JK Paper: Well positioned in a sector on an upturn

We have been recommending JK Paper ever since we published our first note on the paper sector in May. Read: Profitability of paper cos on an uptrend; JK Paper a worthy contender

The subdued sentiment for midcaps led to a steep price correction after our note. We firmly believe that the story was far from over for JK Paper and suggested that investors capitalise on the weak stock price, which was unwarranted in the light of its improved financials. Read: Here’s a 16-stock Moneycontrol Research mid-cap portfolio to weather rough seas

While many midcaps and smallcaps have lost sheen, the stock recovered lost ground on a positive set of Q1 earnings.  The stock’s outperformance is justified by improving financials and strong earnings growth. While some part of the valuation re-rating seems to have played out, more can follow from the company’s planned capacity expansion and recent acquisition of Sirpur Paper Mills.

JK Paper, with an installed annual capacity of 455,000 tonne per annum (tpa) of paper and paper boards, reported a robust Q1 earnings, with net profit increasing 58 percent year-on-year to Rs 95 crore, led by strong revenue growth and margin expansion.

At present, JK Paper is operating at full capacity. The last two years have been favourable for the company as demand held up well, while input pressures have eased out. Domestic paper demand remains buoyant as closure of stressed domestic capacities led to supply constraints. The industry has not added any significant capacities over the last 3-4 years following shortage of a key raw material (wood pulp) and rising local waste paper prices.

We see paper realisations sustaining at current levels, given the positive industry demand-supply outlook. Rising imports at predatory prices from surplus countries remains a concern. The Directorate General of Anti-Dumping and Allied Duties (DGAD) has already found ‘sufficient prima facie evidence’ during the anti-dumping probe into cheap imports of ‘uncoated paper’. In light of this, outcome of the government investigation and any decision on imposition of anti-dumping duty is to be watched closely. As JK Paper is one of the largest players in both coated and uncoated paper segments, it would be the major beneficiary of any favourable outcome of the anti-dumping investigation.

Reduced raw material and power prices, which form nearly 60-70 percent of operating cost, have aided profit growth. While global pulp prices have been on a rising trajectory in the past five years, zero dependence on imports, agro-forestry initiatives and usage of captive wood have resulted in the company not being affected by rising prices.

The management's continued efforts towards farm forestry (increasing tree plantations) have led to increased availability of wood near manufacturing plants, thereby reducing average wood procurement costs for mills. For instance, the management increased the proportion of hardwood procured from within a 200-km radius of its manufacturing facilities from 41 percent in FY16 to 71 percent in FY18.

Ramping up of production at its new unit (commissioned in FY14) at the Odisha plant has helped achieve operational efficiencies. Earnings before interest, tax, depreciation and amortisation (EBITDA) margin improved to 25 percent in Q1 FY19 from a negative 0.1 percent in Q2 FY14. In addition to input prices, the margin improvement is on account of lower inputs used per tonne of paper produced. Despite operating at 100 percent capacity, the company has increased its production volumes, indicating operational efficiencies.

As operating at full capacity, the management plans to increase capacity to achieve meaningful volume growth. It announced a brownfield investment of Rs 1,450 crore for setting up additional packaging board capacity of 200,000 tpa (including pulping facility of up to 160,000 tpa). Though commercialisation of new capacity addition is likely to take more than 24-30 months, acquisition of Sirpur Paper Mills is a near term positive.

JK Paper acquired Telengana-based Sirpur Paper Mill at Rs 371 crore through the National Company Law Tribunal (NCLT) insolvency process. This consists of a cash payment of Rs 166 crore and issue of equity shares of Rs 43 crore and preference shares of Rs 162 crore. The acquisition will help add 138,300 tpa, at a total investment of around Rs 671 crore, including incremental capex towards modernisation. The total acquisition cost of Sirpur Paper Mills is much less compared to a similar sized greenfield project. As such, we view the deal as value accretive for JK Paper.

The capex, for both the planned organic and inorganic expansion, would lead to an increase in leverage, especially over FY20-21. However, the staggered nature of the capex, with favourable industry fundamentals, mitigates the risk to some extent.

Operating margin of paper companies was in the 13-14 percent range over FY12-15. Margin expanded by about 350 bps to 17 percent at FY17-end and is over 20 percent at present. As per a Crisil report, writing and paper companies are expected to hold onto their healthy operating margin.

Within the sector, JK Paper is well positioned, due to its strong market position with a presence in high-quality paper segments, cost leadership and integrated production capacities. Favourable industry factors such as improved supply-demand dynamics will continue to aid profitability. The stock is currently trading at 5 times FY20e enterprise value/EBITDA, which is reasonable considering its high earnings growth potential.

With earnings visibility and potential upside triggers arising from ramping up additional capacity acquired (Sirpur Paper Mills), JK Paper is a stock worth considering in the paper segment.

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