VIC members will be familiar with Smurfit-Stone ("SSCC" or the "Company") from write-ups by todd1123 both during bankruptcy (6/10/09) and upon emergence (7/2/10). Sentiment towards SSCC has improved somewhat since the summer months, particularly as SSCC has been mentioned as a potential takeover target. While I agree that SSCC would be attractive to an acquirer, I think that SSCC remains attractive in a standalone case as well. Based on productivity improvements and the potential for a price increase in 1H11, I see significant upside for the stock from current levels.
SSCC is the 2nd largest containerboard (used to make cardboard boxes) producer in North America, with 18% market share and approximately 6.3 million tons of capacity. The top 5 containerboard producers control approximately 77% of the industry, with International Paper at 28%, SSCC at 18%, Georgia Pacific at 12%, Temple-Inland at 12% and Packaging Corp. at 7%. The containerboard industry structure has improved since the late 1990s, when the top 5 producers controlled approximately 42% of the industry. In addition, the large public containerboard producers have made significant divestitures of non-containerboard businesses over the years, to the point where each one's performance is largely dependent on containerboard profitability.
SSCC's containerboard business is largely integrated, with 71% of containerboard sales going to internal box plants. 17% of containerboard is sold to domestic third parties, with the remaining 12% exported. 53% of box sales are to the food and beverage end market. The company also produces relatively low volumes of other wood and paper products (market pulp, solid bleached liner, kraft paper) and is also the #2 paper recycler in the US.
SSCC emerged from bankruptcy on June 30 (with a bond-implied stock price of ~$24), and the timing turned out to be unfortunate for the stock. The focus of the pre-bankruptcy months was a valuation fight with the pre-petition equity, at a time when the markets were embracing turnaround stories. The forgiving market environment of the early spring (in which the bonds peaked above par, equivalent to a stock price in the low $30s) allowed the company to emerge with some unresolved issues: (i) management succession, given CEO Pat Moore's intention to retire; (ii) strategy to cut overhead and improve margins, given the SSCC's historic under-performance; and (iii) its under-funded pension, which swelled as treasury rates declined in the couple months prior to emergence.
When the company emerged, concerns about a double dip had heightened and led the market to fear that containerboard prices were at risk. The industry had successfully implemented two price increases during the first half of 2010, and producers announced a third price increase, effective August 1st. The market was pricing the equities as if not only would the 3rd price increase not succeed, but the 2nd price increase would not stick either. When technical pressure from credit funds' selling combined with economic concerns and unanswered questions at the company, the share price bottomed below $16 (intra-day) in late August.
The 3rd price increase ultimately failed in September, which I think was ultimately helpful to the industry. My simple explanation for the failure is that the publication which reports industry pricing (Pulp & Paper Week) concluded that even though industry conditions were supportive of increased pricing, three price increases in one year would be too much, too fast in a still-weak economy. Bears took this news as a sign that pricing would start rolling over, but pricing has held since. The industry is going through its slowest seasonal demand period right now, but inventories remain low and operating rates are still in the mid-90s. Should the industry remain balanced through the next month or two, the industry should have a good opportunity to raise pricing as demand accelerates in the March/April time frame.
SSCC reported a strong third quarter in early November, helping to allay the market's fears about lack of permanent leadership. The company generated $239 million of EBITDA (consensus was around $200 million) and $122 million of free cash flow during the quarter and also announced a cost-cutting program that would produce an expected $50 million of savings in 2011 with incremental savings in 2012 (I think more than $50 million is highly achievable). The Company had guided to a CEO change announcement by year-end but backed off of that timetable into the end of the year. One sell side analyst has written that SSCC may be in merger talks with another party currently, particularly since SSCC announced a three-month consulting agreement with outgoing COO Steve Klinger earlier this week. While I have no special insights here, I could see buyers being interested in SSCC. International Paper achieved $500 million of synergies after it acquired Weyerhauser's containerboard business (almost exactly the same size as SSCC) in 2008.
Financials / Valuation:
Given the pension underfunding, minimal cash tax payments in the upcoming years (NOLs ~ $700mm, though I exclude the value for conservatism) and depreciation that significantly exceeds maintenance capex (which is ~$200-225mm/yr), I think it makes most sense to look at valuation on an adjusted EV / EBITDAP basis. Below is the current market valuation, under two different operating scenarios, one in which the industry achieves another price increase, and one in which pricing remains flat.
Pension Underfunding (6/30/10)
Pension Contribution Tax Shield
Adj. Enterprise Value
2011E Pension Expense
EV / EBITDAP
Based on my 2011 FCF estimates, SSCC is trading at a yield of ~18% in the price increase case and 13% in the no price increase case.
So the stock looks inexpensive in either case. From a historical perspective, my forecasted EBITDA is towards the high end of the SSCC's performance (long-term average is ~$675m), but I do not think that current earnings power represents peak-like earnings. First, as discussed above, I believe that the industry has changed. IP and SSCC permanently shut >5% of industry capacity late in 2009, and major players have no intention of adding capacity. Second, given the stable end markets, the industry grows at "GDP minus," and volumes remain mid-high single digits below pre-recession levels. Assuming the economy continues to grow, the market should stay balanced with demand growth sufficient to offset capacity creep and modest capacity increases from conversions of other grades. This backdrop (and supportive global pricing) provides the opportunity for further pricing.
Assuming that the industry succeeds in implementing a price increase in the first half of 2011 and the market then values SSCC based on a full year of earnings power which reflects that increase, SSCC could be worth ~$40/share in 6 months, based on a multiple range of 4.5-5.0x EV/EBITDAP and giving the Company credit for free cash flow generated between September 2010 and June 2011.
Comps currently trade at 5.0-6.0x 2011E EBITDA and 5.5-6.0x EBITDAP.
In terms of the pension, my use of the June 30 (most recent) under-funding figure likely over-states what the figure will be as of December 31, since (i) assets likely increased in value over this period and (ii) the 10-year treasury rate increased 36 basis points, which will increase the discount rate and lower the value of the PBO. As of June 30, 2010, the Company estimated that it make a total of ~$1.1b of cash contributions to the pension from 2011-2014. These contribution levels are very manageable at the levels of cash flow that I expect.
Greater than expected conversions (from other grades) to containerboard (though this is expensive and challenging)
Input cost pressure (particularly in recycled fiber)
Resolution of CEO search (some time in 1Q)
Potential strategic interest in the company
Earnings report on January 27th
Potential price increase announcement (some time in 2-4 months)