Gross Expectations – Why the Paper Bet is a Bold One

Print Friendly, PDF & Email


Graham Copley / Nick Lipinski



September 5th, 2012

Gross Expectations – Why the Paper Bet is a Bold One

  • Our initial work on Return on Capital noted that the Paper sector may have hit a point of inflection in the early part of the last decade and was perhaps showing an improving trend after decades of decline. Current valuation implies that returns on capital will continue to improve but recent gross margin moves suggest more caution.
  • Recent declining gross margin trends for Paper suggest consolidation may not have succeeded in driving pricing, which contrasts sharply with both the Rail space and the Metals space. While we may not have given Paper enough time to show the improving trend, the market is pricing in the outcome before the proof. In a period of weak global economic activity (today), we will quickly find out whether discipline has improved in the Paper industry.
  • Historically gross margin down cycles in Paper lasted an average of 10 quarters, (a minimum of 7), margins declined by an average of 4.4% and excluding 2000, the sector has underperformed the S&P500 by 19.4% in the first 12 months of gross margin decline. The sector has never been this expensive going into a period of gross margin weakness and if this time is different it is going to be very different.
  • Paper remains the most expensive sector in our valuation framework and is little changed in relative value since we initiated coverage in April of this year.
  • Focus on Metals for cheap cyclical exposure, Commodity Chems for improving US production economics and Packaging based on valuation and lower costs.

Exhibit 1

Source: Capital IQ and SSR Analysis


Industrials and Basic materials have had relatively robust earnings over the last couple of years despite lackluster volume growth. As we explore the reasons for this positive earnings performance we look at gross margins. Companies and sectors growing earnings in a low growth environment without gross margin expansion are pulling on levers that have limited range, while those that have found the means to expand gross margins might have more success in sustaining the better earnings.

Originally we had intended for this piece to look at the whole group, but the analysis is so interesting for Paper that we have decided to focus on that sector today. We will publish the more general piece shortly.

Gross margin expansion comes from a limited number of factors:

  • Lower raw material costs; often cyclical, but can come from different raw material use or lower volume use.
  • Lower processing costs: most often associated with scale, but can come from process changes.
  • Pricing; again often cyclical, rarely but occasionally the result of better market structure and more commonly due to product differentiation/innovation.

The cyclicality shown in the gross margin charts for Paper, Chemicals, Metals (Exhibit 2) is almost always driven by movements in raw material prices or product prices. What we are more focused on here is the trend rather than the cycle. Improving trends suggest better market structure; leading to more rational pricing, a shift in raw material costs relative to whoever or whatever sets pricing, greater product differentiation (again leading to pricing) and/or relative production innovation.

Exhibit 2

Source: Capital IQ and SSR Analysis

Sizing Up Paper

our initiation work back in April
, we talked at length about the terrible return on capital trends in Paper over time and whether the consolidation seen in the sector in the middle of the last decade had been enough to change the trajectory of returns on capital. We concluded that it might have had an effect, but that the sector valuation was discounting a greater improvement than we could justify – consequently we concluded that the sector was expensive and have held that view ever since. One of the key questions at the time was whether the improvement that we were seeing in returns on capital was the beginning of a new and more positive trend or a cycle with more pronounced amplitude. The updated return on capital chart that we showed at the time is repeated in Exhibit 3. The chart shows a downward leg over the last few months of 2011 and early 2012, followed by a recovery.

Exhibit 3

Source: Capital IQ and SSR Analysis

The downward leg fits with the decline in Gross Margins that we identified above in Exhibit 1, and this is where we want to focus. Our return on capital analysis is driven by current year earnings and consequently the most current data picks up earnings estimates to get an average for the year. As actual come in they replace the estimates – not a perfect system, but a good proxy as long as earnings estimates are in the right ball park. For Paper they have been very wrong for 2012, and this is where we think the risk for the sector is most pronounced. Estimates have been way off the mark, as shown in the chart in Exhibit 4, and our return on capital analysis only shows an uptick in the most recent data points because it is picking up estimates that based on the first half of 2012 could be too high. It is worth noting that Q3 estimates for IP have fallen 7% since the Q2 earnings release and are 24% lower than they were a year ago. UFS Q3 estimates are 19% lower than they were prior to the Q2 release and 35% lower than they were a year ago. The picture is more positive for MVW.

While we do not have the empirical analysis, it is common in cyclical industries for periods of earnings underperformance to at first appear as a surprise and initially be treated as an unusual event and dismissed as such. However, more often than not they are prolonged, driven by demand weakness and more acute price competition. IP has had plant outages in the first half of the year and these have been used as an excuse to explain away the weaker than expected earnings. Historically, basic industry companies have taken more prolonged outages in initial periods of demand weakness rather than cut prices in order to move product and keep operating rates tolerable – while this may not be the case at IP, we will soon find out.

Exhibit 4

Source: Capital IQ and SSR Analysis

We should perhaps be guided more by the Gross Margin trend than by the forward estimates as clearly the recent decline in gross margin was a negative surprise. Again, the key question for Paper is whether the gross margin improvement seen from 2009 to 2011 was the start of an improved trend or just another cycle.

Comparing the trends for commodity and diversified chemicals underscores some of the issues – Exhibit 5. For commodities there is almost no product differentiation and the last 30 years has all been about production coming on line in locations that have lower costs than facilities in the US and Europe. Economies of scale from plant size increases and from consolidation have reduced costs below the gross margin line and gross margin has been competed away. Diversified Chemicals have benefitted from lower costs of basic chemicals but have also benefitted from product innovation that has resulted in less pressure on pricing – here the gross margin trend is positive. The Paper chart does not look like either of these, but has the overall negative slope of the commodity group.

Exhibit 5

Source: Capital IQ and SSR Analysis

The best and perhaps only example of improved market structure resulting in better pricing is in the rail subsector of transports – Exhibit 6. Paper does not look like this either and the industry does not have the dynamics to ever look like this in our opinion.

Exhibit 6

Source: Capital IQ and SSR Analysis

If the Paper industry really is different now, it should be able to rectify the gross margin problem quickly – as suggested in estimates and even more so in valuation.

The Sector underperforms in periods of gross margin decline

Exhibit 7 shows the discount from normal value for Paper sector and the blue arrows show the points in time when gross margins peaked. When the bars are becoming more positive, the sector is underperforming and when they become more negative, the sector is outperforming. With the exception of 2000, gross margin peaks have been followed by significant sector underperformance. The S&P500 peaked in 2000 and subsequently lost around 40% of its value, so Paper’s out-performance in that period despite declining gross margins has more to do with the direction of the broader market. Gross margins peaked at the end of 2011 and have declined for two quarters – the stocks wobbled for a month or so but have essentially returned to the level of valuation seen at the end of 2011 and are significantly more expensive than they were at any prior gross margin peak on a relative basis.

The data for each cycle is summarized in Exhibit 8.

The simple way to look at this is that either the nature of the business has changed, and, as reflected in estimates, gross margins can recover quickly (something the industry has never achieved in the past), or the sector has a great deal of relative downside as numbers continue to disappoint.

Exhibit 7

= GM Peak

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

Print Friendly, PDF & Email