Why Sappi is a stock to buy

The world may have moved increasingly online these past few years, but reports of the death of paper have been greatly exaggerated.

For many product lines, in fact, demand has been exceptional, judging by Sappi’s results for the first quarter to end-December.

The numbers reflect internal efforts but have also benefited from market conditions such as tight supply, rising demand and higher prices.

The market had expected an improvement but was clearly surprised at the size of it — Sappi’s shares soared more than 14% on February 9, the day its results were published.

Notorious for being a one-quarter wonder, Sappi has now produced six quarters of improved earnings from a low point in the third quarter of 2020, and there are several reasons to believe the momentum can be sustained.

CEO Steve Binnie is adamant that Sappi is "out of the stop-start growth phase". Rather, he tells the FM, "the trend is indeed progressively upwards".

SBG Securities, for one, says Sappi has long traded at a discount to its peers in the paper and packaging sector. The bank rates Sappi a buy with a price target of R64 — implying a gain of more than 20% from its current level.

Chronux Research director and analyst Sean Ungerer, who had a buy recommendation on the stock and raised the target price prior to the results, has since pushed it further up. "Looking at earnings on a 12 months’ view vs the global universe, it is one of the cheapest stocks out there offering the most growth," he says.

In the last quarter to end-December, sales jumped 46% year on year to $1.7bn and earnings before interest, tax, depreciation and amortisation (ebitda), excluding special items of $240m, more than doubled. Profits in its North American business were three times the previous year.

The numbers were flattered by an extra sales week (accounting for an extra $25m of ebitda).

While pulp sales still account for less than a fifth of the business, volumes climbed 48% quarter on quarter as Sappi secured more shipping capacity for SA exports. Sales volumes of packaging and speciality papers increased 26% year on year with demand for containerboard, self-adhesives and consumer packaging being particularly strong.

Graphic paper — used for newsprint and other print applications — is the least promising of the group’s products, certainly in the long term, though there was no evidence of this in the results. Sales volumes rose 20% year on year, thanks to healthy demand and reduced industry-wide capacity.

Demand for graphic paper will slowly decline, but André Oberholzer, Sappi’s head of corporate affairs and communications, says that under the prevailing abnormal trading conditions and logistics challenges, "graphics has delivered good returns and will continue to do so into the foreseeable future".

This doesn’t change Sappi’s strategy of realigning "to higher-growth and higher-value segments, in particular packaging, speciality papers, dissolving pulp and biomaterials and biochemicals", he says. Rather, Sappi will use the cash generated from graphic paper to invest in these businessess.

The fundamental growth driver, says Oberholzer, is the transition from such materials as plastic to renewable natural materials. Demand for packaging materials, boosted by e-commerce, and for speciality paper is opening new markets for Sappi’s lignin, composite fibre and fibrillated cellulose biomaterial products.

For dissolving pulp — which is not used to make paper but goes into such products as textiles — a growing preference for natural fibres and a burgeoning middle class, particularly in Asia, "create the audience and market for this shift".

Demand for containerboard, self-adhesives and consumer packaging has been strong too.

"In SA our containerboard is used for the packaging of export fruit, which has shown exponential growth throughout Covid, driving strong demand for our product," says Oberholzer.

Still, Sappi will have to cut capacity over time given a shrinking graphic paper market, says Avior Capital Markets investment analyst Wade Napier. Packaging, however, is a different story, as "this market has not really stopped growing".

The biggest problem for Sappi remains its stubbornly high debt — which, while it fell $139m year on year, remains at a chunky $1.9bn and acts as a considerable handbrake on the business.

Sappi’s target is a net debt to ebitda ratio (excluding special items) of below 2 times. At the moment, its gearing stands at 2.8 times — down from an eye-watering 6.1 times in December 2020.

"As it stands, Sappi would not be able to invest in growth or pursue opportunistic M&A [mergers & acquisitions]," says Napier. "We estimate it will take two years before it is in a position to consider growth investments." He says that if markets "normalise", Sappi could take longer to cut its borrowings.

Ungerer says that while gearing concerns are not as acute now as they have been over the past 18 months, Sappi’s debt/ebitda target is too high. "If you want to make it a sustainable investment, 1-1.5 times would be the number to provide a sufficient rerating for the stock on a continuous basis."

Sappi has been reluctant to sell assets, and the only deal on the table now is the potential sale of its Maastricht mill in the Netherlands, a possibility that remains at an "exploratory" stage, according to Binnie.

Binnie exuded optimism in his results presentation, forecasting better earnings in the second quarter. He argues that demand for dissolving pulp remains strong, while viscose prices have improved since the end of the quarter. Extra shipping containers should also help Sappi reduce a 100,000t sales backlog of dissolving pulp.

Debt, says Binnie, is "coming down fast", and should fall sharply over the rest of the financial year.

In the meantime, says Oberholzer, Sappi has completed the dissolving pulp expansion and upgrade project at its Saiccor mill in Umkomaas, which is expected to result in higher sales volumes and reduced costs from the second half of 2022.

Ungerer says Sappi’s earnings could hit a record in 2022, or come close to it. In 2023, the performance should moderate, but still be better than the past few years.

The North America business offers some upside risk in 2022 and 2023, he says, "whereas visibility in Europe is probably more questionable in terms of graphic paper demand and prices". Sappi is likely to consider converting its graphic paper assets to packaging, says Ungerer.

Napier says Sappi has "successfully pivoted towards increased packaging exposure", while industry-wide initiatives to cut graphic paper capacity have paid off.

"The results gave me more confidence in Sappi’s ability to fix its balance sheet and resume dividend payments by 2023 instead of 2024," he says.

Investors have preferred Mondi, which has shown better profitability and has lower costs and better assets, with less exposure to coated paper.

Yet, over 12 months Sappi has trounced Mondi with a 21% gain compared with Mondi’s 7%. Over five years, however, Sappi has delivered a negative total return of 36% against Mondi’s 54% rise.

Napier says Mondi operates in better markets and has a stronger balance sheet. "These qualities are reflected in the price and valuation so it’s probably unrealistic to compare the two companies like-for-like. However, currently, I believe there is more upside potential in Sappi’s share price."