13% Short-Term Bond Yields From Recycling Waste Paper?

| About: Bio Pappel (CDURQ)
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Recycle your way to higher income with these high yielding bonds from Bio PAPPEL, S.A.B. de C.V. (OTCPK:CDURQ), the largest paper producer in Mexico and the leader in the production of 100% recycled, recyclable and biodegradable paper throughout Mexico and Latin America. Each week, we screen thousands of corporate bond listings to find what we believe to currently be the best corporate bond for investors needing or seeking higher yields with the least amount of risk as possible relative to its projected return. The following is our review process that shows why we believe these near 13% yielding US dollar short-term 4-year "step up" bonds from Bio PAPPEL pass the stringent criteria for our clients, and why we have selected them for addition to other high yielding corporate bonds in their investment portfolios.

Step 1 - Assessing the Yield Curve

The higher yield fixed income market continues to be driven by money inflows, and remains resilient despite stock market action. Along with declining fixed income yields are heightened concerns for acquiring fixed income instruments that can outpace inflation without adding excessive risks. With the 5-year treasuries still trading near a low 0.75% yield and the official (but seemingly flawed) CPI for all items (less food and energy) now reported at 2.1%, this one year shorter-term 13% bond might has the possibility of taking a big stride towards improving cash flow and in preserving wealth as long the underlying fundamentals of the issuer, which we will review the major elements of here in this article, remain sound.

Step 2 - A look at the issuer

Since its founding 25 years ago, Bio PAPPEL's vision of sustainability is founded on competitiveness, environmental protection, and social responsibility. The paper industry itself is the largest consumer of wood and forests worldwide, since it uses them as raw material for paper production. However, Bio PAPPEL has replaced use of forest woods with the use of urban woods (paper recycling), with investments of over 500 million US dollars in the past 10 years and not cutting down trees for use in manufacturing paper. This is the structural foundation of Bio PAPPEL's change of corporate identity. In 2011, the company recycled 1.5 million metric tons of paper, which is equivalent to saving 685 thousand trees. Bio PAPPEL is the only Mexican company to obtain "FSC-Certification 100% Recycled," which can be reproduced by the users of its products.

Bio PAPPEL currently has 31 Industrial plants in the lower US and (primarily) throughout Mexico, and about 7,500 employees. It has a broad and diversified customer base in Mexico and the USA, which includes most of Mexico's top 500 companies.

Step 3 - We like companies that are profitable

When first starting our review of Bio PAPPEL, we were naturally inclined to think of it as just another troubled forest commodities producer afflicted over the last four or five years by global economic woes. Surprising us, was the relative consistency of its net sales numbers over the last five years:






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deprec. and amort.
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Also somewhat surprising to us was the relatively stable earnings (EBITDA) generation over the last three years. Furthermore, after looking deeper into their income statements, it confirmed to us that the risks to earnings and cash flow were not likely to be big fluctuations in the demand for their products, but rather, in currency exchange and production costs.

Fitch, which recently affirmed Bio PAPPEL's bond rating at "B", expects somewhat higher EBITDA generation through the remainder of this year. Given that Chinese purchasing demands for waste paper supplies have recently fallen off, after considering the following three key points, we think the comment is probably overly conservative or too vague to draw much attention to the primary reasons:

  1. The global recovery rates for waste paper appear to be rising. They currently average about 44% in Latin America and about 65% in North America. Along with a curtailed demand from Chinese buyers for North America's waste paper, this is likely to stabilize or perhaps even lower Bio PAPPEL's raw material costs.
  1. Energy is Bio PAPPEL's second biggest production cost, and it is primarily dependent on natural gas costs. Considering the projected continued low prices for natural gas and the integration of some savvy longer-term (2 ½ year) hedging in January of 2012 when natural gas pricing was near 10-year lows, there appears to be little doubt that this cost reduction will continue to reflect in strong EBITDA number going forward.
  1. As a result of a majority of its costs being linked to dollars, any appreciation of the Mexican peso relative to the US dollar would result in additional costs savings. According to a July 2012 Global Emerging Markets Equity Research report from JP Morgan, Mexico was outperforming most other Latin American countries primarily as a result of the sharply appreciating peso from its lows in May. More significantly, the MXN was the only currency in Latin America that appreciation was expected to be seen in going forward.

Overall, it appears that Bio PAPPEL adjusted to and survived the global economic whirlwinds of 2008 with remarkable ease, and is now very well positioned to turn continued cost savings into solid earnings and cash flow going forward.

Step 4 - Interest Coverage Ratios

Interest expenses for Q2 were reported at about $5.3 million, while operating income was about $20.1 million, indicating reasonably good 4 to 1 coverage ratio and a 90% year-over-year improvement in 2Q 2011's operating income, which was $10.6 million. The full year for 2011 (ended Dec. 2011) showed interest expenses at Ps 284.5 million ($20.8 million), while operating income was reported as Ps 406.3 million ($29.7 million.) Earnings before taxes, depreciation and amortization (EBITDA) was Ps 768 million ($56.3 million), giving about a 3 to 1 coverage ration of the interest expenses. Years 2009 and 2010 both indicated higher cash flows than 2011 against lower interest expenses, with significant variations evidently resulting from or magnified by USD-MXN currency exchange rates.

Given Bio PAPPEL's recently reported strong cash flow and rapidly rising EBITDA, it would truly be no surprise to us to see the bond called next year prior to the interest coupon payment increase to 10%. Furthermore, should the Mexican peso continue to strengthen against the dollar, it will likely bode very well for this company and we would be quite surprised to see these bonds left outstanding.

Step 5 - We like companies with lower debt to cash ratio

The consolidated debt of Bio PAPPEL at the end of Q2 2012 was $261.8 million, primarily attributed to the 2016 Notes. Cash and cash equivalents at end of Q2 had increased to $80.1 million from the 2011 year end amount of $70.8 million, giving it a quite reasonable debt to cash ratio of about 3.25 to 1.

Step 6 - We like companies that have good balance sheets

Bio PAPPEL's current debt appears to be about 60% of its currently indicated enterprise value of about $425 million. This plainly shows the valuation currently given to it by the capital markets, but what it doesn't reveal is how low this valuation is relative to its much higher book value of over $880 million. So, while there may be reduced opportunity from the equity markets should additional capital need to be raised, the strong property, plant and equipment valuation it holds on its books does provide sound and tangible assurance for its bondholders.

Step 7 - We like higher yields

This US dollar denominated debt of Bio PAPPEL was issued in August of 2009 at the coupon rate of 6% for the first year, 7% for the following three years, and 10% for the last three years, payable quarterly. Its principal amount of $250 million is callable, and it maintains certain restrictions affecting the ability of Bio PAPPEL or its subsidiaries to such things as (but not limited to): incurring new debt; paying dividends; becoming involved in a lines of business not allowed; mergers, leases or sales of all or substantially all of the company's assets; or repurchasing the 2016 Notes in case of a change of control.

At its current discounted price of 87.50, the indicated yield to maturity in 2016 is about 13%, or if it were to be called next August, about 20%. Although the credit ratings are widely different, when set in comparison to longer five-year U.S. Treasuries yielding a paltry 0.75%, we believe this greater than 12% difference in yield is stunning given the level of risks that we can identify.

Step 8 - Risks Considerations

Bio PAPEL is relatively small compared to other paper and packaging products manufactures and their subsidiaries, such as International Paper Company (NYSE:IP), Domtar Corporation (NYSE:UFS), Weyerhaeuser (NYSE:WY), and MeadWestvaco Corporation (MWV), and may face increasing competition from substantially larger and better financed companies for the raw materials that are needed.

The cost of recycled fiber (OCC and ONP) is directly affected by trends in international and domestic prices, as well as by the exchange rate of the Mexican peso. Fluctuations in the price and supply of energy are also unpredictable, but recently implemented commodities hedging should help alleviate some of these uncertainties going forward. Considering that most of its revenues are generated in pesos, it is our opinion that Bio PAPPEL's vulnerability to a sharp devaluation of the peso may be the most significant risk.

We believe that these Bio PAPPEL bonds have similar risks, similar maturities, or similar yields to the StoneMor (NYSE:STON), KEMET Corporation (NYSE:KEM), Tutor Perini (NYSE:TPC), or Georgian Railway bonds reviewed previously on our Bond-Yields.com blog.

Summary and Conclusion

Although Bio PAPPEL's bonds are only rated as B from Fitch and are unrated by other agencies, we see the overly conservative view from Fitch as a blinder that hides this unusual opportunity from the peripheral vision of those seeking high yields for the least amount of risk. In fact, this is such an unusually high yield relative to its risks that we are inclined to think of it more as an anomaly, especially when the likelihood of being tendered in 2013 is added to it. In light of this, we suspect that there may not be much liquidity in this particular bond issue at its current price levels.

It is our opinion that Bio PAPPEL has not only positioned themselves well for the future as a "green" 100% Recycled materials company, but they are the largest in all of Latin America. They have a good cash position, sound interest coverage, and a sound balance sheet, which is why we have chosen to add them to our other Offshore Bank, Foreign and World Fixed Income holdings.

Coupon: 7.0, stepping up to 10.0 in year 2013 and after
Ratings: NR/NR/B
Maturity: 08/27/2016
Price: 88.25
Yield to Maturity: 12.96%
Yield to Call in 2013: ~20.75%

Disclosure: Durig Capital and certain clients may have a position in PAPPEL 2016 bonds. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than may be initially indicated in our reports.