Mercer International Inc. (MERC) Earnings Call Transcript & Summary

We can start our next session. We'll let the stragglers come in a bit later. Our second session today is with Mercer International. We have the company's Senior VP and CFO, Dave Ure; and the company's Controller, Richard Short, with us today. Mercer is a leading global producer of market pulp with mills in Western Canada and Europe. And the growth focus for this company is they've transitioned in recent years as more on the wood products side, bio-extractives surplus energy sales. So it's a much more diverse company than was the case even a few years ago now. The -- another interesting element of what this company will be pursuing that the guys will talk about is access to mass timber markets, and we're going to hear more about that at lunch with our keynote speaker today as well. So thanks, Dave and Richard for participating today. And I'm going to start with management transition at the company. And although he couldn't be with us, Juan Carlos Bueno has taken over as CEO for David Gandossi, post retirement.

And I want to give you an opportunity to highlight Juan Carlos' background, what he brings to the table in terms of pursuing Mercer's strategic focus going forward. A few comments on his skill sets, if you don't mind.

Yes. Yes. No, we're delighted to have him. Juan Carlos is a global leader in the biomaterial space. He started actually -- where he's probably most well-known as he started the biomaterials business for Stora Enso back in the mid-2015 time. He's an industrial engineer by background, but very focused on chemicals and biomaterials. So he's only been in the house for a few months, but you can already see he's very interested in advancing our -- some of the work that we're doing on lignin extraction, for example, extractives, natural carbon utilization. So he's -- that's sort of what he's interested in. He doesn't have an enormous background in the solid wood business, but he's getting up to speed with that quite quickly. It has been a big supporter of some of the work that we've done with the sawmills and more recently with our mass timber assets. So we're pretty fortunate to have them pretty excited. He's already made a few small leadership changes, and he's done some things to tweak the culture a bit. But yes, good things ahead with him on board, we think.

It's good to hear. There's a lot to talk about with respect to pulp markets and your growth strategy in wood products, but I think topical right now certainly is what's happening in Europe. You're clearly exposed there given your pulp presence and your wood products presence. So two questions to start with respect to Europe. You sell surplus power into that market, and that's been a huge positive for you in recent quarters. There are emerging price caps coming. I'm hoping you can talk about that and how that could affect your results in the near to midterm and gas supply for your facilities as well. If that is compromised, what are options for bridging that gap? Is there a risk of any downtime at your operations, if that is compromised?

Yes. Well, yes, I guess, in short, it is all about gas. All of those topics we've talked about, it's all about gas supply. We've had pretty much a month straight now where there's been no gas coming from Russia or Ukraine into Central Europe. So for us, that's -- as you said, Sean, for us, it's not an enormous burden at the moment because we are self-reliant for electricity. So we're producing probably about, or selling about 700 gigawatts of our own -- gigawatt hours, pardon me, of our own electricity. And we have been getting the prices that we're selling last quarter was about EUR 200 per megawatt hour. A year ago, it would have been closer to 70 or 80. So the prices are considerably higher. It looks like there will be a cap mechanism that's put in place and probably around -- it will fall out to be around 180, EUR 185 per megawatt hour. So we're pretty well-protected on that front as a company. But the gas supply has enormous impact on wood costs. So the gas, a typical homeowner in Central Europe would have a furnace that could be some sort of fossil fuel like natural gas, but also convertible to heating pellets. So as you might imagine, the heating pellet industry is on fire in Europe at the moment. And the heating pellet industry is competing for pulpwood, the same wood that we're looking for to make pulp, the heating industry is also competing for it. So we've seen our pulp wood costs, not sawlogs, but pulp logs, that lower quality of pulp logs. We've seen that the prices for wood increase considerably. Natural gas is an important constituent of a lot of the chemicals that we use. So we've seen some inflation on chemicals, transportation as well. So -- but for us, the electricity even capped at 180 or 200 where it more than covers the inflation that we're seeing on the wood and chemicals and transportation, where we get a little bit more concerned or we're watching carefully is on our customer side. So our typical customers are paper producers, tissue producers, graphic paper producers, and they're quite energy-intensive and they don't have the -- they're not self-sufficient. So they're either generating their electricity with a boiler of some sort, a gas boiler or a biomass boiler. So they're seeing their costs rise considerably. And while our customers are not -- we don't see a threat at the moment of shutdowns. Some of our customers are starting to dial back their production rates just to -- like a car, you're driving at 100 kilometers per hour, if you can reduce that to 90 kilometers per hour, the energy consumption drops considerably, and we're seeing some customers do that a little bit as now they're turning back the speeds of their paper machines to try to conserve electricity.

Can you put some numbers around the pulpwood cost inflation you've seen since the market started to go haywire for...

Yes. They -- I would say from today -- to today from about, I guess, 9 months ago, I would say they're up about 25%.

I want to switch to your wood products growth platform. Friesau, your sawmill in Germany has been a tremendous contributor to your results really since it came into the mix for your company. You're augmenting that now. Well, you've expanded that mill organically and you're augmenting it with the pending acquisition of the HIT facility in Torgau, which is not too far from Friesau. Can you speak to the rationale for that acquisition, both valuation metrics and the product mix there that differs a little bit from what you have at Friesau and how you're thinking about growing that platform in Europe going forward?

Yes. The appeal of this particular mill is -- it's an interesting mill. It's a very large -- it's not as large as our Friesau sawmill, but it's a large mill by world standards, probably about 400 million board feet. And it's a large modern sawmill and it's a little bit interesting because on the back of it, it's got a pallet, a highly automated shipping pallet plant. It has a heating pellet plant attached to it as well and some other Briquettes for heating. So it's an interesting -- when they built the plant, it was done with green money, and the idea was sort of a full utilization of the forest resource. So that actually has no waste coming from it. Everything is going into a product. The problem with it and the appeal for us is not only is it big, but it's got -- the synergies are quite compelling. And for example, because they're making -- their principal product is shipping pallets, it's not lumber, it's shipping pallets. You can imagine they're taking a log and they're cutting it up into 1-inch pallet boards and making pallets at the back end of the plant. That's principally what they're doing. And what our intention is to take that same log, and rather than make pallet boards out of it, we're going to make 2x4s and make J-grade out of it and sell that material to Japan. So they don't have -- that particular mill doesn't have the sorting and grading capability and the planing capability, but we can take -- it's got the sawmill capability. So we'll take those 2x4s, send them down to our freeze-out mill playing them, grade them and then sell them to the U.S. or to Japan. So trying to get more value, making sure you're not making a shipping pallet out of a beautiful piece of wood that could be better made a piece of lumber. The other thing they do is for making wood -- for heating pellets, they're taking -- like all sawmills do, there's waste material on the outside of the log, what they're doing. And typically, what a sawmill would do is chip that they would use a chipping head and create wood chips and sell those wood chips to the pulp mill. What these folks have been doing because they don't have a pulp mill, they've been grinding up those wood chips to make sawdust to make heating pallets. And what we're going to do is rather than grind those chips up, we will send the chips down to one of our pulp mills probably at Rosenthal, send the wood chips down there. And then will that -- with that same truck or train, we'll send sawdust that we're currently making at the pulp mill or our Friesau sawmill will send that sawdust back to Torgay to make heating pellets. So I'm rambling here a little bit, but the -- it's really the synergies are quite compelling. It's a terrific mill. The products are really interesting, but the synergies with our existing sawmill and pulp mill are really what's driving this.

And back to Friesau, Canfor and other competitors in Europe have announced downtime plans through the back half of the year, at least the back quarter of the year to address falling demand. Are you in a position where you're having to take any downtime at Friesau because of order file falling off? Any downtime anticipated for that asset?

No, no, nothing anticipated. The markets -- that mill is about 40% of the production of the mill is going to the U.S. markets. And even at these prices, we can ship to and better and J-grade to the end markets that still be profitable. And the European market, the European lumber market is -- it's been falling, but it's still relatively strong. If I look back at the last 3 to 5 years, the prices we're getting for the benchmark products in Europe, so the construction beams of KVH grades are still better than average. So...

You've historically shipped quite a bit to the U.S. from that mill. Has the North American market fallen off enough that you repatriate some of that product back to Europe as -- even as prices are weakening there, presumably isn't as sharp as the decline we've seen here.

Yes, not materially. We've stretched the mill to supply about 40% to 50% of the U.S. market. The last quarter, it was very close to 50%. We might back that off a little bit, but it's not -- it won't be 10% off, maybe it's 5%, not much.

Any questions in the audience? Go ahead, Don.

First of all, congratulations to you guys, you're one of the few that's actually taking transformation seriously in terms of the product mix. So a good direction in that. But if we look at Slide 5 in your deck, your longterm revenue mix, so can you give us a sense for what your targets are for revenue mix or whatever metric you want to use? Where do you like to see in your set of different products and over what time?

I'll just repeat the question so we can get it on the tape. Don is asking about long-term revenue mix targets. You're still largely a pulp company, even as you diversify into wood products and bio-extractives. What are the long-term objectives in terms of mix?

Yes. So I'm going to be careful because the speed at which we do it, it might be faster or slower, but we have aspirations to make that business. And that business is solid wood in general, I would say, solid wood, either construction materials or mass timber to make that a pillar that is similar in size to the pulp business. But the speed at which we get there will be yet to be determined. But I think we made some -- like you said, we've made some nice strides in the last since 2017, and this acquisition that we'll close here in a few days will be helpful to that. There's lots of opportunity still in Europe. So we're pretty confident that we can do it, but we would love to see that business similar size to the pulp business.

Don, one more?

Yes. So just on -- you mentioned that pulp market went high in general, making this move already either in terms of sort of 5 energy components. I think it was last month, you were working at some registration with regard to taking away all the environmental threats for this [indiscernible]. Could you give us an update on that? And what is the threat here because...

Yes. Yes. I think that it's still in development. It's off the table at the moment given what's going on with energy in Europe. But I think that's probably -- we expect that, that will happen over time. And what -- the way that will materialize is that the subsidies that the government used to provide biomass-generating facilities and the higher fixed tariffs for electricity that will probably disappear over time. In fact, we were party. We have two -- we have three contracts in Europe at the moment that are under such tariffs, these fixed rate put tariffs, if you can put green electricity into the grid. One of them has expired, and we haven't renewed it. So we're totally on the market price. And I think over time, it's probably reasonable to expect that all of these contracts will, when they expire, they won't be renewed with that put option. And I think it's probably reasonable to expect that for new -- for construction of new biomass generating facilities that they won't have the subsidies available and the fixed tariffs that they once had.

Any other questions? I want to transition off the back of that question about diversification to your cross-laminated timber facility, which you guys bought a year ago, I guess, or even a bit longer. It's been a gradual process to add supply there. You've added an extra shift of late. Can you talk about the growth path for that facility in terms of accessing the mass timber market and using that as a jumping off point for further growth in that segment going forward.

Yes. So that -- the facility we acquired it was -- at the time. It was the largest mass timber facility in North America. But it had been shut down for almost a year, the previous owners, Katerra. So all of the order book that they had, it disappeared. And so we've been -- while we've got the mill going quite quickly, got the plant going quite quickly. Today, we're just -- we're principally manufacturing long-length finger-jointed lumber commodity product. But we're in the process of building up a team, a sales team and a design and engineering team. Unlike the other products that most of us are in where you could sell on a spot basis, and there's a commodity market for it. These are highly customized. These are orders that you're taking and the sales channel is very long. Sometimes it's a year, year or two long. So you're getting in front with a developer, typically a building developer, design engineers, structural engineers and you're trying to design your product into the development that they're trying to build. So it's a very long sales process. So we've had some mass timber. We've done a couple of small projects in 2022. And -- but it will really be 2023 when we start to see -- probably towards the end of 2023, where we really start to see the larger projects start to go through the plant.

Okay. The growth is outside of pulp, but it's still a big part of your business, and there's a lot going on with that market right now. We saw prices in China for NBSK dropped $50 over the last few months. It seems to have settled here. There was Ilim, I think, tried to lead a price hike of late that didn't get off the ground. China typically leads everywhere else in terms of pricing. To date, it looks like list prices, at least in Europe and North America have held. What are your expectations near term for pulp markets? And does the recent weakness we've seen in China speak to potential weakness in Europe and North America going forward?

I think in the near term, maybe Europe aside for a moment, in the near term, I think we're pretty optimistic about what's going to happen in China here in the next few months. The shipping -- so for the last year, the shipping channels have really been unavailable for Chinese paper producers. They've been so expensive and the availability of containers to go to North America and Europe has really -- it's kept the Chinese paper producers out of export markets. So it's really been a domestic market for the better part of two years. That's all changing now. The shipping rates are falling very quickly now. The availability of containers is finally coming back to the market. So we're seeing a lot of paper production in China going to the U.S. and even to Europe. So we're expecting with the waning pandemic, hopefully, reduced number of shutdowns and the reduced shipping costs that the Chinese paper business will fire up again and that will create increased demand for NBSK. And we still have -- there's still -- the prices a bit holding up quite well in China despite it being really a domestic market for the last year. And one of the reasons for that has been the supply availabilities. So lots of NBSK mills have been having production problems. We all know about the transportation issues that we've had, particularly in Western Canada with the railways. And I think what our transportation folks tell us is that those railway issues that we've been suffering, even if we have a good winter, they're probably going to be with us for longer -- for particular, I read the other day that the grain folks are expecting this will be a very large bumper crop for grain. And when you're a railroader, the pulp folks and lumber folks rank below the grain folks right now. So I think we're fairly optimistic about the near term in China.

Okay. Europe, potentially not so much...

Yes. We're in the process. We're getting another -- we've got another price increase on the way here in the next week or so. It looks like it's going to go through, but it's hard to see continued growth on the price for pulp in Europe in the near term.

A few minutes left. I just want to touch on your balance sheet and capital allocation. Historically, Mercer has had a relatively balanced approach with the dividends and complementing that with growth, both through M&A and organic spending. How do you currently in the current environment weigh those options, growing the asset base versus returns of capital to shareholders? And how do you think about your overall leverage ratio as well, which is always skewed towards the higher end of the industry range. How do you weigh that versus, I suppose, just security of liquidity and comfort with liquidity cushions going forward given a more uncertain demand environment.

Rich, do you want to talk on that?

So yes, we're -- it's a lot to unpack there, but we're comfortable with our balance sheet at roughly 2x net EBITDA. And we're willing to sort of let that move a little bit up and down, but only where we have line of sight on it being at that 2 level. Yes. And as far as CapEx and capital allocation, we're always looking at projects and evaluating them individually and trying to find the best returns for our shareholders.

And does the M&A opportunity set -- previously, you looked at sawmill acquisition opportunities in North America as well, not just Germany. Is the appetite still there on that front if valuations come back to earth for U.S. sawmill assets? Or do you tamper your M&A ambitions given the current environment?

Yes. No, I think we're still applying a lot of resources to looking for new ideas for M&A. So I don't think you'll see us back off on that. Our Board considers times like this where there's some disruption in the market. As long as we protect the balance sheet, make sure we've got some -- got the liquidity, and we don't stretch the balance sheet, as Rich was saying, we're pretty -- we'd be comfortable doing something more even in this disruptive environment. I think in the U.S., you're right, we've taken a crack at some -- a couple of processes in the U.S. or more than a couple and haven't been successful. And I think you'll see us continue to go in there and try to muscle our way in there with the big Canadians.

Competitive environment for sure.

Yes, yes.

Any other questions in the room? Okay. Thanks very much.