Canadian pulp maker Fibrek, formerly known as SFK Pulp Fund, converted to a corporate structure in conjunction with a rights offering and recapitalization in July. Prem Watsa's Fairfax Financial boosted its equity stake in Fibrek to 26% as a result of the rights offering, and we expect Fairfax's continued strategic "oversight" of the actions of Fibrek management to benefit shareholders. There seems to be little doubt that significant unrecognized value resides in the common equity, as Fibrek trades at one-third of tangible book value despite strongly cash-flowing operations and one of the least leveraged balance sheets in the pulp and paper industry. Fibrek is currently throwing off run-rate EBITDA of C$80 million, and this number could improve to C$100 million due to margin improvement. At a recent enterprise value of C$244 million, we find Fibrek to be meaningfully undervalued.

A valuation comparison to two other pulp makers is particularly striking: Canfor Pulp (Toronto: CFX.UN), which pays monthly distributions, and Mercer (Nasdaq: MERC), which has a more promotional approach to investor relations, trade at no discount to tangible book value. Meanwhile, Mercer retains high financial leverage that could easily cut the other way should pulp industry conditions deteriorate.

Pulp prices have reached record levels this year after falling precipitously in 2008 and early 2009. The rebound has been driven by pulp plant idling and outright shutdowns, low inventories, strong Chinese demand, and the earthquake in Chile. While pulp prices have already pulled back modestly from record levels of roughly $1,000 per tonne, they are expected to stay strong enough to enable producers such as Fibrek to keep delivering strong cash flows.

Fibrek operates a capital-intensive business selling two grades of pulp to paper producers. In Quebec, Canada, Fibrek has one mill producing the high-quality Northern Bleached Softwood Kraft (NBSK) pulp at a rate of ~1,000 tonnes per day, while in the U.S., Fibrek has two plants producing recycled pulp at a combined rate of also approximately 1,000 tonnes per day. Fibrek controls more than one-half the supply of recycled pulp in North America, but this has not translated into strong margins to date due to substitution effects and rising costs for wastepaper, the primary input commodity for recycled pulp.

We believe the market has overlooked Fibrek for several reasons: First, reported profitability is lower than free cash flow, as D&A materially exceeds maintenance capex. Second, investors may be mistakenly interpreting Fibrek's recent profitability as "peak" profitability due to recent record pulp prices. This interpretation ignores the fact that the cost of the input commodities for recycled pulp (wastepaper) and NBSK pulp (wood fibre) has been unusually high and should decline going forward. Third, Fibrek management has been rather inept at communicating the Fibrek story to investors, and the recent rights offering hurt value because the rationale for it was unclear given an organically improving balance sheet and strong cash generation.

Warning: We wrote up Fibrek (SFK Pulp Fund) at C$5 per share back in 2007, so we have little credibility in this situation. Nonetheless, we believe the time and valuation are right for investors to revisit this idea. As always, please do your own work prior to investing.

BUSINESS OVERVIEW

Fibrek, formerly SFK Pulp Fund, owns and operates three mills that produce pulp, a key input into paper production.

NBSK pulp operations: Fibrek's mill has produced northern bleached softwood kraft (NBSK) pulp in Saint-Felicien, Quebec for three decades. Annual production is 360K tonnes. Fibrek acquired the mill from Abitibi for $628 million in '02.

RBK pulp operations: Fibrek acquired two U.S. recycled bleached kraft (RBK) pulp mills for $194 million in 2006 (the mills were built for $462 million in the mid-1990s). The mills have an annual production capacity of 385K tonnes.

INVESTMENT HIGHLIGHTS

• World-class NBSK pulp mill in Quebec. NBSK is a high-quality grade of pulp that commands premium pricing worldwide. The mill's replacement cost may exceed Fibrek's recent enterprise value.
• Commodity provider with sources of competitive advantage: (1) transportation advantages (close to raw materials sources, access to railway network and deepwater port); (2) industry-leading efficiency at Saint-Felicien mill; (3) limited threat to NBSK from Asian producers, as NBSK pulp is available primarily in Canada, Scandinavia and Russia (Canada accounts for 50% of global production).
• Fibrek's two recycled pulp (RBK) mills are unique in North America; there is only one other such mill worldwide. Recycled products are one of the few growth areas of the paper products industry.
• Pulp prices should remain strong in near term, providing Fibrek with an opportunity to maintain and perhaps even improve operating margins.
• Prem Watsa "oversight" should help maximize equity value. Fairfax boosted its stake to 26% in a $40 million rights offering ($1.01 per share) in July.
• Trades at one-third of tangible book, despite profitable operations and strong balance sheet.

INVESTMENT RISKS & CONCERNS

• Disadvantage due to high raw material costs? The cost of the input commodities (wood fibre or wastepaper) accounts for 50%+ of operating costs.^* Wood fibre costs have been higher in Eastern than in Western Canada. Meanwhile, wastepaper costs remain elevated, hurting recycled pulp profitability.
• Capital-intensive business. Most of Fibrek's assets consist of pulp processing equipment, which must be regularly repaired and upgraded. That said, capex has 3% of revenue in recent years (2% YTD 2010), while D&A has averaged 9% (7% YTD 2010).
• Profitability highly dependent on market price of pulp and CAD/USD exchange rate. A US$10 drop in the price of NBSK pulp impacts annual earnings per unit by C$0.03. Appreciation of the Canadian dollar versus the U.S. dollar of $0.01 per dollar reduces annual earnings by C$0.02 per share.
• No downside protection in liquidation scenario, as pulp processing equipment accounts for two-thirds of assets and 100% of equity. Processing equipment would likely have little scrap value in liquidation coincident with industry-wide distress.
• Management owns less than 1% of Fibrek shares and has a checked execution record. While the company was able to avoid bankruptcy in 2009, management pursued a rights offering at a time when Fibrek should have been able to achieve its objectives without raising additional equity capital.

MAJOR HOLDERS

Management <1% (some insider buying recently) | Fairfax Financial 26%

 

OUR ESTIMATE OF THE EQUITY FAIR VALUE RANGE

	Conservative	Base Case	Aggressive
Valuation methodology	Distressed sale value	Enterprise value to run-rate EBITDA	Market value to tangible book value
Conservative case metrics:
Sale of mills at one-third of tangible book	$160 million
Less: Net debt as of 9/30/2010	-$111 million
Estimated distressed sale value	$48 million
Base case metrics:
Run-rate EBITDA, based on 3Q10		$79 million
Assumed fair value multiple		5.0x
Less: Net debt as of 9/30/2010		-$111 million
Aggressive case metrics:
Tangible book value as of 9/30/2010			$480 million
Assumed fair value multiple			1.0x
Estimated fair value of the equity of Fibrek	$48 million	$289 million	$480 million
	$0.40 per share 1	$2.20 per share 1	$3.70 per share 1
Implied price-to-tangible book value multiple	.1x	.6x	1.0x
Implied EV to trailing revenue	.3x	.7x	1.1x
Implied EV to trailing gross profit	2.2x	5.5x	8.2x
Implied EV to trailing EBIT	9.4x	23.4x	34.6x
Implied EV to run-rate EBIT, based on 3Q10	4.0x	9.9x	14.7x
Implied trailing FCF yield	89%	15%	9%
Implied run-rate FCF yield, based on 3Q10	127%	21%	13%

¹ Based on 130 million shares outstanding

 

SELECTED OPERATING DATA BY SEGMENT, 1996 - YTD 2010   (C$ in millions)

FYE December 31	1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	YTD 9/30/10
Revenue by segment:
NBSK mill	226	233	224	236	310	238	209	234	269	236	274	256	251	206	213
RBK mills	0	0	0	0	0	0	0	0	0	0	39	254	281	183	212
	226	233	224	236	310	238	209	234	269	236	312	510	532	389	425
% of revenue by segment:
NBSK mill	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	88%	50%	47%	53%	50%
RBK mills	0%	0%	0%	0%	0%	0%	0%	0%	0%	0%	12%	50%	53%	47%	50%
	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%	100%
Revenue growth by segment:
NBSK mill	-36%	3%	-4%	5%	31%	-23%	-12%	12%	15%	-12%	16%	-6%	-2%	-18%	45%
RBK mills	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/m	555%	11%	-35%	67%
	-36%	3%	-4%	5%	31%	-23%	-12%	12%	15%	-12%	32%	63%	4%	-27%	55%
EBITDA by segment:
NBSK mill	62	77	75	81	143	62	49	42	62	29	40	49	27	(12)	46
RBK mills	0	0	0	0	0	0	0	0	0	0	3	22	20	0	10
	62	77	75	81	143	62	49	42	62	29	43	71	47	(12)	56
Distributable FCF	57	58	62	66	112	58	47	31	49	15	27	29	27	(39)	40
Shares out (mn) 1	57	57	57	57	57	57	57	57	59	59	72	90	90	90	130

¹ Represents basic shares outstanding at period end, in millions.

 

- Continued elevated pulp prices to result in continued strong or growing free cash flow

- Reduction or elimination of debt

- Strategic event at the prodding of Fairfax