Smurfit-Stone: Cheap on Valuation

The large swings in every aspect of the market have created a dislocation of many companies with respect to their markets. Just like the rollover of the deep sea oil drillers where Jimmy Tisch was able to purchase Diamond Offshore (DO) for the same amount it would cost to scrap the company, there are other companies that look to be in dire straights.

To pull off this type of investment, you must see value where others see insurmountable problems. These bottom feeding principals are such that you are able to see value even if the industry rolls over, with the ability to buy the assets and overcome losses that may cripple the underlying growth of the company. As with Diamond Offshore and drilling prices headed south, other industries are seeing the same problems. A keen investor will scoop up some of these companies in the hopes that the truly brilliant will see value and buy them at a amount much more than what you paid.

Smurfit-Stone Container Corp. (SSCC) seems to be a company that may be in this area. Selling at a price to book of .17 and price to sales of .04, there could be value as this company just needs time to weather the current storm. With total cash of nine million and total debt of $3.57 billion, it seems to be ready to fold at anytime. It has been utterly destroyed by higher commodity prices and looks to have little going for it in the wake of the markets' turmoil and panic selling. With only .035 cash per share, it is swallowing investor money just to stay afloat. There have been no insider purchases of shares since late July even after the stock has been hammered as the percent of institutional purchases are down 44.5% over the last six months.

On October 20^th, SSCC closed its pulp mill in Quebec, cutting another 218 jobs. At this point, it stated that it is realizing higher prices which should be reflected in its fourth quarter. On the upside, container board prices are up 50% in the last three years as companies struggle with much higher commodity costs. SSCC is also moving further into the recycling business as it announced the opening of a second waste recycling center with Advanced Disposal Services.

I believe this industry will begin to realize acquisitions as consolidation with begin the rebound of this group. Back in April, International Paper (IP) acquired Weyerhaeuser's (WY) container packaging division, giving it a 30% stake in the market as SSCC had a 19% market share at that time. This was a purchase looking forward and should benefit both as they will realize pricing power that looks to be on the upside, possibly until 2011. The question remains, can they hold on until they can start realizing a profit and paying down debt? By the looks of the stock price, the market believes they cannot.

I think there are many reasons to get involved with this company. For one, the company's assets are more than that of what it is selling for, and even though it is in a fantastic amount of trouble going forward, the industry seems to be headed in a direction that may help the company turn things around. If we look at SSCC, it is a North American packaging leader with respect to containerboard, corrugated containers, and recycling. It is in the process of changing the company to improve cost structure, enhance margins, and give it greater financial flexibility.

North American market share is 20% containerboard, 17% corrugated, and 14% recycled fiber. It has 7.3 million tons of containerboard capacity. Only 14% is exported as the foreign markets seem to be in more disarray than the United States. Corrugated demand is 45% from the beverage industry, which has held up well in the slow down. 16% is durables while the remain 39% is other consumer products, which could take the biggest hit in a recession. Operating profits have been improving in the face of weaker demand. In 2005 they were 4.1%, 2006 7.3%, and last year 8.1%.

The company's transformation has four parts. The first is to centralize the company, which is estimated to achieve savings of $525 million. The second is to improve its cost structure, which includes the closing of plants not central to the company's plan, focus on high return capital investment, and to cut jobs. The third is to increase margins by focusing on the businesses that have not been as affected by the downturn and high commodity prices. Lastly, it is reducing debt and the current debt is being restructured.

In 2006 and 2007 it has beaten its goals. Box plant closures have increased every year and there will be 29 in 2008. Headcount reduction has also increased every year up to 5580 this year. Mill utilization increase is up to 18% this year and converted productivity increased to 15% this year.

Looking at SSCC, its costs are a tremendous burden, but there may be a light at the end of the tunnel. Current inflation with respect to labor has remained somewhat constant. Chemicals have almost doubled. Freight has seen a marked increase. Energy has weighed on the company and continues to do so, while fiber costs are down dramatically.

Energy is the key problem. This should mitigate, as the current recession brings energy costs down dramatically and looks to continue to do so. The company's costs should improve as biofuel use has been somewhat constant. The use as coal has increased the most, which has seen a lower percentage increase in price over the last two years. Gas and oil use has dropped the most as the company switches to coal to power its business. This, coupled with more efficient burners and boilers and other equipment, should continue to help with the bottom line. Higher diesel costs have also increased costs of transportation. The company is continuing to convert to trailer/rail applications to save on these costs.

Looking forward, the business has better margins in the future. RISI has packaging demand up. The fourth quarter of 2008 has an increase of 1.7%, the first quarter of 2009 up 3.3% and the following quarter up 2.3%. It also sees better margins increasing steadily through that time frame. Most importantly, is SSCC and its debt problems. In 2005, debt stood at $4.571 billion. In 2007 it had decreased this debt to $3.359 billion. Most of this was driven by asset sales, as it will continue to do this to develop proper cash flow. It refinanced its bonds to 2012 and this lowered its interest rates. This lowered its interest expense by $65 million. All of this caused an S&P credit upgrade in the fourth quarter of 2007. In 2005 bank debt was $1.511 billion. That amount decreased to $787 billion in 2007. This increased collateral coverage from 3.5 times to 6.6 times (total assets/bank debt).

Looking to 2009, the company seems to be better positioned. To remind the investor, this is a value play and it could take years to recover losses that could be incurred going forward, but the risk/reward seems good at this time. Packaging demand looks to be up, while containerboard exports look to be increasing on demand. Capital expenditures will be lower next year and the company will have much less costs in its pension plan. The box plant should see a nice return on capital. The transition costs will be much lower as much of the work will be completed by the end of this year. Revenue growth and profits should be seen next year.

All of this will help the company's stock price improve, and, more importantly, it will emerge as a stronger company. The last piece of the puzzle is the company has a decent chance of being bought due to its large market share and very cheap stock price. The risk is still great, but an even larger reward will be seen by the patient investor.

Stock position: None.

Comments

[sharksandwich:]

why not look at KPPC. better cash flow yields, lower debt and better management. SSCC is a D+ relative to KPPC

2008 Oct 23 08:56 AM

[Packaging:]

When everyone else is selling is the best time to buy

2008 Oct 24 03:45 AM