Mercer International (MERC) ($11.60) is a relatively unknown small-cap Northern Bleached Softwood Kraft (NBSK) pulp manufacturer that, although not particularly considered value priced based on the cyclical nature of their business, offers above-average capital gains potential. Relatively well liked on the Street, MERC offers investors exposure to a basic material manufacturer that is well positioned in the paper manufacturing supply chain.
Mercer is the 2nd largest global producer of NBSK pulp with two mills in Germany and one in Western Canada. The two German mills are the only local facilities supplying NBSK. The German mills can effectively service the European market and one is position close to export facilities allowing for greater export opportunities. The Canadian mill is well situated for shipments across North America in addition to exports to Asia, specifically the growth market of China.
Revenues in 2010 were $1.2 billion. 60% of Mercer's business is generated in Europe with Germany representing about half, 23% in China, and 11% in North America. Mercer produced 1.2 million metric tons, with about 60% of the production in Germany. Although domiciled in the state of Washington, MERC prefers to report financials in Euros.
The pulp mills owned by Mercer are some of the newest in the industry. Their factories utilize the latest technology, creating lower operating costs. This also reduces the need for costly maintenance and machinery rebuilds.
According to Wikipedia, a description of NBSK:
"This pulp grade is very diverse and all NBSK pulps have long fibers. Cedar, douglas fir, hemlock, larch and spruce from British Colombia have longer fiber lengths and larger fiber diameters than anywhere else in the world due to very long growing season and mild climate. The most common use of NBSK is as reinforcement fibers when making paper or as raw material for Kraft paper. It is also used in tissue paper."
Historically, the pulp market is like many commodities where market high prices lead to excess capacity additions that lead to a glut of product on the market that lead to lower prices that lead to lower profitability and eventually lead to capacity curtailments. As a cyclical commodity, this pulp cycle is also affected by underlying demand and economic growth. Current pulp prices are high. While one would expect additional NBSK capacity to sprout up, that does not appear to be the case.
There are two typed of bleached Kraft pulp – Hardwood and Softwood. Hardwood pulp is characterized as having shorter fibers and is less effective as a reinforcement agent. Mercer specializes in Softwood pulp. One of the advantages of this specialization is showing up in current and anticipated global capacity. While hardwood capacity is expected to continue its annual increase in capacity that started in 1990, softwood capacity is expected to remain flat. In 2006, both hardwood and softwood had about equal global capacity at 23 million metric tons. Capacity of hardwood pulp is expected to grow to about 34 million metric tons by 2014 while softwood capacity is expected to remain flat at 23 metric tons. Between 2008 and 2014, hardwood capacity is expected to expand at a rate of 2.7% annually vs a decline of -0.5% annually for softwood.
In other words, the type of pulp Mercer specializes in, NBSK, is breaking the traditional high pulp price and excess capacity cycle. This should stabilize earnings going forward for Mercer if underlying paper demand stays strong.
Mercer also operates "green" electric power generating facility at their three pulp mills and the combined generating capacity is 260 MW. The electricity that is not used at the mill is sold to third-parties through medium-term power supply contracts. Energy is not a large part of their business with 2011 anticipated energy revenues of $85 million, representing about 7% of total revenues. However, the ability to generate electricity reduces operating costs by about $55 per metric ton of production, compared to purchased power.
Profitability has returned to MERC after a devastating few years due to the economic slowdown. After losing -$2.66 per share in 2009, MERC is expected to earn a consensus $2.45 this year and $2.60 next, after considering additional shares being issued from the conversion to common from a convertible debenture that is in the process of being called. Shares outstanding are anticipated to increase from 44 to 55 million with this conversion. Keep in mind most company reports will indicate euros as the financial currency, while a few reports incorrectly indicate results are in USD without making the exchange conversion. MERC has a market capitalization of $630 million.
Operating margins for the year 2010 increased to 25%, up from just 7% in 2009. However, it is worth noting this matches the peak margins of the last cycle which were 23% in 2006, just before its precipitous decline to -4% in the 3rd qtr 2008. Operating margins have been slipping over the past few quarters, falling from 28% in the 3rd qtr of last year to 24% last qtr.
The important financial number is the company's free cash flow (fcf), or operating cash flow less maintenance capital expenditures. This year, MERC is anticipated to generate $3.70/shr in fcf and $3.16 in 2012. At its current valuation of $11.60/shr, Mercer is trading at just 3.1 times 2011 fcf and 3.6 times 2012 fcf.
Due to capital expenditures on plant construction, machinery upgrades, and additional electric generating capacity, Mercer has taken on added debt. The stated goal of management is to reduce net debt using the current strong free cash flow. Net debt in the 2nd qtr 2010 stood at $980 million with a net debt to total capital ratio of over 60%. With the conversion of some notes to common shares along with aggressive principal pay downs, net debt should be around $700 million by the end of this year and $500 million by the end of next year. This reduction will represent a 32% net debt to total capital ratio, along with interest savings of more than $32 million a year, or about $0.60 a share.
Mercer has an interesting history. Assembled in the early- and mid-1990s by acquiring various German paper facilities, the company grew as an affiliate of Hong Kong-based Mass Financial Corp, a network of businesses run or influenced by Michael Smith with Peter Kellogg as a major investor. While Mercer separated from Smith in 1996, Kellogg still owns 8.4 million shares or about 18% of shares outstanding. Platinum Investment Group, a money manager from Sidney Australia, own 17%.
While it is usually best to buy cyclical basic material stocks during the height of an economic downturn, Mercer offers an interesting value based on continuing strong NBSK pricing and relatively little new global capacity, along with robust free cash flow reducing debt and annual interest expense. This deleveraging will bring debt levels in line with industry peers. Mainly due to its high leverage, Mercer's current stock price valuation represents a 28% discount to the average of its peers and offers the 2nd lowest valuation of the global pulp manufacturers. As debt levels are brought down and corresponding interest savings improves profitability, this discount should be substantially reduced.
For investors looking for greater exposure to the basic materials sector and specifically the paper industry, Mercer is well worth the time for further due diligence. The stock has had an incredible run since bottoming in 2009, and recently has pulled back about 24% from its all time high. A reasonable price target would be in the $16 to $18 range, creating a potential 40% to 55% capital gain over the next two years.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.