Description

In a region challenged with economic uncertainty, we are expecting UPM's shares to produce a lower volatility, with a 3 to1 risk/reward profile paying you a 4% dividend yield while you wait for catalysts to take hold.

UPM offers an appealing earnings profile with a 10% EBIT CAGR, reaping the benefits from its self-funded >€4bn transformational capex & paying a 4% dividend yield (1x net debt/EBITDA).  UPM is the #2 power generator in Finland and is net long energy at a group level. UPM clearly has been underappreciated for its energy division. We see €556m Energy division EBIT, is 40% ahead a limited €400m consensus. The upside case is partly built on better-than-expected macro, above 10-year average pulp prices levels. 2022-27E: We also see material profit upside due to our expected special dividends, share buybacks, and value-accretive M&A. We also added a sector re-rating for ESG premium. These assumptions generates an upside of €45 based on >€30 industrial SOTP, €6 forest value, and €10 for growth projects. The downside is assuming a macro slowdown with faster structural decline in graphic paper and lower prices. Weaker global pulp prices below 10-year average prices. Transformational capex projects encounter operational delays or issues ramping up. Downside get you to a €30. based on €22 industrial SOTP, €5 forest value, and modest >€3 value for growth projects.

Company fundamentals:

To better understand the opportunity outlined below, we need to detail UPM’s energy production capacity breakdown. UPM's renewable power generation capacity is 37% hydropower (726MW), c55% nuclear (1,082MW), which includes the new OL3 plant of 494MW (c25% group) and c8% condensing. OL3 will increase UPM's carbon free electricity generation by nearly c50% and provides reliable CO2 free baseload energy to support electrification of society. UPM sources electricity from its part-owned energy companies at full cost, and the capital employed as at 2Q22 was €3.1bn (€4.80 per share). In our view, the value of the energy division is above the capital employed, and closer to above €3.5bn (or €5.50-€6 per share) assuming mid cycle multiples & pricing.

UPM is a biofore company consisting of six separate business areas. Traditionally a graphic paper producer, it has used FCF from its mature graphic paper businesses to transform itself by investing in growth projects in pulp, labelling materials, specialty paper/packaging, biofuels, and biochemicals.  Capital allocation is very strong which underpins our conviction. With modest 1x FY22E net debt and >€2bn liquidity, UPM has the financial flexibility to self-fund its transformational capex projects, as well as potential shareholder returns (buybacks/dividends) and/or M&A. Capex has been transformational at the company as well. UPM’s share price partially reflects upside from the company's transformational investments: 1) >€3bn Uruguay pulp mill; 2) €750m biochemical refinery 220kT (Germany); 3) possible 500kT biofuels (Netherlands); and 4) smaller-focused growth capex.

This transformation is clearly appealing for the long-term. UPM remains a quality P&P company, with an appealing earnings profile (10% pa 2021-25 EBIT CAGR), whilst paying a c4-5% dividend yield. UPM has the ability to self-fund >€4bn transformational >14% ROCE capex. We see the long-term appeal from the transformation capex, worth €6-9 per share, and believe that the energy division value will likely be highlighted at the upcoming 12 Sep Energy day.  A new green field pulp mill requires an investment of >€2bn+ and requires access to competitive low-cost fibre (wood), reliable cost-efficient logistics, new best-in-class mill technology, and a stable and predictable operating/regulatory environment. In our view, investors underestimate the complexity of these investments & the true barriers to entry of a global scale, low-cost green field pulp mill. We view the key barrier to entry as access to fibre as even in fast growing Southern Hemisphere regions trees take c7-15yrs to grow while they can take over c60-80yrs to grow in the Nordics. In our view the pulp/paper industry has a history of poor capital allocation, overspending in the good times and adding too much capacity that impacts pricing when it comes on stream, reducing industry returns & margins. Thus, we continue to monitor for new supply additions, as long-term overcapacity risks remain in this industry which has historically overspent in good times. However, given limited access to fibre globally, we think the barriers to entry are increasing.

What we are keeping a close eye on is the elevated Finland power price environment. Finland has not been immune to the wider European energy and gas crisis. The July power prices averaged €184MWh in Finland, which is approx. 4.5x above the 2011-21 average of €41MWh and 2023 futures prices have spiked to >€140MWh (see exhibit 4 from UPM's 2Q22 presentation). Longer term, we expect power prices to normalize. However, elevated prices likely to continue throughout 2023, a tailwind to UPM's energy division, where we see upside risk to cons. We have not seen industry discussion on windfall taxes in Finland, with focus rather on reducing Russia energy dependency. UPM has not disclosed its hedging ratio for its power output, but with their recent call noted that they do sell production up to 3-4 years into the future with a greater level of hedging near term. UPM positively has no hedges in place for new supply from the OL3 nuclear plant in 2023.

Given the volatility in power prices, we expect to be given more color in time, as it has a meaningful impact on earnings. Two years ago, the energy division EBIT was €270m (2012-21 avg: €174m) with UPM achieving a €52MWh price including hedges. This was 28% below the average Finland power price of €72MWh in 2021 (excluding hedges). All else equal, we estimate that at a €72MWh power price, the divisional EBIT would have been approximately €380m (vs €270m actual including hedges). If we assume 60-70% of volumes in 2023 were hedged, at average rates of €40MWh and 30-40% at spot 2023 power prices that could be >€120MWh, we could see a UPM hedged energy price of €65-85MWh for the underlying business in 2023, prior to including new OL3 nuclear plant volumes (sold at spot). We estimate €350-450m underlying energy division EBIT (prior to the ramp up of OL3) based on assumed €65-85MWh achieved UPM power prices including hedging (i.e. below the implied 2023 Finland energy futures prices). We estimate that new supply from the OL3 nuclear power plant, which will be sold at higher spot prices in 2023, could add >€150m incremental EBIT. We estimate €500-600m range for the Energy division, and our base case is €556m EBIT in 2023, which is c40% ahead of a limited €400m consensus.

New nuclear supply ramp up of OL3 can be a material tailwind into 2023. The new Okiluoto 3 (OL3) nuclear plant has 1,600MW of capacity, and UPM's c31% share of this is 494MW when it is fully ramped up. This is equivalent to 3.5-4TWh of capacity, assuming 80-90% operating rates (i.e. 494MW x 8760hrs pa x 90% = 4TWh). Regular electricity production from OL3 is scheduled to start in Dec-22, and we estimate 2.8TWh incremental electricity sales from OL3 for UPM in 2023 (c70% operating rate). With no hedges on this energy generation, electricity sales will be at spot prices and could be a material contributor to this year’s group EBIT. We estimate that OL3 alone could contribute €150-220m to EBIT (i.e. €100-120MWh price - €40MWh cost x 2.8TWh = €150-220m). We estimate every €10MWh price adds €20-30m to EBIT. This is material when putting into context that the 2021 EBIT for the entire energy division was €270m. UPM has not guided to any potential EBIT contribution, nor have they guided to the break-even power price needed for OL3, but in the past noted the initial EBIT contribution would be minimal at historical average prices (i.e. approx €30-40MWh). Overall, we estimate that OL3 would be broadly EBIT break-even initially at a €40MWh power price, with anything above this falling through to profit.

Last year, UPM saw a €1.1bn cash outflow from energy hedges due to the unprecedented rise in futures prices. If futures prices were to suddenly pull back, then UPM would receive a cash inflow of a similar amount as their futures margin account would be positive. If prices stay at elevated levels, then UPM would receive this cash flow back through the course of 2H22-2023 as it sells electricity at much higher prices. Our base assumes prices stay elevated into 2023, and thus we assume cash inflows coming through in 2023. We believe investors should look through the near-term cash flow implications as they are temporary. We forecast 1.1x net debt/EBITDA in 2022, declining to 0.5x in 2023 despite capex spending of >€1bn (200-300% of depreciation).

Valuation

UPM SOTP of €45: Our price target is based on SOTP EV/EBITDA multiples and a valuation range for UPM’s transformational projects. We increase our SOTP (sum of the parts) price target by c9% to €37.25 (from €34), driven by a €1 increase from forest & biochemicals value, and €2 from applying higher multiples in our SOTP on modestly higher earnings. Our €37.25 price target is made up of: 1) €27.84 for the industrial SOTP based on 7.1x 2023 EV/EBITDA; 2) €3 for forest value; 3) Biochemicals & Biofuels of €6.37 per share. Assuming 2024-25 division earnings run rate (post ramp up of new capacity), would imply that the €27.84 for the industrial SOTP based valuation declines from on 7.1x on actual 2023 numbers to approximately 6.2x EBITDA. As for the downside, key risks include 1) macro impacting pulp and packaging demand; 2) industry supply/demand; 3) pulp and packaging pricing; 4) FX; and 5) transformational projects.

Catalyst

1. With no hedges on this energy generation, electricity sales will be at spot prices and could be a material contributor to this year’s cash flow and earnings surprise.
2. A special dividends,
3. share buybacks,
4. value-accretive M&A.
5. New nuclear power plant supply ramp up
6. Sector re-rating for ESG premium.