Mercer International (MERC) is a Canadian and European manufacturer of Northern Bleached Softwood Kraft pulp that is finally hitting on all cylinders. While it is trading at multi-year highs, MERC offers interesting long-term exposure to a basic material in short supply in some markets, such as China.
There are two types of Kraft pulp used to add strength to paper products such as tissue paper - softwood pulp and hardwood pulp. Softwood pulp is preferred as it adds more strength per ton of usage. 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 this year while softwood capacity is expected to remain flat at 23 metric tons. Between 2008 and 2014, hardwood capacity is expected to have expanded at a rate of 2.7% annually vs a decline of -0.5% annually for softwood.
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 and Peter Kellogg. 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%.
Mercer is one of the first pulp manufacturers to expand into the bio-mass power generating business, and this gives it a huge leg up on its competitors. A major cost in the manufacturing process pf pulp is the cost of electricity, and MERC not only generates enough electricity to be self-sufficient but to sell the excess power on the open market. This gives the firm not only a cost advantage but also another revenue and income stream. Operating costs decline by about $85 million a year from being energy self-sufficient and excess electricity/chemical sales adds about $100 million in additional revenues. With annual sales in 2014 of $1 billion and EBITDA of $245 million, it is easy to see the importance of power generation and chemical sales is to the bottom line.
Softwood pulp is used in high end paper products such as tissue, fine writing paper and absorbent materials. As emerging markets such as China moves up the economic ladder, tissue usage also increases, creating an ever higher demand profile for the raw material.
MERC benefits from a strong US dollar as explained by the CEO during the most recent earnings release, “As our operating costs are primarily incurred in Euros and Canadian dollars and our principal product, NBSK pulp, is quoted in U.S. dollars, our business and operating margins materially benefit from the current strengthening of the U.S. dollar. Our energy and chemical sales are made in local currencies and as a result decline in U.S. dollar terms when the U.S. dollar strengthens. Going forward, while we will continue to benefit from a stronger U.S. dollar, it will be partially offset as in 2015 the rapid strengthening of the U.S. dollar has put downward pressure on pulp prices as a stronger U.S. dollar increases costs to our European and Asian customers."
As a commodity driven business, profitability is directly impacted by the selling price of NBSK. Below are multi-year graphs of the commodity pricing for Europe and the US. It is safe to say that MERC needs strong NBSK pricing to thrive.
The table below lists the annual operating profit margin per ton of production from 2006 to 2014. As shown, profitability is very volatile.
With the stock price hitting 2-yr highs, having doubled from $7 to $14, and with earnings growth expected to soften this year, investors may want to nibble at the current levels. The firm pays no dividend. As a basic material firm with low cost manufacturing facilities and an excellent export profile, Mercer International has a bright future. Buying on pullbacks is recommended, but MERC is worthy of being put on your radar screen.
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This article first appeared in the March 2015 issue of Guiding Mast Investments newsletter. Thanks for your interest, George Fisshe