Mercer International Inc.
(MERC-Q) US$12.48
Mercer Exploring Options to Produce Dissolving Pulp

Earlier this week, Mercer announced that it had completed a preliminary feasibility analysis on two capital projects that would allow its Celgar and Stendal mills to become “swing” mills, capable of producing both northern bleached softwood kraft (NBSK) pulp and dissolving pulp (DP), depending on market conditions. The company intends to complete a final technical and feasibility study and submit the proposal to the board of directors by mid-2011. If approved, Mercer would likely only undertake one project at a time. With a construction time of 16 months, the earliest that the first mill would be ready to produce DP would be early 2013. In this note, we take a closer look at these projects and the potential economics.

Potentially positive – We expect that Mercer’s core focus will remain NBSK, but management is exploring options to opportunistically take advantage of very robust DP markets. We also believe that Mercer remains committed to reducing net debt, but with our expectation for significant free cash flow generation over the next two years, we believe that management has some breathing room to complete compelling capital projects. We are not changing
our earnings estimates at this time, but will revisit our forecasts if the projects are approved. We continue to see compelling value in Mercer at current levels and reiterate our BUY recommendation and US$16.00 target price.

The preliminary feasibility indicated that the Celgar and Stendal mills could be upgraded to become “swing” mills capable of producing both NBSK pulp and dissolving pulp (DP), depending on market conditions.
Mercer would intend to produce commodity-grade DP targeted for end-use in the viscose rayon market. If upgraded, the Celgar mill would be capable of producing 400,000 tonnes of DP (520,000 tonnes of NBSK pulp) and the Stendal mill would be capable of producing 500,000 tonnes of DP (645,000 tonnes of NBSK pulp). Due to fibre-yield differences between NBSK and DP, the mill capacities for DP are lower than NBSK. Mercer was clear that it would not change its commitment to its core NBSK customers (i.e., it is unlikely that these mills would produce exclusively DP).

Mercer estimates the capital cost for the project is US$30-40 million per mill (US$50-75/tonne). We believe this is low compared to other DP conversion projects that have been announced or are being implemented (many by privately-held companies). We believe the Celgar and Stendal projects enjoy a capital cost advantage over other conversion projects due to their relatively large scale, low technical ages (newer, more modern equipment), favourable fibre supplies and existing infrastructure. Mercer would also have an opportunity to utilize excess power capacity at these two mills – the DP process removes more lignin from the wood fibre than the NBSK process, providing Mercer with more black liquor (fuel) to generate surplus electricity.

The economics of these projects depend on your view of DP prices in the mid-to-long term. Management noted that they believe the Celgar and Stendal mills would be on the lower half of the DP cost curve – we conservatively estimate that this would equate to a cash cost of US$800/tonne (including freight). Historically, DP prices have been very volatile – the current China spot DP price is at a record of US$2,300/tonne (although there have been few transactions at this high level) with an average of US$900/tonne since 2004 and a trough of US$500/tonne (Exhibit 1). If we assume a DP price of US$1,200/tonne (similar to contract prices that other DP producers have secured), we calculate potential EBITDA of US$400/tonne – well above the EBITDA of US$208/tonne that Mercer generated in 2010. If we further assume that Mercer “swings” 20% of its capacity to DP from NBSK, we calculate an incremental 180,000 tonnes of DP production at a cost of 233,000 tonnes of NBSK production. This example yields a net EBITDA gain of US$24 million, but is extremely sensitive to assumptions for DP and NBSK prices.

The recent DP price rally has been driven by higher cotton prices that led to a substitution effect in favour of rayon textiles, which has filtered into much higher DP prices. As is typical, the price surge has led to a supply response, with several companies announcing plans for paper-grade pulp mill conversions or restarts of idled dissolving mills. If prices remain near record levels, we expect other expansion initiatives may be announced in the near-term. Exhibit 2 details announced DP conversions and mill restarts through 2013.

In the mid-term, we forecast positive earnings momentum for Mercer due to robust NBSK pulp markets and higher surplus energy sales from the Celgar mill. We expect pulp prices to improve modestly from current levels through mid-2011, followed by a brief correction during H2/11 and a resumption of positive momentum in 2012. We forecast free cash flow per share of $3.24 and $3.54 in 2011 and 2012, respectively (yields of 26% and 28%, respectively).

Mercer trades at 4.7x on 2011 TEV/EBITDA, a discount to the global peer group average of 6.3x. Adjusted for the free cash flow we expect the company to generate over the next two years, Mercer trades at 4.2x 2011 EV/EBITDA and 3.5x 2012 EV/EBITDA. We consider Mercer attractively valued at current levels.
Our 12-month target price of US$16.00/share is based on a 6.3x target EV/EBITDA multiple using our trend EBITDA estimate. To capture the impact of lower net debt over the next two years, we adjust our enterprise value calculation by expected free cash flows during 2011 and 2012 (we discount the 2012 cash flows given that they are beyond our 12 month target horizon). The target multiple compares to an average of 5.3x applied to pulp, paper and packaging peers.

Key Risks to Target Price
Key risks to our Mercer target price include: 1) a faster–than-expected pulp price decline in 2011; 2) adverse North American and European economic conditions; 3) a stronger Canadian dollar and euro; 4) higher input costs and restriction of supply; 5) equipment failures, production disruptions and environmental liabilities; 6) a highly levered balance sheet and a high interest burden; 7) a complex capital structure; 8) higher fibre costs and restricted availability of wood fibre in B.C. due to the mountain pine beetle epidemic and potentially lower sawmill operating rates; 9) higher fibre costs and restricted availability in Germany due to competition for fibre from renewable energy providers and low sawmill operating rates; and 10) lower than expected power generation at the Celgar Energy Project.

Investment Conclusion
The ability to swing production to dissolving pulp from NBSK pulp at the Celgar and Stendal mills is a desirable characteristic given the robust DP market. We won’t adjust our earnings estimates until the projects are announced, but it is clear that there is potential upside, depending on the view of DP markets in the mid-to-long term. We continue to see compelling value in Mercer at current levels and reiterate our BUY recommendation and US$16.00 target price.