Tuesday, April 16, 2013

Two Paper Industry Stocks as Earth Week Begins

Earth Week begins today – a few days set aside to make the environment a priority.  The landscape in the U.S. has come a long way since the first Earth Day on April 22, 1970.  Most rivers and streams are clean enough for fish and even swimming.  Our skies are becoming clearer and clearer as vehicle emission standards become more stringent.   Yet we are still grappling with serious environmental issues: algae blooms in our major lakes from fertilizers draining into feeder streams, ground water contamination from industrial chemicals and, of course, the ever present threat of global warming and the myriad weather consequences.

The pulp and paper industry is one of the largest industries in the world.  It is the third most pollution intensive industry in North America.  Pulp and production leads to the release of well over 100 million kilograms of toxic pollution each year.   It is also energy intensive.  The pulp and paper industry is the fifth largest consumer of energy, accounting for 4% of world use.  It also uses more water to produce a ton of product than any other industry.  I thought it might be interesting to look at the paper industry from a financial standpoint back in the 1970s and now. 

International Paper (IP:  NYSE) makes a good representative of the pulp and paper industry.  It was founded in 1898, has survived two world wars, several other major periods of conflict, two major recessions and a series of up and down economic cycles.  In the most recent twelve months IP reported $27.8 billion in sales of paper and paper products, on which it earned $749 million in net earnings and $3.0 billion in cash flow.

International Paper has not always been so successful.  In 1970, as the first Earth Day unfolded, IP was struggling.  An expansion production capacity had eroded profit margins in the 1960s and in profits declined sequentially by30%.  By 1971, earnings of $69 million were the lowest in a decade.  The company was also increasing its leverage.  In 1971, long-term debt reached $564 million compared to near zero five years earlier.

It is understandable that a company under such pressure should resist regulatory efforts to clean up toxic discharges from its various paper mills.  Yet the community’s long-term love for the environment finally overcame lobbyists’ efforts to shelter the short-term earnings of a few companies.  Landmark legislation passed in the 1970s began regulating the use of toxic metals such as lead, arsenic, selenium, mercury, cadmium and hexavalent chromium in inks and paper processing.  The Resource Conservation and Recovery Act of 1976 replaced the original Solid Waste Disposal Act, encouraged pulp and paper mills to phase-out production of persistent or bio-accumulative toxic substances and to replace these substances with safer alternatives.  The use of chlorine to bleach wood pulp was subsequently banned in the early 1990s.

Contrary to all predictions that regulations would put paper mills out of business, IP and its various competitors have survived.  International Paper reported a gross profit margin of 26.1% in the most recently reported twelve months.  This compares to an average profit margin of 22.0% for the paper and paper products industry.  The five-year gross profit margins for IP and the industry are 27.7% and 25.2%, respectively.  On a net basis IP manages to squeeze 1.5% out of sales while the industry averages 2.5%. 

Indeed, profit rates and returns on investment for the paper and allied industries has largely been flat since the 1970s.  There is a perception that profitability is eroding.  This is largely due to overcapacity of the industry rather than increased expenses due to environmental regulatory burdens.

It should be no surprise that there are no paper mills in any of the four energy alternatives indices maintained by Crystal Equity Research.  However, we have included Kadant, Inc. (KAI:  NYSE), a supplier of papermaking and paper recycling equipment. Kadant is a small fry in comparison to International Paper.  Kadant has enabled environmental responsibility in the pulp and paper industry with recycling equipment and a variety of systems for fluid handling, water management, cleaning and filtration.  Kadant supplies more than the paper and pulp industries.  Its equipment is installed in plastics, textiles and tire plants among a variety of other manufacturing and processing industries.

Kadant had been on a run before the 2000-2010 recession, but since then has managed to nudged sales higher each year.  Most importantly, Kadant has remained steadfastly profitability through it all.  The company reported $30.9 million in net income on $331.8 million in total sales in the most recently reported twelve months.  The company converted 8.8% of sales to cash in the same period. 

There is only one analyst with published estimates for Kadant.  This analyst apparently has a fairly conservative view on the company, because Kadant has had no difficulty in exceeding the consensus estimate of one in each of the last four quarters.  For the year 2013, his/her expectation is for $2.54 in earnings per share on $331.0 million in total sales.  The implied forward earnings multiple is 9.9 times.  The machinery manufacturing sector, of which Kadant is a part, is currently trading at 21 times trailing earnings.  Thus a 15 multiple for Kadant on a forward basis seems fair.  This suggests fair pricing near $38.00 per share.

A quick review of historic trading patterns suggests that Kadant shares have a good head of steam built up.  With the recent sell-off in the broader market there is some short-term weakness evident.  However, such weakness should simply make it possible to accumulate some shares of a solid company at compelling prices.  There are a few call options available on KAI, but trading is thin.  The stock has a beta of 1.80, suggesting there could be some volatility for those who want to buy and hold for a period of time.  There is a small dividend of two bits per year that could help smooth out returns. 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. KAI is included in The Mothers of Invention Index in the Efficiency Group.


No comments: