10 Sep Our take on Suzano
Franco Dal Pont
Pulp has enjoyed a fair share of good news this year. While most commodities from oil to iron ore collapsed, pulp prices have remained strong. In addition, energy prices in Brazil spiked due to the severe draught, helping energy exporters such as pulp and paper and ethanol plants. Finally, the real devalued against the dollar, boosting the top line of exporters.
Much of the excitement surrounding Suzano has to do with both record revenues and profit figures and all-time high EBITDA margins posted with a strong dollar and the ramp-up of the new Maranhão pulp plant.
Suzano’s shares have followed suit and are up approximately 90% YTD.
As of this week, Suzano has fourteen sell-side buy recommendations in Brazil, the greatest in Brazil.
Production capacity – tons mn
Source: Batalha, Suzano
Revenues and EBITDA R$ mn
Source: Batalha, Suzano
Consensus-wise, Suzano’s share price is still cheap and has room to appreciation. We beg to differ, its share price looks expensive, both on a relative and absolute basis.
But before we lay out our much more conservative absolute valuation, it is worth examining what seems to be the consensus bullish arguments, which are fragile under scrutiny.
1 Competitive Advantage stemmig from low-cost production
Both the Pulp industry and sell-side highlight Brazilian pulp’s inherent competitive advantage stemming from low-cost production. True, given forest productivity and much shorter cycles forests in Brazil are way more economically viable than most parts of the world.
Cash Cost BHKP – US$t
But, once all-in costs, including those out of the farms, are taken into account, Brazil’s competitive edge falls off a cliff.
It’s especially troubling that this cost edge could actually disappear if wood prices had increased over the past five years. In addition, both Fibria and Suzano pay minimal or no income taxes given their net operating losses carry-forwards.
Total Cost BHKP – US$t
Finally, the cost curve continues to flatten out indicating the best and worst producers cost spread is shrinking. Competitive advantage seems to be going away.
BHKP Cost Curve – USD/ ADt
And new capacity coming online does not bode well for long term pulp prices.
2 An obsession with EBITDA
EBITDA is a poor proxy for free cash flow.
Because it fails to account for taxes, capex, working capital, and interest payments it overstates cash flow and masks the true economics of the business.
In Suzano’s case, when all these necessary adjustments are factored in, there’s little cash, if any, available to equity holders.
While the market is obsessed with Suzano’s EBITDA as a valuation and performance metric we avoid it altogether.
Indeed, EBITDA has been historically a misleading cash flow indicator.
Suzano’s cash flow true colors – 2014 R$ billions
Cumulatively, over the past ten years Suzano has failed to generate shareholders any cash, even excluding the capex of the new Maranhão plant.
Cumulative figures – 2014 R$ mn
Source: Batalha, Suzano
To generate more EBITDA, working capital ballooned nearly fivefold.
Suzano’s Invested Capital – R$ mn
So, true business economics remain intact, with poor returns on capital. Schalka, Suzano’s CEO, has acknowledged and criticized the lack prudence (overcapacity) that has led the whole industry to fail to earn its cost of capital.
Returns on Capital %
3 New high margins – A new normal
While it is true Suzano may enjoy a couple of year of positive cash flow post-growth capex we see an optimistic trend of extrapolating the current high margins indefinitely into the future. This might overstate Suzano’s true cash flow earnings power.
The pulp market is a commodity-based, cyclical business and profit margins bounce around wide ranges. Suzano’s EBITDA margin, for example, reached almost a 40% peak in 2004, only to collapse to a low of 23% in 2011. It’s prudent to remember the past and not to get overly excited with the present.
Hence, we prefer to normalize margins for the business cycle, acknowledging bad things can and do happen.
4 Deleveraging is under way
The deleveraging theme is based, again, you guessed, on an EBITDA figure. Sell-side and buy-side analysts commonly use Net Debt over EBITDA as a proxy for levarage. Because Suzano’s EBITDA has grown fast the ratio has gone down.
Nevertheless, to us, deleveraging is paying off debts which means debt balances need to go down, not up. The strong dollar has also hurt Suzano’s balance sheet given most of its liabilities are U$ dollar denominated.
To us, at least for the time being, Suzano’s capital structure continues to lever up to all-time high levels.
5 Relatively Cheap multiples
Another bull argument is that Suzano EBITDA multiple is trading below its historical average (6,5x against 7,0x) and, thus, has room to expand.
However, with the start of the Maranhão plant, Suzano has increasingly morphed into a market pulp company. All else equal, as a larger piece of the revenues and operational profit comes from a less protected, more commoditized revenue source, multiples should be indeed going down, not up.
Why pay more premium if overall business quality is going on the opposite direction?
Quarterly Production – Mn tons
Source: Batalha, Suzano
Importantly, because of the inherent weaknesses of EBITDA, more appropriate valuation ratios should be used instead. Why value a business by putting a multiple on a meaningless figure?
In fact, we are not fans of valuations multiples and would rather use absolute type analysis. But, when using a multiple based approach, we pick the one (s) that better represent real business economics.
Indeed, when we depart from an EBITDA based to either an EBIT or FCFF approach, Suzano’s valuation changes dramatically from cheap to expensive.
Trailing EV/ EBIT multiples
Source: Batalha, Factset
In fact, when discarding EBITDA, Suzano’s whole investment case falls apart.
What’s the catch? We could be plain wrong (exceedingly pessimistic) and failed to appreciate that both Suzano and the pulp market are in for a long-term, value generating trajectory. In this scenario, prices and margins will fail to mean revert. Demand for pulp and paper will prove to be way more resilient. Pulp making will become, contrary to the last fifteen years track record, a cash making business. This time would really be different.
Or, as so often happens, a feel good story will be taken too far. As with any cyclical industry, a few years of bonanza and positive cash flow will be succeeded by difficult times. Demand will suffer, prices will fall, and players will struggle.
As Jim Chanos, the famous short seller once put it, the market is a big, self-reinforcing machine. The bullish, exciting stories take on a life of their own and almost anything would be said and done to fed into the story. For the time being, this machine seems to be firing on all cylinders.
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