U.S. Paper Industry: Miracle or Mirage?

Many US paper companies have had a fantastic run-up this year, particularly smaller, highly levered companies. Cursory review of industry financial statements show weak top-lines, but incredible growth in operating results. Despite the apparent attractiveness of TTM financials, the paper industry is not experiencing a miraculous recovery, rather fundamental improvements have been driven by a stealth industry bailout funded by the increasingly generous US taxpayer.

To illustrate how well the papers have done in this environment, the table below shows recent stock performance of a number of companies in the industry.


Source: Company filings and DF.

EBITDA growth is shown for the 9-month and 3Q09 periods, both including and excluding the Alternative Fuel Mix subsidy. The extent of the importance of the subsidy to financial results is apparent. Growth dwindles dramatically or evaporates completely, as is the case of VRS and KPPC. Multiples, especially those based on operating income due to high debt burdens skyrocket as well. Viewed another way, the Alternative Fuel credits form a significant percentage of operating income. As illustrated below, on a 9-month basis, the lowest figure is 43% of operating income; in the cases of KPPC and VRS, operating income was negative without the credits.

Source: Company filings and DF.

The Alternative Fuel Mixture Tax Credit is set to expire in December of this year. Unless there is a dramatic turnaround in industry fundamentals, weaker companies with excessive debt burdens will experience rapidly deteriorating financial performance and quarterly comparisons will be incredibly ugly. Indeed, the financial results that now appear to be miraculous will be revealed as a mirage.

There are several ways for investors to capitalize on this theme. Most obviously, is to short the financially weak, such as VRS and KPPC, and buy the stronger, such as low-debt CLW or perhaps even one of the majors to create a domestic relative value structure.

The addition of Canadian paper companies could make it a more interesting theme. Canadian companies in the sector have been badly hurt by the subsidy to their US counterparts. Because the credit funding is based on how much fuel is burned, it encourages US companies to produce product below economic levels and dump it on the market. This, combined with weakening US Dollar has devastated financial performance of the industry. With the US subsidy ending, competition should normalize; and as a tit-for-tat, the Canadian government has initiated its own subsidy just as the US subsidy ends. While not as generous as the US subsidy, it should help the industry. Additionally, if the US Dollar strengthens, the Canadians would gain substantial advantage.

There are a range of Canadian companies along the risk curve, including Canfor Pulp Income Fund (CFX-UN.TO), which is currently profitable. Further, if the company and industry become more profitable, the current monthly dividend of CAD 0.01 could be increased significantly.

Disclosure: The author is long CFX-UN.TO and a few other Canadian and US Papers; short KPPC, BZ, and GPK.

Comments

[Mr Market:]

while I agree that the industry has benefitted significantly from the BLT, in the case of KPPC you are forgetting the debt paydown from year end to year end will be huge w/BLT plus warrant excercise , I guess that net/net with lot of capacity taken out and more to come in 2010 as BLT expires and high cost players are killed , if KPPC and other's can't raise prices u are 100% correct , KPPC announced 50 buck increase 12/1---I'll guess we'll see if that sticks, at current prices they are break even, each 50 bucks adds 50-60mm in EBITDA--so we'll see----thanks for your comments

Nov 10 10:59 AM

[Deep Value ...:]

While black liquor certainly saved KPPC, the future is what matters. Yes, the stock clearly looks pricey on historical results. As a non-integrated paper manufacturer, it is prone to significant fundamental volatility in financial results. However, a surface level analysis like this gives the impression that trailing results are normalized. I would argue that the stock is trading 15% below year-end tangible book value and has the ability to absolutely print money when a) pricing recovers, as it should with significant capacity rationalizations next year, and b) its normal mix returns. To me, asset value and a soon to be rock solid balance sheet seriously limit the downside, and many catalysts exist for a significant upward revaluation of the shares next year.

Nov 10 01:48 PM

[FourBrane:]

Also of note with Boise is that there's been some very substantial insider selling (over 50m shares in total) by Madison Dearborn and two directors. All Boise's insider transactions had been buys until the beginning of this year when these three started making serious inroads into their positions. I take that as a vote of confidence in your short position.

Dec 04 02:23 AM