When I was in China this summer, I was a bit disturbed by the bathroom facilities in the rural areas—the communal poo rag had not yet been replaced by toilet paper. Even in tourist locations like the Great Wall, the restrooms had a rag attached to the wall to be used for wiping your ass. I had to ask our tour guide for confirmation that I wasn’t just imagining this—unfortunately I wasn’t. At the time, I just shrugged my shoulders and thought about it as little as possible. That was until I was alerted to the investment implications of this. Put simply, the average westerner uses over 25 lbs of tissue and toilet paper a year (hereafter simply called tissue). In most of the undeveloped world, the usage is a tiny fraction of that number, but it is growing rapidly.
Worldwide tissue consumption in 2009 was 28.2 million tons. Production capacity will increase by 4 million tons by 2012 with 2.6 million tons of that coming online in China. As people reach a certain standard of wealth, they decide that they can afford toilet paper and all the sanitary benefits that go along with it. Per capita tissue consumption in the West has stagnated. Get ready for huge growth from the other 4 billion people who don’t yet use tissue.
Tissue comes from specialized pulp known as Northern-Bleached Softwood Kraft (NBSK). This is a fiber made only from softwood conifers. It is produced primarily in the US, Canada, Chile, Germany, Russia and the Nordic Countries by turning woodchips into pulp using the Kraft process. Because of the specific strength and fiber length of NBSK, you cannot make tissue out of hardwood pulp, though many tissue manufacturers substitute some of the NBSK content with cheaper hardwood pulp. If you have ever been to a truck-stop, you can probably tell the difference between blended pulp and the pure stuff in Charmin.
There was a multi-decade glut of NBSK production with constant boom and bust cycles. These cycles culminated with the complete decimation of the industry and the shuttering of 5.3 million tons of capacity in the last four years, which is very considerable when you realize that 2010 production will come in at only about 23 million tons. 1.9 million tons of shuttered capacity is being restarted but most of the other capacity will never come back online as it is too old or already scrapped. At the same time, there is only one new plant in Russia that will be starting up in the next few years. Any increase in demand should finally lead to some pricing power for the industry.
For the past decade, I have been focused on two things; figuring out what China needs more of and figuring out which commodities have not yet increased in price, but probably will. NBSK fits into both of those categories. Most importantly, it takes years to build a new mill. If these trends gather any momentum at all, we could have huge increases in pulp prices. If not, my two pulp companies will do just fine at current pulp prices.
When I look at commodity charts, it is becoming increasingly difficult to find charts that are not dramatically above previous all time highs. NBSK is just now beginning to challenge prior highs dating back to the past three decades. That alone has my interest piqued. The decade low inventory levels and increased tissue making capacity in China makes me even more excited.
Most Wall Street analysts seem to think that this pulp cycle is like the past ones where shuttered mills are restarted and they lead to another glut. I believe that this cycle is different. The shuttered mills will be much more difficult to restart. They are decades old and they have been cannibalized by still-operating mills for spare parts. Even more importantly, the operating mills got a freebie in the recent round of bailouts that will make them very difficult to compete against.
From Mercer International Presentation
During the worldwide bailouts of 2008 and 2009, struggling mills were thrown a hand-out by certain governments, mainly in Canada. They were given grants to create green energy power plants. I’m not sure how environmental it is to burn sawdust for electricity, but I guess its ‘sustainable,’ or whatever the latest buzzword from the environmental movement is. In any case, these power plants produce almost zero cost energy which is sold into the grid, often at above market rates. This is a very strong competitive advantage compared to those mills that shuttered and did not get this government largesse.
Pulp mills aren’t exactly ‘good businesses.’ If I’m wrong about this pulp cycle, I’m wrong about these two companies. If I’m right, it doesn’t really matter which pulp company you choose. Therefore, the company reviews will be somewhat brief. I prefer these two because they are pure plays on NBSK without the exposure to Hardwood Kraft pulp which is still horribly glutted with overcapacity. This is more of a sector bet than a bet on either of these companies.
Mercer International (MERC: Nasdaq) has nameplate capacity to produce 1.475 million tonnes of NBSK in two mills in Germany and one in British Columbia in Canada. The Celgar mill in Canada just installed 48 MW of electrical generation capacity which alone will add C$ 25 million of cash flow a year. Because of disruptions in wood chip supply and a slow increase in pricing due to longer term contracts, it is difficult to really estimate forward earnings. If you take third quarter cash flow, add in the Celgar mill and adjust for increasing pricing on pulp, I don’t see why they cannot have at least $140 million of free cash flow next year. There are 56.5 million fully diluted shares (if you count converts), so the company trades at only about three times what I expect cash flow will be. Clearly, if pulp prices stay at current prices, this is too cheap. If pulp prices increase, this could be a home run. Every dollar increase in pulp margins creates almost $1.5 million in additional EBIT. Excluding wood chips, most costs are fixed. A $100 increase in pulp margins would add almost $150 to EBIT. That’s a whole lot of operating leverage, but remember leverage cuts both ways and this is a company with over EUR $800 million of debt. There isn’t exactly much margin of safety here.
Fibrek (FBK: Canada) is a bit of a mixed bag with 745,000 tonnes of capacity out of three mills. About half of capacity is recycled paper, which isn’t exactly doing well. The other half is NBSK which excites me. At current pulp prices, the company should have around 60 million of free cash flow a year. If recycled paper demand increases, the company could earn a whole lot more. The company is also getting a new 9.5 MW power plant courtesy of the Canadian government. Unfortunately, this will not be on line until the end of 2012. The current market cap is $165 million and like Mercer, it trades at around three times cash flow. Fibrek isn’t as leveraged as Mercer, so it is a bit less binary of a situation. I would like to point out that the mills are on the books for C$570 million and replacement value is well north of a billion. Then again, replacement value is often a meaningless metric for a commodity business. However, why build new capacity for billions when you could just buy Fibrek for a fraction of that?
The pulp sector has seen significant recent insider buying--In particular, multiple insiders have recently purchased shares of Fibrek. As you will recall, I pay particular attention to insiders. Both companies are riding a wave which may be cresting, or it may become a tsunami. There is no real way to know, but I feel that the supply and demand dynamic favors the latter. Even if I’m wrong and NBSK prices stay at current levels, I’ll do just fine. If NBSK goes higher, these two could be huge winners. As long as NBSK doesn’t drop too badly, I probably won’t lose much. These are the types of investments I like to make, but they are both small positions for me as they’re so binary. I usually hate to invest in ‘bad businesses,’ even if I think I have a secular tailwind. I will do it in this case as I think I can get out without too much pain if pulp prices reverse.
There is only one new NBSK mill currently under construction and it takes two to five years to build more. What happens if 4 billion people decide to start wiping their ass before then?
Disclosure: My investment partnership owns shares of Mercer International. We may buy or sell shares without further notice.