Seven months ago, I recommended purchase of Smurfit-Stone (“SSCC”) on the basis that the market for virgin (as opposed to re-cycled) containerboard would become tight. While, SSCC currently is selling at about the same price as it was seven months ago, the U.S. containerboard market has become tight – and it appears that this tightness could accelerate and last for years. Over the past five months, U.S. linerboard prices have increased $70 per ton (admittedly from a very low level) and an additional $50 increase has been announced for next month. Our best guess is that prices will peak at about $600 – and, at that price, SSCC will earn about $3.00 per share. We estimate that the SSCC is worth about 6-7X peak earnings – and therefore we believe that the company’s shares are worth close to $20 – and we note that the shares sold at the $18 level in early 2005 and as high as $20 in 2004.
Here is some background. U.S. containerboard mills generally have not earned satisfactory returns over the past twenty-five years. Thus, companies have had little incentive to build new mills – and have been motivated to close older, inefficient mills. Because of these forces, over the past eight years, U.S. containerboard capacity has declined about 4% from 37,530,000 tons in 1988 to about 35,975,000 tons currently. As a result of this decline, the “industry’s” operating ratios have increased from 91.4% to 97.3%. Because mills cannot run at full capacity for long periods of time (they need to be maintained and they occasionally break-down), the industry already is tight, as evidenced by the recent decline in linerboard inventories to about a 3.4 week supply (a very low number).
Looking ahead, the very recently released survey of U.S. capacity projects that containerboard capacity will decline at a .2% annual rate in the 2006-2008 period. Therefore, if demand merely remains flat, virgin linerboard should remain in very tight supply. However, we believe that there is a good chance that linerboard demand will increase at a modest rate over the next several years, partially because more goods are being ordered over the Internet (goods purchased over the Internet, such as books from Amazon, normally are shipped in a box made from linerboard). Thus, we project that the already tight market could develop into a market with shortages and high prices.
It is interesting to study linerboard prices during previous periods of market tightness. Between early 1983 and early 1988, the average price of linerboard increased by 51% from $272 per ton to $410 per ton. During the next cycle, between 1993 and 1995, the average price increased by 57% from $320 to $504.
The recent lowest price for linerboard was $365 per ton in mid 2003. Prices in that year averaged $391. Pro forma the recently announced $50 price increase, prices will be $515, or 32% above the 2003 average. Our best guess is that prices could increase to about $600 in the current cycle before there is serious resistance from customers. A $600 price in 2007 would be equal to a 2% average annual increase vs. the 1988 peak price of $410 and a 1% average annual increase vs. the 1995 peak price of $530. A $600 price would be 53% above the 2003 average of $391 (remember, prices in the past two cycles increased by 51% and 57% vs. the trough years).
Smurfit-Stone is the most leveraged play on containerboard. The company has about 8.0 million tons of capacity and has about 260 million diluted shares outstanding. Thus, after a 38% tax rate, the company’s earnings increase by $1.90 per share for each $100 per ton increase in linerboard prices.
In 2005, Smurfit-Stone and other “paper” companies suffered from unusually high costs (mainly due to the run-up in energy costs) at a time when “paper” prices were soft. In that year, Smurfit-Stone reported a deficit of $.46 per share (before non-recurring items). Linerboard prices in 2005 averaged about $428. If costs remain flat with 2005 and if prices increase by $172 per ton ($600 less $428), and if all other things remain equal, Smurfit-Stone would earn about $2.80 per share (the $172 per ton price increase would add about $3.26 to EPS). Other considerations include: (1) costs were abnormally high in 2005; (2) the company has instituted a major cost reduction program; (3) labor and other costs should trend up with time; and (4) the company produces some market pulp that should also benefit from price increases. On balance, if linerboard prices increase to the $600 per ton range, we believe that Smurfit-Stone’s EPS should approach $3.00 per share.
The company currently is an average cost producer of containerboard. Management has engaged in an aggressive cost cutting program to increase earnings by about $600 million pre-tax. Pro-forma the cost cutting program, SSCC’s cost structure should be somewhat lower than the industry average. Very little of the cost reduction program is in our $3.00 per share earnings projection.
Currently, SSCC’s balance sheet is weak: net debt equals about $4.5 billion vs. equity of $1.8 billion. The company plans to sell its consumer packaging business – and we believe that this sale should reduce net debt to below $4.0 billion. If earnings reach close to the $3.00 per share level for any prolonged period of time, SSCC’s balance sheet will improve rapidly, since 100% of the earnings can be used to reduce debt (depreciation exceeds capital expenditures). For example, $2.50 per share of EPS for two years would lead to a reduction in pro forma net debt from $4.0 billion to $2.7 billion and an increase in shareholders’ equity from $1.8 billion to $3.1 billion.
During the winter months, the demand for containerboard is seasonally slow, yet this winter the market for containerboard became tight and prices were increased. With the arrival of the seasonally strong spring months, the containerboard market could become very tight -- and with U.S. containerboard capacity down 4% over the past 8 years and with futher reductions in capacity projected, we expect a prolonged period of prospertiy for the producers of containerboard. While the shares of the petroleum producers, copper producers, etc. have risen sharply in response to tightness in the markets they serve, Smurift-Stone's shares remain depressed and deeply undervalued.