MERC - Mercer International - Pulp Company

[FFHWatcher]

 

This is my first write up, reader beware. I attached write up with (better) formatting.

 

Mercer International – MERC/Nasdaq or MRI-U/TSX. 

Pulp and Paper Industry. Main Office in Vancouver, B.C.

NBSK (Northern Bleached Softwood Kraft) producer and they sell excess electricity to the grid

3 Mills. 1 in British Columbia (called Celgar)/Canada and 2 in Germany (Rosenthal and Stendal)

Mercer owns 100% of Celgar and Rosenthal and 75% of Stendal

Auditor : PriceWaterhouseCoopers LLC

1500 employees

Key Person – Jimmy Lee.  Director since 1985 when it was a small pulp and paper company.  President/CEO since 1992.  Chemical Engineer from UBC.  Mercer was a subsidiary of MFC Bancorp and then spun off.  It looks like Jimmy Lee was Chairman of MFC Bancorp and when Mercer was spun off in the 90's, he left and took over Mercer.  Interestingly, Mercer was the company that sold off mills to Fortress Paper several years ago to get them started.  Jimmy was on the board at Fortress Paper.

Jimmy Lee at the outset earned about $250k/yr and now earns between $500k-$1M in most years in a combination of salary and bonus (salary is about EUR325k).

Approx. 1.3 – 1.4 US$ buys 1 EUR (Euro).

 

Only one large investor stepped up in early 2009 to buy Mercer at rock bottom prices.  Jimmy Lee invested $681k of his personal money to buy shares at $1.70.  No one else did.  It wasn't the first time he stepped up and used a lot of his own money to buy shares.  He now has 2.5M shares which I would estimate that he bought half with his own money and the other half was accumulated via options, restricted shares, etc.  About 6% of shares outstanding.

Mercer was a $25 stock in about 1995 but with fewer shares outstanding.

Share price went to under $1. in March 2009 during the financial crisis and pulp pricing imploded

1.2B US$ in 2010 Revenue.  Mercer reports in EUR, that translates to 900EUR. 

Currently, approx. 1.4US$ = 1EUR.  Double check all currencies as they use Cdn$, US$ and EUR and go back and forth.  If things don't add up, it may be based on when the currency conversion was done.  Some analysts take numbers that were already converted from Euro's to US$ and then convert them again!! (multiply by 1.3 twice, not once!!).

Rosenthal and Stendal are the only 2 NBSK producers in Germany and Germany is the largest market for pulp in Europe. 

EUR231M of working capital including EUR99M in cash.  Half in restricted and half in non-restricted group.  More on Restricted Group later.

44.5M shares outstanding @ $13.50 = ~$600M US$ Market Value.  P/S ratio of .5:1.  Diluted shares may be up to about 55M with their convertibles in 2012. 11M new shares or so.

In March 2005 there were 33M shares outstanding, Stendal was just getting going, they had just bought Celgar, Rosenthal mill conversion/improvements were done and it was their main producer, and their pulp sales were under EUR 200M/yr and their debt was substantially the same as it is today.  Share price 52 week range was $9.75-$11.40.

Approx.  EUR800 of debt or 1.1B US$ (subtract $175M US$ for minority interest). 

Enterprise Value ($600M + $925M) - $124M = $1.4B US$ (approx., not my specialty).

EUR501M bank debt due Sept 2017. 5.28% interest rate. Related directly to the building of Stendal.  Unique debt.  Sinking Fund in good years and interest only in poor years.  Broke some covenants/ratios in 2008/2009 and had some sort of amendment that reduced principal repayments in later years and upon maturity.

The German gov't has guaranteed 80% of this Stendal debt and it is non-recourse to the rest of Mercer. German gov't also contributed hundreds of millions on grants to Mercer for Stendal and Rosenthal Mills over the years. Those grants were not included in income and are not included in shareholders equity. 

November 2010 – Refinanced $300M US$ (about EUR220M) of debt @ 9.5% due 2017.  This was the original debt that required the Restricted Group (Celgar Mill + Rosenthal Mill) to be created.  Mercer shows results of the restricted group because these debt holders want the financial results of the Restricted Group only, as the restricted group assets are used as security for that debt.  The Stendal Mill secures the large EUR501M debt.

$37M US convertible debt due Jan 2012.  Likely convert (as per Mercer) to equity at $3.30/share with 11M new shares being issued.  Afterwards, primary debt is mostly $300M US Restricted Group Debt and EUR501M Non Restricted Group Debt. 

Stendal is extremely leveraged and mostly debt and gov't grants were used to build it.  Very little equity.  It is a new mill finished in 2004.  EUR1B to build, EUR275M in gov't grants with the remainder in debt and equity.  I believe Mercer contributed EUR63.5M into the building and purchase of Stendal back in 2003/2004.

At least EUR 2B ($2.7B US$) invested in the 3 mills.

Rosenthal – 330 million tonnes – restricted group

Celgar – 520 million tonnes – restricted group

Stendal – 645 million tonnes – unrestricted group

 

Electricity Revenue : 2008, 2009, 2010, est. 2011 / EUR 31M, 42.5M, 44M, 60-70M

In 2010, Stendal Mill paid EUR29M in interest on their debt and offset almost all of that with EUR 26M in electricity sales

In Q4 2010, the Restricted Group (Celgar and Rosenthal) had the Rosenthal turbine up and running as well as the Celgar's new turbine running.  That quarter they earned $6.4M in energy revenues and paid $7.4M in interest expense for a net cost of $1M/quarter of interest using energy revenue to offset interest payments. Annually, that is $4M US$ or EUR 3M. 

$25.6M Energy Revenue vs. $29.6M interest expense = $4M or EUR3M

Energy Revenues Vs. Interest payments : EUR3M Restricted Group shortfall + EUR3M Non-Restricted Group Shortfall = approx. EUR6M shortfall of interest payments when using the revenue from electricity generation to offset Mercer's Interest Expense. 

Electricity generation is not free.  There are some costs but it is very profitable as they are already producing it for the mill's usage and much of the capital cost was paid via German and Canadian gov't grants.  There are also principal/sinking fund payments related to the EUR 501M bank debt (as mentioned earlier) and that is paid out of Stendal's excess operating cash flow.  As I understand it, money does not flow back and forth between the Restricted and Non-Restricted Group aside from the original equity contribution from Mercer to fund Stendal.

Debt covenants and restrictions exist that restricts the payment of dividends, Stendal financial ratio maintenance, restriction of stock buybacks, restriction to issue and guarantee debt, restrictions to make distributions, and restrictions with sale/leaseback transactions, etc.

Mercer has tens of millions of dollars in German, Cdn and US tax loss carry-forwards.  Cash taxes paid in 2010, 2009, and 2008 were EUR 461k, 377k, and 1.1M respectively (almost nothing).

2008 and 2009 wasn't all that bad for Mercer.  EUR11.9M loss in cash from operations in 2008 and also purchased EUR25.7M in property/plant/equipment.  In 2009, they were positive EUR37.3M in cash from operations and investment EUR28.8M in p/p/e.  Overall, not that bad. 

Depreciation is about EUR55M/yr.  Capex is approx. half of that. 

Net Income in 2010 reimbursed the combined losses from 2008 and 2009 at the Restricted Group

Sensitivities : $10 US$ NBSK price change = Operating EBITDA EUR10M

Currency : not straightforward.  German expenses in EUR, Celgar expenses in Cdn$, NBSK priced in US$, 75% of debt is in EUR and 25% is in US$, most sales are in US$, etc.  In general, a weak US$ is a negative.  Weak Cdn $ and weak EUR are optimal (and that isn't happening right now).  US$ vs. EUR : EUR 0.01 change = EUR11.4M to annual gross sales. (ie. EUR 0.05 increase reduces gross revenue by EUR57M).

 

Valuation

 

Thesis – Stendal (Non Restricted Groups) debt and underperformance is hiding the very good performance and value in the Restricted Group, but even Stendal may finally be profitable at $950+ ADMT NBSK.

 

Restricted Group and Non Restricted Group.

 

Restricted Group had EUR 62M of net income in 2010.  EUR62M x 1.3 = $80M US @ 8 times earnings = $640M US$.  That supports current market value with no value to Stendal. 

 

I estimate that the Restricted Group alone could generate net income of well over $125M US$ in 2011 based on Celgar Energy coming online, based on Rosenthal Energy producing for 12 months and based on all NBSK price increases being negated by a weakening US$. Restricted Group would need approx. 25% Operating EBITDA Margins in 2011 to accomplish this.  In 2010 their Operating EBITDA was 24.5% (31.1% in Q4 with almost full contribution by new energy projects).  Based on convertibles converting increasing the shares o/s to 55M and an 8 times multiple on $125M = $1B/55M shares = $18+/share with no value being place on Stendal.

 

How much is Stendal worth?  It cost EUR 1B in 2004 to build and still has EUR 0.5B debt associated with it.  It is likely worth more than $0 but not a negative.  Stendal produced over $30M of net income in 2010.  $30M x a multiple of 5 due to lower quality business, restrictions, etc., = $150M/55M shares = $2.70/share in additional value.  That puts a fair value of Mercer just over $20/share.  The leverage at Stendal, due to their debt, is quite high.  If NBSK stays high, earnings could easily double or triple at Stendal from 2010 levels.

 

Electricity Generation Business – Should generate EUR60-70M in 2011, convert at 1.3 to US$ = $78-91M US$.  This has almost no expenses associated with it.  80% profit on this business as they have to generate electricity anyways.  It is possible to look at this area of their business and think that it supports a lot of Mercer's current $600M valuation.  How much would you pay for a business that generated over $60M per year in profits an had fixed term contracts with the gov't?  6x's, 8x's or 10x's? 

 

What if you looked at Mercer and valued them based on their debt being 0% interest with no electricity business, just NBSK sales?  What if you had fixed term contracts with the gov't for the next 10 years that paid all the interest on the debt for the next 10 years and all excess cash flow from NBSK sales accumulated to the benefit of shareholders?  In my opinion, that changes Mercer's risk profile and subsequent valuation multiple. 

 

Catalysts

Debt is being reduced in both the Restricted and Non Restricted Group

NBSK price is rising. Price increases go directly to the bottom line

China – Mercer sells to China now.  Over $250M in sales to China in 2010.

Location – Both Germany and B.C. have access and sell directly to China

Tax Loss Carry-forward – Tens of Millions.  That is worth something.

Energy Revenue Offsets high debt risk – 90%+ of interest payments at each operating group are covered by energy revenue

Litigation : Rec'd EUR 10M in 2010 in a  pre-payment from the Stendal Mill Contractor with regards to a civil claim.

Dissolving Pulp (DP).  Mercer is in the early stages of looking at this opportunity. 

 

Mercer has an excellent website with many, many valuation resources.  http://www.mercerint.com

 

Remember, it is my first write up so don't be a dink and I apologize for any errors, currency conversions, estimations, incorrect assumptions, etc.

[Liberty]

Thanks, I love detailed analyses like this!

[Myth465]

Thanks I will review this in detail over the weekend. I love the way you put the debt into perspective. I think its what turned alot of people off when MERC was under $10.

[Uccmal]

FFHWatcher, Thanks for the analysis.  I will look at it after I finish last years 10k - part way through right now.

 

One thought that occurs to me with all of these grants and money being poured into biomass energy is what happens to pulp if the price of wood and chips starts to rise.

[FFHWatcher]

FFHWatcher, Thanks for the analysis.  I will look at it after I finish last years 10k - part way through right now.

 

One thought that occurs to me with all of these grants and money being poured into biomass energy is what happens to pulp if the price of wood and chips starts to rise.

 

That is exactly what happened in 2008.  Cost of fibre, (essentially : wood chips from saw mills) increased by 100% from 2006 to 2008 at their Celgar facility.  The reason behind that is that the product became very scarce due to all the saw mills shutting down, closing, bankruptcy, etc. due to the housing slowdown in the US and Worldwide.  If the saw mills aren't selling wood to the homebuilders, than there are a lot few wood chips that can be converted to pulp.  It got to the point where Mercer was chipping entire trees at a significantly higher cost than buying the leftover wood chips.  Mercer has a good slide on how they dealt with it. http://www.mercerint.com/i/pdf/CS-ConferenceDeck.pdf

Essentially, they invested $10M in a low-cost chip plant that is capable of supplying 50% of Celgar's needs.  Since then, Celgar has reduced their per tonne fibre cost by EUR 100/tonne (38% reduction annualized). 

 

The cost of fibre is the largest input (i believe) into the operating costs to manufacture pulp.  I had a chart that showed the cost breakdown and when I locate it, I will post it. 

Germany has long term supply agreements for fibre in place to ensure they are properly supplied.  I believe I read that some pricing is fixed and some is at market rates.  I believe the German plants also have the option of buying wood chips as well as chipping whole trees in their modern facilities. 

 

If you go through the last few investor presentations on Mercer's website, it has a lot of info. that makes for a pretty compelling case as to why Mercer is extremely well positioned to benefit significantly going forward.  I have attached their most recent investor presentation from the Credit Suisse Conference.  I would say that most of the industry should benefit significantly based on industry trends, but Mercer more than most others. 

 

Uccmal : Are you asking, what happens if fibre increases to the point that the combination of both NBSK pulp AND electricity sales net out to an overall loss?  That is kinda what happened in 2008 (industry wide losses) but it was more the soft pricing in NBSK vs. the high price of fibre.  Overall, if this does happen, it looks to me that Mercer is best equipped to deal with it.  Paying down Restricted Group debt would reduce this risk even more.  I estimate that within a year or so, electricity generation revenue may not only pay all interest on all of Mercer's debt (assuming approx. 10% of overall debt is paid off in the next 12 months), there will be excess revenue that will be added to the bottom line on top of NBSK profit from $900+/tonne NBSK Pulp pricing.

 

[Uccmal]

Hi FFHwatcher,  Well this morning I finished the 2009 10 k and got part way through the 2010 10k.  I haven't looked at your workup in any detail yet.  I agree with you that interest payments should be able to be made from the biomass sales as of about now.  I will have a look at their slides once I am done with 2010k.

 

I have been to a few factories in the GTA that use large woodstoves for heating with waste wood.  Now, this is only in the winter.  In Canada it is probably not viable to use waste wood for electricity given that gas cogen is so cheap and the set up looks to be in the 20-30 million arena (for wood).  Might work in BC or outside Montreal but not in Ontario where most of the people are.  I cant speak to Germany except to Mercer's discussions on their wood supply agreements coming from managed forests.  Again, it is probable that it is too expensive just to build a biomass power plant for 1 purpose.  If it became widespread there is also the issue of ash disposal in tight urban centers that the pulp mills already adjust.  In fact they get rid of their byproduct this way rather than landfilling most of it.  

[Uccmal]

You ask in your analysis what would you pay for the power assets 6x, 8x, 10x.  I looked at 3 utilities to get a comparison.  Algonquin Power trades at roughly 10 x cash flow, 5% dividend, Enbridge Income trades about the same with similar dividend, Brookfield Renewable trades at nearly 20 x cash flow with a 5% dividend.

 

If you break out the energy income and apply 10 cash flow you get a value for the energy company of 75M US * 10 = 750 Million. 

 

On a per share basis this would be 750/50 = 15 Us.  Now you would need to pay a dividend of 5% which is 37.5 million US.  Treated alone the energy assets are unencumbered - In reality they actually are since very little of the companies own cash was spent on the Energy production.

 

If the P&P business can generate enough cash to pay its own interest then you get your 15 US valuation. 

 

Other:  Using your numbers which are reasonable IMO they should be able to generate 130 M pre-tax this year form the P&P operations.  Applying a pe=8 to this and you get 130 * 8 = 1 B/ 50 million shares = 20 per share. 

 

I would assume that some of the cash this year will go to paying down some of the debentures next year, or even early.  At Stendal they should be able to pay down 10-20% per year of the debt load.  That would be nice because the interest rates they pay are extortion level. 

 

 

[Uccmal]

So, you get a power company valued at $15/share with a margin of safety of a free P&P operation - very new.

 

Or you get a P&P operation at $20/share with a free Power operation. 

 

Pay down 30-40% of the debt and get rid of the dilution of the debentures and you have a share price of at least 35 US. 

 

The  unfortunate kicker is that they may end up waiting out this pulp cycle for the next one, to reach full value.  That is beyond our control.  At very worst you are getting a margin of safety of $15 Us on the power assets.

[Myth465]

I looked at it and thought about it and will probably buy back FBK.

 

I am just cheap. Pulp is outside my forecasting ability, and while prices are holding I have no idea where they are going. FBK should be fairly close to debt free within this cycle and despite our complaints Management is doing all of the blocking and tackling. It looks like they are copying MERC on the investor relations side of things. I love the gearing at MERC, but dont like the debt given my lack of knowledge regarding the pulp cycle. I think they are better managed and have a few levers but FBK is just cheap.

 

The last 2 quarters have been disappointing but I am hoping that that cant go on forever. MERC has been knocking it out of the park.

[alertmeipp]

I will buy CFX when the pulp sector get hit by the next down-turn.

 

Buy low-cost producers in commodities business make the most sense. FBK is driving the cost down now by reducing debt and improving efficient. The wildcard is RBK obviously.

 

Didn't have time to look into MERC yet.

[SharperDingaan]

Keep in mind:

 

They sell to Europe. They get world price, but sell less than they should because Euro demand is so weak. There is no real way to improve demand either, as P&P is heavy to transport.

 

They cannot really benefit from this cycle, but they can use it strengthen their cash-flow & reduce &/or refinance at lower rates. The process will accelerate if they can do an equity financing to repay debt, & materially improve their D/E ratio.

 

This is really a 3 part bet: (1) How long it takes Europe to start to recover - most would suggest 3-5 years at the minimum (2) The assumption that they will not do an interim equity issue to repay debt & improve the D/E ratio - if there is eventually 20% dilution, the wait might not be worthwhile (3) The direction of USD, EUR, & CAD (assumes a CDN investor) FX rates – if they do well but both the USD & EUR devalue 30%, the gain may end up moot.

 

If you are slowly moving gains into Europe they may be a good choice. Right now it is the ugly signet - eventually there may be a swan, but it’ll take a while.

 

SD 

 

[Uccmal]

SD, I deliberately left the currency out of my estimates.  They have created a convoluted mess.  Over a period of time I am calling it a wash.  I am just doing my 2010 taxes.  US stocks that I bought in 2009 and sold in 2010 had a reduced tax bill concurrent with their reduced capital gains.  One day the situation will reverse.  I use whole year averages. 

 

I dont agree that the Euro economies collectively are a factor.  With exceptions my read is that Spain is improving rapidly, as is Ireland.  Germany is running on most cylinders already.  Celgar is producing alot for the Chinese markets which can be a bit of a wild card. 

 

If this cycle stays intact or improves all of these companies benefit.  We have no way of forecasting this except to assume that the end of the cycle gets closer each day. 

 

Another wild card is the number of these companies that move to producing Dissolving Pulp.  The ones that go this route may profit, and the ones that dont go this route may profit by an extension in the cycle. 

 

The way cash is flowing through the door they shouldn't need to do an equity issue unless they proceed with a DP project.

 

[Uccmal]

BTW - FFHWatcher, that was an excellent writeup. 

 

My conclusion is that this is worth buying but not worth selling FBK to purchase.  I will be starting a small position and every tuesday I will be watching those numbers. 

[SharperDingaan]

 

Dissagree on Euroland simply because total revenue is price x volume. To pay, the Euro customer needs credit & confidence in the Euro payments system (Euro banks freely accepting each others LOC's/guarantees), which is not plentiful in unstable Euroland. Price may increase 20%, but how likely is it that volume will also increase 20% ? - even if the buyers are willing. Agreed that Euro volumes will increase, but it may well take a while - hence the sleeper aspect.

 

Agreed the risk goes down the more, & quicker, they generate cashflow. FX risk depends on residency - if you're in a petro/commodity currency you have to be concerned about the likely FX rate when you eventually plan to sell.

 

SD

[Myth465]

Thanks for the writeup I split the difference and just bought a bit of both.

[FFHWatcher]

Just checking out a new presentation on Mercer's website and I noticed a new chart that shows the Global Production of Tissue and Printing and Writing Paper is actually projected to increase over the next few years with China's growth in demand making up for lack of demand in North America and Europe, especially with Tissue Paper.

 

Mercer and other NBSK producers have also implemented $30/tonne price increases for May and June.

 

http://www.mercerint.com

 

http://mercer.ir.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingCONVPDF1?SessionID=RzyKHd-2S5hUaWV&ID=7940536

 

Mercer International to Hike Price for NBSK in Europe

 

May 11, 2011 - Mercer International has begun informing customers of its intent to raise its price for northern bleached softwood kraft (NBSK) pulp in Europe by $30/tonne, effective June 1.

 

SOURCE: RISI

http://www.paperage.com/2011news/05_11_2011mercer_price.html

[alertmeipp]

Anyone still follow this one?

[FFHWatcher]

Anyone still follow this one?

 

Yes, i still follow them pretty closely.  It is my largest holding but the falling share price is (involuntarily) quickly bringing it back to a regular position.  In my opinion the share price is following the expectation that NBSK is at unsustainable levels and that the volumes sold will decline as well. So far, the increasing US $ has offset a lot of the NBSK decline.  We will have to wait and see how the volumes are when they report their quarterly numbers.  They will also provide an update on their $25m stock buyback and equivalent amt of debt buyback.  With a p/e of 2-4 it still seems kinda cheap.  Debt related to Stendal seems to be taking care of itself.

[Myth465]

I bought back my position on the down 10% day. Its cheap...

[alertmeipp]

the pulp price hold up fairly well still. I think the market links MERC to EUR more than it actually is linked.

 

[Green King]

can't download the write up can you attach it again please ?

 

thanks

[FFHWatcher]

See attached.

Mercer_Write_Up.pdf

[Green King]

thank you

[ValueSlant]

MERC is looking interesting at these levels although not sure it is time to jump in yet.

I did a post on the NBSK market more generally, hope to share some more specific thoughts on MERC soon.

http://valueslant.com/2011/12/06/nbsk-pulp-market-overview/

Would be great to hear what others are thinking re NBSK pricing and MERC.

[eclecticvalue]

I have been looking at this for awhile and it is down 22% this year. My concerns are the debt ( D/E>2.0) , the FCF is low, and repayment of debt has been low. The price is attractive compared to the replacement of assets but very leveraged. If there is a commodities bust, it will not bode well for mercer.