MERC - Suzano: Why Investors Should Consider Investing In This Pulp Industry Leader

2023-06-28 08:08:41 ET

Summary

• Suzano S.A. is the leader in the pulp and paper industry, as demonstrated by my in-depth analysis of its margins and rates of turn.
• However, SUZ trades at a significant discount relative to both industry peers and its estimated intrinsic value, and this discount is unjustifiable, even considering its domicile in Brazil.
• The company presents a compelling bullish case for long-term investors to capitalize on the expected growth and upcoming rate cuts by the Brazilian central bank.

Would an investor who sees no problem investing in Netherlands-headquartered ASML Holding N.V. ( ASML ), the world's dominant supplier of lithographic equipment for chipmakers, or Denmark-based Novo Nordisk A/S ( NVO ), a global leader in diabetes and obesity treatment, be willing to invest in the world's number one pulp and paper producer if he learned that the business is based in Brazil?

Yes, I am talking about Suzano S.A. ( SUZ ).

Below, please allow me to explain why a rational value investor may want to consider Suzano as a long-term investment.

An overview of the business

Salvador, Bahia, Brazil-headquartered Suzano S.A. is the world's leading producer of pulp and paper products, which is ~43% controlled by the Feffer family . It specializes in manufacturing and supplying various types of pulp, which are used in making paper products. In terms of pulp production capacity, Suzano is the largest producer in the industry, with a 10.9% global market share.

As a vertically integrated business, Suzano sources raw materials from renewable trees in its 1.4 million hectares of plantations in Brazil, where fast-growing and sustainable eucalyptus hardwood trees grow. At its seven strategically located mills, Suzano processes wood fibers into high-quality pulp. The pulp is then supplied to paper manufacturers to produce different types of paper products, including its own integrated plants capable of producing 1.4 million tons of paper annually. Suzano also owns three export ports and 12 fully dedicated vessels to provide logistical support for its pulp and paper supply chain, as shown in Figure 1.

Industry competitive position

There are two types of pulp: hardwood pulp and softwood pulp.

• Hardwood pulp is commonly used in the production of printing and writing papers, tissues, fine paperboards, and specialty papers. This is because hardwood fibers are generally shorter, denser, more irregularly shaped, and more rigid.
• On the other hand, softwood pulp is frequently used in the making of packaging materials such as corrugated containers, paper bags, and newsprint, because softwood fibers are longer, thinner, and more flexible, making them suitable for producing pulp with good tensile strength and high paper stiffness.

In general, the profit margin for hardwood pulp tends to be higher compared to softwood pulp. This is because hardwood pulp is often used in higher-value products, while softwood pulp is commonly used in lower-priced products.

Competitive advantage

Thanks to its eucalyptus plantations located in Brazil, Suzano commands a significant competitive advantage in the production of higher-margin hardwood pulp. Similar to how Saudi Arabia is blessed with crude oil, Brazil possesses a comparative advantage in cultivating eucalyptus hardwood forests within its vast tropical savanna biome, renowned for its rich biodiversity and unique ecosystems. This advantage is evident in Suzano's low unit production cost and dominant hardwood pulp production capacity, as illustrated in Figure 2.

Among the peer group of select pulp and paper producers, including International Paper ( IP ), UPM-Kymmene Oyj ( UPMKF ), Stora Enso ( SEOJF ), Metsa ( MTSAF ), Sappi Limited ( SPPJY ), Mercer International ( MERC ), Canfor ( CFPZF ), Mondi plc ( MONDY ), Sylvamo Corp. ( SLVM ), Clearwater Paper ( CLW ) and Glatfelter Corp. ( GLT ) as enumerated in Table 1, Suzano stands out in terms of gross margin, EBITDA margin, net margin, as well as the rate of return on assets, equity, and total capital, as shown in Figure 3.

Importantly, on a trailing 12-month basis, Suzano generates an ROIC of 20.5%, which is significantly higher than its WACC of 7.0%. This indicates that Suzano has a large competitive advantage.

Growth

In the decade from 2013 to 2022, Suzano was able to achieve a compound annual growth rate (or CAGR) of 16.4% in its top line, 25.0% in gross profit, 24.8% in EBITDA, 30.9% in operating profit, and 56.3% in free cash flow (or FCF), as illustrated in Figure 4.

The merger between Suzano Papel e Celulose and Fibria in 2019 was a major event in the history of Suzano S.A. The business combination nearly doubled the annual revenue for Suzano S.A. Since the merger, Suzano has grown its top line at a CAGR of 10.5%, gross profit at 35.4%, EBITDA at 20.0%, operating profit at 57.3%, and FCF at 10.7%.

Going forward, the continued growth of Suzano's business is supported by the anticipated global end-use consumption growth at a CAGR of 5.4% over the next 10 years, as illustrated in Figure 5. This growth is driven by population growth and rising consumption per capita, despite the anticipated decline in consumption of printing and writing papers. Additionally, Suzano will benefit from the displacement of bleached softwood kraft pulp (or BSKP) and recycled paper in tissue and cardboard production by bleached hardwood kraft pulp (aka, BHKP).

The Cerrado project

The $2.8 billion Cerrado project is a major initiative undertaken by Suzano to meet anticipated global demand growth. The project aims to expand Suzano's eucalyptus plantations in the Cerrado region of Brazil, and increase its pulp production capacity through the construction of a new eucalyptus pulp plant capable of producing 2.3 million tons of pulp.

Upon the completion of the Cerrado project by early 2024, Suzano is poised to reduce the average distance from forest to mill from 203km to 140km, and boost its pulp production capacity by 20%, thus further solidifying its position as a global leader in the pulp and paper industry.

The bio-business agenda

Additionally, Suzano is allocating capital to its bio-businesses agenda , targeting new addressable markets of $115 billion per year on four fronts beyond its traditional pulp and paper business: textiles, micro-fibrillated cellulose (or MFC), biofuels, and carbon.

• The first textile fiber plant , a joint venture with Spinnova and utilizing Suzano-supplied MFC, started production in February 2023, and the completion of the second plant is anticipated after 2024.
• Suzano is also poised to trade 7.5 million tonnes of carbon equivalent in the voluntary market.

Valuation and risks

Even though Suzano is the undisputed leader in the pulp and paper industry, it captures considerably lower EV/EBITDA, P/E, and P/CF multiples compared to the average peer, as evidenced in Table 1. For instance, Suzano has an EV/EBITDA multiple of 4.5X on a trailing 12-month basis, while UPM-Kymmene has 7.2X, International Paper has 5.8X, Stora Enso has 6.2X, and Mondi has 5.3X.

From a historical perspective, Suzano's EV/EBITDA multiple of 4.5X is significantly cheaper than its trailing 10-year median EV/EBITDA multiple of 12.3X.

Assuming Suzano maintains its FCF growth pace at a CAGR of 10.7% in the next 10 years and posts no growth thereafter, my calculation at a WACC of 7.0% suggests that the stock has an intrinsic value of $32.5 per share. The current share price of $9.55 as of June 23, 2023, implies a discount of over 70%. This means that investors are offered an extremely large margin of safety to compensate for all the perceived risks.

Risks

Suzano indeed exposes shareholders to a slew of risks, some idiosyncratic to the company and others general to the pulp and paper industry.

• Firstly, Suzano is exposed to jurisdictional risks in the form of environmental regulations, sustainability standards, and government fiscal policies in Brazil. The left-leaning president Luiz Inácio Lula da Silva has been feared for potentially implementing anti-market reforms in the post-Jair Bolsonaro era. The perceived political risks may have contributed to the current deep undervaluation of Suzano.
• Secondly, fluctuations in the currency exchange rates of the Brazilian Real against other currencies introduce uncertainties to Suzano's export revenues and debt obligations.
• Thirdly, a steady supply of raw materials, particularly eucalyptus hardwood trees, may be disrupted by or become costly due to changes in weather conditions and/or pest or plant diseases in Brazil.
• Fourthly, the pulp and paper industry is known to be highly cyclical, although the volatility in BHKP at 12% is lower than that of other commodities such as cattle (20%), copper (21%), soy (22%), sugar (28%), crude oil (39%), and iron ore (47%). Any industry downturns or supply chain disruptions could impact Suzano's short- to medium-term financial performance.
• Lastly, Suzano operates in a highly competitive industry, facing competition from both domestic and international pulp and paper producers. Changes in market dynamics, technological advancements, or new market entrants could pose challenges to Suzano's leading position in market share, erode its pricing power, and damage its profitability.

Investor takeaways

All in all, I believe that Suzano offers long-term-oriented investors an extremely attractive risk-reward profile. The stock currently trades at a deep value relative to both industry peers and its estimated intrinsic value, likely due to perceived high political risk under Lula. Such a large discount, in my opinion, is not justified given Suzano's competitive position as the leader in the pulp and paper industry.

The strong growth momentum of Suzano's underlying business, underpinned by the scheduled start of the Cerrado project in early 2024, and the anticipated rate cuts by Banco Central do Brasil, possibly in August or September 2023, amidst falling inflation rates, may provide the necessary drivers for a substantial appreciation of Suzano's share price in the near future.

Therefore, long-term investors willing to take exposure to Brazilian equities may consider allocating some capital to Suzano in the next few months, if not immediately, as shown in Figure 6.

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