Description

Neenah Paper (NP) is a recent (Nov 30) spinoff from Kimberly-Clark (KMB). Holders of KMB received 1 NP share for every 33 KMB shares. I believe NP is cheap when measured against its peers, or on an absolute free cash flow basis.

Neenah Paper is a pulp and paper company with 3 primary operations – the good, the not bad and the fairly ugly - (I) A Fine Paper business (II) A Technical Paper business (III) A Pulp Business

Fine Paper Business
The Fine Paper business produces high quality papers used for invitations, corporate reports etc They own manufacturing facilities in Neenah and Whiting, Wisconsin and have recently upgraded their plant. They also own well known fine paper brands such as CLASSIC, CLASSIC CREST, NEENAH etc. They have an estimated 20% share of the North American Fine paper segment. KMB acquired this business in 1956. 2003 Revenues were 200M. I estimate that this business has net margins of about 20% (see below) and ROA of about 30%.

Technical Paper Business
The Technical Paper Business produces coated papers for use in tapes, abrasives, medical packaging etc to specifications of customers. Neenah have a number one or number two position in various market niches. The business owns manufacturing facilities in Michigan. KMB acquired the business in 1952. 2003 Revenues were 120M. I estimate that this business has net margins of about 6-7% (see below) and ROA of about 12%

Pulp Business
The Pulp business consists of mills in Pictou, Nova Scotia and Terrace Bay, Ontario and produces approx 700K metric tonnes of pulp per annum. Pictou includes 1 million owned acres and non-exclusive rights over 200,000 acres of licensed land. Terrace Bay mill holds non-exclusive rights over 4.6M acres of licensed land. 2003 Revenues for the Pulp Business were 366M. Pictou is a profitable operation but Terrace Bay has older facilities and practises and is currently a drain on the company.



FCF Generation
NP have provided pro-forma Profit and Loss accounts for the last 5 years. Some adjustments need to be made to see how they might have looked if NP had been independent entity –
(I) NP have a long term Pulp Supply contract with KMB to supply pulp at published prices less a discount. According to NP the discount reflects what would be offered to an external customer for such a large contract. For 2001-2003 I have used figures given by NP, for 1999-2000 I have assumed a figure of 7.4% of pulp sales – the highest % in 2001-2003 period, and that Revenues of Fine Paper/Technical Paper were 320M
(II) NP have taken on 225M in Debt (proceeds of which 215M has been remitted to KMB) and have estimated interest of 18.3M based on 7.875% interest rate on first 200M + 3.25% on 25M (they later priced notes at 7 375% so actual interest should be slightly lower).
(III) Management anticipates that beginning in 2005 they will incur ongoing full-year SG&A expenses of approximately $14 million related primarily to reduced economies of scale as a result of operating on a stand-alone basis.
(IV) I assumed tax at 37%

2003 2002 2001 2000 1999
Sales 665.8 658 701.2 871.8 781.5
GP 107.9 131.6 142.8 298.8 204.7
EBIT 63.3 99.3 110.1 270.1 155
Plus adjustments
KMB Discount 24.5 17.5 19.2 40.8 34.2
Extra SG&A 14.0 14.0 14.0 14.0 14.0
Adjusted EBIT 24.8 67.8 76.9 215.3 106.8
Interest 18.3 18.3 18.3 18.3 18.3
Inc PreTax 6.5 49.5 58.6 196.0 88.5
Net Income 4.1 31.2 36.9 124.1 55.8

To get FCF I will add back Depreciation and subtract Capex
Depreciation 35.3 34.3 38.9 40.4 44.9
Capex 24.4 18.4 29.1 16.8 34.8
FCF 15.0 47.1 46.7 147.7 65.9

So total FCF generation over 5 years was approx 322M or average of over 64M p.a. vs market cap of 470M – about a 13% yield.
(However it should be noted that NP
 anticipate increasing Capex to 49.9M in 2005 and 46.6M in 2006 (about 13M in each year related to environmental protection measures))
 have a pension deficit of approx 60M related to their Canadian operations. They project having to contribute about 6M p.a going forward
 will have some additional one-off SG&A expenses next year relating to being in independent operation.

Incidentally, according to the Statement of Cashflows, NP remitted a total of 314M to its parent in the period 1Q 2001 to 3Q 2004, plus they remitted an additional 215M at spinoff time. (some of the cash relates to downsizing of inventories etc)


Comparison to Industry Sale
For comparison, I will use the sale of Weldwood by International Paper to West Fraser for USD 950M in July 2004. Weldwood is a pulp/lumber producer in BC/Alberta.

2003 2002 2001 2000 1999 Total
Weldwood EBITDA 80 95 90 155 130 550
NP EBITDA 60 102 115 255 151 685

NP’s current EV is 470M + 225M (LT Debt) = 695M

Westwood basis was 950/110 = 8.6 times average EBITDA
On this basis, NP EV should be 8.6 x 137 = 1.17B

A brief comparison of the assets:
Assets Weldwood NP
Leased Timberland 8M acres 4.8M acres
Owned Timberland 0 1M acres
Tonnes Pulp 675k p.a. 700k p.a.
Lumber Mills 7 (+ 3JV) 0
Lumber Capacity 1.3M board ft. 0
Fine Paper Business 200M revenues
Technical Paper Business 120M revenues
Total Revenues 800M 2003 665M 2003


Other Comparables
For comparisons I looked at 3 other companies, also in the Fine Paper/Technical Paper or lumber business – LFB (Longview Fibre), GLT (Glatfelter) and WPP (Wausau-Mosinee), of similar size.
2003 2002 2001 2000 1999 Average

NP EBITDA 60 102 115 255 151 137
LFB EBITDA 122 116 146 162 139 140
GLT EBITDA 91 116 67 130 131 107
WPP EBITDA 96 108 89 76 136 101

LFB EV/Average EBITDA = 9.9, GLT EV/EBITDA = 8, WPP EV/EBITDA = 9.9
On this basis NP EV should be over 1.1B



Sum of Parts Valuation
To get a lowball value, I tried to estimate a very conservative sum-of-parts valuation

(For this purpose I estimated additional pretax SG&A of 14M would reduce total net income by 9M (tax rate 37%). The 9M, I arbitrarily allocated - 4M Fine Paper, 2M Technical Paper, 3M Pulp)

The Fine Paper business is not affected by the Pulp Supply contract with KMB. Sales in 2003 were 200M. Net income average over the last 4 years is about 45M (annualizing 2004 figures and assuming tax rate of 37%). Allocating 4M of additional SG&A reduces that to 41M
Put a multiple of 10 on that gets you 410M.
(Although revenues are affected by a long term secular decline, as well as being cyclical, margins appear to be about 20%. Also Capex requirements are very low < 11M total in last 3 years).

The Technical Paper Division is also not affected by Pulp Supply contract with KMB. 2003 Sales were 120M. Net Income average over the last 4 years is 6.3M. However this includes an 18M loss in 2001 which was partly accounted for by the East Ryegate mill closure (27M before tax). If we add this back (annualizing 2004 figures and assuming tax at 37%) then the figure is 10M.
Allocating 2M of additional SG&A, leaves 8M
Put a multiple of 10 on that gives you 80M

Pulp Business
Its hard to value this, as EBITDA has been almost non-existent recently due to the problems at Terrace Bay. However, if we were to assign a value based on the assets, then the 1M acres alone would fetch between CDN150-300 per acre. If we assume the lower figure that’s about USD120M, with no value on the plant or the 4.8M of leased timberland


So total value would be about 410+80+120 = 610M compared to current EV of 695M.


Pulp Supply Agreement
NP have entered into a Pulp Supply agreement under which KMB contract to purchase minimum quantities of pulp. The prices are based on published industry index prices for the pulp, less agreed discounts (I believe approx 3.5-3.7%) and subject to maximum and minimum prices (up to Dec 2007). These commitments will last until at least Jan 2009 after which they may be terminated on either side with a 2 year runoff. The volume of pulp represents about 82% declining to 64% of NSKP (Northern Softwood Kraft Pulp) output of NP, with lower volumes of other pulp types. NP claim that the terms are comparable to those they would obtain from an unaffiliated party. They have not disclosed the maximum and minimum prices but have said it would be unusual for either to be reached.



Catalysts:
1. Terrace Bay is a high cost operator and is loss-making so any rationalisation there could materially impact the bottom line. Management have indicated that they have plans to address four issues
 Terrace Bay are converting full trees into pulp. It would be more efficient if the trees were sent to a sawmill and Terrace Bay converted the woodchips byproduct from the sawmill into pulp. NP are looking to partner with local sawmills to this end.
 The hardwood plant is old – it dates back to 1947. It is also facing increasing competition from South American hardwood imports. There may be rationalisation here.
 Management believe there is scope to improve efficiency of labour practises in the woodlands
 They seek to avoid becoming overly restricted by regulatory agencies
2. Usual spinoff benefits (greater focus, direct incentives, ability to make own capex decisions etc)
3. Just 1 share for every 33 means this will be a nuisance holding for many. Also its in a different sector to KMB (it’s cyclical rather than consumer staple) so selling pressure may continue for a while.
4. According to the Form 10, NP will allow management the right to convert their existing KMB stock options into NP stock options. The number of shares which can be acquired within 60 days of November 1 (ie by Dec 31 2004) will be updated at the time of the distribution based on the respective market prices for NP shares of common stock and for shares of common stock of Kimberly-Clark. Also, the stock option plan of the management team is not yet in place. In other words, it may not have been in management’s best interest to have a high share price at the time of distribution and it still may not be in their interest for the share price to increase – yet.
5. There’s a graph in the Form 10 of Northern Softwood Kraft Pulp (NSKP) prices since 1980. The price now is about US627 per ton. The price in 1980 was about US500 per ton, so it has barely appreciated in 25 years. If lumber prices were to follow the trajectory of other commodity prices recently, this would greatly benefit NP.
6. Resolution of the US/Canada lumber dispute would likely benefit NP.

Risks
1. US Dollar fall. NP estimate that for 2003, each 1 cent fall in the USD (versus CDN) cost them about US5M in pretax income. (This assumes no counteracting rise in pulp prices)
2. Pulp Supply contract with KMB. The agreements last till at least Jan 2009 plus minimum 2 year phase-down. These account for 82% reducing to 64% of NP’s expected production of NSKP. These limit the upside (and downside) somewhat, as there are maximum and minimum NSKP prices specified up to Dec 2007.
3. Pulp prices have a downturn and stay there.
4. Capital Allocation: I don’t know if management will be sensible or not, as there’s no track record. Up until now their job was to send spare cash back to KMB headquarters. However they have said that they will initiate a quarterly dividend of 10c a share

Catalyst

1. Short term spinoff related selling abates, company becomes known
2. Usual spinoff benefits - management focus, direct incentives etc
3. Company fixes problems at Terrace Bay