As i mentioned in the previous post I have taken a position of 5% of my fund in Rottneros mainly because of the weakening SEK. Sitting on the beach (yes my life is hard) I was not in a position to write a full analysis, so here it is.
Rottneros at a glance:
- MCAP: 1 234 million SEK
- Shares Outstanding: 153.4 million
- Largest Shareholder – Arctic Paper 51% of shares outstanding which in-turn is majority owned by Thomas Onstad.
- P/E 7.5
- P/B 1.13
Simple company to understand
The company run two pulp mills located in Rottneros and in Vallvik in northern and middle part of Sweden. Because it is a debt free small company, running two pulp mill plants it’s also easy to understand the drivers of profitability and risk. It’s cash flows depend on a few variables so I will try to map out the main components that determines the value of Rottneros business. The below picture describes the full production process Rottneros is involved in.
Rottneros do the following:
- They buy wood from local production as well as sourced through the Baltic.
- They process the wood. This is done out of two pulp factories located in middle and northern Sweden.
- Out comes different varieties of pulp products, as coffee filters, paper, tissue paper etc. Their products are sold around the world.
The risk components
Rottneros has a quite nice graph showing the business risks:
A few of these components I will try to study, since they dictate the profitability of Rottneros:
- D – Electricity cost, this is about 8% of the companies costs, according to Rottneros. The Vallvik pulp plant is more advanced than the Rottneros plant, it has a turbine for electricity production, producing about 80% of its electricity in-house, whereas the Rottneros plant buys all electricity on the market.
- C2 – Wood costs, this is about 38% of the companies costs, according to Rottneros.
- A/J – The value on the world market of pulp products, meaning the products Rottneros sells.
- F – Efficiency of their plants.
This sensitivity analysis will also be useful to understand Rottneros increased profitability
I will make an attempt to see if we can become wiser by looking at the history.
Electricity cost in Sweden
As you can see above, in red, the spot prices of electricity in Sweden (EUR/MWh) varies significantly over time, therefore a company like Rottneros choose to hedge their electricity cost by locking in future prices. As can be seen spot and future prices have been trending downwards (although with a lot of volatility) since 2011. This means that Rottneros has previously had higher electricity costs, which are now coming down. Below is their latest available electricity hedging prices.
Since Rottneros cost base only depends about 8% on electricity cost, this is not a game changer. Pulp production is obviously not a high margin product and any source of margin increase is important. Looking at spot prices and what prices they are rolling into during 2017/2018, we are looking at potential electricity price cost declines of about 0.1 SEK/kWh comparing to 2015. That is an increase in profits of about 25 million SEK according to the sensitivity analysis.
The price of wood is a more important cost driver than electricity to Rottneros (~38% of costs), but this market seems much more opaque. The company itself unfortunately comments less about it, expect saying they use locally produces wood to source their timber, as well as a small Baltic organisation for sourcing from that region. They source it through their partners more long-term (whatever that means), to avoid price fluctuations. It seems no hedging is done for this and they try to keep a minimal stock of wood, to not bind unnecessary capital. From what I can tell, this means they are buying everything on spot prices, or something close to spot (perhaps decide a price for the coming year).
Eager to understand the history of pulpwood prices I went looking for some historical price graphs, that was easier said than done. After a great amount of googling (grand master googling skills), I found some documents showing historical prices of wood used for pulp mass in Sweden. For you non-Swedes, it says North, Middle, South and Whole Country in the legend. For the full document see Link to source.
I also found some current prices from a listed competitor, Holmen, which quotes current (end of 2015) prices on pulpwood at 280 SEK/m^3 fub. Again we can see that prices have been declining over the last few years. Long-term one can note, that on inflation adjusted basis, it seems wood has become much cheaper. Without trying to become an wood expert here, it seems shut-down of pulp production in Norway has made more wood supply available in Sweden, partly driving down prices. Rottneros also comments about the outlook for the future: “Expansions that have been announced in the forest industry in Sweden and Finland will increase the demand for raw materials.” The lower pulp wood prices must have lifted Rottneros margins significantly over the last 4-5 years. Rottneros states a 10 SEK/m^3 fub change in price will affect the result by approximately 15 million SEK. That should have added about 45 MSEK in profits since peaks levels in early 2010’s.
Value of Pulp products
Rottneros currently mostly sells to the European market (over 80% of sales). In their annual reports they refer to a European index of pulp product prices which I also found on Bloomberg. Looking at historical prices in USD, it seems the revenue from selling pulp products has gone down significantly over the last 12 months. But for Rottneros who has all its cost in SEK, it is more relevant to look at price levels converted to SEK. With the significant SEK depreciation against the USD, the pricing picture looks totally different:
The other way to look at it, is splitting up the components, Pulp price in USD and the effect of USD/SEK movements.
Rottneros states that no hedging of pulp prices is currently done: “The price of pulp (NBSK) is set in USD, while production costs are largely incurred in SEK. The Group held no pulp price hedging contracts on 30 June 2016 or 2015. “.
Longer history of pulp prices
I wanted to look at full available history of Pulp prices (same NSBK Index) to get a better understanding of current price levels (in USD):
And then I adjusted for inflation (using approximation of US inflation at 2.1% per year)
We can see that over 20 years, the selling value of pulp products has not changed much, adjusting for inflation. Which makes sense, this is just a cyclical business where prices grows according to inflation. We can also see, that what I stated in my previous post, that prices in USD are currently high, is not true.
Again I’m not an expert at explaining the fairly weak pulp prices. One factor must the be the strong dollar, a big headwind is of course the digitization, we do not read newspapers and print documents on paper like we used to. In the counter-balance you have a huge emerging markets population starting to use paper as never before. You can jokingly say, we need a lot of paper if 1 billion Chinese are starting to wipe their assess with quality soft tissue paper. Jokes aside, it seems that these effects are somewhat cancelling each other out. But I do not know where this leads us in terms of future pulp prices. All I can say is, pulp prices are below the 20 year historical inflation adjusted average. This is to me comforting, in the sense that I’m not buying a stock at peak pulp prices.
Efficiency of plants – Agenda 500
Rottneros has taken a decision to invest heavily into their current mills, to increase production and efficiency. The first investments have already been made (around 190 million SEK up until June 30, 2016), taken from retained earnings. The company still has a healthy cash buffer of 79 million SEK and is planning to spend another 260 million SEK over the coming years. This adds up to 450 million SEK which do not totally align with the picture below, probably because 50 million is standard maintance re-investments needed anyway.
This plan means that the company is taking a gamble on continued strong cash-flow to be able to finance the expansion. If that fails, either finance through debt or equity will be needed.
After a fairly long-winded discussion to understand the input costs and output sales prices it, now move over to valuing the business. The things we learned above will come in handy here, I directly relate it to the Income Statement:
With this as a base, I add the (not comprehensive) break down of Net Income
We can see how Rottneros is at the mercy of the market powers in terms of Cost of Materials and Revenues earned. It’s a low margin business over the cycle, which will be advantageous to run if you have a competitive advantage in terms of local market prices versus the other players located elsewhere in the world. The last few years has been advantageous for Rottneros, with high pulp prices in USD, cheap electricity and falling wood costs.
I have to admit although I took a position on weakening SEK, that was an easy call. It’s not as easy to accurately value this type of cyclical business.
My base case valuation assumptions:
- EBIT Margin – Currently at 14.65% – Deteriorating to 8% (industry average) in 10 years
- Discount rate: 8%
- Growth Rate: 40% compounded over 5 years due to Agenda 500, thereafter 2% per year.
- Re-investment needs first 4 years 150 million SEK (financed through retained earnings). then 70 MSEK growing with 2% inflation
This gives me a current value of 9.5 SEK per share
My blue sky valuation assumption:
- EBIT Margin – stays flat at current 14.65% – Pulp selling prices below historical average, no sign of increasing wood prices and electricity is hedged.
- Other assumptions like base case.
This gives me a current value of 19 SEK per share
My bearish valuation assumption:
- EBIT Margin deteriorates in 3 years to 8% industry average and after that goes down to 7% over 7 years.
- Discount rate: 10% – Due to small business with higher risk.
- Growth Rate: 5% yearly growth over 4 years due to Agenda 500 not being able to continue to the second phase, thereafter 0% per growth year.
- Re-investment needs first 2 years 150 million SEK (financed through retained earnings). then 70 MSEK growing with 2% inflation
This gives me a current value of 5 SEK per share
Majority owner not doing to well
A dark cloud on the horizon is the majority owner Arctic Paper (also a listed company). Except Arctic’s holding in Rottneros, they own pulp plants in Poland, which are not doing well at all. Because of the company being in debt, the EV on the rest of the company excluding Rottneros is negative. I’m not sure what this means for Rottneros, but it could mean that the majority owner needs to sell shares. And being a forced seller, he will probably not get a great price. If pulp prices would deteriorate and Rottneros would not be in such a good shape, Arctic Paper would be in serious trouble. Although this is short term noise for Rottneros, it’s still a negative overhang.
At current market rates, things are looking good indeed for Rottneros. I’m comfortable with the downside risk and upside potential, putting a target price at 10 SEK for this stock. I also like the strong price trend the stock is showing (momentum). The current NBSK Pulp Price index is at 7226 SEK, inline with average levels for 2015. Further we know current wood prices are stable and most likely electricity cost is going to go down further (due to the hedging). So if market conditions stay this good (blue sky scenario), Rottneros can keep it’s healthy EBIT margin of 14.65%, the stock is worth about double, 19 SEK per share. Clearly the market is pricing in some type of deterioration, either through lower pulp selling prices or increased wood prices, or a combination of the two. Either way it goes, if the pulp market does not collapse, it looks like Rottneros will have a couple of good years, generating healthy cash-flows, which it will use to ramp up production through its Agenda 500 program.