Description

As a follow-up to armand440's write-up from March 2006 (price at the time of the long equity recommendation was ~$13 / share - with net debt at the time of around $4Bln and equity market capitalization of ~$1.8Bln, equated to a TEV of roughly ~$5.8Bln), I am recommending a long position in the Smurfit Stone Container ("Smurfit" or "SSCC") bonds at ~35 cents (effectively creating the business for around ~$1.8Bln - details noted further below or approximately 25% of the valuation ascribed by Mr. Market just 2-years ago and ~35% of the valuation ascribed just 9 months ago) which presents a compelling near-term risk / reward proposition, with total return potential of >100% over the next 3 - 6 months (based on probability tree matrix further below).  In addition, as we look at the upside / downside to various reorganized stub equities (reference Ackman's General Growth presentation - slides 24 - 32 in particular - at the Ira Sohn conference re: U-HAUL, Alexanders, etc), I'd label SSCCQ equity (trades on the pink sheets as the company filed for bankruptcy in late January 2009) as a hyper-call option with the potential for >10x return on invested capital (currently at around 10 - 15 cents / share).  It's also worth pointing out that one of the more attractive aspects to the SSCC long investment thesis (bonds / equity stub) is that there are multiple /  liquid securities to "hedge out" market risk (re: containerboard pricing concerns - which is the biggest near-term risk in my mind).  In particular, I'd favor International Paper (IP - 800-pound guerilla in the containerboard space and notable that their containerboard division has been their saving grace post their acquisition of WY's containerboard division) and Temple Inland (TIN) CDS (both IP and TIN CDS trade in the 200 - 220 context which compares to Jan - March wides of 870+ / 910+, respectively) or alternatively looking at the equity puts or shorting the equities outright. 

VALUATION:

Based on my 2009E EBITDA of $400MM (note that if you remove some of the one-time derivative / swap termination charges in the Q1 period, run-rate EBITDA is closer to ~$500MM based on Q1's PF EBITDA of $120 - $130MM - while I'm using the $400MM 09E EBITDA, I believe there is an incremental cushion especially as we take into consideration further contract rationalizations of the overly-punitive contracts and right-sizing the cost structure should be one of the key benefits of going through a bankruptcy proceeding and Q1 saw early / promising signs of this), SSCC trades for around 4.4x through the bonds (which compares to its public peers - IP / PKG / TIN - which trade for a 2 - 3x multiple premium - my view is that this should be less than a 0.5x - 1x premium in the near-term).  Moreover, based on my "normalized" EBITDA of $550 - $600MM (i.e. mid-pt of peak EBITDA from the 2006 - 2007 period of $700 - $750MM and trough EBITDA of $400 - $450MM), the business can be created (assuming an entry price of ~35 cents on the bonds) for less than 3.1x.  This mid-cycle creation multiple compares to my view that a FV multiple will likely be closer to 5.5x - 6.5x depending on how generous / "whiskey-induced" Mr. Market wants to be).  Given this ~2.5x - 3.5x multiple discount to FV (and assuming $575MM of EBITDA), this equates to another $1.4Bln - $2.0Bln of FV value to the unsecured claim pool.  Using $1.4 - $2.0Bln in the numerator and ~2.4Bln in the denominator (as the unsecured pool which does not include the underfunded pension claims with the rationale being that I think the PBGC will defer / work with the company to manage through this period - discussed in more detail below), this equates to another 55 - 82.5 cents of additional value to the bonds.  Using a somewhat punitive 25% discount rate and 1 - 1.5 year bankruptcy proceeding (multiple conversations with the advisors involved would suggest the process is being played out for the full / 1.5-yr duration to provide greater visibility on a "mid-cycle" EBITDA), this brings my FV bond valuation closer to 75 - 100 (or 40 - 67.5 pts of upside versus the current 35 entry point- upside / downside scenarios below).

BRIEF CO BACKGROUND / SUMMARY THESIS:

As you recall from armand440 write-up, Smurfit is the 2^nd largest player in the containerboard industry with revenue of approximately ~$7Bln and properties which include: 16 paper mills (13 US, 3 Canada); 124 container plants (102 US, 16 Canada, 3 Mexican, 2 China, 1 Puerto Rico), 24 reclamation plants, 1 paper tube/core plant, 1 wood products plant, 1 lamination plant (Canada).  The Company has its roots deeply implanted in the Mid-West - Stone Container has its roots in Chicago and Jefferson Smurfit in St. Louis - which means that a significant % of its business is beer / soda / pizza boxes / Internet purchase related (end-markets include Food & Bev - 44%, Household - 30%, Durables - 16%, Non-durables - 10%.  While pricing pressure is probably the largest near-term concern on everyone's minds, its worth pointing that the top 5 players (IP - 29% market share / SSCC - 18% / GP - 11% / TIN - 10% / PKG - 6%) control over 75% of the industry (which - to date - has led to a rational inventory management / capacity closure dynamic).  Also worth pointing out that while I'm skeptical the industry has changed (i.e. management teams harp on the fact that consolidation has improved the pricing / inventory dynamic), my view is that SSCC and IP largely dictate the pricing moves given their focus on large customers who require automated / standardized production runs.

Overall, I view the Smurfit business as a hyper-call option on: (i) US GDP / velocity in general (regardless of your views on where the US economy is headed over the longer-term, its hard not to acknowledge the fact that if GDP is flat / slightly up in Q3 - Q4 2009, this will feel a whole lot different than the down -6% for the past 6+ months), (ii) the containerboard market in specific (given the fact that 50%+ of SSCC revenues are driven by food / beverage - for SSCC, given their particular exposure in the Midwest, you're making a near-term bet on the Big 10 football season) and (iii) pension deferral or less punitive view on the pension claims (my best guess at this point is that there will be an announced agreement over the next couple months with the PBGC for a "Hardship Deferral" that effectively allows for Smurfit to defer any pension obligation payments until the end of 2011 - if viewed in this light, and using your own assumptions on the markets / the potential for improved legislation under Team Obama during this 2 / 3 year period - given its highly likely he'll continue to help aid the bloated / pension-infested US industrial base, the pension claims could be materially reduced and in particular, could be very easily managed on a reemergence scenario).

CAPITALIZATION:

UPSIDE / DOWNSIDE:

UPSIDE: assuming 6 - 6.5x multiple to "mid-cycle" EBITDA (let's assume Mr. Market goes a bit of a drinking booze - given Bernanke's penchant to infuse $ into the system, this seems to be a higher probability scenario by the day as we're probably witnessing the near-term formation of multiple future bubbles), equates to a discounted recovery value of ~75 - 102.5 bond pts (which has been discounted back at 25% / 1.5 yrs) and compares to ~35 current or approx >100 - 193% upside.  Re: the equity, looking at the Pilgrims Pride and GGP equities as relevant / recent proxies, the upside could be $1.50 - $3.00 / share (vs current 10 - 15 cents) if we see a "real economic" recovery (especially given SSCC's significant exposure to defensive food / beverage end-markets, this does not seem like a stretch - notably, this compares to Mr. Market's $6 - $7 / share value ascribed to SSCC equity just 9-mths back).  Given the high octane nature of the Smurfit business and Mr. Market's penchant to slap a high "mid-cycle" multiple on above "normal" earnings, this scenario could be real possibility

BASE: assuming 5 - 6x multiple to "mid-cycle" EBITDA (let's assume Mr. Market tempers his drinking binge), equates to a discounted recovery of approximately 55 - 77.5 bond pts (which has been discounted back at 25% / 1.5 yrs) and compares to ~35 current or approx 55% - 115% upside on the bonds.  Re: the equity, given the fact that the bonds would likely trade into the 60 - 70 range, an equity committee would likely be formed and depending on the committee dynamics / process / judge, I could see a scenario (comparable to what's going on in GGP / Pilgrims Price, etc) in which we see the equity trading for >$0.50 - $1.50 / share of value (vs current 10 - 15 cents) - this scenario is largely dictated by who buys the equity and how they organize a single voice

DOWNSIDE: assuming I'm off the mark on "normalized" EBITDA and it comes out closer to $500MM (versus my view of $550 - $600MM) and ascribe a punitive / 5x multiple - this results in a discounted bond recovery of approximately 40 - 50 (which has been discounted back at 25% / 1.5 years), and compares to current ~35 pts or approx ~15% - 45% upside

CATALYSTS:

NEAR-TERM (1 - 3 months): ASSET SALES - most likely culprits include selected facilities - ala the Fullerton plant chatter in multiple news sources from earlier this week - and timberland assets ($100 - $250MM of potential value)   

NEAR-TERM (1 - 3 months): Q2 RESULTS LESS BAD THAN FEARED - for the industry surprise to the upside (largely driven by end-market pricing holding up / and input cost benefits providing a big boost - with the two big movers being virgin fiber and caustic soda - note that spot prices are being quoted in the sub-$200 range versus peak mid-2008 levels of >$800)

NEAR-TERM (1 - 3 months): ADDITIONAL MANGEMENT CHANGES / NEW TALENT -SSCC recently hired John Murphy as its new CFO (he formerly led Accuride from 1998 - 2008 - reputation as a highly proactive executive) and replaced Chuck Hinrichs.  Over the next couple months, I would NOT be surprised to hear a CEO transition with the most likely scenario being Steven Klinger - formerly with GP / solid reputation / current COO - as the replacement.  If Klinger were to be the new CEO, I'd view this as very positive given it's a strong statement on taking a fresh / more cost / capital efficient approach (note that current SSCC management has a reputation of being a bit lazy and a bit bloated) and also may help augment selective (or potentially a larger strategic) asset sales down the road (GP - backed by the deep-pocketed Koch family - or IP would likely be the top culprits BUT I wouldn't be surprised if TIN / PKG was interested in selected assets).

NEAR-TERM (3 - 6 months): FACILITY CLOSURES / HEADCOUNT RATIONALIZATION - the Q1 10Q detailed early steps in rationalizing costs which were encouraging (including headcount reductions that should equate to $50 - $100MM of cost savings and potential for further facility closures).  In addition, there were detailed notes on one-time expenses for rataionalizing contracts (when you factor in these $20 - $30MM of costs, note that Q1 2009 EBITDA was in the $120 - $130MM range which suggests run-rate EBITDA is closer to $500MM).  I'd anticipate further disclosure in the Q2 10Q that provides updates on these cost cutting initiatives

NEAR-TERM (2 - 9 months): SSCC BALANCE SHEET IMPROVEMENT - continued balance sheet improvement from the realization of potential asset sales / black liquor tax credit - NOTABLE as the DIP (w/ a overly-punitive 10% coupon) will likely be paid back in full over this period

NEAR-TERM (1 - 3 months): CAPACITY CLOSURES - I don't mean to toot DB analyst's horn (Wilde), but the most likely scenario (which I agree w/) is that Smurfit will lead the way w/ more permanent closures and IP / GP will follow suite

NEAR-TERM (1 - 3 months): PENSION CLARITY - Over the next couple months, I'd anticipate getting more clarity re: pension payments and in particular around a potential Hardship Deferral which would most likely allow the Company to defer payments until end of 2011.  Using your own views on the market level, discount rate, etc, I get to a potential claim that's significantly below the $1Bln underfunded amount at year end ($300 - $500MM).  More pragmatically, pension is an issue that ails the entire containerboard industry (not to mention most of the US industrial base).  Given how critical this issue is, I'd anticipate seeing pension legislation over the next 6 - 18 months that provides additional cushion to businesses to manage through these issues (pay out over longer period of time) - any form of legislation would be encouraging for the SSCC long bond / equity position.

NEAR-TERM (1 - 6 months): TECHNICALS / BONDHOLDER BASE IMPROVES - Over the past few months, we have seen the bondholder base transition from fast money players (that successfully purchased the bonds in the teens and traded out in the 20 - 30 range with the credit rebound) to "longer-term" distressed / value players (perhaps this is also a misnomer but let's assume the days of severe redemptions have alleviated).  This is a positive technical dynamic from BOTH downside protection (there are multiple buyers in / around this level) BUT also provides longer-term clarity on the fulcrum security (i.e. having deep-pocketed value funds that want to own the equity in a post-reorganized business is critical for the longer-term "par+" recovery.

MEDIUM-TERM (3 - 6 months): LARGER / STRATEGIC ASSET SALE(S): Company advisor (Lazard) will likely leverage (no pun intended or mockery of SSCC's ultimate bankruptcy filing) their M&A department to seek out selective asset sales (notable as the WY containerboard business has been the IP saving grace - given the credit market easing w/ IP doing a recent deal at ~9.5% - there may be opportunities to pick up assets that are highly accretive to SSCC bondholders) 

LONG-TERM (1 - 2 years): NORMALIZATION - potential reflation / normalization and Mr. Market ascribes a 6.5x+ multiple to "mid-cycle" earnings of $550 - $650MM (as in any cycle, there will likely be an overshoot to the upside)

KEY RISKS:

NORMALIZED EBITDA: given the benefits of rationalizing contracts, my view is $550 - $600MM.  If I'm wrong, the benefit of this trade is that there are very liquid "hedges" available to take remove any concerns you may with further pricing pressure and the underlying cyclicality of this industry

PENSION: ~$1Bln underfunded amount at YE.  While I view the highest probability scenario as longer-term deferral / and ultimately the PBGC working with Smurfit to help alleviate this potential claim, I fully acknowledge this is a risk.  Fortunately, most of the Street has assumed the full $1Bln underfunded amount in their waterfall analyses so is already factoring in the most punitive / downside scenario (thus, the margin of safety is any surprise announcement of payment deferrals / legislation, etc)

EXIT FINANCING: while this was a concern in the Feb - April period (before the credit market rallied and BEFORE SSCC disclosed they would likely receive >$400 - $500MM of black liquor tax credits), I view this as much less of a concern.  The primary reason is that I fully anticipate the DIP being paid off in full over the next 3 - 6 months given there is approximately $300MM of cash on the balance sheet (as of April per the latest MOR) and the Company has already begun to receive tax credits ($150MM came in at the end of May) - which compares to $440MM of outstanding DIP.  Assuming around $1.1 - 1.25Bln of secured claims (net of cash / tax credits) upon the exit (mid-2010),

CREDIT / EQUITY SIDE-NOTE:

On a side note, as I look across the credit spectrum (which has been on an absolute tear - and that's probably an understatement), I view the Smurfit bonds as having one of the most attractive risk / reward profiles (given the low-$ price point / the business fundamentals / the multiple "hedges" that can help remove "market" risk / improved technicals / multiple near-term and longer-term catalysts).  More pragmatically, my sense is that we're starting to (or have seen) real capitulation on the short side within credit (this is clearly witnessed through the CDS market at large - hard to find many credits that are wide of 500 bps).  More to the point, on the credit side, it seems like funds that were stubbornly bearish have started to chase performance (perhaps because of the massive cash hoards and mandate / perhaps because of LIBOR being sub 1% and Bernanke showing no signs of easing) - in addition, there appears to be a tremendous amount of new money entering the credit system with a long bias (this may be a massive head-fake).  Overall, given the moves in credit, Smurfit seems like one of the few / remaining mis-priced securities (especially as you compare this business to other highly-leveraged / more challenged industry verticals such as gaming / building products, etc).   

On the flip side, sentiment in the equity markets (in my humble / naïve opinion) is still stubbornly binary (this may be rightly so).  As we look at the high-octane potency of the SSCCQ equity, the true upside case of $1.50 - $3.00 / share could (as viewed as a call option) be very potent especially if we see the same type of equity capitulation / chasing performance / sentiment shift as we're witnessing in the credit markets (I guess my point being, if you think HY credit is fairly priced, COULD arguably make an argument that the equity markets are on the cusp of various / nuanced bubbles within certain industries).  While I'm still very skeptical of this type of scenario in the equity markets, I'm cognizant of the massive reflation that Bernanke / and his $ dumping helicopters have opened up.  Overall, if you think the reflation scenario has a real probability of occurring, the SSCCQ stub equity could be a nimble / cheap way to articulate a hyper call-option

Catalyst

NEAR-TERM (1 - 3 months): ASSET SALES - most likely culprits include selected facilities - ala the Fullerton plant chatter in multiple news sources from earlier this week - and timberland assets ($100 - $250MM of potential value)   

NEAR-TERM (1 - 3 months): Q2 RESULTS LESS BAD THAN FEARED - for the industry surprise to the upside (largely driven by end-market pricing holding up / and input cost benefits providing a big boost - with the two big movers being virgin fiber and caustic soda - note that spot prices are being quoted in the sub-$200 range versus peak mid-2008 levels of >$800)

NEAR-TERM (1 - 3 months): ADDITIONAL MANGEMENT CHANGES / NEW TALENT -SSCC recently hired John Murphy as its new CFO (he formerly led Accuride from 1998 - 2008 - reputation as a highly proactive executive) and replaced Chuck Hinrichs.  Over the next couple months, I would NOT be surprised to hear a CEO transition with the most likely scenario being Steven Klinger - formerly with GP / solid reputation / current COO - as the replacement.  If Klinger were to be the new CEO, I'd view this as very positive given it's a strong statement on taking a fresh / more cost / capital efficient approach (note that current SSCC management has a reputation of being a bit lazy and a bit bloated) and also may help augment selective (or potentially a larger strategic) asset sales down the road (GP - backed by the deep-pocketed Koch family - or IP would likely be the top culprits BUT I wouldn't be surprised if TIN / PKG was interested in selected assets).

NEAR-TERM (3 - 6 months): FACILITY CLOSURES / HEADCOUNT RATIONALIZATION - the Q1 10Q detailed early steps in rationalizing costs which were encouraging (including headcount reductions that should equate to $50 - $100MM of cost savings and potential for further facility closures).  In addition, there were detailed notes on one-time expenses for rataionalizing contracts (when you factor in these $20 - $30MM of costs, note that Q1 2009 EBITDA was in the $120 - $130MM range which suggests run-rate EBITDA is closer to $500MM).  I'd anticipate further disclosure in the Q2 10Q that provides updates on these cost cutting initiatives

NEAR-TERM (2 - 9 months): SSCC BALANCE SHEET IMPROVEMENT - continued balance sheet improvement from the realization of potential asset sales / black liquor tax credit - NOTABLE as the DIP (w/ a overly-punitive 10% coupon) will likely be paid back in full over this period

NEAR-TERM (1 - 3 months): CAPACITY CLOSURES - I don't mean to toot DB analyst's horn (Wilde), but the most likely scenario (which I agree w/) is that Smurfit will lead the way w/ more permanent closures and IP / GP will follow suite

NEAR-TERM (1 - 3 months): PENSION CLARITY - Over the next couple months, I'd anticipate getting more clarity re: pension payments and in particular around a potential Hardship Deferral which would most likely allow the Company to defer payments until end of 2011.  Using your own views on the market level, discount rate, etc, I get to a potential claim that's significantly below the $1Bln underfunded amount at year end ($300 - $500MM).  More pragmatically, pension is an issue that ails the entire containerboard industry (not to mention most of the US industrial base).  Given how critical this issue is, I'd anticipate seeing pension legislation over the next 6 - 18 months that provides additional cushion to businesses to manage through these issues (pay out over longer period of time) - any form of legislation would be encouraging for the SSCC long bond / equity position.

NEAR-TERM (1 - 6 months): TECHNICALS / BONDHOLDER BASE IMPROVES - Over the past few months, we have seen the bondholder base transition from fast money players (that successfully purchased the bonds in the teens and traded out in the 20 - 30 range with the credit rebound) to "longer-term" distressed / value players (perhaps this is also a misnomer but let's assume the days of severe redemptions have alleviated).  This is a positive technical dynamic from BOTH downside protection (there are multiple buyers in / around this level) BUT also provides longer-term clarity on the fulcrum security (i.e. having deep-pocketed value funds that want to own the equity in a post-reorganized business is critical for the longer-term "par+" recovery.

MEDIUM-TERM (3 - 6 months): LARGER / STRATEGIC ASSET SALE(S): Company advisor (Lazard) will likely leverage (no pun intended or mockery of SSCC's ultimate bankruptcy filing) their M&A department to seek out selective asset sales (notable as the WY containerboard business has been the IP saving grace - given the credit market easing w/ IP doing a recent deal at ~9.5% - there may be opportunities to pick up assets that are highly accretive to SSCC bondholders) 

LONG-TERM (1 - 2 years): NORMALIZATION - potential reflation / normalization and Mr. Market ascribes a 6.5x+ multiple to "mid-cycle" earnings of $550 - $650MM (as in any cycle, there will likely be an overshoot to the upside)