Lowered expectations and a rising stock price have me selling out of this paper manufacturer.
I bought Sylvamo about a year and a half ago at almost exactly the same $51 share price that I just sold it for. At the time I bought it, the company was earning over $7 a share on a trailing basis, giving it a p:e ratio of 7. The debt was a little high and the long term outlook for the paper industry was not great, but as long as the company could continue to churn out those earnings, I thought the low p:e provided adequate compensation for the risks.
In retrospect, this company was a classic value trap and I took the bait, hook, line and sinker. Supply constraints and heavy demand from its customers, who were presumably stockpiling their paper inventory to get ahead of the shortages, meant that the company was able to earn outsized profits during the pandemic. These profits are now coming back down to earth as the pendulum swings in the opposite direction.
Sylvamo was spun out from a larger company during the early days of covid, so there is unfortunately no past history to offer a guide as to what steady state, sustainable earnings might look like once conditions fully normalize. I’ve reluctantly lowered my initial earnings expectations for this company in light of the recent deterioration in profits and am now targeting baseline earnings at a much more conservative $4 a share. With the recent rally in the share price, that puts the p:e ratio above 12 which is no longer as attractive as it was, considering the poor longer-term outlook for the paper industry and the company’s weak guidance for the upcoming quarter. As well, at this reduced level of profitability, the debt the company is carrying starts to look uncomfortably high.
I still like the company and its story of a low-cost, vertically integrated paper producer that can generate loads of free cash flow as it squeezes out competitors and endeavours to be one of the last men standing in the sector. But there’s obviously execution risk here and the possibility that excess capacity in the industry could suppress profits for all participants if paper demand falls too quickly.
So I need a very low p:e ratio to stay invested. With my lowered earnings estimate, the p:e has risen enough that I no longer feel comfortable making this gamble. If earnings recover strongly after the current period of inventory de-stocking is over then I will of course reassess, and perhaps Sylvamo might make its way back into the portfolio at some point.
For now, though, I’m out. With the sale of Sylvamo, I have some extra cash to play with, but I found nothing in my latest review of third quarter results that compels me to put this cash immediately to work. I’m going to park the money for the time being and see if some better opportunities present themselves as 2024 unfolds.
Full disclosure: I do not own shares in Sylvamo Corp.