Each week we screen thousands of corporate bond listings to find what we believe is currently the best corporate bond for investors needing or seeking higher yields with the least amount of risk possible relative to its projected return. This week, we revisit Bio PAPPEL, S.A.B. de C.V. (CDURQ), the largest paper producer in Mexico and the leader in the production of 100% recycled, recyclable and biodegradable paper throughout Mexico and Latin America. Although the currently indicated 11% yield to maturity of this bond is lower than the 13% yields that we first reviewed that at several months earlier, the following update shows why we believe these less than 4 year, short term, very high yield, "step up" bonds from Bio PAPPEL represent an even better reward to risk than previously noted. Therefore, we believe these bonds merit an increased weighting in our client's high yield corporate bond investment portfolios.
Assessing the Yield Curve
Wealth preservation by achieving returns that can outpace moderately rising inflation continues to be one of the biggest concerns among our clients. As politicians in Washington face what most see as hard choices as they try to fashion a long term budget compromise, one measure designed by economists to generate large savings over the next decade involves a further "tweaking" of the index used for cost of living adjustments to federal benefits and income taxes. In other words, another "more realistic" (so they say) way to measure inflation by using a "chained CPI" (Consumer Price Index) which has averaged a little under 0.3 less than existing measures. That's right… it averages LESS than the existing official US Bureau of Labor's CPI already remarkably low 2% inflation measure for all items (less food and energy.) Whether this new method will be implemented as part of the plan to reduced the budget deficit remains to be seen, but considering that the way that government calculates inflation has changed more than 20 times since 1978 and that government would plainly benefit (a 10 year savings estimate of $299 billion) from being linked to a lower index, such a change should come as no surprise.
Regardless of who or what agency considers inflation to be hovering near 2% or not, it seems that most Americans simply aren't buying into the story that there is barely any inflation right now. According to John Williams of shadowstats.com, if inflation was measured the same way that it was in 1990, the inflation rate would be about 5 percent right now (and much higher than that if reported by earlier standards.) According to the American Institute of Economic Research, the real rate of inflation was about 8 percent last year, and some analysts are projecting that we could see food prices rise by 14 percent or more over the next year. Therefore, achieving yields high enough to outpace inflation is therefore not only a matter of intelligently assimilating as little risk as possible in order to achieve higher rewards, but it also requires each investor to consider the enigma of how high is high enough. Here at Durig Capital, we believe this short, 45 month bond yielding about 11% offers a superior balance of rewards to acceptable risks, and provides a savvy solution to preserving one's wealth as long as the underlying fundamentals of the issuer, which we will review in more detail here in this article, remain sound.
A look at the issuer
Since its foundation 25 years ago, Bio PAPPEL's vision of sustainability is founded on competitiveness, environmental protection, and social responsibility. The paper industry itself is the largest consumer of wood and forests worldwide, since it uses them as raw material for paper production. However, Bio-PAPPEL has replaced a use of forest woods with a use of urban woods (paper recycling), with investments of over 500 million US dollars in the past 10 years and not cutting down trees for use in manufacturing paper. This is the structural foundation of Bio PAPPEL's change of corporate identity. In 2011, the company recycled 1.5 million metric tons of paper, which is equivalent to saving 685 thousand trees. Bio PAPPEL is the only Mexican company to obtain "FSC-Certification 100% Recycled", which can be reproduced by the users of its products.
Bio PAPPEL currently has 31 Industrial plants in the lower US and (primarily) throughout Mexico, and about 7,500 employees. It has a broad and diversified customer base in Mexico and the USA, which includes most of Mexico's top 500 companies.
We like companies that are profitable
In our first review of Bio PAPPEL, we were impressed with the relatively stable earnings (EBITDA) generation over the last three years, and saw the biggest risks to earnings and cash flow were not likely to be big fluctuations in the demand for their products, but rather, in currency exchange and production costs. Considering that the Fed appears to be resolute in its desire for a weaker dollar and that the Mexican peso appeared to be well poised for appreciation relative to the dollar, we expected this to be advantageous to Bio PAPEL going forward. After examining its third quarter results ending Sept. 30, 2012, we were pleasantly surprised to see the combination of a net sales increase of 11.5% over the previous year's Q3 and a unit cost reduction of 2.4%. Even more impressive was its EBITDA growth of 134.1% vs. the 3Q of 2011, the effective result of increased shipments, pricing growth, sales increase, and cost reductions. The company's EBITDA rose by 20.9% (to US$32.6 million) when compared to 2Q12, and for the first nine months of 2012, the company reached an EBITDA of US$76.0 million, a 47.5% increase when compared with last year's same period.
As of result of higher EBITDA generation Bio PAPPEL's financial statistics ratios have improved significantly and have confirmed our belief that Fitch's rating of "B" for these Bio PAPPEL's bonds appears to be overly conservative. Repeated below are previously cited reasons why we believe Bio PAPPEL will continue to improve their performance:
- The global recovery rates for waste paper appear to be rising. They currently average about 44% in Latin America and about 65% in North America. Along with a curtailed demand from Chinese buyers for North America's waste paper, this is likely to stabilize or perhaps even lower Bio PAPPEL's raw material costs.
- Energy is Bio PAPPEL's second biggest production cost, and it is primarily dependant on natural gas costs. Considering the projected continued low prices for natural gas, and the integration of some savvy longer term (2 ½ year) hedging in January of 2012 when natural gas pricing was near 10 year lows, there appears to be little doubt that this cost reduction will continue to reflect in strong EBITDA number going forward.
- As a result of a majority of its costs being linked to dollars, any appreciation of the Mexican peso relative to the US dollar would result in additional costs savings. According to a July 2012 Global Emerging Markets Equity Research report from JP Morgan (JPM), Mexico was outperforming most other Latin American countries primarily as a result of the sharply appreciating peso from its lows in May. More significantly, the Mexican peso was the only currency in Latin America that appreciation was expected to be seen in going forward.
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Overall, it appears that Bio PAPPEL remains very well positioned to turn continued cost savings into solid earnings and cash flow going forward.
Interest Coverage Ratios
Interest expenses for Q3 were reported at about $5.53 million, while operating income was about $41.8 million, indicating a significant improvement to an over 7 to 1 coverage ratio and a 120% year over year improvement in 3Q 2011's operating income, which was $18.94 million.
We like companies with lower debt to cash ratio.
The consolidated debt of Bio PAPPEL at the end of 3Q 2012 was $261.1 million, primarily attributed to the 2016 Notes. Cash and cash equivalent at the end of Q3 has increased to about US$89.4 million from the US$80.1 million of the previous quarter and from the US$70.8 million at the year end of 2011, giving it a modest debt to cash ratio of less than 3 to 1.
Considering such recently reported strong cash flow, rapidly rising EBITDA, and increased cash position, we remain of the opinion that it is reasonable to anticipate some or all of this outstanding debt issue being called at par next August when the interest coupon payment is scheduled to step up to 10%.
We like companies that have good balance sheets
Given Bio PAPPEL's gains over the last few months in the capital markets, its total debt appears to have eased to less than 40% of its currently indicated enterprise value of about $456 million. While this very notable improvement in the valuation given to it by the capital markets adds very good balance sheet flexibility to our list of preferred criteria, it bears repeating that this still doesn't reflect its much higher book value of over $880 million. So, while significantly better opportunities may be available in the equity markets should additional capital need to be raised, the strong property, plant and equipment valuation it holds on its books continue to provide sound and tangible assurance for its bondholders.
We like higher yields.
This US dollar denominated debt of Bio PAPPEL was issued in August of 2009 at the coupon rate of 6% for the first year, 7% for the following three years, and 10% for the last three years, payable quarterly. Its principal amount of $250 million is presently callable, although it maintains certain restrictions affecting the ability of Bio PAPPEL or its subsidiaries to such things as (but not limited to): incurring new debt; paying dividends; becoming involved in a lines of business not allowed; mergers, leases or sales of all or substantially all of the company's assets; or repurchasing the 2016 Notes in case of a change of control.
At its current discounted price of about 94.87, the indicated yield to maturity in 2016 is about 11%, or if it were to be called next August, about 14.5%. Although the credit ratings are widely different, when set in comparison to longer five year U.S. Treasuries yielding a paltry 0.63%, we believe this greater than 10% difference in yield is the most stunning we have seen given the level of risks that we can identify.
Step 8 – Risks Considerations
Bio PAPPEL is relatively small compared to other paper and packaging products manufactures and their subsidiaries, such as International Paper Company (IP), Domtar Corporation (UFS), Weyerhaeser (WY), and MeadWestvaco Corporation (MWV), and may face increasing competition from substantially larger and better financed companies for the raw materials that are needed.
The cost of recycled fiber (OCC and ONP) is directly affected by trends in the international and domestic prices, as well as by the exchange rate of the Mexican peso. Fluctuations in the price and supply of energy are also unpredictable, but recently implemented commodities hedging should help alleviate some of these uncertainties going forward. Considering that most of its revenues are generated in pesos, it is our opinion that Bio PAPPEL's vulnerability to a sharp devaluation of the peso may be the most significant risk.
We believe that these Bio PAPPEL bonds have similar risks, similar maturities, or similar yields to the StoneMor (STON), KEMET Corporation (KEM), Tutor Perini (TPC), or Georgian Railway bonds reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
It is our opinion that Bio PAPPEL has not only positioned itself well for the future as a "green" 100% Recycled materials company, but it should be noted that it is the largest in all of Latin America. It has a very good cash position, excellent interest coverage, and a superior balance sheet. We believe these Bio PAPPEL bonds represent such an unusually high yield relative to the risks that we can identify for it that we continue to refer to it more as an anomaly, especially when the likelihood of being tendered in 2013 is added to it. Furthermore, it bears repeating that we would be quite surprised to see these bonds left outstanding after August of 2013. Therefore, we think these Bio PAPPEL bonds should be considered for an overweighted position in our Foreign and World Fixed Income holdings.
Coupon: 7.0, stepping up to 10.0 in year 2013 and after
Yield to Maturity: 11.57 %
Yield to Call in 2013: ~14.5%
Disclosure: Durig Capital and certain clients have positions in PAPPEL 2016 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. If you intend to use our research efforts to make an investment decision, we kindly ask that you respect our fiduciary business model and allow us the opportunity to assist in your equity acquisition. We sincerely appreciate your courtesy and understanding.