Wednesday, August 08, 2007

SFK Pulp 2nd Quarter Conference Call and Recap

A lot of people are dissapointed with SFK's 2nd quarter report, so I thought I'd share my thoughts.
The two main things I think need to be addressed are the drop in sales volume, and the strengthening Canadian dollar and its effects.

Sales Volume
SFK's NBSK pulp sales volume was a very low 75,514 tonnes this quarter. In the conference call, the company addressed this due to a major customer cutting back purchases for the quarter. Someone on the call asked whether the drop was due to them being unable to shift the business fast enough, and management said it was partly that and partly a decision to wait until the customer came back, because the customer was close by and the transportation savings accrete to SFK. Regardless, I wouldn't be concerned because in the end pulp is still a commodity product, and one that is currently at low industrywide inventories. In the end, sales volume will be close to production, and in the call management said sales volume and inventories have already returned to normal. The NBSK Mill has a yearly production of 375,000 tonnes, so "normal" is about 93,750 tonnes per quarter. Note also that 2nd quarter and 4th quarter take maintenance downtime, so these quarters have lower production, offset by higher 1st and 3rd quarter production.

For those that want to know the effect, here's some basic math:
NBSK business cost of sales as total sales was 78.8% (47,628/ 60,414)
18,236 more tonnes x $800 CAN price per tonne = $14,589,000
21.2% x 14,589,000 = $3,093,000 extra free cashflow

Note also that this doesn't take into account the fact that labor and maintenance would not take additional expenses for the added sales volume, meaning our gross margin used is likely understating the extra free cash flow. But at the risk of becoming short-term Wall Street analyst-like, im going to not bother doing that calculation.

Strengthening of the Loony
This is where things that getting (more) complicated. The Canadian dollar strengthened from an average of .8535 to .9107 US/CAN. This has a few effects. First, since pulp prices are derived in US dollars, a stronger Canadian dollar means lower realized prices for SFK in its own currency, while its costs remain the same. But also, the company had an additional 3.8 million impairment of cash and accounts recievable that are denominated in U.S. dollars.

Also, and this seems to have been missed by many, is the effect of this on the RBK business. The RBK business is cost, revenues, and profit are all in US dollars, but since SFK reports in Canadian dollars, the income from this segment drops when the loony rises (in canadian dollar terms). But, to hedge this currency risk, SFK took the debt for this acquisition out in US dollars, so its debt obligations also fall as the Canadian dollar rises. However, due to accounting treatment, the company does not report this change on the income statement until the RBK business pays its first dividend to the parent company. So instead, SFK recorded a 5,451 million currency translation adjustment on its balance sheet to take into account the lower debt outstanding in Canadian dollar terms, but this never made it to the income statement (Unlike the 3.8 million impairment mentioned above)

Where Now?
The Canadian dollar has continued to increase since last quarter. Assuming the rate averages out to a new .95, we get the following "run rate" quarterly calculations:
1. Exchange rate at .95 US/CAN

2.$786 CAN NBSK revenue per tonne
2nd Quarter sales price was $800/tonne CAN. If you take into account an $18US rise in prices and the new exchange rate, the sales price for 3Q will be about $786.

3.$618 CAN NBSK cost per tonne
Cost of sales in 3Q is usually lower due to a lack of maintenance expense- it was $571 CAN 3Q06. But since this is run rate calculations, I will start from the 2006 cost of sales of $603 CAN. Costs are up 1.8% this year so far, but I added some leeway, giving a cost of sales of $618.

4. 93,750 tonnes sold per quarter
Again, due to the sales slowdown in 2Q, sales volume will likely be much higher than average next quarter, but since this is run rate im using the average number.

Run Rate
NBSK EBITDA 15,624,000
RBK EBITDA.. 3,500,000
SG&A Expense -1,350,000
Interest Expe. -4,000,000
Capital Expen. -4,000,000

Yields Free Cash Flow of $9,764,000. For those that were concerned, yes this run rate would mean a distribution cut seems likely. Oh, and also, the stronger Canadian dollar would also reduce debt obligation by 4,850,000 in the 3rd quarter, meaning when that currency adjustment is realized, that will be upward of 10 million now on the income statement, though that should also be ignored as far as income goes.

Those are the numbers. Now here's why I'm holding, and you can choose to agree or disagree from here. The company is still cheap, at about 10x cashflow under current conditions. But on a broader worldwide scale, the Eastern Canadian production is ripe for change. Canadian pulp does not need to be automatically considered at a disadvantage to worldwide production. Labor makes up a small percentage of costs, and in fact operational costs at most eastern Canadian mills are actually lower than other places due to very low energy cost. The main burden is fiber. Fiber makes up about $300 of the cost per tonne of pulp in Eastern Canada, about $125 in Western Canada, and significantly lower in Latin America. Canadian fiber doesnt need to be so expensive- rather, it is a problem of too much fiber demand in one region, escalating prices. The industry figures are below:
49 million tonnes worldwide hardwood pulp demand per year
11 million tonnes of pulp(all grades) production in Canada
12 million tonnes of pulp production in Europe including Nordic countries and Russia
9 million tonnes of pulp production in South America

13 million tonnes worldwide NBSK pulp demand per year
7 million tonnes NBSK pulp production in Canada

NBSK pulp is a particular grade that requires stronger fibers found in only some places (mostly, Canada). NBSK also accounts for 28.8% of pulp demand. As a grade, it will likely survive, and give Canadian producers a competitive advantage. But on a broader scale, the fiber disadvantage of Eastern Canada is taking its toll, and this is the first place that excess capacity is coming off. Looking at it today, both Tembec and Pope and Talbot seem discounted already for bankruptcy in the markets. Tembec has 825,000 NBSK production, 1,035,000 hardwood production; Pope & Talbot has 820,000 NBSK production. Also, the merger of Abitibi and Bowater combine two powerhouses in Eastern Canada, possibly spurring much needed rationalization. As a very low cost producer, obviously any fall in fiber prices will greatly benefit SFK. This may sound like wishful thinking to some, and you are slightly right- more research is needed to make a compelling case one way or the next, and hopefully a few calls can help answer some of my new questions. Yet, this year western Canadian fiber is up 57%, compared to only 3% in eastern Canada. A cheap valuation with a possible catalyst, good management, and secured by higher replacement value keeps me invested and feeling relatively safe.

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