At Sanlam Private Wealth, our investment philosophy with regard to cyclical businesses is based on the view that the market typically overreacts at both the top and the bottom of cycles. We generally seek to act countercyclically in this space by having the fortitude to buy near the bottom of the cycle at attractive prices – and then reduce our stakes once product prices have increased. Typically, at this point, company profits and therefore share prices reach unsustainable levels.
We employ this thought process when we consider the mining industry and other businesses that sell commoditised products (such as oil, chemicals and paper), as well as cyclical businesses like banks. South Africa has a more cyclical economy than its developed market peers, so we are fairly comfortable with this approach. We believe it gives us an edge over our global competition, which is often hesitant to invest in areas of relatively lower predictability.
When choosing individual companies within these sectors, we aim to own the players with the highest quality, since operators whose assets are low on the cost curve have a greater ability to weather the cyclical storms without encountering too many problems. Some degree of product and geographic diversification also helps.
MONDI FITS THE BILL
As the leading producer of kraft paper (for example, for paper shopping bags or cement bags) globally, Mondi fits this bill. The group is the largest manufacturer of packaging paper in Europe. With 75% of its capacity in the bottom half of the cost curve, it is typically more resilient during downcycles than its peers. Mondi has a healthy balance sheet and historically tends to be proactive during stressful periods for its markets, executing targeted, countercyclical acquisitions at attractive prices to grow the business.
The group’s management has a history of being shareholder-focused and allocating capital effectively. Its conversion of accounting profits to cash has long been attractive to us. Over the years, we have visited a number of Mondi’s facilities in both Europe and South Africa, and have found them to mirror management’s attitudes: they are modern facilities where the quest for efficiency is about using the best technology at scale as opposed to being tight on costs.
During 2022, our strategy for Mondi was to follow the plan described above. Through the latter parts of the Covid-19 period, paper and packaging product prices rose aggressively due to the soaring demand for cardboard boxes to hold goods purchased via e-commerce while we were all locked down.
Most commodity prices rose over this period as we all spent a greater proportion of our money on goods rather than services. The share prices of Mondi’s European peers, DS Smith and Smurfit Kappa, increased by over 75% in pound sterling from July 2020 to September 2021.
Over the same period, Mondi’s price rose only around 50% due to the group’s greater reliance on contracted volumes, where prices are only adjusted yearly (around a third of revenue) or half-yearly (roughly another third), so it didn’t benefit from high prices as much as its peers. On this basis, we expected a strong result from the group for 2021 and an excellent 2022.
RUSSIAN INVASION
Then, on 24 February 2022, Russia invaded Ukraine. Mondi’s share price fell by nearly a third in the space of two weeks. In 2021, Mondi’s Russian operation accounted for only around 12% of sales, but more than a quarter of group profit. Soon after the war broke out, Mondi classified its Russian operations as discontinued as the group sought to exit that business.
Mondi’s integrated Russian mill in Syktyvkar in northern Russia is very close to the bottom of the global cost curve for the pulp, cardboard and office paper that it produces, allowing the plant to generate a disproportionate share of group profit.
Facilities that are low on the cost curve not only generate higher margins when times are good and prices are high, but they’re also able to remain profitable when product prices are at the bottom of their cycle. Accordingly, they are disproportionately valuable to any business in a cyclical industry. This is no different in concept to the value that the market places on BHP’s Australian iron ore business, for example.
Mondi found a buyer for its Russian mill around mid-2022. Although the agreed price was very attractive for the buyer, it was also still survivable for Mondi at around R37 per share (versus a ~R95 decline in Mondi’s share price post the start of the war). Unfortunately, the parties were unable to obtain the necessary approvals from the Russian authorities to complete the transaction and it was cancelled in mid-2023.
The market – and we at Sanlam Private Wealth – had doubts about the conclusion of the deal and the exchange rate at which it would eventually take place, so the shares remained priced for a complete loss of the Russian business. The mid-year cancellation of the deal therefore had almost no impact on the share price.
Last week Mondi announced that a new deal had been concluded to sell the Russian business for around R30 per share at current exchange rates. While the price is far below our estimate of the mill’s value before the war, it is better than nothing.
This time, all approvals have been obtained from the government in advance, and we therefore view the successful conclusion of the deal as likely. Mondi has committed to paying out these proceeds to shareholders once the cash is received, so we expect a special dividend in 2024.
Excluding the Russian business, Mondi’s underlying earnings per share rose 78% in 2022 on high product prices (+63% including Russia). Had it not been for the effective loss of Russia, this would likely have delivered the top-of-the-cycle share price of over R480 per share that we had originally planned for as the time to trim our exposure.
THE WAY FORWARD
This is all in the past now, and the company must look to the road ahead. Through 2023, product prices have receded along with the European manufacturing economy and are now close to our view of the cyclical low. Mondi is not standing still but rather seeking to use cash generated at the top of the cycle to steadily replace the lost Russian volumes through an aggressive capital expenditure programme. With a number of small competitors struggling at the moment, Mondi may consider taking advantage of acquisition opportunities.
As the group expands its capacity in an industry with secular growth due to the shift in Europe away from plastic towards paper, we expect earnings to recover well over the coming years. However, they’re likely to return to the previous peak only in 2025 or 2026. Any cash received from the planned Russian exit provides upside optionality, management having committed to distributing this to shareholders.
Mondi was the only company in Sanlam Private Wealth’s client portfolios to suffer material pain as a result of the Ukraine war. It is a stark reminder, however, that no matter how correct one’s base-case expectations might be, unexpected events have the potential to disrupt any well-considered investment case. It also again highlights the importance of appropriate diversification in an investment portfolio.
