MERC - Mercer International: Falling Pulp Prices Putting Pressure On Stock

Summary

• Falling pulp prices are putting downward pressure on MERC, and they will probably continue to fall through 2024.
• With its Pulp segment accounting for the majority of its EBITDA, this is going to significantly impact its performance going forward.
• Its share price has fallen since the end of October 2022, and is approaching its 52-week low.
• If it breaks down through the $11.50 mark, it's likely to continue on to test the $10.00 level or lower.

After a decent earnings report for Mercer International Inc. ( MERC ) in the third quarter of 2022 where it beat on the top and bottom lines, it may be the last solid performance it has for a while if North American NBSK prices continue to fall over the next couple of years, as they're expected to.

From August when North American northern bleached softwood kraft (NBSK) prices reached a high of $1,805 per ton, they have since fallen to $1,745 per ton in August 2022. RBC analyst Paul Quinn sees prices dropping to $1,600 per ton in 2023 and to $1,445 per ton in 2024.

Even if he's a little low in his estimates, this is still going to have a significant impact on revenue and earnings in the quarters ahead, and the next couple of years at least, depending on NBSK price support at that time.

If that's how it plays out, it means not only lower prices but higher input costs as well, pointing to tightening margins in the near and long term.

In this article we'll look at some of the numbers from its last earnings report and the implication of falling NBSK prices on the performance of the company.

Latest numbers

Revenue in the third quarter was $533 million, up approximately $63 million from the third quarter of 2021, when the company generated $470 million in revenue.

Cost of sales was $368 million in the reporting period, up $65 million from last year in the third quarter. Cost of sales for the first nine months of 2022 were $1.2 billion, compared to $910 million in the first nine months of 2021.

Net income in the third quarter of 2022 was $67 million, or $1.00 per diluted share, down from the $69 million in net income, or $1.04 per diluted share in the third quarter of 2021. Net income in the first nine months of 2022 was $227 million, or $3.41 per diluted share, far above the $96 million in net income or $1.46 per diluted share from the first nine months of 2021.

EBITDA in the reporting period was $141 million compared to $145 million in EBITDA in the prior quarter. EBITDA in the first nine months of 2022 was $440 million, a record for the company.

With its Pulp segment contributing approximately $138 million to EBITDA, it's clear that the impact of falling pulp prices on the company is going to be substantial in the near term.

The solid results came from higher pulp and energy prices, which I believe are reaching their peak, if they haven't already. If that's accurate, it means the company is going to struggle to perform in the quarters ahead as it has been over the last year or so. I think the market agrees with that assessment based upon the downward pressure in its share price.

Cash and cash equivalents at the end of the quarter were $287 million, with $259 million in undrawn revolvers.

What remains to be seen is how much of this will be partially offset by its acquisition of the Torgau mill, which is the largest producer of "European pallet associated or EPAL wood pallets" in the world. It has the capacity to produce approximately 17 million pallets annually.

If the estimated synergies of around $16 million is close to being accurate, it could potentially offset some of the expected decline in pulp prices, although I think that will be modest in the impact on the company in the next year because of the time it'll take to take advantage of the expected synergies.

Combined with higher freight, energy and fuel costs, MERC is going to struggle to maintain its recent performance; I don't think it will be able to over the next few quarters or possibly, couple of years.

Share price considerations

Over the last couple of years, the share price of MERC has been trading very volatile, with prices from approximately $18.00 per share in April 2021, to as low as about $9.50 on November 1, 2022. Since then, it's climbed nicely to a 52-week high of $17.50 on August 15, 2022, before pulling back to about an $11.50 per share level on September 25, 2022, and moving up from there to $14.50 in mid-October 2022, and back down again to about $11.50 per share.

With a double bottom near the $11.50 per share mark, I think the stock will drop quite a bit further if it falls below that level in any significant and sustainable manner.

I draw that conclusion because there really aren't any short-term catalysts, I see that will offset the steadily falling pulp prices. Unless pulp prices reverse direction, it's going to be a tough 2023 for MERC.

Looking at support levels over the last two years, the stock has found support at close to $10.00 per share. So that's what I would look for on the downside, and it if were to break to the downside there, it's very likely to fall below its two-year support. If that were to happen, it would test the resolve of a lot of investors in my opinion.

That said, with the long-term outlook for MERC being positive in my view, it would provide some terrific entry points for those willing to hold for the long-term.

Even at its current price level it's interesting, but because of the expectations that pulp prices are going to continue to fall over the next couple of years, it could have more downside left in it before it finds a bottom. All it'll take to trigger that will be a weak earnings report and outlook.

Conclusion

Over the long term I think MERC should do well, but in the near term I see the potential for it to come under heavy pressure if input costs remain high while pulp prices continue to fall.

If it can find the synergies it's looking for from the acquisition of Torgau, some of that downside could be partially offset; even more so if it's able to improve efficiencies in other areas of the company at the same time.

But if revenue starts to fall, margins tighten, and EBITDA drops going forward, it's going to put a lot of pressure on the stock until conditions improve.

Since I believe the upside is limited for the next year or two, probably the best way to play the stock would be to wait to see where the bottom is while waiting for confirmation it has bounced off it.

The other way would be to dollar-cost average during this time in order to build a position with a favorable cost basis and lots of upside potential in the years ahead.

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