Rival's price an indicator of Smurfit's value

Business Opinion:Jefferson Smurfit is set to return to the Irish stock market this week and has gone to considerable efforts to ensure that it is welcomed like the old friend that it purports to be.

It is of course a vastly different company to the one that departed the market in 2002, when it was taken private by Madison Dearborn. The US operation - as represented by its stake in Smurfit Stone Container Corporation - is gone and Jefferson Smurfit itself merged two years ago with Kappa Packaging to form Smurfit Kappa, the business that returns to the market this week.

Smurfit Kappa was always going to be a tough sell and the market turmoil of the past few weeks have not helped. The packaging industry is notoriously cyclical and the view is that the next peak is almost upon us.

The company is very heavily leveraged as a result of the combination of two groups that were the subject of a leveraged buyout. The subsequent refinancing and merger accounting make valuing Smurfit Kappa very complicated.

The decision to confine the initial public offering (IPO) to institutional investors is presumably a reflection of this. Equally, the commitment by the current shareholders not to sell any shares in the IPO and to agree to a 180-day lock up is also aimed at ensuring the new shareholders don't get mugged. And given that the venture capital firms behind the original move to take Kappa private - CVC and Cinven - have been on board for the best part of nine years, that is to be commended.

When you add that to a cashflow that most believe capable of supporting modest dividends and creating value for equity shareholders through debt reduction, it is a reasonable proposition for the institutional investor.

It also seems reasonable - given the risk and complexity - to shut retail investors out at this stage. But that does not mean that they are not interested, and of course the institutional investors who come on board at this stage will be counting on some sort of retail interest after the IPO to give the shares a kick.

So what is the retail investor to do? Well, some help is on hand from Merrion Stockbrokers, who have put out a pre-IPO report on Smurfit Kappa. The report's author, John Mattimoe, takes the view that the accounting used by Smurfit Kappa and its peers is so fiendishly complicated that many of the traditional methods of valuation are redundant. His metric of choice is the ratio of enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA).

Mattimoe's argument is that this approach is an established method for paper and other cyclical stocks and also gets around the difference in the capital structures of the various companies in the sector.

On that basis, he plumps for an EV/EBITDA multiple of 7.5 for Smurfit Kappa, which would suggest that based on the information provided by Smurfit Kappa and their own estimates, the shares should be worth €18.10 - €18.90 - depending on how many new shares are issued.

Allowances then have to be made for the volatility in the market and the fact that the existing shareholders will be persistent sellers once the lock up period has expired. Taking these factors into account, Merrion suggests the shares should be worth €14.50 - €16.10 at flotation.

Where things go from there is really a question of how much you believe in Smurfit Kappa's management's ability to manage through the turn in the cycle, pay down debt and cut costs.

And this is one area where retail investors may have an insight of their own, particularly if they were shareholders in Jefferson Smurfit. When it was taken private, they would have received one share in Smurfit Stone for every 16 shares they held in Jefferson Smurfit, along with their cash payments. Any of them who held onto the Smurfit Stone shares would have received a salutary lesson in the risks of being an investor in this sector.

Smurfit Stone, a former US-based associate, is one of the peers that Merrion use to value Smurfit Kappa, although they do not see it as the best fit, preferring Swedish-based rival SCA instead, which is forecast to trade at an EV/EBITDA multiple of 7.5 this year. Smurfit Stone is on a forecasted EV/EBITDA of 8.2 this year. But there is one aspect to it that singles it out as good proxy for Jefferson Smurfit and that is their shared parentage as reflected in the two companies' names.

Much is made, by Merrion and others, of the abilities of the Smurfit Kappa management under the leadership of Michael Smurfit who, despite having relinquished operational control some time ago, remains the éminence grise. Depending on your view of these things, an interesting question to pose then is to what extent do these two companies still share the same management culture or corporate thinking. Quite a lot, one suspects.

It is worth noting that despite its management's efforts to cut costs, reduce capacity and drive prices, Smurfit Stone's shares are currently the best part of $2.50 (€1.90) below the $14 level they enjoyed when Jefferson Smurfit was taken private. It is a simple point and perhaps not to much should be made of it.

But it is something to bear in mind as you grapple with EV/EBITA, capacity, tonnage, box prices and all the rest.