Description

Background

As a result of an import restriction on waste paper into China starting in Jan 2018, demand for waste-paper processing (e.g. paper recycling) ex-China suddenly took a step function up as pricing on a host of recycling inputs which historically were exported to China plummeted and pricing on end-products (e.g. pulp, recycled paper, corrugated boxes) grew consequently to Chinese recyclers’ limited access to key raw material. Resultantly, existing recycling facilities outside of China suddenly became flush with cash and have expanded their operations aggressively given excess returns; domestic Chinese pulp & paper producers have expanded in SE Asia to get access to needed waste-paper imports.

Idea

Short the largest maker of waste-paper conversion capital equipment for recycled linerboard (i.e. boxes) and tissue, Kadant Inc, which is trading at a peak multiple of peak earnings. The idea is timely given pricing for the key raw-material, pulp, has already started coming down with expectations of another 30% drop by 1Q19. This should strain returns at recyclers and pulp & paper manufacturers and cease their currently elevated capacity expansion resulting in material declines in orders and earnings for Kadant.

Business explained

Kadant primarily sells papermaking and wood processing capital equipment along with consumables to support ongoing customer operations. Parts and consumables are roughly 60% of revenue and are primarily driven by plant utilization while capital equipment sales are levered to direct capacity expansion by recyclers, packaging, and pulp manufacturers. Around 80% of the Company’s whole business is in North America and Europe.

Papermaking

Kadant’s largest segment within papermaking (50% of segment) is stock-preparation. These machines are typically custom-engineered and are the initial step to converting waste paper into “recycled” paper (the end-product can wind up being paper, linerboard for boxes, or tissue). For context, “recycled paper” is a key input for corrugated boxes (recycled materials make up ~40% of domestic corrugated box producers’ inputs and are nearly all the input for Chinese producers). Key processes include baling, pulping, de-inking, and cleaning recycled fiber before they enter a larger paper making apparatus. This is the key segment of focus.

The rest of the paper-making segment is split evenly between “doctoring, cleaning & filtration” machines that help to clean surfaces of paper rolls and recycle process water as well as “fluid-handling” machines that transfer fluid throughout the system; both of these are relatively more skewed to consumables/parts than stock-preparation.

Wood Processing

Kadant recently also got into the wood processing capital equipment business through acquisition – most recently it spent $171mm in July of 2017 to purchase the forest products business of NII FPG. Machines in this segment mostly include debarkers, chippers, and loggers that aid in the production of lumber and oriented strand board (“OSB”); Kadant holds the number one share in debarkers and stranders.

This is mostly levered to North American housing starts and as such this business should be trending flat-to-down given the surprisingly low starts seen beginning in September and October. As it drives a smaller fraction of earnings (~23%) it is not a large focus, however.

Thesis

There has been a one-time pull-in of paper making capital equipment due to import restrictions placed on waste paper in China that went into effect in Jan 2018; the current pace of capacity build-outs should not be extrapolated forward (as consensus does).

Background on China’s Policies

Cutting imports of scrap plastic and paper has been an overarching environmental policy in China for a number of years now.

China has in fact been driving global investment in recycling centers since 2013 with its implementation of “Operation Green Fence.” Green Fence was a way to enforce regulations already existing in China since 2011, in which inspections of incoming recyclables were stepped up heavily. Indeed, in the first year of Green Fence’s implementation, ~70% of incoming shipping containers with recyclables were inspected. The net-result of this enforcement action, even though not many containers were found ineligible for importation (.04%), was an increase in investment spend to ensure proper quality of exported recyclable material (as taking return shipments of ineligible containers was extremely costly).

China took another, more severe step, with the enforcement of the “National Sword” policy beginning in January of 2018 in which 24 types of solid waste were out-right banned from importation (including unsorted mixed papers). This policy has had extreme effects, with imported waste paper in China down 52% in 1H18 y/y. Furthermore, packaging manufacturers in China all of a sudden could not get access to the key raw materials they needed, resulting in spikes in the price of pulp in China (with other end-products following); more below.

https://www.reuters.com/article/us-usa-trade-pulp-focus/pulp-problems-why-shoppers-may-pay-more-for-tissues-toilet-paper-idUSKBN1KL1I6

No longer willing to be the trash dump of the world, this policy immediately led to significant build-ups of waste-paper and other recyclables originally exported to China across the U.S. and Europe.

“We’re looking at 150 to 200 tractor trailer loads of paper. It’s stacked approximately 12 feet high and it goes for quite a distance” – President of E.L. Harvey and Sons, recycling center in Massachusetts.

So what did recycling centers and pulp & paper manufacturers start to do throughout the U.S. and Europe? They either 1) built new plants domestically or 2) exported their waste to countries in Southeast Asia.

Recycled Paper Capacity Increases and Cyclicality

While the recycled paper (in the broad sense of the term) end-market only grows 4% annually, Kadant’s stock-preparation segment has grown 16% and 22% in 2Q18 and 3Q18 (y/y respectively) due to capacity build-outs by pulp & paper producers concentrated in Europe, SE Asia, and North America due to demand created by China’s policies driving elevated pricing.

Most end-markets are cyclical - to start with - due to the boom-bust nature that capacity expansions in commodity industries create. Below is an example of such cyclicality in the corrugated box industry; the most recent up-cycle has been especially strong due to aforementioned Chinese regulations:

A report recently put out by NERC cleanly lays out capacity expansions undertaken by domestic recycled paper manufacturers -- mostly concentrated in linerboard.

NERC notes: “More than a year ago, China announced a ban on imports of a number of recyclables including mixed paper, which provides a large percentage of the recyclables collected in curbside recycling programs. The ban went into effect earlier this year. As a result, many local recycling programs were faced with limited markets and collapsing prices for many of their recyclables. However, in response to the availability of these raw materials, new North American capacity for consuming domestically recovered fiber is being announced.”

https://nerc.org/documents/Recycled%20Paper%20Market%20Expansion%20Nov%2016,%202018.pdf

I’ve simplified the list in a table below; most of the capacity comes online by late next year. Key to note is that, while not all of this capacity is stated as directly for producing linerboard (and not all are green-field), most are either 1) convertible or 2) produce an intermediary product which allows for the production of linerboard.

This capacity expansion is significant in the context of both U.S. and China capacity:

This phenomenon is not unique to just the U.S, elsewhere in Europe and widely in SE Asia capacity expansions have grown in-vogue. As a simple demonstration of the latter, during the first three months of 2018, scrap paper exports to Indonesia were up 300% y/y (a similar dynamic has been seen elsewhere in SE Asia). Most of this expansion has in fact carried out by existing pulp producers in China, like Nine Dragons Paper (as Kadant is mostly indexed to just American and European producers I’ll defer belaboring the point). https://resource-recycling.com/recycling/2018/06/05/import-restrictions-ripple-across-southeast-asia/

Given such rampant expansion relative to capacity, Kadant has in a sense pulled-forward a lot of its machinery sales. As the market shifts to oversupply (which has already begun, detailed later), capacity build-outs will cease and Kadant’s currently elevate level of orders (shown below) will normalize:

Importantly, this thesis does not rest on recycling paper end-markets rapidly going into over-supply – it simply works as long as the recent abnormal capacity build-outs do not sustain.

Why now?

Pricing of pulp is already down in China, with expectations of prices to follow elsewhere in the near-term, suggesting a near-term cut to further growth capex at the pulp & paper manufacturers.  Here’s a price chart of pulp (market price in China) from National Bureau of Statistics data:

This suggests that capacity expansion as a result of the aforementioned import restriction policies has mostly completed; as prices fall for pulp in china, pulp prices elsewhere globally should follow along recycled paper and other end-products. Lower prices will drive returns materially lower for this high fixed cost industry.

The market has already reacted to this phenomenon with major pulp & paper producers down 30%+ in recent months (International Paper, Westrock, UPM, Stora Enso, among others) and now trade for mid-high single digit multiples of LTM earnings. Expectations are clearly priced for globally lower returns.

With lower returns capacity expansion should naturally slow down/cease, which will materially impair Kadant Inc and other capital equipment suppliers into the pulp & paper industry.

Resultantly, I expect material downside in orders next year for wastepaper conversion capital equipment and given the delta to consensus extrapolating further growth the peak multiple should compress – though we make money such a healthy multiple regardless:

Valuation

Initial effects that should be seen are a reduction in Asian orders with follow on to other markets following pricing degradation. On just lower capital equipment sales for Kadant, I estimate about 26% downside; this assumes down 12% for the stock-preparation segment and down 6% for wood-processing with other segments flat for total sales down 6% (vs. consensus which estimates 6% growth) with gross margin up slightly (mix-shift to consumables). Applying the current multiple of 12x to my 2019e EBIT of $81mm yields 22% downside (28% at a PV8).

I think there is room for further downside to these numbers in the extent the industry experiences a more pronounced downturn resulting in utilization rates dropping (which would impair the consumables business as well) and we have a put option on the multiple compressing from the current peak.

Appendix

Paper Processing

This is what the whole process looks like, for personal interest; stock-preparation is circled in red:

Wood Processing

The Wood Processing business could in fact slow-down more significantly but it is not key to the thesis. Since demand for oriented strand board and lumber is mostly levered to new home construction in North America, the demand for capital equipment for processing lumber and OSB also follow new home starts, though on a slightly lagged basis.  

Housing starts for October 2018 were down 2.9% y/y; permits were down 6%. I do not have a fundamental view here but note declining permits and starts that are already in the data for September and October should strain production requirements for lumber and OSB and resultantly lead to lower orders for new equipment from Kadand into the first half of next year.

Why opportunity exists

• Undercovered
• Consensus just straight-lines the current operating results
• 2nd derivative play – limited discussion / understanding of impact of China regulations on Kadant’s business while ample discussion w/r/t the pulp & paper manufacturers.

 Risks

• Import restrictions on waste-paper imports in SE Asia countries resulting in further capacity expansions elsewhere.
• EPS accretive acquisitions; Kadant has some additional capacity as it is at 2x net debt/ebitda currently (post its recent acquisition of Syntron).

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation. This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

• Capex cuts at major pulp & paper manufacturers 
• Further downturn in end-product pricing leading to limited medium-term capacity expansions and a cut in orders for Kadant's capital equipment
• Further downturn in housing starts / lumber and OSB cut to capex post already declining housing-start data