are fully implemented.

Analysts are concerned that management will not be able to fully recover higher input costs and don't give the benefit of the doubt. Given their track record, we do. Management indicated in 2010 that from September 2009, price increases of 20% would be needed to recover higher input cost. Remember that OCC trades today at over €160/t Vs less than €40/t in Q1 and Q2 2009. As of April 2011, corrugated prices did increase by 20% as management targeted. However, given accelerating OCC prices, predominantly driven by strong Chinese demand for recycled paper, additional price increases in the order of magnitude of 3-4% are needed to fully offset higher input costs. SKG is the largest producer in Europe and it is therefore the one that many competitors look at before rising prices. When SKG moves prices higher, other competitors tend to follow as they tend to have much lower margins than SKG.

Finally, we are not concerned about dilutive M&A. Whilst the sector is highly fragmented and ripe for consolidation, management has a very rigorous capital allocation policy and will not make a large acquisition unless its synergies would make the case compelling. We see M&A as a potentially positive catalyst.

Valuation

At current prices, SKG trades at little over 6x P/E 2011 and 4.3x EV / EBITDA with a 16% free cash flow yield. FCF yield is expected to be above 20% in 2012. Moreover, as Net Debt / EBITDA falls to below 3x in 2011, we think that the company will reinstate a dividend in 2012. We think the company could sustain a dividend of over 60p from 2012 for a dividend yield of over 8%.

Fair value: many sell side analysts focus on the cyclicality of the business. If we use a 14-15% mid-cycle EBITDA margin, as explained above, we get some €1.05-1.1bn EBITDA as mid cycle EBITDA. In terms of multiples, let's look at most recent M&A:

• SSCC is direct comparable in the US and was acquired in January 2011 by Rock-Tenn in a cash and share deal that valued the company at above 6.5x EV / EBITDA current year (2011)
• In June of this year, International Paper made hostile bid for Temple Inland implying EV / EBITDA valuation for 2011 of over 7.5x.

If we apply a conservative 15% discount to the lower multiple paid this year we get a 5.5x EV / EBITDA multiple. We feel this to be very low, at the very bottom of the European paper and packaging industry, for a business that is arguably the best in its sector. At 5.5X EV / EBITDA, we get a fair share price of between €11 and €15, implying an upside of between 40 and 80%.

Catalyst

• Q2 2011 and especially Q3 2011 will vindicate management stated aim to fully recover input cost increases by implementing price increases
• Continuous delivery of cost take-out programme
• Continuous deleverage that will bring to dividend reinstatement in 2012
• Possible M&A will be a catalyst