We would consider a (market hedged) long position in Smurfit Kappa Group (SKG ID) in the EUR 17-18  range.  We believe it is only a matter of time before rumours re-surface that International Paper (IP US) is looking at Smurfit. Downside: EUR 15. Upside: EUR 30-36.

We have stayed away from such position in last months as price and valuations had been running ahead of itself since Sky News reported last year in April 2015 that IP had hired Deutsche Bank to advise on a potential take over offer for Irish rival Smurfit Kappa for EUR 36 a share. However, with Smurfit’s price having come down from EUR 30 levels since (and largely trading in line with historic average NTM P/E and EV/EBITDA multiples of 12x and 6.5x), we like the situation/price again. 

Below we highlight the arguments why a deal seems more likely than not (caveat: we don’t want to make a call on timing, however with share pricing having come down to more conservative standalone valuations, we feel comfortable with near-medium term upside/downside risks)

Arguments why deal might be on the cards:

–          New IP CEO with European experience: IP’s CEO Mark Sutton knows European markets given his previous experience as GM in IP’s European corrugated packaging operations between 2000 and 2005

– Mark Sutton took over as CEO only last November and has defined packaging as the core business for International Paper (Note: Smurfit is 100% packaging business)

–          If there is a large scale deal to be done by IP, it would most likely be away from USA as a) European market is far less consolidated than the USA, with the top 5 holding 38% share vs 76% in N America; b) IP’s North American market share alone is already 32%; and c) Smurfit is one of largest players in European packaging markets (#1 market positions in containerboard and corrugated boxes in Europe overall with about 18% market share); and d) core North American businesses facing limited prospects for price & volume growth and competitors (RKT-MWV) and customers (Kraft-Heinz) consolidating.

–         History of large scale acquisitions: IP has transformed itself via two large scale acquisitions in the last seven years: (1) The $4+ billion acquisition of Temple-Inland (2012) and (2) The $6 billion purchase of Weyerhaeuser’s packaging business in 2008.

– IP has the balance sheet (again) to do a deal size of Smurfit: 100% cash acquisition at 30% premium to current Smurfit share pricing would bring IP’s pro-forma net leverage to 4x which would be in line where IP’s net leverage was after its TIN acquisition in 2012 (since closing of the deal IP managed to bring down its leverage again to below 2.5x now)

–         Although contentious issue currently after Treasury’s recent new set of rules to deter tax inversions, IP could easily benefit from tax inversion dynamics (shifting its tax domicile to Ireland) if it would offer about 60% of any offer consideration in IP stock (where IP shareholders would own less than 80% of new pro-forma company).

–          High 84% free float shareholder base in Smurfit, making Smurfit easier to acquire vs some of the other large scale European packaging companies which are family owned/controlled.

–          Although IP mainly focused on US and Smurfit focused on Europe, there would be good synergestic overlap in both companies’ Latin American business: IP is the #3 containerboard producer in Brazil and Smurfit has leading positions outside Brazil (#1 in Colombia-Venezuela,#2 in Mexico, #3 in Chile-Argentina).

–          Still not overly relatively expensive vs IP:  Smurfit only trades about 5-10% more expensive than IP (Smurfit 2015/16e EV/EBITDA of 7.5x and 6.8x and P/E of 12.5x and 11x vs IP trading at  EV/EBITDA of 7.0x and 6.8x and P/E of 11.5x and 11x).

–          Largely accretive for IP: Assuming low end synergies (about 3% cost synergies as % of Smurfit Total Revenues vs comparable paperdeals synergies average around 6.3 %), deal would be 15%+ 2016e EPS accretive for IP

Arguments against a deal:

–        IP recently revisited its capital allocation strategy and focused on dividend and share capital returns while determining a that dividend payout ratio should be 40-50% (prior 30-40%) of FCF. Although company did not hint at large scale M&A, it mentioned that company would opportunistically pursue acquisitions.

– Limited scope for synergies as there is fairly limited operational and geographic overlap: IP’s European box business is still small relative to IP’s scale while Smurfit owns a mill and few box plants in the USA, very small relative to IP.

–          Europe and US packaging and containerboard markets are very different in nature: US has much lower cost structure than Europe (given main input material wood/trees growing much faster in US  than in northern climates such as Scandinavia) and US pricing is much more stable than in Europe.