SFK Writeup April 12 2010

8/8/2019 SFK Writeup April 12 2010

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SFK Pulp Fund: Not Pulp Fiction 4/12/10

SFK Pulp Fund (SFK-U CN) is a small cap Canadian income trust which operates three millsthat manufacture two types of market pulp: Northern Bleached Softwood Kraft (NBSK) andRecycled Bleached Kraft (RBK) – these are the primary ingredients for most of the paper gradeswe consume today. A relatively high cost producer, SFK suffered from the perfect storm in 2009as an appreciating Canadian dollar exacerbated a rapid decline in pulp prices, and the terminationof a favorable wood chip supply agreement effectively increased wood chip prices (50% of cashcost) by 15%. To make matters worse, SFK had a leveraged balance sheet, and was forced tonegotiate a waiver for a breach of its financial covenants.

In a remarkable turn of events, the pulp market over the past 12 months has gone from bust toboom, yet the market has yet to recognize what a dramatic increase in pulp prices can do for a

company with such high operating and financial leverage to this commodity. SFK now benefitsfrom a rare combination of tailwinds: 1) the global market pulp market has moved from a surplusto a shortage, resulting in a near vertical ascent in prices, 2) SFK’s cash flow generation is set tomassively deleverage the balance sheet, and 3) SFK is converting from an income trust to acorporation, which creates a strong technical backdrop. As detailed below, I believeconservative fair value for the stock is C$2.90, a 132% gain from the C$1.25 close on April 12,2010. For those investors who are more risk averse and look for yield, SFK’s convertibledebentures (ticker SFKCN on Bloomberg) could provide both, they rank higher than the equityin the capital structure and pay a 7% coupon (price of $88 for a 15% yield to maturity on12/31/11).

Investment Thesis Strong leverage to the global pulp price recovery cycle. Pulp prices have increased 45% from thetrough in May 2009 (11% year-to-date in 2010) and are highly likely to continue the positivemomentum throughout 2010 due to supply constraints, global demand recovery and unexpecteddisruptions (more detailed discussion below). SFK is in a great position to benefit directly fromthis robust tail wind:

• Product mix: 60% of its EBITDA over the cycle comes from the Saint-Felicien,Quebec virgin-based NBSK pulp mill (66% in FY10E) with high fixed costs (ie highoperating leverage). The annual capacity of this mill is 360K tonnes. The remaining40% comes from the spread-based business of RBK pulp, whose margins tend toincrease with higher NBSK prices. For every USD $50/tonne price hike in NBSK,

SFK EBITDA will increase by about C$33M, though the move could be partiallyoffset by a strengthening Canadian dollar and/or high fiber cost (annual contracts onthe latter mitigate volatility, however). The capacity of the two RBK mills (both inthe US) is 385K tonnes.

• High quality asset portfolio: SFK’s Saint-Felicien NBSK pulp mill historically hasbeen regarded as one of the highest quality mills in the Northern Hemisphere. Recentbalance sheet woes and the spat with wood chip supplier Abitibi-Bowater have takensome of the shine off this asset, but it is indeed high quality.

• Committed customer base: SFK has a very committed core customer base for allthree of its mills (its top five customers contributed more than 50% of its revenue).During the recovery phase of a market cycle (where we are now), these core



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customers tend to provide a more stable production schedule and more visibleearnings power.

• Street underestimates the pulp price momentum: So far in this cycle, the Streethas been behind the curve and is still playing catch-up in terms of judging both priceand earnings power – we may soon see rounds of pulp stock re-ratings over the nextseveral months as 1Q10 earnings hit the tape.

Pulp Prices in Context

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Technical boost from conversion into a corporation. The upcoming conversion will most likelylead to additional technical support for SFK stock price. Company management has alreadyreceived feedback from various interested shareholders who are unable to purchase shares untilafter the conversion.

• Minimal shareholder defection: Management has communicated with its majorshareholders about the conversion and they are effectively all on board, i.e. thereshould be minimal “forced selling” from existing shareholders after the conversionbecomes effective in July.

• Diversifying investor base: Some of the institutional investors that are not allowedto invest in the income trusts can now buy into SFK post conversion. In addition, USinvestors may become shareholders as they are more comfortable with a“corporation” structure. US investors currently account for 30% of SFK shares only.



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SFK-U CN Top 10 Unitholders

FirmShares

(mm)% ofTotal

Mackenzie Financial 8.8 9.7%Fairfax Financial 8.7 9.7%

Odyssey America Reinsurance Co 6.2 6.9%

US Fire Insurance Co 2.8 3.1%

Israel Brokerage Investments 2.1 2.4%

TIG Insurance Co 2.0 2.2%

TD Asset Management 1.5 1.7%

Chou Associates 1.0 1.1%

Arkansas Blue Cross & Blue Shield 0.3 0.3%

Pennsylvania Trust Company 0.1 0.2%

Top 10 unitholders 33.6 37.2%

• Making the company more comparable to its “corporation” peers: Theconversion will make it possible to compare SFK with its sector peers on a moreapples to apples basis and thus demonstrate that SFK is the best name in the sector toplay the pulp market recovery (see valuation section for more details).

Significant balance sheet improvement potential. As a reminder of the market carnage in 2009,SFK is currently rated CCC+ with a negative outlook by S&P and B3 (B2 for bank debt) with anegative outlook by Moody’s – both at the low end even in the high yield ratings spectrum. Atthis point, increasing shareholder value is really dictated by balance sheet improvement. SFKmanagement has set that as a top priority in 2010. The change will stem from two fronts:

• Refinancing: In July 2009, SFK amended the credit agreement to obtain a waiver of the interest coverage covenant until June 30, 2010. As part of the amendment, thecompany had to pay higher interest rates and live with more restrictions on itsdebt/liquidity levels, capex, and cash distributions. SFK’s C$55M revolving creditfacility will mature on Oct 30, 2010, and it is highly likely that SFK will refinanceand restructure this credit facility during 2Q10 to push out the maturity, obtain a morelenient covenant package and a lower interest rate. The CFO says “you’d besurprised at how much the credit market has changed, from our perspective, in a year.People are now lining up to give us loans.” Refinancing the converts may also be inthe cards as the 7% coupon is high given the strong rally in the credit markets.

• Debt reduction: Unlike its asset-rich rivals such as Fibria Celulose (FBR) in Brazil,which can easily sell off non-core assets for debt reduction, SFK will need to relyprimarily on internally generated cash flow. SFK has approximately C$146M NOLto offset future taxes and the cash flow savings (from NOL and potentially lowerinterest payment after refinancing) can be applied to debt reduction.

With the strong rally in the high yield market and overall improvement of general marketconditions, SFK should have little difficulty achieving these goals during the next three to sixmonths and thus eliminating the liquidity overhang. Note that management just spoke with bothrating agencies last week and sounded pretty optimistic that they’re about to change theiroutlooks to “positive”. Actual upgrades will probably come after a couple quarters of solid debtreduction. In my model I have net debt/cap falling from 30% at 4Q09 to 15% by 4Q11 (note thatthe debt in the debt to cap covenant calculation excludes converts).



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Takeout candidate. High and rising pulp prices will most likely lead to restarts of higher costmills and/or M&A activities. SFK has high quality manufacturing assets and one of the smallestmarket caps among its peers, making it an ideal takeout candidate. Note that SFK purchased the

Saint Felicien NBSK mill from Abitibi in August 2002 for US $400M. The enterprise value of the whole company today is around US $300M, which incidentally meshes with the mediantransaction value of US $416/tonne of capacity (745K tonnes divided among the 3 mills). To geta sense for replacement value, Fibria’s Guaiba mill, which was sold to CMPC will cost $2.2B toexpand its capacity from 450K tonnes to 1.75M tonnes, or roughly US $1,700/tonne. Inaddition, Ilim, Russia’s largest pulp & paper company, is building a 720K tonne softwood pulpmill in Sibera for US $700M (US $970/tonne).

Market Pulp Transactions over the past 15 years

Buyer Target Date

Transaction Value(US$M)

AnnualCapacity000 mt US$/MT

Paper Excellence Tembec (French pulp mills) Apr-10 $136.0 565 $241

Wayzata Investment Partners Halsey Pulp mill (Pope & Talbot) May-08 $32.0 180 $178

Asia Pulp & Paper Meadow Lake Pulp Mill Jan-07 $32.0 325 $98

Mercer Celgar Pulp Feb-05 $210.0 430 $488

Koch Industries Georgia Pacific's Pulp Mills May-04 $610.0 1,300 $469

SFK Pulp Fund (Public) Abitibi's - St. Felicien mill Aug-02 397.0 355 $1,118

Japan Brazil Paper ResourcesCenibra (remaining 51.48%interest)

Sep-01 1,542.4 820 $1,881

Domtar

Georgia-Pacific's 4 UFS and pulp

mills

Aug-01 200.0 450 $444

Pope & Talbot NorskeCanada's Mackenzie mill Mar-01 100.0 240 $435

Tembec La Rochette Pulp Sep-00 158.0 550 $287

Asia Pulp & Paper Celgar Pulp Company Jun-00 400.0 420 $952

Sodra Norske Skog's Tofte mill May-00 200.0 480 $416

Tembec / Kruger Fort James' Marathon mill Dec-99 74.2 200 $371

Tembec Donohue Matane Nov-99 33.2 175 $190

Canfor Northwood Nov-99 540.3 535 $566

Tembec Tartas (remaining 50%) Oct-99 23.2 165 $281

Pope Talbot Harmac Pacifc (remaining 39.8%)Oct-99 62.9 380 $416

Tembec CrestbrookJan-99 181.9 225 $414

Pope & TalbotHarmac Pacific (interest upped60%)

Dec-98 6.5 380 $233

Mitsubishi & Oji Al-Pac JV (remaining 40% interest)Mar-98 261.8 550 $1,190

Pope & Talbot Harmac Pacific (initial 53.5%)Dec-97 83.2 380 $297

Harmac Pacific (failed)Kimberly Clark's Pictou & TerraceBay

Nov-97 540.0 700 $771

Alliance Forest Products KC's Coosa PinesDec-96 600.0 663 $437

Average $529

Median $416



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Cheap valuation. Using pulp price increases that have already been announced, and flatliningprices through 2010, I get a base case 2010 EBITDA of C$75M for SFK, which is above Streetconsensus of C$55M. SFK’s peer group is currently trading at 7.2X EV/EBITDA. Using a

conservative 6X forward multiple, I get a base case price target of C$2.90, 132% above the closeof $1.25 on April 12. (More detailed discussion on valuation below)

The pulp market in context: Pulp markets are getting extremely tight, as an already tight market was further squeezed by theChilean earthquakes, which curtailed 8% of the global supply of pulp, potentially for months.Pulp was already benefiting from a structural vortex into China (which is building a number of non-integrated paper mills that will require high quality virgin pulp), and there is no significantpulp capacity coming on before 2012.

Global nameplate capacity of pulp is about 52M tons, and current production is pretty muchmaxed out at 50M tons. In 2009, demand actually grew by 2% because China’s 55% growthsoaked up all the excess supply caused by a slowdown in the developed world (North America

down 11%, W Europe down 11%, Japan down 17%, Oceania down 13%). China’s share of global shipments is now 21%, up from about 10% in 2002-2008. This is not a one-time shift,rather a structural shift, in my opinion.



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So while global production (largely in Europe) was cut by about 3-4M (6-8% of global supply)

tons in 2009, demand actually grew, causing a depletion of inventories from 50 days in Jan 2009to 25 days in November 2009. We’re back to a “balanced” market at 30 days supply, but thatassumes Chile gets back to full production immediately (which is unlikely). European producerpulp inventories are still at extremely low levels of 24 days.

Pretty much all of the 3-4M tons of capacity has returned to production, and a 1M ton plant inChina is starting this year. So what’s the problem? News to no one, but an earthquake hitChile’s pulp operations dead on on 2/27/10, disrupting all of Chile’s mills (4M tons, or 8% of supply). While the damage to the mills is fairly easy to fix, the roads and ports will take longer –these mills may not return to full production for months. At a minimum, we have lost roughly1M tons of supply for 2010 that cannot be recouped, because the mills were running flat out

before the earthquake.

In addition, Finnish dockworkers recently had a two-week strike (ended on 3/19/10). Finland isa net exporter of pulp to other parts of Europe. Its supply is roughly 2M tons (4% of supply). Itmay be a conspiracy, or it may be dumb luck, but the pulp market has never seen a disruption of this magnitude, and with the market already extremely tight, each disruption is magnifiedtremendously.

So what next? The extreme tightness will likely subside once Chile is up and running (somerestarts have already been announced), but China is not suddenly going away – there has been astructural shift in the pulp market – very similar to the one that has affected the iron ore and metcoal markets. Chinese environmental initiatives have forced the permanent closure of some of their non-wood pulp lines. And with a number of non-integrated paper mills starting in Chinaover the next few years, their demand for virgin pulp is likely to grow. China is also learning asimilar lesson from its experience in the steel markets – when you shift from non-wood pulp tovirgin wood pulp, your paper mills run more efficiently and you actually drive down cost. It isunlikely that they will shift back to their nonwood pulp in a significant way.



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Trust to corporation conversion in Canada: Before the tax law change in 2006, a Canadian income trust paid little to no corporate income taxbecause it distributed essentially all the pre-tax earnings to its unit holders. The income trust wasonce a very popular investment vehicle in Canada and the sector alone was worth over C$160Bby the end of 2005.

On October 31, 2006, however, the Canadian federal government announced a plan to changethe tax treatment of income trusts. Under the new plan, the government would apply a tax at thetrust level on distributions of certain income from most publicly traded income trusts andpartnerships in Canada (referred to as specified investment flow-through or SIFTs) at a tax ratecomparable to the combined federal and provincial corporate tax rate and treat such distributionsas dividends to unit holders. These tax changes will apply to income trusts at the beginning of

the 2011 taxation year.

Stocks of the Canadian income trusts reacted negatively on the announcement as expected – bythe end of 2006 TSX Income Trust Index had tanked by 20% from October. The announcementalso triggered waves of M&A deals involving income trusts. In 2008 as the Canadiangovernment published more details on SIFT conversion rules, the pace of income trustsconverting into corporations also accelerated. There were 9 income trust conversions in 2008and approximately 23 conversions in 2009. SFK announced its conversion plan in 2009 and isexpected to complete the process in June 2010. The new company will be called Fibrek Inc.



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Upcoming Catalysts

• First quarter earnings release around mid May, 2010

• Annual meeting on May 19th, 2010 to approve the conversion

• End of waiver period on June 30th, 2010

• Maturity of revolving credit facility on October 30, 2010

• December 31, 2010 and after, the company is free to call 7% converts at par.

Valuation

Trading Comps AnalysisWith net debt of C$184M, and 90.5M fully diluted units, the enterprise value is roughlyC$300M. The company posted negative EBITDA in 2009, therefore the key to its valuation isreally its forward EBITDA in 2010. My base case EBITDA forecast is C$75M (using average

NBSK pulp price of US $905/ton), implying a forward EV/EBITDA of 4.1X. If the pulp priceincreases to $955/ton, the multiple will drop to 2.8X.

SFK’s peer group is trading at 7.2X EV/EBITDA, if we use a conservative 6X multiple, SFKshould be worth C$2.90/share, or 132% above the close price on Apr 12. Incidentally this wouldbe a P/E of If pulp price assumption is increased to $955/ton, a 6X multiple will imply a targetprice of C$5.10/share, or over 4X the closing price on Apr 12t.

Global Market Pulp Comparables

Ticker Company% 2008

Pulp Sales Price (local) EV (US $M)EV/EBITDA

(FY10E)EV/EBITDA

(FY11E)

CFX-U CN CANFOR PULP INCO 84% 11.96 424 2.6X 3.4X

CMPC CI CMPC 30% 22200.00 11,774 12.5X 11.0X

FIBR3 BZ FIBRIA CELULOSE 80% 37.65 14,125 8.2X 7.5X

MERC MERCER INTERNATI 100% 5.78 1,290 6.0X 6.6X

SUZB5 BZ SUZANO PAPEL-PRA 35% 23.23 6,332 7.5X 6.9X

TMB CN TEMBEC INC 53% 2.43 636 6.5X 6.9X

WFT CN WEST FRASER TIMB 35% 42.05 2,279 7.4X 6.8X

SFK-U CN SFK PULP FUND 100% 1.25 297 4.1X 3.6X

Average excluding SFK 5,266 7.2X 7.0X

SFK-U CN Sensitivity of 2011E EBITDA to pulp prices, exchange rate

NBSK pulp price ($/tonne)

$830 $880 $930 $980 $1,030

0.93 55 68 82 95 108

0.98 58 72 86 100 114

1.03 61 76 90 105 120

1.08 64 79 95 110 125

E x c h a n g e r a t e

( C A D / U S D )

1.13 67 83 99 115 131



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Distressed liquidation analysisSFK has a top heavy capital structure, typical for companies with high yield credit ratings.

Capital structure (maxed out) (C$M)

Debt

Senior secured revolver (max) 55

Senior secured term facility 177

Capital lease and PSIF grant 8

Convertible debentures 48Total debt 288

Market cap of equity 118

Total capital 406

In order to get a sense of the potential downside for shareholders in this capital structure, I did aquick liquidation analysis assuming SFK is liquidated based on its 2009 year end balance sheetdata. The analysis, which by no means is scientific or comprehensive, suggests that equity valuewill NOT be entirely wiped out even SFK maxed out all the borrowing capacity under its creditfacilities. Using my base case EBITDA, the residual equity value ranges from C$0.55 to C$1.38,a max 56% discount to the current share price.

SFK-U CN Distressed Liquidation Analysis

Enterprise Value (C$M)

EV/EBITDA (2010E) multiple

4.0X 4.5X 5.0X 5.5X 6.0X

55 220 248 275 303 33065 260 293 325 358 390

75 300 338 375 413 450

85 340 383 425 468 510 2 0 1 0 E E B I T D A

95 380 428 475 523 570

Less Total Debt Obligations (C$M)


4.0X 4.5X 5.0X 5.5X 6.0X

55 0 0 0 15 42

65 0 5 37 70 102

75 12 50 87 125 162

85 52 95 137 180 222 2 0

1 0 E E B I T D A

95 92 140 187 235 282

Implied Equity Value Per Share


4.0X 4.5X 5.0X 5.5X 6.0X

55 0.00 0.00 0.00 0.16 0.46

65 0.00 0.05 0.41 0.77 1.13

75 0.13 0.55 0.96 1.38 1.79

85 0.58 1.04 1.51 1.98 2.45 2 0 1 0 E E B I T D A

95 1.02 1.54 2.07 2.59 3.12



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7% Convertible unsecured subordinated debentures (ticker SFKCN)

The 7% converts due 12/31/11 are a decent yield product but upside may be capped at 22% dueto possible refinancing.

SFK issued the 7% converts back in August 2006 to finance its acquisition of AFR Mills.Compared with SFK common stock which no longer makes cash distributions (or dividendpayments after conversion) due to the covenant restrictions, the converts provide both capitalappreciation potential and a more likely coupon payment – as part of the credit agreementwaiver, SFK can not pay converts interest unless it meets a cumulative EBITDA test which is notpublicly disclosed. According to the company’s 4Q09 earnings release, SFK paid the scheduledconverts coupon on Dec 31 2009 (confirmed with management) implying that it was at least incompliance with that covenant at year end and may continue to pay the coupon in June 2010.The converts are currently quoted at C$88 and yield over 15% (yield to maturity), which is evenhigher than SFK’s comp Canfor Fund’s (CFX-U CN) dividend yield of 11.6%.

However, SFKCN’s total return could be capped due to a high likelihood of a refinancing during2010. Management has indicated that it may refinance its high coupon converts as part of theirefforts to improve SFK’s balance sheet. So for a C$88 investment in SFKCN, the most likelyupside (maybe also the max upside) by year end 2010 is the $7 coupon payment plus another $12of premium (not necessarily in cash) if the company calls, or tenders for the converts at parand/or refinances it with debt of a lower interest rate, implying a combined expected return of approximately 22%. If there is a change of control event, investors may get an additional C$1upside due to the 101% change of control put.

Call/redemption feature in its prospectus:

“The Debentures will not be redeemable prior to December 31, 2009. On or after December 31,2009, and prior to December 31, 2010, the Debentures may be redeemed, in whole or in part,from time to time at the option of the Fund on not more than 60 days and not less than 30 daysnotice, at a price equal to the principal amount thereof plus accrued and unpaid interest, providedthat the Current Market Price is at least 125% of the Conversion Price. On or after December 31,2010, the Debentures may be redeemed in whole or in part from time to time at the option of theFund on not more than 60 days and not less than 30 days prior notice at a price equal to theprincipal amount thereof plus accrued and unpaid interest.”



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SFK-U CN Stock vs 7% Converts due '11

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Variant ViewSFK is not well liked by the Street – of the 6 analysts who cover it, 4 have “Holds” and 2 have“Sells”. Each analyst has conservative (ie stale) pulp prices in their model and seems to

underestimate (or ignore) the deleveraging ability of this company in a rising pulp priceenvironment. I also believe the Street is underestimating the favorable technicals post trust tocorp conversion.

Documents

SFK Writeup April 12 2010