Smurfit Stone fundamentals look positive

US stocks of containerboard have fallen from three million tons in February 2001 to 2.52 million tons at the end of June 2002. This decline in a weak demand environment is reckoned to be evidence of the increased supply discipline in the industry. The relatively low price fall of 12 per cent to $415 per ton in the 12 months to the beginning of 2002 appears to back up this contention, writes Bill Murdoch

Jefferson Smurfit Group's shareholders are naturally focused on the progress of the €3.7 billion (€3.8 billion) bid from Chicago venture capitalist, Madison Dearborn Partners. With the first hurdle over following a spectacularly successful proxy win at this week's extraordinary general meeting, the crucial test will come at 1 p.m. next Tuesday, the initial closing time for all the shareholders.

If the target 80 per cent of acceptances is reached then, or later, Smurfit shareholders will have to decide what to do with the Smurfit Stone Container Corp shares they receive as part of the deal.

The Smurfit Stone element in the offer represents about 30 per cent (the balance is cash) of the total. That percentage varies according to the value of the dollar and the Smurfit Stone share price. So how has Smurfit Stone, the US affiliate of Jefferson Smurfit Group - (Smurfit is spinning off its 29.3 per cent stake as part of the deal) - performed?

So far, it has been a disappointment as its performance has not matched expectations. On a number of occasions, for example, linerboard price increases have failed to stick.

A few figures tell their own tale. Sales rose from $7.4 billion in 1999 to $8.8 billion in 2000 but then fell to $8.4 billion in 2001. Profits before interest and tax rose from $869 million to $939 million, but then fell to $623 million over the same period.

The cyclical trend was even more accentuated at the earnings-per-share level - $0.74 to $0.93 and a drop to $0.29.

The fall in 2001 reflected a weaker demand for its paper products. Smurfit Stone is the world's biggest producer of corrugated boxes and containerboard and the largest recycler of paper, and with an estimated 18 per cent share of the North American containerboard industry, it is not immune to the industry cycles.

A big financial hindrance for the company is its debt mountain. It had a net debt of $4.97 billion (€5.04 billion) in 2001. That was reflected in an interest payment of $455 million, which represented a cool 42 per cent of earnings before interest and tax.

However, a look behind these figures puts a somewhat better gloss on Smurfit Stone's underlying financial position. The net debt has come down from $6.6 billion in 1998 and the decline was after the $1.3 billion acquisition of St Laurent.

So the high debt has not inhibited its ability to make big acquisitions. The interest cover of 1.4 was reasonable in 2001, though lower than the 1.8 in 2000.

All that is now past: so what about the future? A great deal of rationalisation has been taking place in the US containerboard industry, starting with the merger of Jefferson Smurfit Corporation with Stone Container (now Smurfit Stone). Market sources estimate that the top five US producers now account for 71 per cent of the US containerboard market; that contrasts with only 47 per cent in 1998.

There is now a tendency to close down excess capacity rather than to build up stocks. Those in the industry feel there is now a more stable pricing structure.

Two events happened last month that should be positive for Smurfit Stone. First, the industry introduced a 7 per cent price hike for containerboard and corrugated boxes. It can be a high operating profit margin business and there is always the fear that higher margins can encourage closed-down capacity to re-emerge, thereby defeating the exercise. But if the price increase is sustained, and followed by other increases, it would have a disproportional positive impact on Smurfit Stone because of its high leverage.

Second, Smurfit Stone has agreed to acquire the corrugated mill and related assets, including seven container plants and 82,000 acres of timberland, from MeadWestvaco for $375 million, or $25 million below book value.

Morgan Stanley (it is adviser to Smurfit Stone and owns 730,886 shares in Jefferson Smurfit Group) reckons this "should prove to be highly accretive for Smurfit Stone Container Corp on both earnings and return on capital". The company expects synergy benefits of more than $40 million and the deal is expected to add eight US cents to earnings per share in 2003.

US investors will view the decision of Smurfit to spin off its stake in Smurfit Stone as positive. They did not particularly like to see the US-quoted group effectively controlled by a foreign company, and saw the 29.3 per cent stake as a negative overhang on the market.

Credit Suisse First Boston reckons over half of Smurfit investors are US companies and they are unlikely to dump the Smurfit Stone shares they receive. Only a quarter of the 29 per cent is thought to be an overhang risk.

But if you believe US analysts, that might be an overestimate; they reckon the outlook is positively rosy for Smurfit Stone. Out of 10 brokers covering the stock, seven are recommending a strong buy, two a buy and one a hold. And out of seven brokers nominating a target share price in the next 12 months, the range is $17 to $26 with a mean of $20.07.

The shares were $18 in June but fell to a low of $11.70 last month. They have since recovered to $15 plus this week before slipping yesterday.

The consensus forecast is for a modest rise in earnings per share from $0.29 in 2001 to $0.34 this year. The big rise is expected in 2003 when earnings per share could reach $1.47.

Brokers have been wrong before but the fundamentals look better for Smurfit Stone. If the linerboard price increase doesn't hold, it has good operating margins to ride it out, but that is not really an attractive scenario. However, if it sticks, and others also hold, then Smurfit Stone is geared to reap the rewards.