value and opportunity

Based on the positive results from the “quick check”, I will follow up with the first step of my standard analysis process, the so called “Replacement Value” analysis.

As a starting point, I will use the Net Equity position from the 2010 Annual report of UPM.

Then as a standard I would normally subtract the following entries from the Net Equity:

– minority interests (small, only -16 mn EUR)
– Goodwill (-1.022)

However, if we look at the goodwill breakdown in the annual report, we see the following:

Goodwill by reporting segment
As at 31 December
EURm 2010 2009
Pulp 202 197
Forest and Timber 1 1
Paper 799 799
Label 7 7
Plywood 13 13
Total 1,022 1,017

If we look at the segment numbers of the pulp business on page 90 of the report, we can easily see that the pulp business (basically the pulp mill acquired in Urugay in 2007) was extremely profitable in 2010, providing a significant share of UPM’s profit. So in this case I would consider the goodwill of the acquisition not as worthless, but include it into the replacement value. (remark: It looks like that the investment into the Uruguayan pulp mill was really perfectly timed, UPM got back most of its investment already after one year !!!)

Next in line are the “other intangible assets”, worth 424 mn EUR. The largest portion of this position are “intangible rights”, with ” water rights” (189 mn EUR) having the largest share.

These water rights are explained as follows:

Intangible rights include EUR 189 million (189 million) in respect of the water rights of hydropower plants belonging to the Energy segment. The water rights of power plants are deemed to have an indefinite useful life as the company has a contractual right to exploit water resources in the energy production of power plants. The values of water rights are tested annually for impairment based on expected future cash flows of each separate hydropower plant.

Any other company which would like to start a similar Hydro Power project would have to buy those rights as well, so we can assume that this part of the “Intangible Assets” has value. The rest of the intangibles seem to be software licences and carbon rights, so in the absence of fancy stuff I would not make any further deductions.

This results in the following adjusted value for equity after minorities, Goodwill and intangibles:

	FY 2010 mn EUR	per share
Equity	7,109	13.67
-minorities	-16	-0.03
-goodwill	-1,022	-1.97
+ goodwill pulp	202	0.39
-intangibles	0	0.00
adj. Equity	6,273	12.06

Next are “special” balance sheet items such as pensions, land and buildings etc.

Pensions:UPM has 424 mn EUR pension liabilities on-balance sheet. According to the notes, the total pension liabilities including funded schemes are around 1 bn EUR.

The underlying assumptions (~ 4.4% discount rates, 6.5% assumed yield on plan assets) seem to be OK, however the large percentage of stocks in the pension funds (60%) results in a certain risk to the sponsor of those plans. So as a conservative approach, I will deduct 100 mn EUR (or 10% of gross pension liabilities) from UPM’s net equity as “buffer” for pension plan asset risk.

Buildings:
Other than for example a REIT, a company like UPM which owns most of their buildings outright has to write them down to zero over the term of their “economical life”. As everyone knows this appoach is quite conservative, as even 25 or 40 year old building keep some of their value if they are properly maintained.

If one looks at private equity buyouts, own real estate is often one of the “quick wins” for LBO investors if they sell and lease back the written down real estate at a large profit.

So as a rule of thumb I usually add back 50% of the cumulative depriciation on buildings. UPM has 1.505 mn EUR of buildings on its balance sheet, with an original cost of 3.207 mn EUR. So 50% of 1.702 mn EUR is 851 mn EUR which I add back to the equity value of UPM.

Biological Assets:
As UPM owns ~ 1 mn hectares of timber land, we see ~ 1.4 bn of biological assets. As the discount rates (7.5% for Finland, 10% for Urugay) seem to look OK, I don’t adjust this position. However this is something worth to be monitored closely.

“Extra Assets”:

UPM shows 573 mn of investments in “associated” companies. The largest by far with around 540 mn EUR is the participation of 43% in a company named “Pohjolan Voima Oy, FI”.

The homepage of the company states the following:

Pohjolan Voima produces energy at cost for its owners and manages the entire lifespan of power plants reliably, cost-effectively and in an environmentally friendly manner.

In another section of the homepage, the business model is explained as follows:

Pohjolan Voima supplies electricity and heat to its shareholders at cost, and the shareholders cover the costs of the operations – this operating model is also called the “Mankala principle”. The name is derived from a ruling issued by the Supreme Administrative Court in the 1960s, constituting a precedent. In this ruling, the shareholders of a company called Oy Mankala Ab were found not to have received taxable income when Mankala generated and supplied them with electricity at a price lower than the market price and the shareholders covered the company’s costs on the basis of its Articles of Association.

So this is really interesting. UPM carries the participation “at Equity”, but what would be a fair price ? Any new competitor would have to purchase electricity at market prices. One easy answer would be to look at Fortum. The big Finish utility with approx. the same mix of energy assets (nuclear/hydro) trades around 1.8 times book value. If we apply a more conservative multiple of 1.5 book value, we should add 270 nn EUR to UPM’s replacement value in order to reflect the value of the Pohjolan Voima participation.

R&D + Marketing / Branding

Last but not least we have to look at R&D and marketing expenses, if there is some “hidden” replacement value in the form of brand value or “off balance know how”. For acompanylike UPM,the value of the brand is moreor less neglectible, however we can attach some value to R&D.

UPM spends 40-50 mn EUR peryear on R&D. If we use as a rule of thumb 50% of the R&D expenses of the last 5 years as additional “replacement value”, we should add (5x45x0.5) = 112.5 mn to UPM’s replacment value.

So bringing all this together we get the folowing replacemnt value for UPM:

	FY 2010 mn EUR	per share
Equity	7,109	13.67
-minorities	-16	-0.03
-goodwill	-1,022	-1.97
+ goodwill pulp	202	0.39
-intangibles	0	0.00
adj. Equity	6,273	12.06
-pensions	-100	-0.19
+ real estate	851	1.64
+ at Equ.part	270	0.52
+ R&D	122	0.23
Repl.Value	7,416	14.26

Summary: UPM is a very asset rich company. A relatively conservative approach results in an replacement value of ~ 14.26 EUR per share, mostly the result of undervalued real estate and at-equity participations. This alone would be an interesting investment case, as based on a current share price of 8,25 EUR, this equals a discount of 42% to replacement value or an upside of 72%.

In the following days I will take a closer look at free cash flows and “Earnings Power Value”.