Lenzing is the world leader in terms of production and technology of man-made cellulose fibers (MMCFs). MMCFs are used in the textile industry (women’s outerwear, sportswear, home textiles) and the nonwovens industry (hygiene products, cosmetics). The company holds a market share of 20% in its industry. Currently, an increase in capacity coming mostly from China is harming the industry’s profitability. After a consolidation of the industry and a reversion of prices for MMFCs from their low level, I expect Lenzing to profit from ongoing cost reductions and product mix improvements. From my perspective, the current share price is not reflecting the potential upside in Lenzing’s profitability coming from a structural demand growth for MMCFs and a decline in the growth rate of capacity expansion.
The raw material for Lenzing’s fibers is wood, which is the basis for producing dissolving wood pulp subsequently processed into cellulose fibers. Wood Pulp is the main input factor with a 31% share of total costs. 52% of the wood pulp supply are secured through own production and 40% over long term supply contracts linked to the paper pulp index and not the spot price. The vertical integration of the company’s wood pulp supply leads to cost advantages of 20% compared to the current spot price for wood pulp.
Lenzing has seven production sites located in Austria, Indonesia, Czech Republic (pulp production), UK, US and China. The company’s total fiber production increased from 334,000 tonnes in 2000 to 891,000 tonnes in 2013 with revenues increasing from EUR 599 m to EUR 1,909 m.
Over the last years the company shifted its product mix towards higher quality specialty fibers. For the company’s trademarks Tencel and Modal customers pay premiums of up to 50% compared to the standard viscose fiber prices. Specialty fibers make up 35% of revenue and the company has a market share of more than 80% in this segment. With the new Tencel production line in Austria to be completed in 2014, the company meets the growing demand from spinning mills. Lenzing specialty fibers have comparable characteristics to cotton and are more sustainable from an environmental perspective. The environmental impact from cellulose fibers is 17.5x lower than from cotton. Lenzing is not only producing a product which is more sustainable than its substitutes, but is also the leader in terms of sustainability within its industry. Companies like Marks & Spencer, H&M, Ikea and Inditex are aware of the positive effects for their brands, if they make use of sustainable materials in their products. Given Lenzing’s position in its industry this offers substantial growth potential for the company. Recently, H&M started a large sustainability campaign called “H&M Consciuos Fashion”. Lenzing’s Tencel fiber is one of the materials used in H&M’s Conscious Fashion line.
After a record year in 2011, the company faced a steady decrease in the price for viscose fibers from a high of EUR 2.40/kg in Q2 2011 to a low of EUR 1.56/kg in Q1 2014. There are two major reasons for this development:
1) Overcapacity in the industry
Despite growing demand for MMCFs, increasing capacity in the industry puts continuous pressure on pricing. Since 2011 world production capacity has increased by 23%. In the latest conference call, management reported that capacity increases have come down to single digit growth numbers and that many Chinese fiber producers face liquidity constrains at the current price level. As a consequence, Lenzing is operating in a cash driven industry. The company’s Chinese competitors are currently producing at 85% of total capacity to generate cash serving their large debt burdens. Further credit tightening in China is limiting their financial flexibility. Consequently, they have no ability at the moment to decrease utilisation rates and influence prices upwards, although price agreements between these companies seem to be common. The following table provides an industry overview:
1) Private company
As you can see from the table above, Lenzing has the second lowest production costs for viscose fibers despite the company’s focus on sustainable production. Financial information is not available for Grasim and Fulida, but solvency ratios for the other companies look stressed compared to Lenzing.
2) The price for cotton
Cotton is the major substitute for men-made cellulose fibers. After a price spike in 2011, the price for cotton has trended downwards. Prices for Lenzing products generally have a high correlation with the cotton price. The U.S. Department of Agriculture’s (USDA) world 2014/15 cotton projections anticipate that cotton production will exceed consumption for the fifth consecutive season. This is mostly due to overproduction in China.
China, the world’s largest cotton producer, implemented a price floor for cotton in 2011 that exceeds world prices and a stock-building policy to support local farmers. Consequently, world stocks more than doubled between 2009/10 and 2013/14. China’s stocks are now 146% of 2013/14 domestic consumption, surpassing the previous stocks-to-use record set in 1998/99. The USDA expects the Chinese state reserve to purchase 85 % of the total 2013/14 Chinese crop to maintain internal prices substantially above world price levels. As a consequence, the Chinese textile industry currently substitutes cheaper man-made fiber in finished goods, which is positive for Lenzing but has so far not led to price increases for fiber viscose.
There are signs that the Chinese government is now reducing incentives to cotton farmers outside of the Xinjiang province (where half of China’s cotton is produced and quality reaches world standards) and that a growing number of farmers is diverting from cotton into food crops. The Government is now also trying to actively reduce its stock pile. However, it is important to note that most of the cotton produced in China is of secondary quality and that local mills prefer imported fibers. Due to the market distortion in China the correlation between world cotton prices and man-made fibers decreased over the last years. Without the Chinese intervention the world cotton price should be much lower.
The situation is different in the rest of the world. Here the stock-to-use ratio is only 54% which is rather at the lower end of the range from a historic perspective. Overall, the market for cotton is highly distorted which makes it even more difficult to forecast the price development over the short term.
From the table below you can see, that the company witnessed strong top line growth until 2011:
Despite a 30% price decline since 2011, revenues have been relatively stable mainly due to an increase in sales volumes from 713,000 tonnes in 2011 to 891,000 tonnes in 2013 and an improved product mix. It is also noteworthy that the company sold its plastics segment concluded in the middle of 2013 leading to a revenue reduction of roughly EUR 65 m in 2013. The company will reach a production capacity of close to one million tonnes in 2014 (17% of world capacity). Management expects that the company’s production lines will remain fully booked in 2014.
With surplus production capacities for viscose fibers and Chinese manufacturers keeping capacity utilization as high as possible in order to generate cash, profitability came further under pressure in 2013. This development was supported by the partially lower prices for wood pulp, the most important raw material used in manufacturing viscose. Lower prices combined with high capacity utilization led to market share gains on the part of Chinese producers.
As a consequence, the company started a cost savings initiative in 2013 in order to achieve a declared objective of generating annual cost savings of EUR 120 m p.a. Management estimates that the programme will already positively impact earnings to the amount of up to EUR 80 m in the course of 2014. In addition, the company decided to postpone any capacity expansion projects with the exception of the new Tencel plant in Lenzing, Austria.
Returns on capital are now under pressure. However, with decreasing capacity expansion in the industry and continuing demand growth for MMCFs a reversion to higher profitability over the next two years seems to be a likely outcome. So let me point out to you the general reasons for an investment in the next paragraph.
The long term investment thesis
First, over the long term it seems to be pretty clear that the demand for fibers will rise due to population growth and an overall increase of GDP per capita. In addition, there are structural limitations in cotton production due to a lack of arable land and water supply, a potential peak in cotton yields and caprious weather. So there is reason to believe that the proportion of MMCFs as a percentage of total cellulose fiber production will continue to grow disproportionately.
Second, Lenzing is the technological leader in its industry. The company owns approx. 1,400 patent applications and patents in 63 countries mainly for its Tencel products where it has been active for more than 20 years. The production of Tencel is quite complicated and Lenzing’s competitors are still trying to get an edge in this segment.
Third, Lenzing enjoys cost advantages on the basis of pulp integration, and benefits from economies of scale. The integration of pulp production and long-term pulp delivery contracts for its most important raw material give the company a competitive edge. Lenzing also profits from its size. Lenzing operates the largest and second largest production plants for man-made cellulose fibers.
Fourth, Lenzing sets the highest environmental standards in the industry. The required raw material wood is derived from ecologically sound forests and a large portion of energy consumption comes from renewable resources. In addition, the integrated wood pulp production reduces the need for drying, packaging and transportation of pulp. With the improving sustainability awareness among end-users Lenzing provides an almost perfect product to the textile and nonwoven industry.
However, I don’t want to be too enthusiastic here. Needless to say, there are also a number of risks:
Lenzing is operating a commodity business where barriers to entry are low as can be seen from the recent entry of new competitors after the high price levels for MMCFs in 2010 and 2011. In addition, Lenzing’s strategy of product differentiation will only work as long as it keeps its technological leadership. Moreover, price agreements between Lenzing’s Chinese competitors seem to be standard and provide a structural disadvantage to the company. Though I do not believe that China will also start to subsidise its MMCFs industry, market intervention from the Government is also a potential risk.
First, I try to model the company’s profitability with regard to the average realized price for Lenzing’s products. Based on the company’s information a EUR 0.01 change in the fiber price per kg is equal to a EUR 10 m change in EBITDA.
In 2013, Lenzing realized an average price of EUR 1.70/kg at an utilisation rate of 97% (Total capacity 921,000 tonnes) leading to a revenue in the fiber segment of EUR 1,512 m. The company will add another 67,000 tonnes of Tencel production to its capacity in 2014. Assuming that the new production line will have the same utilisation rate, but ignoring any price premiums for Tencel this will add another EUR 110 m of revenue.
I also assume that other revenues from the engineering segment and the sale of raw materials will stay flat.
In addition, I imply a EUR 100 m cost reduction which is EUR 20 m below the management’s target.
Based on these assumptions, I come up with an estimation of EBITDA for different price levels. To get to the EBIT number I use an annual depreciation of EUR 130 m.
This is only an approximation of the actual profitability potential, but it shows the upside potential of the share price should the fiber price recover from its currently low level.
Second, with an equity ratio of 45%, no goodwill and intangibles making up only 3.6% of total assets, the balance sheet looks solid. The average ROCE is 13.0% and the average ROE is 16.0% over the last ten years. At the same time the company is only trading with a price-to-book ratio of 1.1x.
An investment in Lenzing is a bet on the company’s ability to keep its strong market position and that prices for MMCFs will revert from their low levels. As outlined above, I think there is reason to believe that demand for MMCFs will grow further in the future. The price increases in 2010/11 led to enormous capacity expansion. The current overcapacity puts pressure on the return on capital of all industry participants. So it should take some time for the oversupply to be reduced ultimately leading to higher pricing levels. At the end of this process Lenzing could be in an even stronger position than before given a more effective cost structure and a more diversified product range.
I will establish a 3% portfolio position with a share price limit of EUR 47.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!