Monday, February 05, 2007

SFK Pulp Fund- My Top Holding:

Ticker: SFK-UN.TO
Price: 4.90 CAN
Shares Outstanding: 101 Million
Debt: 114 million
Market Cap: 495 Million
Note: All above figures take into account recent acquisition and share offerings, to show position today, and all numbers will be in Can$, unless otherwise noted.

Investment Thesis Summary:
SFK operates some of the most efficient pulp mills in a depressed industry and has a yield of 20% under these depressed conditions, and there are several significant sources of potential surprises. (phew, got that all in one sentence )

Business Description:
SFK Pulp Fund("SFK") is a Canadian income trust that now operates several pulp mills and is finally recieving some upswing in an industry that has been severely depressed. For those completely clueless to the pulp industry, i recommend reading the 2005 SFK annual report available at But basically, pulp is the product of processing trees, and it is the matierial used to make paper. For sake of this analysis, I will split the business into two parts: the NBSK business ("NBSK") which has been historically operated by SFK, and the AFRI mills ("AFRI"), which SFK recently acquired.

The NBSK business
SFK operates one of the lowest operating cost pulp mills before and even after accounting for fibre costs. See Exhibit A. There has been a large divergence between the fibre costs for Western and Eastern Canadian pulp companies. Western Canada has been plagued with a pinebeetle infestation that has forced them to excessively cut down trees in order to stop their spread. The result has been a huge divergence between the fibre costs for Western and Canadian pulp companies- Fibre accounts for about $125 per ADMT (ton of pulp) of the cost in the West, compared to about $310 ADMT in the East - and the selling price for an ADMT of pulp is only $784. Obviously, this has had a huge effect on Eastern Canada, and several Eastern pulp mills have had no choice but to close. SFK has been able to survive this due to its low operating costs.

The NBSK mill has production volume of 356,000 ADMTs.

NBSK Industry
The NBSK industry, as well as Pulp and Paper in general, have been plagued with losses and overcapacity for several years now as a result of very excessive investment in the 90's. However, the NBSK pulp industry in particular has several attractive characteristics to it. NBSK pulp is essential in several types of paper because it is the only way to add considerable strength. Importantly, NBSK pulp can only be produced from certain tree types that exist only in Canada, Scandinavia, and Russia, with 50% of the production coming from Canada. Thus, there is no threat from low cost countries. In addition, it is much less cyclical than some of your other commodities- the derived demand for their pulp stems from newspapers, specialty papers, etc.

Second, there has been no addition to supply for several years and little money is being reinvested in the industry because conditions and returns would of been poor for so long. As an example, a mill with similar production to SFK's would now cost about 600 million to set up, while EBITDA for SFK was only 30 million last year. In fact, the opposite has been happening- over 1.6 million ADMT production has been shut down over the last year and a half, in an industry with production of 14 million ADMTs. Meanwhile, Demand has steadily grown over the last 15 years at about 2% annually.

The AFRI Business
The AFRI business consists of two mills that were recently acquired. These mills sell RBK, or recycled pulp, which competes and prices similarly to BHK pulp. I believe managements statement does the best job of discussing the rationale for the acquisition, and this can be found at the bottom. See Exhibit B. They have a production capacity of 360,000 ADMTs of RBK.

Investment Opportunity
The market has not yet adjusted the price for the currently improved conditions or the acquisition for SFK. For the 3rd Quarter of 2006, SFK generated EBITDA of 15 million. Note: this doesnt include the acquired mills. Also, this business is not seasonal. Furthermore conditions have improved since this point.

3Q06 EBITDA 15 million x 4 = 60 million
Yearly Maint. Shutdown - 10 million
Pricing Improvement +38 million
Exhange Rate Improvement +13 million

Forward EBITDA = 101 million

Let me explain the above. I 4x EBITDA of 3Q06 because the business is not seasonal, but there is a 14 day shutdown of the business for yearly maintenance, so i subtract the 10 million from that lower output and those costs. (VERY conservative, its probably closer to 5) Next, the pricing improvement. In 3Q06, SFK realized prices of $671 US/ADMT of NBSK pulp, but NBSK in the US is currently at $784 US. The reason for the huge difference is because there have been significant price improvements since the 3rd Quarter (+74$), and because there is a small lag between price increases and when SFK can pass them on to its customers(+39$), partially offset by 20% of their sales in Europe, where there is less favorable pricing(-6$). Its also important to note that historically SFK has actually charged about $30 premium to the market rate of pulp because it uses a higher cost black fir tree which has greater strength properties, but I left this out to avoid confusion and add conservatism. The reason this premium is not showing is again, because prices for pulp have gained significantly recently from their very depressed levels and SFK still hasnt fully passed these along. Finally, the exchange rate has improved from an average of .896 in the 3Q to the current .8462 . According to management, this adds 2.6 million per .01 change. Thus, we end up with 100 million in EBITDA for the NBSK business, and after subtracting annual maintenace of 6 million (managements statement, found in Annual Report 05) we get Free Cash Flow for "NBSK" of 94 million. (please also remember I havent subtracted interest yet and this is only "NBSK" so far)

Next, the AFRI Business.
For the Twelve month ended on June 30, 06, the business generated EBITDA of 36 million. (See short form prospectus dated Aug 23, 06 at direct link isnt possible)

EBITDA = 36 million
Pricing Improv. +21 million

Forward EBITDA = 57 million

At dec05, the price of BHK was at $570US in Europe, compared to the current price of $670US in Europe. The US usually gets better pricing than this. I cant find price at June 06, but lets assume the average price AFRI realized over the 12 months ended june 30 06 was $620 US. This $50 improvement would translate into $50 US x 1.18 US/Can x 360,000 ADMTS = 21 million more.

Finally, Lets Put it all together

trailing EBITDA's = 86 million
Pricing Improvs. + 59 million
Exchange Rate +13 million

Total Forward EBITDA = 158 million

Capital Structure
Pre-acquisition, there was 59.2 million units outstanding.

Immediately after the acquisition, there were 72,072,500 units outstanding plus 51 million in debentures convertible into 10.7 million units, and 200 milion in debt.

And finally, they recently issued 18.4 million units for proceeds of 86 million.

So, you have 114 million in debt (probably 100 now after the past few months of saving up money), and 101.2 million units outstanding.

Put it together:
There is a market cap of 495 million and net debt of 114 million.
EBITDA was 86 million to 158 million depending on trailing or forward figures.
NBSK capex is -6 million
AFRI capex is -4 million
Interest Expense is -10 million (114 million x 9%)

This leaves you with free cash flow of 66 million to 138 million after all is said and done on a 495 million market cap, with the 138 million assuming nothing but current market prices and rates.

Other Potential Upsides
As i mentioned earlier, fibre accounts for $310 per ADMT of the cost for SFK compared to about $125 of the cost in Western Canada. There is no long term reason for this discrepency- rather, it has been exacerbated as a result of the pinebeetle infestation in the West and the a 20% cutback in cutting in Quebec. Simple economics tells us this will eventually balance out, as Eastern pulp mills have been forced to shut down while Western mills have prospered. Any reduction in cost will be multiplied by the 365,000 NBSK production. I see a reduction in their fibre costs as VERY likely.

Pulp Pricing
The Pulp industry has not added production in ages, and even current prices barely justify the high costs of starting up a pulp mill. If demand continues to increase and new capacity isnt built soon, there is good potential for pricing to continue to increase. Regardless, there is little downside to prices as marginal cost of production is barely lower and new capacity won't be built if prices fall. (1.6 million in capacity shut down when NBSK pulp was around $660)

Synergy + Recylced Pulp Benefit?
Management sees 5 million in costs they can cut out from the acquisition. But also, the AFRI business has a 45% market share of the recycled market, and if the eco-friendly crazy continues, you might see increased volume and pricing from this segment.

Management is one of the greatest in the industries, and they're bonuses are tied very closely to operational success. It is one of the better compensation plans I have seen, but you can read for yourself in their annual proxy. They've done an excellent job of ranking amonst the lowest costs in the industry, while improving productivity from 950 ADMTS/day to 1050 over the last 4 years.

At these prices, it is no surprise that SFK is my largest position. (Disclosure: I own shares of SFK... duh)

Exhibit A - Comparison of Operating Costs

Canfor Pulp Operating Cash Costs 2003
Fibre Cost 183
Other Operating 310
Total 493

SFK Operating Cash Costs 2001
Fibre Cost 251
Other Costs:
Labor 75
Chemicals 68
Reg Maint. 35
Energy 26
Major Maint. 19
Other 18

Total 492

Note: Total other costs equals $241 for SFK, compared to $310 for Canfor. Also, SFK expenses $54 in other costs which are actually maintenance, which has resulted in significant capex savings over Canfor. In all, this makes the operating cash cost difference 187 to 310, or $123
per ADMT.

Exhibit B- Management Rationale for Acquisition

Rationale for the Acquisition

Management believes that the Acquisition is consistent with the Fund’s objective of generating sustainable

cash distributions in a manner consistent with the Fund’s acquisition and investment strategy and believes that

the Acquisition will position SFK Pulp as the owner of a premier NBSK and RBK market pulp operation in

North America. The rationale for the Acquisition is as follows and is described in greater details under ‘‘The

Acquisition — Rationale for the Acquisition’’.

Business Strengths of the AFRI Mills. Management expects to benefit from the following business

strengths of the AFRI Mills:

• The AFRI Mills benefit from a well-protected market share (as capital costs are a significant barrier

to entry) in a growing market for recycled and environmentally friendly content. The AFRI Mills

hold a market share of approximately 45% in the North American RBK pulp market and are the

only two air-dried RBK market pulp producers in North America;

• The AFRI Mills are among the newest facilities of their type in North America and were constructed

between 1994 and 1996 at a total cost of approximately US$462 million. Management currently

estimates that capital expenditures should be limited to US$4.0 million per year in the foreseeable


• As a result of their technology and process capabilities, the AFRI Mills are capable of producing an

RBK market pulp comparable in quality to pulp produced from virgin hardwood fibre, at production

costs which are among the lowest in North America;

• The AFRI Mills currently supply approximately 63% of their pulp on a contractual basis with terms

up to three years on average (see ‘‘Description of the Business of the AFRI Mills — Sales and


• In 2005, approximately 74% of the AFRI Mills’ wastepaper was purchased under long-term

contracts with suppliers; and

• The AFRI Mills can count on an experienced team of managers and employees.

Accretive to Distributable Cash per Unit. The Acquisition would have been 77% accretive (91% fullydiluted)

to the Fund’s Distributable Cash per Unit on a pro forma basis for the twelve months ended

June 30, 2006, without accounting for synergies but including potential savings. See ‘‘Summary of

Distributable Cash of the Fund’’.

Potential Savings. Management believes it has identified sources of cash flow improvement totalling

approximately $6.5 million within the AFRI Mills, which Management expects will help to reduce costs

and avoid duplication of certain management and administrative functions. See ‘‘Summary of

Distributable Cash of the Fund’’.

Reduced Risk Profile. The Acquisition is expected to reduce the risk profile of SFK Pulp by diversifying its

operating base through the acquisition of two high-quality pulp assets (thereby reducing operating and

financial risks inherent to a single-mill operation, including those related to fibre supply, labour related

issues and equipment breakdown) and reducing exposure to volatility in the CDN$ / US$ exchange rate.

Business Opportunities. SFK Pulp supplies NBSK pulp throughout North America and Europe to leading

printing and writing paper producers. With the acquisition of the AFRI Mills, Management will be able

to offer more than one product to the same buyer and intends to take advantage of cross-selling

opportunities with customers not previously served. In addition, Management believes that with a

consistently high-quality product (comparable to virgin pulp), opportunities currently exist to deepen and

broaden the customer base of the AFRI Mills.


Anonymous said...

Thanks for excellent article..


highlowbrow said...

Nice writeup. SFK Pulp is one of my largest positions. I also own Canfor Pulp and when taken as a basket they become my largest position.

One thing that I disagree about is that softwood pulp is a competitve threat to north American pulp producers. As southern kraft capacity continues to come online, the pricing spread between northern and southern kraft will widen. As the spread widens, consumers will shift their consumption toward southern kraft.

At present SFK is enjoying highly favorable pricing for its product. This is not however due to increased demand, but rather supply destruction in Canada. The supply destruction was a result of North American operations not being competitive with South American operators. I think it is quite likely that the medium term (say five years) will bring another very bad pulp market.

However, at present SFK is probably trading at a cash flow yield of 20% or so. Meaning it is a very attractive security. But over the long term it faces some difficult hurdles.

Nnejad said...

You brought up a good point and I should of gone into more detail. There are two types of softwood pulp- Northern and Southern. Southern softwood refers to the usage of a different type of tree, but these trees are still found pretty much in the same areas as northern softwood (North America, Nordic Countries). There is about 1.5 million of softwood capacity in Chile, but that is pretty much the extent of South American competiton. All the rest of South American pulp is eucalyptus pulp, a hardwood type. Because eucalyptus is so abundant in the region, this has given South America a huge fiber cost advantage with respect to the rest of the world in hardwood pulp. Besides fiber costs, however, South American mills are not much more cost competitive than the rest of the world. Papermakers require softwood pulp to add strength to paper, and since there is only a limited softwood fiber supply in Chile, there is not a significant threat from South American competition. I've searched for signs of more softwood capacity coming on in South America, but up until this point I just haven't seen it.

highlowbrow said...

I probably mis-phrased things. I am refering to the difference between south american and north american pulp.

My understanding is that paper manufacturers face choices of how to compose their paper. The more recycled kraft they employ, the more they need softwood kraft. On the other hand the same mills have an incentive to shift toward more hardwood use as prices widen. The paper below goes over that a little bit:

One thing that I noticed is that the Russians are starting to play games with their lumber supplies (similar to what they have done with natural gas). They are tariffing lumber exports to Finnish mills which are now scheduled to rise to economically uncompetitive levels in a few years. The goal appears to get mills to relocate into Russia. It's possible that we will or are seeing a supply disruption there.

Nnejad said...

Okay, that makes more sense. There is a threat that hardwood will steal from demand for softwood, and it does occur as the price gap widens. But, its a long term situation, and I do not think it will greatly hurt SFK. Latin America's cost advantage comes mostly on fiber. The advantages from labor is small and slightly cancelled out by transportation costs. If capacity keeps shifting towards South America, this will just lower the demand for fiber in North America. Eventually, this should balance out at a point where fiber costs are comparable to that of South America. SFK as a lower cost producer should be around to benefit from this. The report discusses SFK's cost advantage in particular:
"The $20/tonne–$30/tonne difference between Canfor Pulp and SFK is a
testimony to SFK’s continuing advantage in conversion costs. SFK starts
producing pulp with a handicap of $150/tonne of pulp due to higher fiber costs.
However, this disadvantage is reduced significantly throughout the production
and delivery process."