Description

It’s 2021, the year of work from home, the digital revolution, nay, the metaverse. And the most interesting spin-off of the year is…an uncoated freesheet paper company.

International Paper (IP) spun out its uncoated freesheet paper (“UFP”) business as Sylvamo on October 1^st. IP shareholders, there for the longstanding dividend (3.5% yield) and ecommerce containerboard exposure, have jettisoned their rounding error stake in Sylvamo.

Sylvamo is 5% of the combined company, it doesn’t pay a dividend, there’s only one analyst, there’s no US public comp, it’s highly leveraged, and it makes paper. What else could you want?

I think Sylvamo is worth substantially (50+%) more than current trading levels. This write-up will establish the following:

1. Sylvamo’s economic trajectory is fundamentally different than most would assume due to owning the lowest cost mill in North America and low-cost duopolies in South America and Europe
2. The public comparable with a comparably advantaged cost curve position trades for 12x EBITDA – CapEx, compared to Sylvamo at 6.6x
3. Near-term trends are positive as a resumption of demand (back to school, office) collides with lowered industry capacity from mills shut or converted to containerboard 
4. Estimates from the one publishing analyst are much too low

Point 1: Low-Cost Position / Better Secular Outlook

SLVM’s Brazilian operations represent ~50% of ongoing profitability. These plants are vertically integrated into owned eucalyptus plantations, making them perhaps the lowest cost global paper mills. As the company noted in its investor presentation, “global low-cost position allows all Sylvamo Brazilian mills to run at full capacity.” Old IP disclosure further reinforces this point – consider the following snippet which demonstrates best-in-class margins and flat tons sold for years prior to the pandemic. Moreover, Suzano and SLVM anchor the LatAm market and have historically behaved like a stable duopoly.      

SLVM’s European operations represent ~30% of ongoing profitability, with the presence anchored by 1^st quartile mill Svetogorsk. While this mill is not vertically integrated into its own plantations (and thus lower margins than Brazil), it ought to produce full out for a very long time as higher cost mills close or convert to containerboard. Svetogorsk and Mondi anchor the Eastern European market and have historically behaved like a stable duopoly.

SLVM’s North American operations are anchored by Eastover, the lowest cost UFP mill in the region. This mill should produce full-out for decades as other higher cost mills eventually shut or convert to containerboard.

To recap the general argument: everyone knows that UFP demand is declining, with developed regions (North America) exhibiting worse trends than emerging economies (Brazil, Eastern Europe). Nevertheless, due to the company’s highly advantaged cost curve position, the significant majority of SLVM’s production capacity will produce full out (read: flattish EBIT) for decades and thus not decline in concert with overall paper demand trends.

Point 2: Close Comp in Europe

Many investors will instinctively focus on Domtar as the appropriate comparable. Domtar is a mix of 100% North American UFP production (worst market structure and secular outlook) and merchant pulp production (a much more volatile business). Their mix of mills is substantially less advantaged than Sylvamo and thus will have more pronounced volume declines. Based on my estimate of normalized EBITDA – CapEx, Domtar traded for 6.4x EBITDA – Cx prior to deal rumors (using a share price of $38.50) and is being acquired by Paper Excellence for 9.0x EBITDA – Cx. 

However, the real comp for most of SLVM trades on the Portugal exchange – The Navigator Company (NVG PL). NVG is a near-pure play UFP company with a market leading position in Western Europe. The company’s investor materials have excellent charts outlining the European market structure and the impending mill closures from competitors. NVG trades for 8.1x EBITDA, 12.2x EBITDA – CapEx and 13.2x P/E, with the valuation multiples conveying that investors expect flattish cash flows in near perpetuity. I believe NVG is a close comp for SLVM’s LatAm position, Svetogorsk and Eastover (collectively ~85% of SLVM ongoing EBITDA).

Point 3: Positive Near-Term Trends

Industry data suggests that back-to-work and back-to-school have driven increases in UFP demand from the COVID lows, with increased demand colliding with structurally lower production capacity due to mills shut or converted to containerboard. NVG reported strong Q3 earnings on 10/28 (which strangely had no impact on SLVM stock, although NVG appreciated) and noted: 

• “…paper demand is strong, especially in Europe, taking order books to historically high levels”
• “The third quarter of 2021 represents a clear improvement on the second quarter of the year”
• “PIX A4-Copy B paper index rose by 3% from the 2^nd quarter to the 3^rd quarter”
• “Navigator closed the quarter with an order book of 61 days…ending September with 11 stock days, an all-time low record”
• “The benchmark index for office paper in Europe stood at €866 / ton at the end of September, up from €806 / ton at the start of the year”

The NVG financials go on to note that benchmark prices for Q3 were €843 / ton, indicating a further 2.7% price increase to their exit rate as of September. As can be seen in transcripts, UFP companies report results with a lag to market price trends as it takes time to push prices through their contracts.

While SLVM will report full standalone earnings soon, International Paper’s release from 10/27 with snippets on the paper business noted that “performance in the third quarter was strong with continued demand recovery globally and price realization outpacing rising input costs.”

Point 4: Sell-side Estimate Too Low

Bank of America’s analyst initiated on SLVM with a Buy and a $38 price target. The figures used to generate this price target, though, are much too conservative in my opinion. First, he underpins his analysis with $472mm of normalized EBITDA. His estimate excludes two mills under offtake agreements with IP (we exclude these, too), though he does not give credit for the interim free cash generation from these mills (which we estimate as ~$220mm after-tax or $5 / share). He derives this normalized EBITDA using cycle-average per ton EBITDA of $100 for North America, $115 for Europe, and $185 for LatAm.

However, old IP Data suggests that SLVM's LatAm facilities have produced ~$229 / ton of EBITDA (pre-pandemic average). 

The analyst uses comparably conservative figures for the other regions. North America averaged ~$141 / ton of EBITDA pre-COVID, compared to his normalized estimate of $100 / ton. Europe averaged ~$135 / ton compared to his estimate of $115 / ton.

I believe he likely set intentionally conservative figures considering he is the first initiating analyst on a new company and  he wanted to create a margin of safety.

Nevertheless, even taking haircuts to pre-pandemic profitability yields normalized EBITDA considerably higher than BAML – my own analysis yields $550 million of normalized EBITDA excluding the offtake mills.

Offtake Mills

SLVM and IP have a put / call arrangement related to two small North American mills to accommodate IP’s potential need to convert one or both to containerboard production in the future. In the meantime, IP pays for the CapEx at these facilities and SLVM earns the EBITDA. Assuming IP takes back the mills one year after the minimum call date implies ~$220 million of after-tax NPV of cash flow for SLVM. I am happy to elaborate on the assumptions in this analysis if anyone has questions. Notably, if IP migrates this production capacity from UFP to containerboard it will only serve to enhance the value of SLVM’s remaining UFP facilities.

Valuation

SLVM spun with $1.4 billion in reported net debt. I further penalize this figure for $41 million in after-tax spin expenses, a $30 million working capital payment to IP, $165 million of one-time after-tax CapEx for a Russian boiler project, and $60 million for the near-max liability from a Brazilian tax issue. I net against these figures the $222 million in NPV from the offtake mills.

I believe the above argument establishes that SLVM deserves a meaningful premium to Domtar’s undisturbed valuation and probably a modest discount to The Navigator Group listed in Portugal. I use 8x EBITDA – CapEx myself, which implies a share price of ~$41 / share, although I think this is the output of numerous conservative assumptions. Should the market eventually value Sylvamo comparably to The Navigator Company, the share price will more than double.

Catalyst

First, I believe SLVM will report better than expected earnings for Q3 and Q4, with the run-rate implied from those reports suggesting that the sellside normalized estimate is too low. Second, I expect multiple sellside initiations and the passage of time to increase investor awareness of the opportunity.