SLVM - Sylvamo: Valuable Paper

2023-10-16 14:08:26 ET

Summary

• Sylvamo shares have been flat since March, but the quarterly dividend has been raised in conjunction with increased share repurchases.
• The current environment for office paper is challenging in terms of both costs and demand, leading to lower free cash flow expectations for 2023.
• However, shares remain attractively valued for the long-term on an earnings and operating cash flow multiple basis.

Sylvamo ( SLVM ) shares have been treading water since my last review in March of this year, sitting at basically break even on a total return basis. That figure could perk up some as shareholders receive the regular quarterly dividend of $0.30 per share (a 20% boost to the prior payout), as well as a matching special dividend in the same amount in mid-October (not reflected in the chart), but the two payments will likely not be enough to close the gap versus the general market. Nevertheless, it is an opportune moment to take a fresh look and consider if the investment thesis still holds together.

For a very basic summary, Sylvamo is one of the world's leading manufacturers of uncoated freesheet paper, along with other types of specialty paper. Uncoated freesheet is the type of paper that is ultimately used as copier or printer paper in offices daily, and Sylvamo is known through its paper brands bearing such names as Hammermill and Hewlett Packard. The company has its headquarters in Memphis, but operates fixed assets like mills and forestland acres in countries from Sweden to Brazil. Sylvamo was spun out from International Paper ( IP ) two years ago, leaving investors who started with shares of International Paper now with shares of major firms in both paper packaging and office paper.

Summary of Q2 and H1 Financial Results

Sylvamo reported its second quarter results in early August, with revenue coming in at $919 million for the period, just slightly higher than Q2 of the prior year. However, the costs of the raw inputs increased quite noticeably, rising from $659 million for Q2 of 2022 to $721 million for Q2 of 2023, a 9.4% increase that weighed on gross margins. Other operating expenses and taxes were well managed, and the bottom line was an EPS result of $1.14, versus a loss of ($1.33) in the same period of 2022, though that loss is fully attributable to losses from discontinued operations (the company's Russian assets). Backing out that loss, the EPS for Q2 of 2022 from continuing operations was $1.89 on the back of better gross margins conditions a year ago. On a six-month basis, the comparison to last year hold up better, with modest revenue growth of 7.3% to reach $1,860 million. More importantly, gross margins degraded less dramatically relative to the quarterly comparisons, going from 26.2% in 2022 to 25.3% for H1 of 2023. Total EPS through the first half of 2023 has come in at $3.40, as compared to $3.13 from continuing operations a year ago. Nevertheless, the whole picture missed expectations sufficiently to cause at least one analyst downgrade , from outperform to market perform.

The company's overall cash position has dropped over the first half of 2023, falling by more than 50% from $360 million to start out the year, now down to $164 million, while inventories have crept up by 33%, from $364 million to $486 million, and overall more cash is tied up in working capital. On the liability side of the ledger, total debt has not really changed, sitting at $1.3 billion, with the distribution between current debt and long-term shifting slightly (more current debt, less long-term debt than at the start of the year). Specifically, the long-term debt profile has dropped to under $1 billion, and the ratio of debt to equity has improved to 1.20x from 1.52x. Six months through the year, I see no major red flags in terms of the strength of the balance sheet, but more minor concerns on the inventory build-up relative to the cash on hand.

Valuation Notes

While gross margin compression is a challenge, it is not an issue that is beyond fixing. Similar to plenty of other industries, there have been some swings in demand as customers built up inventory last year, leading to lower volumes this year while dealing with inflation on labor and materials and attempting to adjust pricing to match. However, such fixes take time, and have to be implemented in the context of the real world economy. In Sylvamo's case, there are some near-term headwinds, specifically slowdowns in the European and Latin American markets. The net impact is revised guidance on free cash flows for full year 2023, to a range of $220 million to $250 million, a clear drop from prior guidance on this front of at least $300 million. While nobody wants to see lower cash flow, it is understandable in the current moment. Nevertheless, at the mid-point of guidance, that imputes a price to free cash flow multiple of 7.36x, which is telling, as its forward P/E multiple is nearly the same at 7.28x. In other words, GAAP earnings and free cash flow are expected to be close in value, though as an investor in this type of mature industry, I am keenly interested in the free cash flows.

The good news is that Sylvamo is a cash flow opportunity, albeit one in a slowly fading industry. For its investors, that translates into uses of cash that benefit the shareholders directly and immediately, in the form of dividends, share repurchases, or both (although Sylvamo has been selectively investing in additional operating fixed assets, most notably with the acquisition of the Nymölla mill in Sweden). Specifically, shareholders will be the recipients of $125 million in planned returns for 2023, between dividends and buybacks, a nearly 40% increase over the prior year's $90 million plan. As mentioned earlier, the normal quarterly dividend was just raised by 20%, which puts the yield at modest ~2.80%, but a very conservative earnings payout ratio, under 20% on a forward EPS expectation of $6.80. As the special $0.30 dividend points to, there is room for even the regular dividend to go higher in time. In fact, as mentioned earlier, Sylvamo has business assets in Brazil, and a tax-dispute there has previously capped their shareholder distribution capacity as part of credit agreement. The company has deposited $60 million in escrow for this case, which was a condition for allowing higher returns.

The total return of cash is likely to split relatively evenly between dividends and buybacks for 2023 based on the share count and dividend payouts, with slightly more going into share buybacks. In broad strokes, the repurchases would come to approximately $65 million, enough to remove 1.3 million shares (at $50 per share). While it is nothing extravagant, it still would equal out to reducing somewhere around 3% of the shares.

Sylvamo's shareholders have a claim to an attractive stream of cash flows that are being largely utilized to their direct benefit. So at a share price currently just under $43, is it an attractive value, even if it is in a slow or declining industry? Relative to its peers, I believe Sylvamo remains fundamentally attractive from a valuation standpoint and its capacity to throw off cash.

While pure-play paper industry peers that are public companies are not widespread, there a couple of firms that can function as proxies, including Veritiv ( VRTV ), who has a business line for uncoated free sheet amongst its other product offerings, and Ennis ( EBF ), a leading name in supplying businesses with printing solutions, labels, and paper checks - largely items and services that can go hand-in-hand with the demand for office paper. Finally, there is Stora Enso Oyj ( SEOAY ), the Finnish company that Sylvamo acquired the mill from in Sweden.

While carrying higher debt relative to its equity than this particular peer group, the ratio is not worrisome, while Sylvamo maintains exceptionally attractive price to earnings and price to operating cash flow metrics, all while paying a modest but safe dividend that could be setting-up for continued growth. I do not expect to see some massive upside develop for Sylvamo shareholders soon, but I think patience will ultimately be rewarded between the combined impact of the buybacks, dividends, falling debt, and very attractive operating cash flow for the price.

Conclusions

While the paper industry is about as far away from a high-flying growth sector as one can possibly get, it certainly retains plenty of merits. The American humorist and author Mark Twain supposedly heard that his obituary was mistakenly run in newspapers before he had actually died, and replied to the effect that "reports of my death are grossly exaggerated." While that's not exactly how the origin of that story came about, the sentiment as applied to the business of manufacturing office paper holds its own truth. Though the long-term trend is well-accepted (and not new ) as going down while digitization becomes ever-more common, world-wide demand for paper will continue to go through ebbs and flows over a natural lifetime. Those businesses that are best-managed will balance that journey, rewarding shareholders along the way.

In that mix, I continue to find Sylvamo working on behalf of its shareholders' interests to maximize their value, and at the current levels, I believe Sylvamo remains an attractive investment opportunity for the long-term.

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