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Which Pulp Producer Is Out of the Woods?


Many people don't realize that commodity pricing effects everything down to our toilet paper. Pulp producers have been on a roller coaster along with the global economy, but this company is on the comeback trail.


Mercer International (MERC) is the leading global producer of northern bleached softwood kraft (or NBSK) pulp. Kraft pulp, which is derived from wood fibers such as wood chips and pulp logs, is used to make paper, tissues, and other paper-based products.

Mercer International operates two NBSK pulp mills in Germany and one in British Columbia, with collective annual production capacity of 1.5 million air-dried metric tons (ADMTs). These mills produce pulp in various grades and strengths and with different underlying chemical properties.

Pulp sales generated 93% of net revenues in 2011. The remainder of Mercer International's revenues was derived from the sale of excess electricity its mills generate during pulp production.

Because this is considered a renewable form of energy, the company benefits from favorable regulations in both Germany and Canada. In 2011, its mills generated 652,000 megawatt-hours of surplus renewable energy.

Due to rising demand and tight industry capacity, pulp prices rose from mid-2009 through the first half of 2011. However, NBSK prices fell sharply in the second half on weaker demand stemming from economic uncertainty in Europe and credit tightening in China.

The average European list price at year-end was $825 per ADMT, down 20% from its summer peak. Coupled with higher raw material costs, net income in 2011 dropped 40% from the prior year.

Net revenues in the fourth quarter of 2011 fell 7.5% year-over-year to $308.9 million. Pulp volume increased 3.6% to 400,005 ADMT. But this was more than offset by a 9.3% decline in the average European NBSK pulp price, to $868 per ADMT.

Renewable energy sales climbed 18.1% to $21.5 million. Lower selling prices, expenses related to scheduled maintenance, and increased wood fiber costs led to a net loss of $2.4 million, or $.04 per share, versus net income of $48 million or $.86 per share in the same period the prior year. This was a penny shy of the consensus estimate.

Given that shares rose 6% the day following the Q4 earnings announcement and were up 13% two weeks after its release, my firm believes most investors may have been expecting even more disappointing results. Yet the stock has been unable to maintain this momentum, resulting in relative underperformance last month.

My firm attributes this recent weakness to uncertainty regarding Mercer International's pending acquisition of Canada-based virgin and recycled pulp producer Fibrek. The acquisition is being contested by paper-products maker Resolute Forest Products, which had initiated a hostile takeover of Fibrek prior to Mercer International's bid.

Mercer International's offer is 30% more generous and has the approval of Fibrek's Board of Directors. But it is also contingent on the private placement of special warrants, which would result in Mercer International owning about 20% of Fibrek once converted. However, a recent ruling by the Quebec Court of Appeal reinstated a cease trade order, preventing the placement of the warrants. Mercer International and Fibrek plan to appeal, but investors may be staying away until a resolution is reached.

Should Mercer International win out, the company would acquire three high-quality pulp mills at great value, which would increase its total annual production capacity by roughly 50% while also augmenting its quick-growing energy business.

Yet even without Fibrek, we believe Mercer International's shares offer excellent value. We are especially encouraged by the recent trend in NBSK prices, which are up about $15 per metric ton in Europe and $36 per metric ton in China since the beginning of the year, to roughly $844 and $697 per ton, respectively.

After falling $20 per ton to start the year, NBSK prices in North America have remained remarkably steady at $870 per ton over the past eight weeks. These price trends are consistent with Mercer International's belief that pulp prices have bottomed and should begin to see modest recovery over the near term.

At the same time, wood fiber prices, which showed material weakness towards the end of 2011, are expected to see further declines in 2012. This is partly due to Russia's expected entry into the World Trade Organization in June, which will reduce the nation's export tariff on pulp wood from 25% to 15% for pine logs and to 13% for spruce logs.

Thus, while near-term profits will likely remain below last year's levels, they could come in well above current expectations and should strengthen significantly as the year progresses if recent price trends hold. As such, Mercer International's current stock price, which we believe is being held down by the uncertainty surrounding the Fibrek acquisition, offers an attractive buying opportunity.

We also expect to see resolution on the acquisition issue sometime next month. Once this occurs, investor interest in Mercer International is likely to grow as they focus more on the company's improving cost environment. This should have a favorable impact on the stock.

Editor's Note: This article was written by Taesik Yoon of Forbes Investor.

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