Mercer International: Well-Positioned And Seems Cheap

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About: Mercer International Inc. (MERC)
by: David Lojkasek
Summary

Mercer is seems to be well-positioned in the market as it has modernized its mills ahead of its competitors.

Global demand for pulp is increasing and should continue to do so in the future, according to research.

The company trades cheaper than in the past on all EV/EBITDA, PE, as well PBV.

Mercer International (NASDAQ:MERC) is a Washington state-incorporated company with headquarters in British Columbia, Canada. Its operations are located in Canada and, mostly, in Germany near the country's capital of Berlin. The company is one of the world's largest producers of NBSK (Northern Bleached Softwood Kraft) pulp, a premium grade of pulp. As a result of Mercer's philosophy, which is to leave no forest resource wasted, the company also sells green energy, chemicals, and lumber.

Mercer International

There are many reasons why I like the company including its operations, dividends as well as the market outlook. Let me start with the operations–the company operates three pulp mills, two of which are located in Germany (Rosenthal and Stendal) and one in Castlegar, British Columbia (Celgar). In 2017, the company acquired a sawmill in Saalburg-Ebersdorf, Germany (Friesau), which is located near Berlin as well as only 16km from the Rosenthal pulp mill.

Pulp production, the company's core operation, accounts for the majority of sales but it is important to note that all Mercer's plants are net producers of electricity, which is green–an important aspect, given the recent moves towards more environment-friendly power generation in the EU and the West in general. Similarly, the company sells tall oil, a by-product of the pulping process. Doing this, the company adheres to its philosophy of utilizing every forest resource and leaving none wasted. It helps to diversify the sales of the company as well. In the table below, you can find Mercer's production capacity.

Production capacity Pulp (ADMTs) Electricity (MW)* Tall oil (tonnes) Softwood lumber products (Mfbm)
Rosenthal 360,000 57 6,000 -
Stendal 660,000 148 25,500 -
Celgar 520,000 100 - -
Friesau - 13 - 550
Total 1,540,000 318 31,500 550

* In addition, the Friesau plant generates 49.5 MW of thermal energy

Source: The company data

Early in December 2018, Mercer announced it completed the acquisition of Daishowa-Marubeni International Ltd (DMI). DMI owns 100% stake in a bleached kraft pulp mill in Peace River, Alberta and a 50% stake in Cariboo Pulp and Paper Company, a JV which is operates the bleached kraft pulp mill in Quesnel, British Columbia. The pulp mill owned by DMI have a combined production capacity of 645,000 ADMTs, increasing the total production capacity of the company by 41.9% and a surplus energy c. 890,000 MWh. The table below highlights DMI's financial data–what MERC is essentially buying.

DMI Financial highlights (USD m) Revenues EBITDA Net income
8M2018 320.3 90.7 42.2
FY2017 351.6 55.3 8.2

Source: Mercer International press release from Oct 3, 18

The acquisition is strategic–what the company is buying is not only an increase production capacity, enhanced presence in Canada but also an expanded presence in the Asian market. In a press release, the management of the company has stated it sees synergies in the range of USD 15-20 million per year. In order to complete the acquisition, however, MERC has issued and successfully placed senior notes worth USD 350 million with a coupon rate of 7.375% (an annual interest cost of approximately USD 25.8 million). The notes are due in January 2025.

The company indicated, in its 3Q18 earnings call, that it intends to focus on a safe balance sheet. At the same time, the company is committed to be a dividend payer and intends to increase the dividends slowly and steadily over time. The acquisition can certainly pose a risk to Mercer's dividend which currently yields c. 4.6% but as the payout ratio has decreased recently, I would not deem the risk to the dividend large.

Source: Author based on MERC's SEC filings

While the company operates in two segments–the Pulp segment and the Wood products segment, its business is actually divided into three different operations–NBSK Pulp, Wood products, and Energy & Chemicals businesses.

Majority of sales in all three businesses are generated in the EU, followed by China in Pulp, Canada in Energy & Chemicals and US in the Wood business. The sales mix is summarized in the charts below.

Mercer International sales mix

Source: Mercer's Investor Presentation from Sept 2018 (Sales data: 12M Trailing revenues as of June 30, 2018).

The company started to report the Wood business segment only in 2017, when it acquired the Friesau sawmill for USD 55.1 million plus a defined working capital of USD 6.5 million. The Friesau sawmill is one of the largest softwood sawmills in the World and second largest in Europe, according to the company's presentation. Before the acquisition of the mill by Mercer, the mill had been operating on restricted basis but after the acquisition, Mercer managed to ramp up production faster than it initially budgeted. Furthermore, the company has proposed certain expansion and optimization initiatives, which should increase the production capacity of the sawmill from the current 550 Mfbm to 750 Mfbm.

From the market point of view, it seems the company is increasing its production capacity at the right time. The company says it is ahead of its competitors in the investment cycle and older mills of Mercer's competitors are experiencing unplanned maintenance downtime. Mercer's competitive advantage is shown on the chart below. This should help the company in the near- and mid-term future.

Mercer International competitiveness

Source: Mercer's Investor Presentation from Sept 2018

According to Transparency Market Research, the pulp market is constantly boosted by a push for product development. Transparency Market Research further writes that:

...the Europe region is setting a laudable precedent in this direction because of constant innovations in the region’s paper industry and increasing pulp production capacities of the regional vendors. [source]

Transparency Market Research sees the CAGR of the global pulp market from 2017 through 2026 at 3.7% when the market should become as large as USD 60 billion. The Asian market will continue to account for a lion's share of the global pulp market. The growth is and will be led by the drive towards lightweight packaging solutions as well as the fact that most developing nations are adopting to various types of paper on the back of their increasing development and literacy rates. India, China or Indonesia may be listed among such countries. The company also sees a stable demand in western countries, which is important to mention as well.

China, which accounts for approximately 30% of Mercer's NBSK pulp sales, will continue to reshape the global pulp and paper industry in the future. According to Fisher International, China is the largest producer of tissue but in terms of consumption, it is far behind the developed countries. Due to a large and dense population, a small percentage change can have a far reaching consequences for the entire market. Fisher International actually writes:

..., if China continues to grow as projected, it will need to add more tissue and container board machines than exist in all of North America today! [source]

This is all showing that China and other countries, the development of which continues at a fast pace, will help the pulp and paper market grow in the future. The following chart presents the the global demand for BSK by the world's regions.

Global BSK Demand - Pulp and Paper Product Council

Source: Mercer's Investor Presentation from Sept 2018

China's growing demand between 2000 and 2020e shows a CAGR of 10.9%, according to the company's presentation and the Pulp and Paper Product Council. Looking at Mercer, the company seems to be well-positioned to capture and ride the growth.

In terms of lumber, the industry indicates 2018 may have been another record year. According to International Forest Industries, six of the ten largest exporters of lumber increased their exports on the year-on-year basis. Germany, where the company's Friesau sawmill is located, was one of the countries which recorded the highest year-on-year growth.

Mercer's fundamentals seem to be supportive as well. While the sales have seen their ups and downs recently (see the chart below), in 2017, the company reported an increase in the revenues on the back of higher price realizations and higher sales volume in the Pulp segment as well as the addition of the Wood segment. The operating margin has increased from 12.21% in 2016 to 14.29% in 2017 and the profit margin has recorded an increase from 3.75% to 6.03%. Had it not been for the USD 10.7 million one-off expense regarding an early redemption of Mercer's 7.0% 2019 Senior Notes, the profit margin would be near 7%. Likewise, the 2017 ROA and ROE profitability ratios were higher than in 2016.

Source: Author based on MERC's SEC filings

Source: Author based on MERC's SEC filings

In the first nine months of 2018, Mercer reported sales of USD 1,045 million with the operating margin coming at 16.92% and the profit margin at 7.99%. Thus in 2018, the company is likely to show higher margins and higher profitability than in 2017 due to increased efficiency as well as growth of sales–both organic and through M&A.

With regards to the insiders trading the stock, going through the SEC filings from 2018, what I have stumbled upon most often was an insider disposing of a half of the stock he has been awarded and keeping the other half. The most recent filing of Form 4 showed James Shepherd disposing of 4,800 shares for a price of USD 17.75 per share. On the other hand, Peter R Kellogg, a major shareholder who owns most of the shares (13,475,000) via IAT Insurance Co. Ltd. has acquired 9,000 shares for a price of USD 14.249 on Dec 29, 17 and 1,000 shares for USD 14.308 on Jan 8, 18. This brings us to valuation.

In terms of valuation, the company is trading below the levels it used to do in the past.

Chart MERC EV to EBITDA (NYSE:TTM) data by YCharts
Chart MERC Price to Book Value (5y Median) data by YCharts
Chart MERC PE Ratio (TTM) data by YCharts

The recent drop in price is attributable, in my opinion, to both the acquisition of DMI which may have some investors worry as well as the recent drop in the markets which dragged the company's share price down. The company has not changed and while some of the risks regarding the acquisition, China, Brexit, etc. still remain, I believe the company is trading cheap currently.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.