UPM Kymmene part 3: Qualitative aspects, Value Trap check and conclusion

So after the quick check, the Replacement Value analysis and the calculation of the EPV we have the following result:

Replacement Value ~ 14 EUR
EPV between 9.2 and 13.5 EUR depending on the assumption for future Capex.

Reader Weljo grouv however made a very good comment: The lower Capex seems to be an industry wide developement, so actually projecting the currently low capex expenditures into the future might be aggressive.

If we then just try to explain, why a conservative EPV is so much lower (maybe ~10 EUR) than the replacement value, the simple answer could be that I falsely took all the machinery at book value instead of applying a discount.

At this point in time it makes also sense to check for characteristics of a value trap. I posted already the great presentation from Jim Chanos and like to use now as a exercise.

I will start with the first mentioned characteristic:

Cyclical and/or Single Product
• Cycles sometimes become secular (Steel, Autos)
• Fad does not equal sustainable value (Coleco,Salton, Renewable Energy)
• Illegal does not equal value (Online Poker)

The first point is really the key: Will demand for paper (especially magazine paper where UPM is market leader) really recover ? Or will the Ipad take over. I am not an expert in this, but this is definitely a “red light”.

Hindsight Drives Perceived Value
• Technological obsolescence (Minicomputers,Eastman Kodak, Video Rental)
• Rapid prior growth – “Law of Large Numbers”(Telecom Build-Out)

This is also an interesting point. Although UPM is not a technology company, its major product magazine paper could be a victim of technolgy change. Let’s call this an “yellow light”.

Marquis Management and/or Famous Investor(s)
• New CEO as a savior – ignoring Buffett’s maxim(Conseco)
• The “Smart Guy Syndrome” (Take your pick!)

No problem here, “green light”.

Cheap on Management’s Metric
• EBITDA…Arrgh! (Cable TV, Blockbuster)
• Ignore restructuring charges at your own peril(Eastman Kodak)
• ‘Free’ cash flow…? (Tyco)

This could be a problem. Management stresses “free cashflow” based on current low Capex. We don’t know how sustainable that is. “yellow light”.

Accounting Issues
• Confusing disclosure (Bally Total Fitness)
• Nonsensical GAAP (Subprime lenders)
• Growth by acquisition (Tyco, Roll-ups)
• Fair value (Level 3 assets)

“Green Light” here I would say.

So all in all, that makes 2 green lights, two yellow one red.

So basically we can stop at this point. Especially based on the EPV analysis, UPM doesn’t really offer a “hard” Margin of Safety. It also shows several characteristics of potential value traps. The relativley high free cashflow could be at least partly more a liquidation than a going concern.

Despite some very positive characteristics like

– transparent use of free cash flow
– strong market position
– some upside due to consolidation (recent takeover of smaller competitor)
– vertical integration
– some “extra assets”

the risk of ending up with a value trap in a secular declining industry is not offset by the margin of safety.

As a result, I will still follow UPM and maybe look at other paper companies (SCA is maybe a better choice), but for the time being I will not buy any shares of UPM at the current price.


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