Tuesday 21 August 2018

Pressure mounting on Smurfit to hold 11th-hour talks as takeover deadline looms

Smurfit is facing its day of reckoning with International Paper having until Wednesday to come forward with a bid - or walk away, writes Dan White

'International Paper’s (IP) courtship of Smurfit Kappa (SK) began on February 14, when the Memphis-based company first approached SK boss Tony Smurfit about a possible takeover. Six days later SK told IP that the proposed takeover was not in the interests of its shareholders.' Photo: Mike Ellis Photography
'International Paper’s (IP) courtship of Smurfit Kappa (SK) began on February 14, when the Memphis-based company first approached SK boss Tony Smurfit about a possible takeover. Six days later SK told IP that the proposed takeover was not in the interests of its shareholders.' Photo: Mike Ellis Photography
Dan White

Dan White

On Wednesday the country's secondary school students face in to the ordeal of their leaving and junior certificate examinations. Meanwhile, Smurfit Kappa, Ireland's sixth-most valuable quoted company, faces its own day of reckoning as the deadline imposed by the Irish Takeover Panel for International Paper to make a bid expires.

International Paper's (IP) courtship of Smurfit Kappa (SK) began on February 14, when the Memphis-based company first approached SK boss Tony Smurfit about a possible takeover. Six days later SK told IP that the proposed takeover was not in the interests of its shareholders.

Still refusing to take no for an answer, IP representatives personally delivered the proposal to Tony Smurfit and SK chairman Liam O'Mahony on February 23. On March 5, SK privately told IP that it had rejected its offer and publicly announced this rejection the following day.

"The board of Smurfit Kappa has unanimously rejected this unsolicited and highly opportunistic proposal. It does not reflect the group's true intrinsic business worth or its prospects," said O'Mahony.

On March 12, IP approached SK once more and submitted a revised proposal to O'Mahony on March 22, which was in turn also rejected by SK on March 26.

"The revised proposal does not offer Smurfit Kappa shareholders much more than compensation for the fall in International Paper's share price," said O'Mahony.

Not surprisingly, IP viewed the situation somewhat differently, with chairman and chief executive Mark Sutton saying: "We have approached Smurfit Kappa because we believe that there is a compelling strategic and financial logic for a combination… Smurfit Kappa shareholders will benefit from an attractive premium with a combination of cash up front and will have the opportunity to participate in the future value creation of the combined business."

As if to emphasise the point that it sees its future as an independent company, Smurfit Kappa unveiled an acquisition of its own last month when it agreed to pay €460m for Dutch paper and packaging company Reparenco. SK is planning to invest €1.6bn over the next five years and to push up its return on capital employed to 17pc.

With IP having repeatedly ruled out a hostile bid and matters dragging with no sign of a resolution, the Irish Takeover Panel stepped in on May 16 and ordered IP to either launch a bid for SK by June 6 - this Wednesday - or walk away. If IP does walk away it won't be able to bid again for SK for 12 months without the permission of the panel.

So, with the clock ticking on the deadline, what will IP do? Having invested so much time and effort into wooing Smurfit Kappa, will it meekly walk away? IP has estimated the annual cost savings from acquiring SK would hit $450m (€385m) by the end of the fourth year.

IP already produces 19 million tonnes of paper packaging annually, mainly in North America, while SK produces another five million tonnes, mainly in Europe and Latin America. The combined group would have annual sales of $31bn (€26bn).

IP also points to its success in extracting higher-than-promised synergies from its previous acquisitions. It promised $400m of cost savings when it took over Weyerhauser Packaging in 2008, and claims to have delivered $490m. The promised $300m of synergies from the 2012 acquisition of Temple Packaging panned out at $400m. In 2016 it promised $175m of synergies from Weyerhauser Cellulose Fibers. It reckons that the actual cost savings were $205m.

Quite clearly Smurfit Kappa's suitor is a highly-acquisitive company with a track record of successfully squeezing costs out of its acquisitions. This makes it unlikely it will walk away empty-handed on Wednesday.

The foreign exchange markets have also moved in favour of the IP offer of cash and shares for Smurfit Kappa. It is offering €25.52 cash and 0.3028 IP shares for every SK share. Way back in March this offer valued SK at €37.50 per share. However, since then the value of the euro has fallen from $1.24 to $1.17 meaning that the value of IP's offer has risen to about $39.35 per share.

At this price IP is offering to pay €9.3bn for Smurfit Kappa's equity with SK shareholdings ending up with a combined 15pc shareholding in the enlarged IP. Throw in SK's net debt of €2.8bn and the total cost to IP rises to €12.1bn. This compares with IP's existing market value of almost €8.4bn.

There are also clear signs that at least some Smurfit Kappa shareholders have been tempted by the IP approach. On May 23 the Financial Times reported that Janus Henderson Investors (which owns 4.3pc of SK) and two other major unnamed shareholders had "demanded" that SK enters into talks with IP.

"The message to Smurfit is to please either engage and get around the table with IP or give us reasons why you are not engaging," said Janus Henderson's head of European equities, John Bennett. Janus Henderson has told IP it will not support any offer under €40 a share.

Goodbody Stockbrokers analyst David O'Brien has done the numbers on Smurfit Kappa. In a recent note he calculated the mid-range fair value of the shares at €39.50. "However, if International Paper is unsuccessful there may be short-term pressure on the share price," he wrote.

Smurfit Kappa announced better-than-expected full-year results in February with 2017 sales up 5pc to €8.5bn and operating (pre-interest) profits virtually unchanged at €820m. This good run has continued into 2018 with SK recording a 7pc increase in sales and a 22pc increase in ebitda for the first three months of the year. Goodbody's O'Brien is predicting this strong growth will continue for the full year. He is now predicting a 6pc increase in full-year sales to almost €9.1bn and a 25pc increase in operating profits to €1.03bn.

Further out the going gets tougher. While he is predicting a further 3pc sales increase to €9.3bn in 2019 and a 3.5pc increase to more than €9.6bn in 2020, operating profits will fall by 3pc to €1bn in 2019 before recovering by 6pc to €1.06bn in 2020. Based on these forecasts the cumulative increase in Smurfit Kappa's operating profits between 2018 and 2020 will be less than 3pc.

What these forecasts demonstrate is that paper and packaging is a highly-cyclical business where even small increases or falls in demand can have a disproportionate impact on the bottom line. Smurfit Kappa is hoping to push up the prices it charges its customers by 6pc-8pc in 2018. However, the demand for packaging is very closely linked to the health of the overall economy. When times are good we buy more stuff, along with the boxes in which it is packed, but when times are poor the opposite is the case.

O'Brien is basing his forecasts on 5pc annual increases in European corrugated paper prices in 2019 and 2020. How would those forecasts bear up if the current political difficulties in Italy and Spain, not to mention Brexit, were to trigger yet another eurozone financial crisis?

All of which means that the pressure on Smurfit Kappa to agree to talk to IP by the Wednesday deadline will be intense, particularly if IP sweetens the pot by increasing its offer over the symbolic €40-per-share level.

The share prices of most of the major European paper and packaging producers, and not just that of Smurfit Kappa, have risen strongly this year. Shares of DS Smith and Mondi, the two groups that most closely resemble Smurfit Kappa, have each risen by 13pc since news of IP's interest in SK first emerged almost three months ago. This means that the SK share price is unlikely to fall all the way back to the levels of last February even if IP does walk away.

But, of course, it probably won't.

"I'd be surprised if they [IP] did walk away having taken it this far. There has been pressure from investors. I'd be surprised if they [IP] did not come back with a little bit more," says O'Brien.

However, even if Tony Smurfit and Liam O'Mahony execute a U-turn before 7am on Wednesday, they are unlikely to run up the white flag just yet. Far more likely is that a tweaking of the IP offer to bring it above the symbolically all-important €40 level - something that will have been made slightly more difficult by the weakness in the dollar late last week following the Trump administration's imposition of tariffs on steel and aluminium imports - will serve as a trigger for the opening of talks about a possible deal between the two companies.

When this possibility was put to Smurfit, the company declined to comment.

As the country's schoolchildren prepare for the exams that will shape their futures, Tony Smurfit and Liam O'Mahony will be getting ready for their very own test.

Will they stand firm in their rejection of the IP offer or will they instead agree to a sale of the company that was founded 84 years ago by Tony Smurfit's grandfather Jeff in the Dublin suburb of Rathmines?

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