Description

Please note:

This write-up has taken me a little while to complete due to time constraints. As such, the last price and multiples are not completely updated. By chance, the write-up quotes the last price as 44.50, which it was at the time I uploaded this. That turned out to be where the share price bottomed (so far anyway). Using 44.50 as the last price is not an attempt to make the investment case more attractive and is coincidental. I am long BRG from an average price of 49.50 myself. As of right now, the last price is 47.30. Buying below 51 NOK should provide at least a 25% margin of safety.

Borregaard - a quality business with 60%+ upside to fair value

"I don't all believe all this nonsense about market timing. Just buy very good value, and when the market is ready that value will be recognized."

Henry Singleton

Thesis summary

I recommend a long position in Borregaard ASA, ticker BRG NO Equity. Borregaard is interesting because it is too cheap considering its long term earnings power, and because it has sold off over the last few quarters after an impressive run post-IPO. The market has overreacted to a few weaker than expected quarters and the stock has fallen from the mid-sixties to the mid-forties today. During the first two quarters of 2015, production hiccups and supply issues led to disappointed consensus, and in Q3, signs of weaker demand in performance chemicals scared investors. I think cyclical fears are overdone and that the long term story is still very compelling, and will try to explain why below.

It is important to first understand that the run-up since the IPO is entirely justified. The stock was clearly too cheap at the time of listing (listed at around 7.5x 12m fwd EPS). Orkla (ORK NO) spun off BRG in 2012 as part of a restructuring effort to become a more pure FMCG company, the chosen strategy of the main shareholder of ORK, Stein Erik Hagen. It was almost as if economics became secondary to "doing something," in this case something structurally dramatic. This imperative led Orkla to abandon its historical diversified structure and make a series of stupid transactions in my opinion, and the spin-off of BRG at a far too low price is among the worst examples. ORK's new policy seems to be buy expensively, sell cheaply - a strategy with a poor historical record.

What has proven effective however, is to buy quality on the cheap when short term events lead to negative market psychology and mispricing, and sell when Mr Market regains his sanity (however briefly). At the time of writing, BRG looks cheap both on an absolute and a relative basis. At 44.5NOK, BRG is valued at 10x 2016 EPS, and 8x EV/EBIT. A conservative DCF shows BRG is worth 72 NOK, 60% above today's price. The potential downside should be limited from here as the company is now valued at only 14x the 5yr average EPS, despite increasing earnings power. There’ll be tailwinds from the weaker NOK in 2016 (much of the USD and EUR revenue is hedged forward at much higher levels than in 2015) which reduces estimate risk markedly. Comparables trade at higher multiples, how much higher depends on what business segment you're looking at. Global and specialty chemical peers are valued at about 15x earnings and most comparable cellulose peers at 13x. Since performance chemicals is most like specialty chemistry and contributes over 80% of the EBITA (over 80%), about 15x EPS seems a fair enough multiple for the market leader in this niche. On 2019 EPS, that implies an 89 NOK share price and a potential double over the next 3 years.

I believe an investment in BRG today should yield a 15% annual return from capital gains alone. In addition, ca 4% in annual dividends can be expected, for a total annual return of about 18%. That's very attractive, especially in a durable quality business such as this. The company has an open shareholder structure and a solid balance sheet, and although the push of negative cyclical forces appears to depress the growth prospects in the short term (the key word being appears), longer term growth is probable given recent capacity expansion efforts and the Exilva potential. If you’re a competitor with more of a commodity product profile and you see the the market leader in lignin severely undervalued in the stock market, BRG should be an interesting acquisition target. This thesis is not at all dependent on a takeover, but it should certainly not be ruled out.

Share price development last 2 yrs

Borregaard's business

BRG is a company with a long history dating back to the 17th century, a summary of which can be found here http://www.borregaard.com/About-us/History so I won't go into it here in further detail. The company owns and operates biorefineries that extract different wood based products through proprietary technologies. Senior management is experienced and competent and have been with BRG for many years. Today, the company has two main business segments, Performance Chemicals and Specialty Cellulose, as well as new initiative Exilva and two less important segments, Ingredients and Synthesis (see «other businesses»). Borregaard has an integrated production concept which utilizes the entire wood input (at its facility in Sarpsborg, Norway which contributes about 75% of revenue). Wood consists of three main components; sugar, cellulose fibres and lignin. Out of 1t of feedstock, BRG produces about 400 kg of lignin, roughly the same amount of specialty cellulose, 50 kg of ethanol and 3 kg of vanillin (artificial vanilla flavor). This is about 3x the output of a normal pulp mill (see below). BRG also has six satellite plants outside Norway as well, but here only lignin based products are extracted from the residual flows of sulphite based pulp mills. BRG is a global company. About 47% of sales are to Europe, 27% to the Americas, 23% to Asia and 3% goes to the rest of the world.

Overview of BRGs production concept at the Sarpsborg plant

EBITA contribution by segment as reported, jan-sep 2015

Performance Chemicals (LignoTech) and the lignin market

This is BRGs most profitable segment with a 23% EBITA margin so far in 2015, and also the best business in terms of having durable competitive advantages (proprietary technology and fairly high switching costs for customers). This is the most stable segment, with historical average EBIT margins of 15-17%. Borregaard has evolved into the dominant supplier of specialty lignin based products (the binding material in wood and plants) primarily because they have better technology and processes, there is no natural advantage in terms of raw material cost being lower, for example. Over time, BRG has become the dominant supplier. Borregaard has succesfully raised prices per metric ton dry solids in this segment by a CAGR of 5.4% since 2006 (measured in dollars to separate out the effects of the weakening NOK since then), which indicates some pricing power, but it should also be credited to developing and increasing sales of more medium and high value products and less low value products over that period, so we’re not really comparing the sales price for the same basket of products. In any case, the company is now making significantly more money in the segment, and this trend is likely to continue in my opinion. Hence, EBIT margins in performance chemicals should be more in line with current than historical averages. I am assuming realized performance chemicals prices will rise by 2.5% per annum going forward, but keep them flat in 2016.

In the lignin market where BRG is present (calsium ligonosulfonates https://en.wikipedia.org/wiki/Lignosulfonates), BRG has about 45% market share in terms of volume and about 60% in terms of value. The company is the only global supplier, and sells into about 80 countries. BRG is undoubtedly the market leader. Lignin is primarily used as a plasticizer or binding / dispersion agent and a stabilizer. Some examples of uses for lignin are animal pellets, pesticides, ceramics, as a concrete and cement additive, dyes and agrochemicals. Borregaard has over the years succesfully developed niche products for a variety of uses that in many cases are now burdensome to design out of customer production processes. This leads to higher switching costs for the customers (and moderates the threat from petrochemical substitutes somewhat now that oil prices have come down a lot). Borregaard produces over 600 different lignin based products and sells to a diversified customer base (over 3000). The most important single end market is construction (40%). BRG sells mostly direct to customers instead of through wholesalers and agents, which better facilitates relevant product development (this is also reflected in higher R&D spending compared to peers) and produces tight and longer lasting relationships with customers.

Long term underlying market growth looks ok, but nothing more. BRG estimates about 2.5% demand growth with an emphasis on demand from South America, Asia and Eastern Europe. With economies in these markets like Brazil, China and Russia weaker, BRG has seen some moderation in demand, as communicated in the Q3 report. This has been one of the data points the market has latched onto when sending BRG shares down. The fact that performance chemicals EBITA was down 5% yoy in Q3 was too much for Mr Market, and the stock dived about 20% from 54 to 45 NOK over a few days. 

But the future success of BRG is not very dependent on a booming construction market in China, e.g. This is important and where I believe the market is making a mistake at the moment. Demand is holding up well in the Americas generally and in Europe, and I think the cyclical fears are overdone. Actually, I believe EBIT will rise by over 20% from 2015 until 2016 as a function of several factors: a reallocation of volumes to markets with higher demand, large currency tailwinds and the first contribution from Exilva. BRG has historically been very good at adjusting production to market conditions, and there's an inherent plasticity in the business as BRG can shift production from one product to another to a certain degree as demand dictates and also reallocate volumes from regions with low to regions with higher demand, although that may weaken margins somewhat. I would also argue that over the longer term, demand from the mentioned regions is likely to rise, rather than fall. In the meantime, BRG's competitive position is not likely to be threatened. A slow growing market tends to favor the incumbent. In any case my thesis is not dependent on assuming a high growth rate in earnings, far from it. One circumstantial piece of evidence in favor of hypothesizing that long term demand looks ok is that BRG is adding a good deal of capacity right now. They have unparallelled insights into this space, and I don't think this experienced and competent management team would be willing to waste money on speculative or unnecessary capacity expansion. In 2015, BRG has signed a LOI for the addition of 150 000 tonnes capacity in a recent JV with Rayonier Advanced Materials which I have not given credit in my base case estimates at this stage. They’ve also announced a JV with Sappi for 20 000 tonnes (coming online in 2017) and on Oct. 21st they announced that they've signed an agreement with Flambeu Rivers to acquire their lignin business in the US, which adds about 40 000 tonnes annual capacity.

BRG does not see the general market growth as its own growth limit, and has repeatedly stated that raw material supply rather than weak demand has been the growth obstacle. For example, BRG says the increased volumes from the BALI initative could easily be absorbed by the market and that BALI can increase annual performance chemical capacity by 20-25%. Another important thing to remeber is that the company has a strong track record of creating new products with higher value for both BRG and customers, and I expect this to continue in the future.

The lignin market is and has historically been supply constrained. This means that cyclical variations in demand is what drives volumes and mix shifts, rather than big changes in supply. Adequate supply has been an important issue for BRG - it has been hard to get enough suitable raw material, although a reasonably good job has been done in much of the existing market to try to secure supply to the plants that are not fully integrated like Sarpsborg. But historically, even a minor supply disruption slows the growth rate of BRG noticably. Recent capacity expansion initatives should mitigate this problem over the longer term, and there is also the possibility of a realization of BRG's BALI project in the future. Note that I don't include any contribution from this in my estimates. This would solve the problem to a large extent. A final investment decision on BALI was supposed to be made in 2014, but has been pushed so far. Details on the BALI project:

 http://www.nararenewables.org/2014conference/wpcontent/uploads/2014/05/GargulakNWBCC2014p.pdf 

The other major players in the lignin space are Tembec, Nippon and Domsjoe (owned by Aditya). Burgo Group is the only one with the same type of lignin plant as BRG (same method, but not the same technology) but lacks scale and a global network. There are 18 sulphite based plants in Europe that are roughly comparable to BRG's, but most do not have calsium as a base and end up having to produce other products with different chemical properties. It would be very costly to shift production to the same method as BRG, and this therefore seems unlikely to happen.

All things considered, I believe BRG will end up strengthening its competitive position in performance chemicals over the next few years, and that this will become very visible (and profitable) when the market grows tighter again.

Specialty Cellulose (ChemCell)

Specialty cellulose and bioethanol is produced at the Sarpsborg plant. Borregaard has made wood pulp for more than 100 years and delivered specialty cellulose since 1921. Over the last decades Borregaard has made a strategic move toward advanced or higher grade specialty cellulose. BRG is one of the world's largest players in this segment with a 10% market share, after RYAM and Tembec. BRG's revenues in the SC reporting segment can be broken down into specialty cellulose grades, viscose (commodity) and bioethanol. The % of each varies a bit year to year, but in 2015, I think it's roughly 60% SC, 10% bioethanol and 30% acetate.

BRG does not disclose exactly how their specialty celulose production is broken down. Based on conversations with analysts on the subject though, I think specialty cellulose is roughly split further as follows: 50-60% ethers, 30-40% acetate and 10-20% other grades. BRG concentrates mostly on producing cellulose ethers rather than acetate (which e.g. is used in cigarette filters) because competition is less fierce there and because the economic return on specialization efforts is largest there.

Ethers are used as components in a variety of products across several industries: pharmaceuticals, cosmetics and food products among other things. BRG has a competitive advantage in ether production since the type of factory that BRG has (softwood, calcium based process) gives a higher viscosity cellulose with greater number of applications than a hardwood based plant could. BRG is working on some interesting inititatives here; creating higher end niche products, both in the Specialty Cellulose segment generally and also through the Exilva initiative (see below). BRGs ether focus also seems strategically smart considering that cigarette production globally will probably fall or at least plateau going forward, and since Bracell looks like the new low cost provider of acetate for cigarette filters. (RYAM is still the market leader in that particular space). With regard to acetate, there's a very good discussion of the acetate part of the SC market in a recent write-up here on RYAM which I recommend reading. BRG looks vulnerable in acetate longer term in my opinion. Thus, I view it as positive that they are trying to tweak production increasingly toward ethers and higher specialization.

Longer term I think it's reasonable to assume demand for ethers will grow at about 3-5% per year based on comments by companies in the sector. European economic activity seems to be the most important variable for ether demand, but I'm not going to pretend to know that European economic growth will improve going forward. Nor do I see any reason to assume a dramatic worsening of conditions. Tembec sounded slightly upbeat on the subject in their latest conference call.

Specialty cellulose is not as high tech as lignin based products, but also not as unsophisticated a business as producing commodity dissolving pulp, which has low barriers to entry and much more impurities than specialty cellulose, and requires little technical knowledge. While producers of specialty cellulose can easily make commodity dissolving pulp, and tweak production towad more commodity grades when apecialty grade demand is weaker, commodity producers are unable to make specialty products without a great deal of incremental investment in their facilities. So it looks like there are barriers to entry in specialty cellulose.

Customer relationships tend to be long lasting as specialty cellulose products tend to be a low cost input into end user products and there’s little incentive to switch supplier. (This is also the case for the lignin products made by BRG). That being said, in Specialty Cellulose generally, BRG is more of a price taker than in Lignin as its integrated production system at Sarpsborg means they to a large extent have to accept market prices at a given time to get to the extraction of lignin, which is more profitable and the most important thing. Exact details on how BRG's contracts in SC are structured are not disclosed. I believe they sign contracts for volumes and prices toward the end of the calendar year and that contracts usually have a duration of 1 year. Contracts differ from customer to customer, but generally, it's not unusual to have at least partial meet-or-release or take-or-pay provisions included.

The Specialty Cellulose market

The CS players and their respective production capacities and production profiles

(The source of these images is Rayonier Advanced Material’s latest presentation, which I recommend reading. There’s some good background stuff here in addition to the information here).

It doesn’t look like there’s significant new capacity coming onstream currently. In the past five years, RYAM, Buckeye and Tembec were supposed to add a combined total of 200 000 t of new capacity, most of which was from RYAM (190 kt). That would have meant an increase in total market capacity of about 200kt to 2000kt (a 20% increase). During the same period, Brazilian company Bracell has restarted specialty cellulose production, and there’s been quite a bit of uncertainty regarding their actual capacity. In 2014, one of RYAM’s biggest customers Celanese chose to switch supplier to Bracell from RYAM, leading RYAM to pull most of its capacity expansion plans. The net result is a supply side for specialty cellulose (some lower grade) at around 1930t (RYAM estimate, see table above) and a demand side at about 1600t. The demand side of the market is estimated by RYAM to be roughly split into 700-750 kt of acetate cellulose, 500 kt of ether cellulose and 350 kt of other grades (viscose, nitro and microcrystalline cellulose).

There's a supply overhang obviously, and I expect a weak development in general going forward.

The EBITA margin for the SC business at BRG has been 14% so far this year and was 16% last year. I am however, not as optimistic going forward. Specialty cellulose prices have fallen for the last two years and are widely expected to fall in the coming year as well, though not at the same pace. I think prices might very well fall by another 5-10%, but in BRG’s case I expect this to be offset by a stronger USD and EUR against the NOK. I expect EBIT margins of 12% going forward here.

Implicitly, I’m assuming BRG sells the same volumes at the same NOK prices in '15, as well as the next few years. Hence, I keep SC revenue flat through my forecast period.

Exilva

The Exilva plant cost about 225m NOK to build and is located in Sarpsborg at BRG’s site there in 2014. Exilva MFC is an extremely interesting product line. MFC is short for microfibrillar cellulose and this line has been developed in cooperation with potential customers for years - R&D efforts have been ongoing since 2005. This long term development effort with customers is a company characteristic and seems like a wise business strategy for long term value creation. Exilva MFC is essentially a sustainable, natural cellulose based enhancing additive developed by Borregaard, and according to BRG offers better, more environmentally friendly alternatives to products based on petrochemicals.

The raw material, specialty cellulose, is split into a complex network of fibrils through the use of proprietary technology. Exilva MFC is designed to promote stability, increase formulation efficiency and improve rheology properties https://en.wikipedia.org/wiki/Rheology in a variety of products across several end markets (some examples include adhesives, coatings, agrichemicals, personal care products and construction materials). For example, Exilva will give a coating formulation like acrylic paint improved dispersion properties, or yield better control of viscosity and stability in face creams (it also has documented wrinkle-reducing effects, albeit temporary). It has strong robustness in harsh environments and is extremely stable in a wide variety of temperatures and pH environments. More info on Exilva MFC specifically and the uses of MFC can be found here:

http://www.borregaard.com/Business-Areas/Exilva/What-is-Exilva

http://www.biofuelsdigest.com/bdigest/2014/10/29/the-strange-world-of-super-strong-super-light-nanocellulose/

https://en.wikipedia.org/wiki/Nanocellulose

http://www.borregaard.com/content/download/106221/19406441/file/Exilva%20Technical%20Bulletin%20Formulation%20Rheology%20Improvement.pdf 

http://www.borregaard.com/content/download/106036/19402169/file/Personal%20Care_Application_Bulletin.pdf

The Exilva facility will have an initial capacity of about 1000 tons per year from 2016, and production will probably be expanded over time. The company has previously indicated that the price pr ton of MFC is much higher than regular specialty cellulose. How much higher remains to be seen. My best guess is somewhere between 5-10x the average price of BRG’s other specialty cellulose lines. Below I  sketch out how I see production being ramped up over time and the likely pricing. This is admittedly speculative and based on what little information I have gotten from the company and other analysts.

Other businesses:

Other businesses consists of Ingredients, Fine Chemicals and sales of surplus basic chemicals from chlor-alkali production in Sarpsborg. Corporate functions overhead, R&D, utilities and services at Sarpsborg is also included in this segment (hence the negative EBIT contribution). Borregaard is the only producer of wood based vanillin in the world and supplies vanillin products to flavor and fragrance companies as well as the food industry. Fine chemicals supplies intermediates for non-ionic X-ray contrast media. I expect revenues in OB to remain flat in my forecast period.

Valuation

I make an effort to model likely revenues bottom up by segment, but these estimates should be taken with a grain of salt. In reality, it’s not as easy as volumes x volume weighted price = revenues. This is because of the timing of currency adjustements and because of how the company accounts for internal cost allocation. But estimates are never 100% accurate anyway, and I think it’s a reasonably good approximation. As mentioned above, I assume no contribution from the Rayonier JV, and no contribution from the Sappi JV until 2017, when I add half of those volumes. The rest are added in 2018. Afterwards I keep volumes flat. I expect avg lignin pricing to stay flat in 2016, then rise by 2.5% from 2017 compared to a 5.4% historical avg annual price increase. Cellulose volumes are kept flat, and so is pricing (in NOK). The contribution from Exilva is speculative, as we have no historical figures to serve as a guide. A zero from Exilva would reduce 2020 EBIT by about 10%.

Revenue and margin assumptions

P&L

The most important risk factors

• Major outage at Sarpsborg plant

• Cost increases (wood, energy, other raw materials)

• Lignin supply interruption

• Exilva being a dud or production delays and cost overruns on the new plant

• Worse than expected demand weakness in the Lignin market (lower prices, worse mix)

• New capacity coming onstream in specialty cellulose, further pressuring prices

• Macro collapse in Russia, Brazil and China (though even that would have a limited impact)

• Oil price rise strengthening the NOK vs the USD and EUR (though that also increases e.g. Exilva’s and the Lignin business’ competitiveness further). About 95% of BRGs income is in USD & EUR so this is important. On the other hand, it’s a nice way to play lower oil prices. And BRG hedges most of its currency exposure nine months forward.

Conclusions and investment recommendation

Based on the assumptions above, I see a likely annual return around 19% over the next 3 years in a base case scenario. Not bad. The bull case above includes all the volumes that are supposed to come online from the Rayonier JV. This is not included in my base case. Ceteris paribus, this increases the DCF value of BRG to 88 NOK per share.

I think cyclical fears are overdone, and believe BRG is a more flexible business than it is given credit for. It’s a solid, well-run company with a moderate amount of debt mostly in the form of a five-year bond issued in 2014, clear competitive advantages and a very strong position in its key niche Lignin/performance chemicals. Despite a few quarters of weaker than expected reports, think it’s likely that BRG has a bright future ahead. Put simply: BRG is a very good, sustainable business available at a great price. Evidently, the chairman of the board, the CEO and the VP of HR and communications agree with me, as they have all bought shares in the open market over the last few days (though in modest amounts).

Buy.

Appendix:

Historical profitability

Shareholder overview per October 22nd 2015

Notable skilled and value-oriented shareholders: Taiga Funds (2.9m shares), Mustad, Home Capital, Odin.

Lignin and cellulose volume assumptions (kt)

Lignin and specialty cellulose price assumptions (‘000 NOK pr ton)

Insider ownership and options outstanding after most recent issue: 

Primary insiders have the following holdings of options and shares in BRG after new share options were issued on 27 October 2015 (new options in parentheses). One could perhaps argue that the timing of the issuance was not coincidental. Two days later, there have been two separate insider buys in the open market as well (small amounts).

• CEO Per A. Sørlie holds 370,000 options (60,000) and owns 110,987 shares (+7500)

• Morten Harlem holds 85,000 options (45,000) and owns 45,084 shares

• Tom Erik Foss-Jacobsen holds 60,000 options (30,000) and owns 34,740 shares

• Per Bjarne Lyngstad holds 70,000 options (30,000) and owns 52,721 shares

• Tuva Barnholt holds 50,000 options (25,000) and owns 28,293 shares

• Sveinung Heggen holds 50,000 options (25,000) and owns 4,209 shares

• Ole Gunnar Jakobsen holds 56,300 options (25,000) and owns 27,488 shares

• Gisle Løhre Johansen holds 50,000 options (25,000) and owns 29,184 shares

• Dag Arthur Aasbø holds 62,500 options (25,000) and owns 39,721 shares (+2000)

The total number of outstanding share options is now 1,458,800, equivalent to 1.46% of the number of shares (including 777,883 treasury shares) in Borregaard.

As most have strikes above today’s price, I have not included them in my share count.

Catalyst

Time.