La Fábrica de Papel

Many are familiar with the Netflix show Money Heist, a Spanish crime drama about a heist on the Spanish Royal Mint. The original title in Spanish is "La Casa de Papel", literally the "Paper House", a nod to the material money used to be made of.

In the same way that paper money is being replaced by digital money, something similar happens with cigarette paper. As the use of electronic cigarettes rises and health concerns grow against the use of tobacco in general, cigarette paper´s days seem to be numbered. With this bad omen lurking around the corner for cigarette paper producers, who in his right mind would want to own a paper factory? That is what I will talk about today. As you read this article, keep in mind that the more attractive investments opportunities seldom are where everybody is looking.

Both the Netflix show and the company we are analysing today, Miquel y Costas & Miquel (BME: MCM), share its origins in Spain.

MCM was founded in 1725 and is headquartered in Barcelona. They manufacture and sell paper products for the cigar industry and smoking paper books, but also for other uses and industries (printing paper, special papers and textile pastes). In particular, MCM manufactures the following types of paper:

• Papers for the cigar industry: plugwrap paper, tipping paper and cigarette paper.

• Printing papers: high quality thin and opaque papers for printing.

• Rolling papers: brand rolling papers "Smoking" and "Pure Hemp".

• Specialty papers: papers for various industrial applications (applications in the construction, automotive, food and beverage and textile industries).

• Textile pulps: special pulps for industrial uses.

• Colored papers and cardboards: papers and cardboards for a variety of uses.

SEGMENT REVENUE

MCM's main business is the manufacture and sale of papers for the tobacco industry, but it is also engaged in other markets that are gaining importance in the overall portfolio of products (and revenues).

MCM presents its financial information for the following segments:

• Tobacco Industry (pastes and papers for the tobacco industry);

• Industrial Products (products with industrial applications); and

• "Other" (marketing of services and others).

Sales distribution by segment

Although the Tobacco Industry segment still accounts for the majority of sales (approximately 62%), the Industrial Products segment is the main bet of the paper group (currently accounting for 31% of sales). In this sense, MCM made a significant investment in the Terranova plant in 2012/2013 to drive the growth of the Industrial Products segment and is currently beginning to reap the fruits of the effort. As simple as a paper product may seem, it involves high specialisation and technological expertise. As such, the learning curve in this sector is about 7 to 8 years. While the company has not achieved the full potential of the Industrial Products segment yet, we are at a turning point that the market is not fully appreciating.

While it is true that the Industrial Products segment generates lower margins than those of the Tobacco segment, we can expect sales of Industrial Products to deliver significant growth in the medium term, driven by:

• MCM has the technology and knowledge necessary to gain market share in the Industrial Products market.

• MCM was already present in this market prior to the investment in the Terranova plant.

• Asset Turnover ratios declined significantly after the investment in the Terranova plant and while some improvement have occurred in the last four or five years, they have not reached yet the levels achieved in 2010 – 2011. This suggests there is room for further revenue growth in the segment without needing investment in additional assets.

Asset Turnover - Industrial Products

GEOGRAPHICAL REVENUE AND COMPETITIVE ENVIRONMENT

While MCM's origins are in Spain and it currently occupies a leading position in its sector in Spain, the group's total sales in the Spanish market represent just 11% of total MCM's sales. The lion's share of MCM's revenue is generated internationally.

Globally, MCM competes in the production of paper for the tobacco industry with the US company Schweitzer-Maudauit Inc., the Austrian Delfort Group AG, the German Julius Glatz GmbH, the Indonesian PT Bukit Muria Jaya (all of them privately owned), and with the public company Imperial Brands (formerly known as Imperial Tobacco), producer of the paper Rizla in addition to being the fourth-largest international cigarette company.

Paper manufacturing for the tobacco industry is an oligopolistic sector, in which MCM does not have a dominant position but is able to maintain a stable market share since there are significant barriers to entry (remember that the learning curve is about 7 to 8 years long, and incumbents have longstanding client relationships with the largest companies in the cigarette industry, also an oligopoly itself).

There is not a great amount of publicly available data out there to estimate market shares in the industry, but based on conversations with people knowledgeable of the sector, I estimate that MCM has a market share of around 9%. Since MCM cannot compete in volume with its customers (large tobacco companies) or competitors, its main competitive focus is on the technology used in its production plants, allowing it to offer its customers consistent quality paper, safety in supply and a high level of service and technical performance according to the requirements of their customers' cigarette manufacturing equipment.

CAPITAL STRUCTURE

Jordi Mercader Miró and his son, Jordi Mercader Barata, control the company, of which they own more than 15%. Together with other members of the Miquel family, they control 30% of the shares. The rest of the shareholding is in the hands of Santander Asset Management, Seguros Santa Lucía, the Dominguez family and other wealth management entities.

Generally speaking, when a company's management team is also a shareholder, it is a guarantee that the interests of shareholders and management are aligned...as long as they don´t force other shareholders to sell at a price below fair value (which I doubt will happen as the advantages of being a public company for MCM outweigh the disadvantages). In addition, during the last days of January 2020 we have seen the CEO and several directors increase their participation in the Company at an average price of 15-16 euros.

CAPITAL MANAGEMENT

The share capital of MCM is represented by 31.061.604 shares, 55% of which are admitted to trading on the exchanges of Barcelona, Madrid, Bilbao and Valencia. All shares enjoy the same political and economic rights and there are no legal or statutory restrictions on the acquisition and transfer of shares.

As for the level of Net Financial Debt, the Company has a solid financial position: as of 31 March 2020, MCM held net cash of €19 million, including €37 million of short-term financial investments. Even if we were to conservatively ignore these short-term financial investments for their lower liquidity, MCM's Net Financial Debt to EBITDA ratio would be just 0.3x.

My valuation analysis does not even include the cash position, as the effects of the current Covid-19 crisis are unknown as of the date of this article. However, given the cash-preservation measures taken by MCM, it is unlikely that all of the cash will be used during the economic lock-down and the following slowdown. In addition, given MCM´s history of healthy cash position and cash flow generation, I believe that even in the worst case, the company has the solvency to continue operating during the most pessimistic lock-down scenarios of the economy.

Looking ahead, it seems unlikely that the group's conservative capital management policy will change significantly in the short term, given the management team´s profile.

FINANCIAL PERFORMANCE

MCM's activity is closely linked to demand for smoking cigarettes, which is quite stable, although the growing social concern about the adverse effects of tobacco and the shift of many smokers towards electronic cigarettes will challenge MCM´s revenue in the long run. Management is trying to counteract this trend by focusing on the Industrial Products segment and diversifying the portfolio of products. By looking at the cash flow statement we can draw three conclusions:

• Cash flows generated by the cigarette paper sales are reassuringly stable.

• A significant investment effort was made in 2012 – 2013 to drive growth in the Industrial Products segment.

• We are in the early years of the Industrial Products division´s take-off.

• Attractive policy of remuneration to the shareholder, through consistent repurchase of shares and paying dividends.

The three factors mentioned above have put MCM´s stock in an optimal place to invest: growth prospects coinciding over time with a period of low profits produced by the investment efforts made.

IS IT A GOOD TIME TO BUY?

While the price of the share recovered between 2017 and 2019 after the market realised that the investment in the Industrial Products segment would effectively diversify MCM away from being a pure smoking paper company, the Covid-19 crisis has created yet another investment opportunity in MCM. As I write this post, the stock trades at around €12,9 per share.

Production was temporarily interrupted during the economic lock-down as production personnel was affected by the confinement mandated by the Spanish authorities. During the various phases of the pandemic, MCM took various cash-preservation measures and contingency actions to minimise the impact of operations due to possible breaks in supply chains.

The stability of the company´s revenues and its solid financial position (€ 7 million in cash and equivalents and € 37 million in short-term financial investments as of 31 December 2019) will allow MCM to survive the crisis and go back to profitability as soon as operations restart.

In addition, it is an unattractive sector for the bulk of the investor population, due to its still large exposure to the tobacco sector. Despite MCM´s high technological knowledge of paper production processes, it is not perceived as a technology company and is ignored by the majority of the investment community (something that is not at all favoured by MCM´s opaque culture of giving very little information to the shareholders).

VALUATION

MCM´s shares have historically traded at 15x earnings. As of 25 May 2020, they are currently trading at less than 10x earnings. Conservatively assuming no cash, a decline in earnings of 4.0% for 2020 and no growth for 2021, we would still be looking at a 40% upside potential in 2 to 3 years. That is an annual return of 12% to 20%, with a lot of upside and significant safety margin, given the conservative assumptions used.

IMPORTANT DISCLOSURE

The views, thoughts, and opinions expressed in this blog are for educational and informational purposes only. They do not represent investment advice. You are responsible for your own investment decisions and I cannot be responsible for your use of the information contained in or linked from this web page. You should NOT make investment decisions blindly relying upon the information or opinions you read here. Rather, you should use what you read here as starting points for doing independent research on companies and investment ideas. Based on your own research, you should assess for yourself the merits of the views presented in this web page and form your own judgement.

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