TRADE OF THE MONTH

Short on Sappi, long on Mondi

Financial Mail - Investors Monthly - - Contents - Shaun Har­ris

Seem­ingly against fi­nan­cial re­port­ing trends, we go short on the world’s largest pro­ducer of glossy pa­per, Sappi, and long on its ri­val in SA, and Europe, Mondi. There are two main rea­sons for this call: Mondi’s fi­nan­cial re­sults are good and get­ting bet­ter. Sappi’s re­sults have im­proved sig­nif­i­cantly, but off a low, loss-mak­ing base. The sec­ond rea­son is Mondi pays a gen­er­ous div­i­dend. Sappi has not paid a div­i­dend since 2008, and ac­cord­ing to CEO Steve Bin­nie prob­a­bly will not for the next two years, at least.

On Fe­bru­ary 10 Mondi re­leased an up­beat trad­ing state­ment, stat­ing that un­der­ly­ing op­er­at­ing profit for the year to end-De­cem­ber 2014 was ex­pected to be higher than the €699m posted in 2013, lead­ing to an im­prove­ment in earn­ings per share of be­tween 7% to 11%. At the in­terim Mondi paid a div­i­dend of €0,1323 a share, an in­crease of 39%. On the back of even stronger fi­nan­cial re­sults share­hold­ers will be look­ing for­ward to a re­ward­ing full-year div­i­dend.

Bet­ter re­sults from Mondi are largely due to the ge­o­graph­i­cal po­si­tion­ing of its mills in Europe. Un­like Sappi, which bought mills in ex­pen­sive op­er­at­ing coun­tries in cen­tral Europe, Mondi in­stead bought and set up cheaper op­er­a­tions in Eastern Europe. CEO David Hathorn, who says he’s not in­ter­ested in be­ing the largest op­er­a­tor in Europe, the US and SA, but in­stead the most prof­itable, is ob­ses­sive about bring­ing costs down. This can lead to some harsh de­ci­sions but it pays off.

Sappi has been the op­po­site, ob­sessed, through ear­lier man­age­ment (some of whom re­main on the board), with be­ing the big­gest. This has been its fa­tal mis­take. In 2008 it bought four pa­per mills in Europe for a huge €750m. Share­holder ac­tivist Theo Botha was very crit­i­cal of this ac­qui­si­tion, and time has proved him right. The ac­qui­si­tion was the start of Sappi’s debt prob­lems and the last time it paid a div­i­dend. In ear­lier years the ex­pec­ta­tion of an­nu­ally in­creas­ing div­i­dends was the rea­son many in­vestors bought shares in Sappi. At the time, one cyn­i­cal in­vest­ment an­a­lyst said Sappi was buy­ing mills to close them down. Looks like he was right. Sappi has closed two of the mills it bought in 2008.

Sappi is start­ing to box clever now. Bin­nie says the group plans to cut $30m off its an­nual in­ter­est pay­ments by sell­ing bonds to re­fi­nance up to $500m debt. It’s a good idea but will de­pend on the up­take for the bonds. At present Sappi’s bonds in SA is junk sta­tus. And Sappi’s debt re­mains ex­ceed­ingly high, $2,04bn at the end of its first quar­ter.

How­ever first quar­ter fi­nan­cial re­sults were strong, with un­der­ly­ing profit up 33%, largely from ris­ing pa­per prices in Europe. But glossy pa­per, Sappi’s bread and but­ter, faces an un­cer­tain fu­ture as or­gan­i­sa­tions in­creas­ingly ditch brochures and pa­per re­ports for in­ter­net pre­sen­ta­tions. Sappi is now fo­cus­ing on dis­solv­ing wood pulp, but it should have done this ear­lier. Mondi de­cided some time ago to fo­cus on pack­ag­ing pa­per, a higher mar­gin busi­ness than its un­coated fine pa­per. Fi­nan­cial re­sults are ben­e­fit­ing from pack­ag­ing pa­per price in­creases.

Share prices of both groups have been on a run, Mondi up 22% over the past year and Sappi by 51%. Both shares are on a sim­i­lar price to earn­ings ra­tio of around 16 times, though the for­ward PE for Sappi drops to a less de­mand­ing 13 times while Mondi is 15 times. But for longer-term in­vestors Mondi is the place to be. Its lower-cost op­er­a­tions in Europe should con­tinue to feed through healthy prof­its, and prob­a­bly healthy div­i­dend pay­ments as well. Div­i­dends, of course, is why in­vestors buy shares, not cap­i­tal gains.

Sappi, on the other hand, should keep pro­duc­ing bet­ter fi­nan­cials, but for how long will that sup­port the share price? It has prob­a­bly run too hard al­ready. Our bet is that it will be lower in a year’s time, there­fore we call it short. And why buy a group that you know is not go­ing to pay a div­i­dend for at least two years?

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