TRADE OF THE MONTH
Short on Sappi, long on Mondi
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?