UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2012
OR
For the transition period from to
Commission File No.: 000-51826
MERCER INTERNATIONAL INC.
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
Suite 1120, 700 West Pender Street, Vancouver, British Columbia, Canada, V6C 1G8
(Address of office)
(604) 684-1099
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months or for such shorter period that the registrant was required to submit and post such files). YES x NO ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x
The Registrant had 55,815,704 shares of common stock outstanding as at November 1, 2012.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERIM CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012
(Unaudited)
QUARTERLY REPORT - PAGE 2
INTERIM CONSOLIDATED BALANCE SHEETS
(In thousands of Euros)
ASSETS
Current assets
Cash and cash equivalents
Marketable securities
Receivables
Inventories (Note 2)
Prepaid expenses and other
Deferred income tax
Total current assets
Long-term assets
Property, plant and equipment
Deferred note issuance and other
Total assets
LIABILITIES
Current liabilities
Accounts payable and other
Pension and other post-retirement benefit obligations (Note 4)
Debt (Note 3)
Total current liabilities
Long-term liabilities
Unrealized interest rate derivative losses (Note 8)
Capital leases and other
Total liabilities
EQUITY
Shareholders’ equity
Share capital (Note 5)
Paid-in capital
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
Noncontrolling deficit
Total equity
Total liabilities and equity
Commitments and contingencies (Note 10)
The accompanying notes are an integral part of these interim consolidated financial statements.
QUARTERLY REPORT - PAGE 3
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands of Euros, except per share data)
Revenues
Pulp
Energy and chemicals
Costs and expenses
Operating costs
Operating depreciation and amortization
Selling, general and administrative expenses
Operating income
Other income (expense)
Interest expense
Gain (loss) on derivative instruments (Note 8)
Foreign exchange gain (loss) on debt
Total other income (expense)
Income (loss) before income taxes
Income tax benefit (provision)
Current
Deferred
Net income (loss)
Less: net loss (income) attributable to noncontrolling interest
Net income (loss) attributable to common shareholders
Net income (loss) per share attributable to common shareholders (Note 7)
Basic
Diluted
QUARTERLY REPORT - PAGE 4
INTERIM CONSOLIDATED STATEMENTS OF RETAINED EARNINGS
Retained earnings (deficit), beginning of period
Retirement of treasury shares
Retained earnings, end of period
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss), net of taxes
Foreign currency translation adjustment during the three and nine month periods, net of tax provision of €328 and tax benefit of €197, respectively (2011 – benefit of €1,559 and provision of €90)
Pension income (expense)
Unrealized gains (losses) on securities arising during the period
Total comprehensive income (loss)
Comprehensive loss (income) attributable to noncontrolling interest
Comprehensive income (loss) attributable to common shareholders
QUARTERLY REPORT - PAGE 5
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from (used in) operating activities
Adjustments to reconcile net income (loss) attributable to common shareholders to cash flows from operating activities
Loss (gain) on derivative instruments
Foreign exchange loss (gain) on debt
Depreciation and amortization
Noncontrolling interest
Deferred income taxes
Stock compensation expense
Pension and other post-retirement expense, net of funding
Other
Changes in current assets and liabilities
Inventories
Accounts payable and accrued expenses
Net cash from (used in) operating activities
Cash flows from (used in) investing activities
Purchase of property, plant and equipment
Proceeds on sale of property, plant and equipment
Purchase of marketable securities
Proceeds on maturity of marketable securities
Note receivable
Net cash from (used in) investing activities
Cash flows from (used in) financing activities
Repayment of notes payable and debt
Repayment of capital lease obligations
Repayment of credit facilities, net
Payment of note issuance costs
Proceeds from government grants
Purchase of treasury shares
Net cash from (used in) financing activities
Effect of exchange rate changes on cash and cash equivalents
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
QUARTERLY REPORT - PAGE 6
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Supplemental disclosure of cash flow information
Cash paid during the period for
Interest
Income taxes
Supplemental schedule of non-cash investing and financing activities
Acquisition of production and other equipment under capital lease obligations
Increase (decrease) in accrued purchases of property, plant and equipment
Increase (decrease) in receivables of government grants for long-term assets
QUARTERLY REPORT - PAGE 7
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
Note 1. The Company and Summary of Significant Accounting Policies
Basis of Presentation
The interim consolidated financial statements contained herein include the accounts of Mercer International Inc. (“Mercer Inc.”) and its wholly-owned and majority-owned subsidiaries (collectively the “Company”). The Company’s shares of common stock are quoted and listed for trading on both the NASDAQ Global Market and the Toronto Stock Exchange.
The interim consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). The year-end Consolidated Balance Sheet data was derived from audited financial statements. The footnote disclosure included herein has been prepared in accordance with accounting principles generally accepted for interim financial statements in the United States (“GAAP”). The interim consolidated financial statements should be read together with the audited consolidated financial statements and accompanying notes included in the Company’s latest annual report on Form 10-K for the fiscal year ended December 31, 2011. In the opinion of the Company, the unaudited interim consolidated financial statements contained herein contain all adjustments necessary to fairly present the results of the interim periods included. The results for the periods included herein may not be indicative of the results for the entire year.
The Company has three pulp mills that are aggregated into one reportable business segment, market pulp. Accordingly, the results presented are those of the reportable business segment.
Certain prior year amounts in the interim consolidated financial statements have been reclassified to conform to the current year presentation. Beginning in the second quarter of 2012, the Company has presented revenue from the sale of chemicals within energy and chemicals revenue in the Interim Consolidated Statement of Operations. This revenue had previously been presented within operating costs. Chemical revenue for the three and nine month periods ended September 30, 2012 was €2,936 and €8,923, respectively (2011 – €2,287 and €7,762).
In these interim consolidated financial statements, unless otherwise indicated, all amounts are expressed in Euros (“€”). The term “U.S. dollars” and the symbol “$” refer to United States dollars. The symbol “C$” refers to Canadian dollars.
Use of Estimates
Preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Significant management judgment is required in determining the accounting for, among other things, doubtful accounts and reserves, depreciation and amortization, future cash flows associated with impairment testing for long-lived assets, derivative financial instruments, environmental conservation and legal liabilities, asset retirement obligations, pensions and post-retirement benefit obligations, income taxes, contingencies, and inventory obsolescence and provisions. Actual results could differ from these estimates, and changes in these estimates are recorded when known.
QUARTERLY REPORT - PAGE 8
Note 1. The Company and Summary of Significant Accounting Policies (continued)
Recently Implemented Accounting Standards
In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2011-04, Fair Value Measurements(“ASU 2011-04”), which expands the existing disclosure requirements for fair value measurements (particularly for Level 3 inputs) defined under FASB’s Accounting Standards Codification No. 820, Fair Value Measurement(“ASC 820”), and makes other amendments. Many of the amendments to ASC 820 are being made to eliminate wording differences between GAAP and International Financial Reporting Standards and are not intended to result in a change in the application of the requirements of ASC 820. However, some of the amendments clarify the application of existing fair value measurement requirements and others change certain requirements for measuring fair value and could change how the fair value measurement guidance in ASC 820 is applied. The measurement and disclosure requirements of ASU 2011-04 were effective for reporting periods beginning after December 15, 2011 and were applied prospectively. The adoption of this new guidance did not have an impact on the interim consolidated financial statements or related note disclosures.
In June 2011, FASB issued Accounting Standards Update 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”), which revises the manner in which entities present comprehensive income in their financial statements. The new guidance amends FASB’s Accounting Standards Codification No. 220, Comprehensive Income (“ASC 220”), and gives reporting entities the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. Under the two-statement approach, which the Company currently uses, the first statement includes components of net income, and the second statement includes components of other comprehensive income. ASU 2011-05 does not change the items that must be reported in other comprehensive income. This new guidance was effective for reporting periods beginning after December 15, 2011 and was applied retrospectively. The adoption of this guidance did not have an impact on the interim consolidated financial statements or related note disclosures.
Note 2. Inventories
Raw materials
Finished goods
Spare parts, work in process and other
QUARTERLY REPORT - PAGE 9
Note 3. Debt
Debt consists of the following:
Note payable to bank, included in a total loan credit facility of €827,950 to finance the construction related to the Stendal mill (a)
Senior notes, interest at 9.50% accrued and payable semi-annually, unsecured (b)
Credit agreement with a lender with respect to a revolving credit facility of C$40 million (c)
Term bank facility for a project at the Stendal mill of €17,000 (d)
Loans payable to the noncontrolling shareholder of the Stendal mill (e)
Investment loan agreement with a lender with respect to a project at the Rosenthal mill of €4,351 (f)
Credit agreement with a bank with respect to a revolving credit facility of €25,000 (g)
Credit agreement with a bank with respect to a revolving credit facility of €3,500 (h)
Less: current portion
Debt, less current portion
The Company made principal repayments under these facilities of €27,254 during the nine month period ended September 30, 2012 (2011 – €42,511). As of September 30, 2012, the principal maturities of debt are as follows:
Matures
2012
2013
2014
2015
2016
Thereafter
Certain of the Company’s debt instruments were issued under an indenture which, among other things, restricts its ability and the ability of its restricted subsidiaries to make certain payments. These limitations are subject to other important qualifications and exceptions. As at September 30, 2012, the Company was in compliance with the terms of the indenture.
QUARTERLY REPORT - PAGE 10
Note 3. Debt (continued)
On March 13, 2009, the Company finalized an agreement with its lenders to amend its Stendal Loan Facility. The amendment deferred approximately €164,000 of scheduled principal payments until the maturity date, September 30, 2017. The amendment also provided for a 100% cash sweep, referred to as the “Cash Sweep”, of any cash, in excess of a €15,000 working capital reserve and the Guarantee Amount, as discussed in Note 10(a) – Commitments and Contingencies, and other amounts as contemplated in the amendment, held by Stendal which will be used first to fund the DSRA to a level sufficient to service the amounts due and payable under the Stendal Loan Facility during the then following 12 months, which means the DSRA is “Fully Funded”, and second to prepay the deferred principal amounts. As at September 30, 2012, the DSRA balance was €31,821 and was not Fully Funded.
In August 2011, the Company’s Board of Directors authorized the purchase of up to $25.0 million in aggregate principal amount of the Company’s Senior Notes from time to time, over a period ending August 2012. In June 2012, the Company’s Board of Directors authorized the purchase of up to €50,000 in aggregate principal amount of the Company’s Senior Notes from time to time, over a period ending June 2013. During the nine month period ended September 30, 2012, the Company purchased $2.0 million of its outstanding Senior Notes. During the twelve month period ended December 31, 2011, the Company purchased $13.6 million of its outstanding Senior Notes.
The Senior Notes are general unsecured senior obligations of the Company. The Senior Notes rank equal in right of payment with all existing and future senior unsecured indebtedness of the Company and senior in right of payment to any current or future subordinated indebtedness of the Company. The Senior Notes are effectively junior in right of payment to all borrowings of the Company’s restricted subsidiaries, including borrowings under the Company’s credit agreements which are secured by certain assets of its restricted subsidiaries.
The Company may redeem all or a part of the Senior Notes, upon not less than 30 days’ or more than 60 days’ notice, at the redemption prices (expressed as percentages of principal amount) equal to 104.75% for the twelve month period beginning on December 1, 2014, 102.38% for the twelve month period beginning on December 1, 2015, and 100.00% beginning on December 1, 2016 and at any time thereafter, plus accrued and unpaid interest.
QUARTERLY REPORT - PAGE 11
In January 2012, the Stendal mill entered into two additional loans payable by the Stendal mill to its noncontrolling shareholder as part of the financing for Project Blue Mill. The first loan has a principal amount of €1,192 and the second loan has a principal amount of €440. Both loans bear interest at 7.00% per annum and are due in 2017, provided that the Project Blue Mill facility (Note 3(d)) and the Stendal Loan Facility (Note 3(a)) have been fully repaid on such date. The second loan may be repaid prior to October 1, 2017 if the DSRA has been Fully Funded for the first time. The first loan is subordinated to all liabilities of the Stendal mill and the second loan is subordinated to all liabilities of the Stendal mill only until such time as the DSRA is Fully Funded for the first time.
As at September 30, 2012, accrued interest on these loans was €9,392. As at December 31, 2011, accrued interest on the loan was €7,996.
QUARTERLY REPORT - PAGE 12
Note 4. Pension and Other Post-Retirement Benefit Obligations
Included in pension and other post-retirement benefit obligations are amounts related to the Company’s Celgar and Rosenthal mills. The largest component of this obligation is with respect to the Celgar mill which maintains a defined benefit pension plan and post-retirement benefit plans for certain employees (“Celgar Plans”).
Pension benefits are based on employees’ earnings and years of service. The Celgar Plans are funded by contributions from the Company based on actuarial estimates and statutory requirements. Pension contributions during the three and nine month periods ended September 30, 2012 totaled €481 and €1,493, respectively (2011 – €534 and €1,429).
Effective December 31, 2008, the defined benefit plan was closed to new members. In addition, the defined benefit service accrual ceased on December 31, 2008, and members began to receive pension benefits, at a fixed contractual rate, under a new defined contribution plan effective January 1, 2009. During the three and nine month periods ended September 30, 2012, the Company made contributions of €142 and €462, respectively (2011 – €141 and €426) to this plan.
Information about the Celgar Plans, in aggregate for the three and nine month periods ended September 30, 2012 and September 30, 2011 is as follows:
Service cost
Interest cost
Expected return on plan assets
Recognized net loss (gain)
Net periodic benefit cost
The Company participates in a multiemployer plan for hourly-paid employees at the Celgar mill. The contributions to this plan are determined based on an amount per hour worked pursuant to a collective bargaining agreement. The Company has no current or future contribution obligations in excess of the contractual contributions. During the three and nine month periods ended September 30, 2012, the Company made contributions of €632 and €1,572, respectively (2011 – €455 and €1,429) to this plan.
QUARTERLY REPORT - PAGE 13
Note 5. Share Capital
Common shares
The Company has authorized 200,000,000 common shares with a par value of $1 per share.
As at September 30, 2012, the Company had 55,815,704 common shares issued and outstanding. As at December 31, 2011, the Company had 55,779,204 common shares issued and outstanding. During the nine months ended September 30, 2012, the Company issued 36,500 restricted shares to directors of the Company.
Share Repurchase Program
In August 2011, the Company’s Board of Directors authorized a share repurchase program (the “Program”) to repurchase up to $25.0 million worth of the Company’s outstanding common shares from time to time over a period ending August 2012. In July 2012, the Company’s Board of Directors re-authorized the Program to allow for the repurchase of up to approximately $14.4 million of the Company’s outstanding shares of common stock over a period ending August 2013. During the nine month period ended September 30, 2012, the Company did not repurchase any of its common shares. During the twelve month period ended December 31, 2011, the Company repurchased 1,263,401 of its common shares at an aggregate cost of $10.6 million.
Preferred shares
The Company has authorized 50,000,000 preferred shares with $1 par value issuable in series, of which 2,000,000 shares have been designated as Series A. The preferred shares may be issued in one or more series and with such designations and preferences for each series as shall be stated in the resolutions providing for the designation and issue of each such series adopted by the Board of Directors of the Company. The Board of Directors is authorized by the Company’s articles of incorporation to determine the voting, dividend, redemption and liquidation preferences pertaining to each such series. As at September 30, 2012, no preferred shares had been issued by the Company.
Note 6. Stock-Based Compensation
In June 2010, the Company adopted a new stock incentive plan (the “2010 Plan”) which provides for options, restricted stock rights, restricted shares, performance shares, performance share units (“PSUs”) and stock appreciation rights to be awarded to employees, consultants and non-employee directors. As at September 30, 2012, after factoring in all allocated shares, there remain approximately 1.1 million common shares available for grant pursuant to the 2010 Plan.
Performance Shares and PSUs
Performance shares are common shares granted to an employee which have restrictive conditions, such as the ability to sell the shares, until the Company and the grantee achieve certain performance objectives. PSUs comprise rights to receive common shares at a future date that are contingent on the Company and the grantee achieving certain performance objectives.
The fair value of the performance shares and PSUs is recorded as compensation expense over the vesting period. The fair value is determined based upon the targeted number of shares awarded and the quoted price of the Company’s shares at the reporting date. The target number of shares is determined using management’s best estimate. The final determination of the number of shares to be granted or unrestricted will be made by the Company’s Board of Directors. For the three and nine month periods ended September 30, 2012 the Company recognized an expense of €714 and €1,091, respectively, related to the PSUs (2011 expense – €13 and €771).
As at September 30, 2012, there are no performance shares outstanding.
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Note 6. Stock-Based Compensation (continued)
The following table summarizes PSU activity during the period:
Outstanding at January 1, 2011
Granted
Vested and issued
Cancelled
Forfeited
Outstanding at December 31, 2011
Outstanding at September 30, 2012
Restricted Shares
The fair value of restricted shares is determined based upon the number of shares granted and the quoted price of the Company’s shares on the date of grant. Restricted shares generally vest over one year; however, 200,000 restricted shares granted during the year ended December 31, 2011 vest in equal amounts over a five-year period commencing in 2012. The fair value of the restricted shares is recorded as compensation expense on a straight-line basis over the vesting period.
For the three and nine month periods ended September 30, 2012, the Company recognized an expense of €177 and €662, respectively (2011 – €295 and €691) related to the restricted shares. As at September 30, 2012, the total remaining unrecognized compensation cost related to restricted shares amounted to approximately €901 (2011 – €1,642), which will be amortized over the remaining vesting periods.
The following table summarizes restricted share activity during the period:
Vested
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Stock Options
During the nine month periods ended September 30, 2012 and 2011, no options were granted, exercised or cancelled. During the nine month period ended September 30, 2012, no options expired (2011 – 15,000). The aggregate intrinsic value of options is calculated as the difference between the quoted market price for the Company’s common stock as at September 30, 2012, and the exercise price of the stock options for those options where the exercise price is below the quoted market price. As at September 30, 2012, the Company had 130,000 options (2011 – 100,000) with an exercise price below the quoted market price resulting in an aggregate intrinsic value of €145 (2011 - €82). The Company issues new shares upon the exercise of stock options.
Stock option expense recognized for the three and nine month periods ended September 30, 2012 was €nil (2011 – €nil). As at September 30, 2012 the Company had 175,000 stock options which have fully vested.
Note 7. Net Income (Loss) Per Share Attributable to Common Shareholders
Net income (loss) attributable to common shareholders – basic
Interest on convertible notes, net of tax
Net income (loss) attributable to common shareholders – diluted
Net income (loss) per share attributable to common shareholders
Weighted average number of common shares outstanding:
Basic(1)
Effect of dilutive instruments:
Performance shares and PSUs
Restricted shares
Stock options and awards
Convertible notes
QUARTERLY REPORT - PAGE 16
Note 7. Net Income (Loss) Per Share Attributable to Common Shareholders (continued)
The calculation of diluted net income (loss) per share attributable to common shareholders does not assume the exercise of any instruments that would have an anti-dilutive effect on earnings per share. The following table summarizes the instruments excluded from the calculation of net income (loss) per share attributable to common shareholders because they were anti-dilutive.
PSUs
Note 8. Derivative Transactions
The Company is exposed to certain market risks relating to its ongoing business. The Company seeks to manage these risks through internal risk management policies as well as, from time to time, the use of derivatives. The Company currently manages its interest rate risk and a small portion of its pulp sales price risk with the use of derivative instruments. The derivatives are measured at fair value with changes in fair value immediately recognized in the Interim Consolidated Statement of Operations.
Interest Rate Derivative
During 2004, the Company entered into certain variable-to-fixed interest rate swaps in connection with the Stendal Loan Facility with respect to an aggregate maximum principal amount of approximately €612,600 of the principal of the total indebtedness under the Stendal Loan Facility. Under the remaining interest rate swap, the Company pays a fixed rate and receives a floating rate with the interest payments being calculated on a notional amount. Currently, the contract has an aggregate notional amount of €381,489 at a fixed interest rate of 5.28% and it matures in October 2017, which for the most part matches the maturity of the Stendal Loan Facility. With respect to this interest rate swap for the three and nine month periods ended September 30, 2012, the Company recognized unrealized losses of €1,236 and €636, respectively (2011 – losses of €10,484 and €580), in gain (loss) on derivative instruments in the Interim Consolidated Statement of Operations. The fair value of the interest rate swap is presented in unrealized interest rate derivative losses in the Interim Consolidated Balance Sheet, which currently amounts to a cumulative unrealized loss of €53,027. As at December 31, 2011 the unrealized interest rate derivative loss was €52,391.
The interest rate derivative contract is with the same bank that holds the Stendal Loan Facility and the Company does not anticipate non-performance by the bank.
Pulp Price Derivative
During May 2012, the Company entered into a fixed price pulp swap contract with a bank. Under the contract, 5,000 metric tonnes (“MT”) of pulp per month is fixed at a price of $915 per MT. The contract expires in December 2012. With respect to this contract for the three and nine month periods ended September 30, 2012, the Company recognized gains of €353 and €1,972, respectively in gain (loss) on derivative instruments in the Interim Consolidated Statement of Operations. The fair value of the fixed price pulp swap contract was €1,462 as at September 30, 2012 and was presented in prepaid expenses and other in the Interim Consolidated Balance Sheet.
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Note 9. Financial Instruments
The fair value of financial instruments is summarized as follows:
Marketable securities(1)
Pulp price derivative contract – asset
Debt
Interest rate derivative contract – liability
The carrying value of cash and cash equivalents and accounts payable and other approximates the fair value due to the immediate or short-term maturity of these financial instruments. The carrying value of receivables approximates the fair value due to their short-term nature and historical collectability. The fair value of debt reflects recent market transactions and discounted cash flow estimates. Marketable securities are recorded at fair value based on recent transactions. See the Fair Value Measurement and Disclosure section below for details on how the fair value of the pulp price derivative contract and interest rate derivative contract was determined.
Many of the Company’s transactions are denominated in foreign currencies, primarily the U.S. dollar. As a result of these transactions, the Company and its subsidiaries have financial risk that the value of the Company’s financial instruments will vary due to fluctuations in foreign exchange rates.
Fair Value Measurement and Disclosure
The fair value methodologies and, as a result, the fair value of the Company’s investments and derivative instruments are determined based on the fair value hierarchy provided in the Fair Value Measurements and Disclosures topic of the FASB Accounting Standards Codification, and are as follows:
Level 1 – Valuations based on quoted prices in active markets for identical assets and liabilities.
Level 2 – Valuations based on observable inputs in active markets for similar assets and liabilities, other than Level 1 prices, such as quoted commodity prices or interest or currency exchange rates.
Level 3 – Valuations based on significant unobservable inputs that are supported by little or no market activity, such as discounted cash flow methodologies based on internal cash flow forecasts.
The Company classified its marketable securities within Level 1 of the valuation hierarchy because quoted prices are available in an active market for both exchange-traded equities and the German federal government bonds.
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Note 9. Financial Instruments (continued)
The Company’s interest rate and pulp price derivatives are classified within Level 2 of the valuation hierarchy, as they are valued using internal models that use as their basis readily observable market inputs, such as forward interest rates, yield curves observable at specified intervals and commodity price curves. The observable inputs reflect market data obtained from independent sources. In addition, the Company considered the risk of non-performance of the obligor, which in some cases reflects the Company’s own credit risk. The counterparty to our interest rate and pulp price derivatives are multi-national financial institutions.
The following table presents a summary of the Company’s outstanding financial instruments and their estimated fair values under the hierarchy defined in Fair Value Measurements and Disclosures Topic of the FASB Accounting Standards Codification:
Assets
Exchange traded equities
Derivative—fixed price pulp swaps
Liabilities
Derivative—interest rate swap
German federal government bonds
QUARTERLY REPORT - PAGE 19
Note 10. Commitments and Contingencies
The €10,000 was initially recognized as an increase in cash and a corresponding increase in accounts payable and other. As civil works remediation steps are agreed to with the general construction contractor an agreed-to portion of the payable is reversed with the offset recorded in operating costs to offset the remediation expenditures. In January 2012, the noncontrolling shareholder contributed its required €1,632 from the Guarantee Amount as part of the financing agreement for Project Blue Mill. This contribution was reclassified to long-term debt as part of the loan payable to the noncontrolling shareholder. See Note 3(e) – Debt. As at September 30, 2012, the Company had Guarantee Amount proceeds of €3,769 remaining in accounts payable and other.
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Note 11. Restricted Group Supplemental Disclosure
The terms of the indenture governing our Senior Notes require that we provide the results of operations and financial condition of Mercer International Inc. and our restricted subsidiaries under the indenture, collectively referred to as the “Restricted Group”. As at and during the three and nine months ended September 30, 2012 and 2011, the Restricted Group was comprised of Mercer International Inc., certain holding subsidiaries and our Rosenthal and Celgar mills. The Restricted Group excludes the Stendal mill.
Combined Condensed Balance Sheets
Due from unrestricted group
Pension and other post-retirement benefit obligations
Due to restricted group
Unrealized interest rate derivative losses
Total shareholders’ equity (deficit)
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Note 11. Restricted Group Supplemental Disclosure (continued)
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Combined Condensed Statements of Operations
Operating income (loss)
Gain (loss) on derivative instruments
Income tax provision
Less: net income attributable to noncontrolling interest
Foreign exchange loss on debt
Less: net loss attributable to noncontrolling interest
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Foreign exchange gain on debt
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Combined Condensed Statements of Cash Flows
Other(1)
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In this document: (i) unless the context otherwise requires, references to “we”, “our”, “us”, the “Company” or “Mercer” mean Mercer International Inc. and its subsidiaries; (ii) references to “Mercer Inc.” mean the Company excluding its subsidiaries; (iii) information is provided as of September 30, 2012, unless otherwise stated; (iv) all references to monetary amounts are to “Euros”, the lawful currency adopted by most members of the European Union, unless otherwise stated; (v) “€” refers to Euros, “$” refers to U.S. dollars and “C$” refers to Canadian dollars; (vi) “ADMTs” refers to air-dried metric tonnes; (vii) “MW” refers to megawatts; and (viii) “MWh” refers to megawatt hours.
Results of Operations
General
We operate three northern bleached softwood kraft (“NBSK”) pulp mills through our wholly owned subsidiaries, Rosenthal and Celgar, and our 74.9% owned subsidiary, Stendal, which have a consolidated annual production capacity of approximately 1.5 million ADMTs.
The following discussion and analysis of our results of operations and financial condition for the three and nine months ended September 30, 2012 should be read in conjunction with our interim consolidated financial statements and related notes included in this quarterly report, as well as our most recent annual report on Form 10-K for the fiscal year ended December 31, 2011 filed with the Securities and Exchange Commission (the “SEC”).
Current Market Environment
During the three months ended September 30, 2012, NBSK pulp prices decreased due to global economic uncertainty and the traditionally low pulp demand of the summer period. We believe that the market is bottoming and we currently anticipate that NBSK pulp prices will begin to gradually increase in the medium term as a result of improving demand and the relatively low level of NBSK inventories globally.
QUARTERLY REPORT - PAGE 29
Third Quarter Operational Snapshot
Selected production, sales and exchange rate data for the three and nine months ended September 30, 2012 and 2011 is as follows:
Pulp production (‘000 ADMTs)
Scheduled production downtime (‘000 ADMTs)
Pulp sales (‘000 ADMTs)
Pulp revenues (in millions)
Average NBSK pulp list prices in Europe ($/ADMT)(1)
Average NBSK pulp list prices in Europe (€/ADMT)
Average pulp sales realizations (€/ADMT)(2)
Energy production (‘000 MWh)
Energy sales (‘000 MWh)
Energy revenue (in millions)
Average energy sales realizations (€/MWh)
Chemical sales revenue (in millions)
Total energy and chemical sales revenue (in millions)
Average spot currency exchange rates
€ / $(3)
C$ / $(3)
C$ / €(4)
Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011
Total revenues for the three months ended September 30, 2012 increased to €223.3 million ($279.6 million) from €207.1 million ($292.4 million) in the same period in 2011, due to higher pulp and energy sales volumes and a stronger U.S. dollar relative to the Euro, partially offset by lower average pulp realizations.
Pulp revenues for the three months ended September 30, 2012 increased to €205.1 million from €190.4 million in the comparative quarter of 2011, primarily due to record pulp sales volumes and a stronger U.S. dollar relative to the Euro, partially offset by lower average pulp realizations. The U.S. dollar was approximately 13% stronger versus the Euro in the current quarter compared to the same quarter of last year.
Energy and chemical revenues increased by approximately 10% to €18.2 million in the third quarter from €16.6 million in the same quarter last year, primarily as a result of strong production at all of our mills. Energy and chemical revenues in the quarter included €15.2 million from the sale of electricity and €2.9 million of revenue from the sale of a biochemical called tall oil. Tall oil had previously been classified as an offset to operating costs and has been included with revenues as we currently expect proceeds from the sale of tall oil to remain stable in future periods.
QUARTERLY REPORT - PAGE 30
List prices for NBSK pulp in Europe were approximately €620 ($777) per ADMT in the current quarter, compared to €694 ($980) per ADMT in the same quarter last year. In the third quarter of 2012, average pulp sales realizations decreased by 14% to €501 ($627) per ADMT from €584 ($824) per ADMT in the same quarter last year, primarily due to lower pulp prices, partially offset by a stronger U.S. dollar relative to the Euro.
Pulp production increased to 373,369 ADMTs in the current quarter from 362,330 ADMTs in the same quarter of 2011, due to increased production at our Rosenthal and Stendal mills. We took seven days (approximately 10,200 ADMTs) of scheduled maintenance downtime at our Celgar mill in the third quarter of 2012.
Pulp sales volumes increased by approximately 26% and 16% to a record 404,301 ADMTs in the current quarter from 321,338 ADMTs and 349,177 ADMTs in the comparative and prior quarters, respectively, primarily as a result of increased sales to China. During the current quarter, our Celgar and Stendal mills ramped up sales volumes to realize upon increased demand from China in the latter part of the quarter and re-balanced their inventory levels.
Costs and expenses in the third quarter of 2012 increased by 26% to €216.1 million from €171.8 million in the comparative period of 2011, primarily due to a 26% increase in sales volumes.
In the third quarter of 2012, operating depreciation and amortization increased to €15.0 million from €13.8 million in the same quarter last year. Selling, general and administrative expenses were €10.0 million in the third quarter of 2012, compared to €8.8 million in the third quarter of 2011, primarily as a result of higher stock compensation and selling costs.
Transportation costs increased to €21.1 million in the third quarter of 2012 from €15.3 million in the third quarter of 2011, primarily due to higher sales volumes, including significantly higher sales to China.
On average, our per unit fiber costs in the current quarter decreased by approximately 9% from the same period in 2011, due to lower fiber costs in Germany caused by reduced demand for fiber by other residual fiber users. Fiber costs at our Celgar mill were slightly higher, primarily due to increased demand for fiber. As we move into the fourth quarter, we currently expect fiber prices for our German mills to increase slightly as a result of seasonal demand and to decline slightly at our Celgar mill due to increased regional sawmill activity.
For the third quarter of 2012, operating income decreased to €7.2 million from €35.3 million in the comparative quarter of 2011, primarily due to lower average pulp realizations, partially offset by a stronger U.S. dollar relative to the Euro and lower fiber costs.
Interest expense in the third quarter of 2012 and 2011 was unchanged at €14.1 million.
We recorded a derivative loss of €0.9 million, which includes an approximately €0.3 million gain related to a fixed price pulp swap contract entered into in the second quarter of 2012 and an unrealized loss of €1.2 million on the mark to market adjustment of our Stendal mill’s interest rate derivative, compared to an unrealized derivative loss of €10.5 million in the same quarter of last year. We did not incur any foreign exchange gain or loss on our foreign currency denominated debt in the third quarter of 2012, compared to a loss of €0.2 million in the same period of 2011.
QUARTERLY REPORT - PAGE 31
During the current quarter, we recorded an income tax expense of €1.9 million, compared to an expense of €3.1 million in the same quarter of 2011, due to decreased taxable income.
In the third quarter of 2012, the noncontrolling shareholder’s interest in the Stendal mill’s income was €0.6 million, compared to a loss of €0.8 million in the same quarter last year.
We reported a net loss attributable to common shareholders of €9.7 million, or €0.17 per basic and diluted share, for the third quarter of 2012, which included a total non-cash unrealized loss of €1.3 million on the fixed price pulp swaps and Stendal interest rate derivative and a non-cash charge for stock compensation of €0.9 million. In the third quarter of 2011, net income attributable to common shareholders was €8.4 million, or €0.15 per basic and diluted share, which included a non-cash unrealized loss of €10.7 million, or €0.19 per basic share, on the Stendal interest rate derivative and foreign exchange losses on certain of our foreign currency denominated debt and a non-cash charge for stock compensation of €0.3 million.
Operating EBITDA in the third quarter of 2012 was €22.3 million, compared to €49.2 million in the third quarter of 2011. Operating EBITDA is defined as operating income (loss) plus depreciation and amortization and non-recurring capital asset impairment charges. Management uses Operating EBITDA as a benchmark measurement of its own operating results, and as a benchmark relative to its competitors. Management considers it to be a meaningful supplement to operating income (loss) as a performance measure primarily because depreciation expense and non-recurring capital asset impairment charges are not an actual cash cost, and depreciation expense varies widely from company to company in a manner that management considers largely independent of the underlying cost efficiency of their operating facilities. In addition, we believe Operating EBITDA is commonly used by securities analysts, investors and other interested parties to evaluate our financial performance.
Operating EBITDA does not reflect the impact of a number of items that affect our net income (loss) attributable to common shareholders, including financing costs and the effect of derivative instruments. Operating EBITDA is not a measure of financial performance under the accounting principles generally accepted in the United States of America (“GAAP”), and should not be considered as an alternative to net income (loss) or income (loss) from operations as a measure of performance, nor as an alternative to net cash from operating activities as a measure of liquidity.
Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that Operating EBITDA does not reflect: (i) our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) changes in, or cash requirements for, working capital needs; (iii) the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt; (iv) noncontrolling interests on our Stendal mill operations; (v) the impact of realized or marked to market changes in our derivative positions, which can be substantial; and (vi) the impact of impairment charges against our investments or assets. Because of these limitations, Operating EBITDA should only be considered as a supplemental operational performance measure and should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. See the Statement of Cash Flows set out in our interim consolidated financial statements included herein. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA or EBITDA as calculated by other companies. We compensate for these limitations by using Operating EBITDA as a supplemental measure of our operational performance and relying primarily on our GAAP financial statements.
QUARTERLY REPORT - PAGE 32
The following table provides a reconciliation of net income (loss) attributable to common shareholders to operating income and Operating EBITDA for the periods indicated:
Net income (loss) attributable to noncontrolling interest
Other expense (income)
Add: Depreciation and amortization
Operating EBITDA
Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011
Total revenues for the nine months ended September 30, 2012 decreased to €645.7 million ($827.9 million) from €667.9 million ($939.5 million) in the same period of 2011, primarily due to lower average pulp prices, partially offset by higher pulp and energy sales volumes and a stronger U.S. dollar relative to the Euro.
Pulp revenues for the nine months ended September 30, 2012 decreased to €590.6 million from €618.2 million in the comparative period of 2011, primarily due to lower pulp prices, partially offset by higher sales volumes and a stronger U.S. dollar compared to the Euro. The U.S. dollar was approximately 10% stronger versus the Euro in the nine months ended September 30, 2012 compared to the same period of 2011.
Energy and chemical revenues increased by approximately 11% to €55.1 million in the nine months ended September 30, 2012 from €49.7 million in the same period last year, primarily as a result of strong production at all of our mills. Energy and chemical revenues in the period include €46.2 million in revenues from the sale of electricity at our mills and €8.9 million from the sale of tall oil at our Stendal mill.
List prices for NBSK pulp in Europe were approximately €637 ($817) per ADMT in the nine months ended September 30, 2012, compared to €701 ($986) per ADMT in the same period of 2011. In the nine months ended September 30, 2012, average pulp sales realizations decreased by 14% to €512 ($656) per ADMT from €592 ($833) per ADMT in the same period last year, primarily due to lower pulp prices, partially offset by a stronger U.S. dollar relative to the Euro.
QUARTERLY REPORT - PAGE 33
Pulp production increased to 1,118,758 ADMTs in the nine months ended September 30, 2012 from 1,088,801 ADMTs in the same period of 2011, due to increased pulp production at our Celgar and Stendal mills.
Pulp sales volumes increased by approximately 11% to 1,138,304 ADMTs in the nine months ended September 30, 2012 from 1,027,918 ADMTs in the comparative period of 2011, primarily as a result of a significant increase in sales to China. During the third quarter of 2012, our Celgar and Stendal mills ramped up sales volumes to take advantage of increased demand from China in the latter part of the third quarter and re-balanced their inventory levels.
Costs and expenses in the nine months ended September 30, 2012 increased by approximately 8% to €603.9 million from €559.7 million in the same period of 2011, primarily due to an 11% increase in sales volumes, partially offset by lower fiber costs.
In the nine months ended September 30, 2012, operating depreciation and amortization increased to €43.8 million from €41.8 million in the same period last year. Selling, general and administrative expenses were €28.7 million in the nine months ended September 30, 2012, compared to €27.4 million in the same period of 2011.
Transportation costs increased to €56.5 million in the nine months ended September 30, 2012 from €47.5 million in the same period of 2011, primarily due to increased shipments to China and higher container costs.
On average, our per unit fiber costs in the nine months ended September 30, 2012 decreased by approximately 6% from the same period in 2011, primarily due to lower fiber costs in Germany caused by decreased demand from other residual fiber users. Fiber costs at our Celgar mill were higher, primarily due to increased demand for fiber. As we move into the fourth quarter, we currently expect fiber prices for our German mills to increase slightly as a result of seasonal demand and to decline slightly at our Celgar mill due to increased regional sawmill activity.
For the nine months ended September 30, 2012, operating income decreased to €41.8 million from €108.2 million in the same period of 2011, primarily due to lower pulp prices, partially offset by a stronger U.S. dollar relative to the Euro and lower fiber costs.
Interest expense in the nine months ended September 30, 2012 decreased to €42.1 million from €44.9 million in the comparative period of 2011, primarily due to reduced debt levels associated with the Stendal mill and the conversion of our remaining convertible notes in 2011.
We recorded a derivative gain of €1.3 million which included an approximately €1.9 million gain related to a fixed price pulp swap contract entered into in the second quarter of 2012, partially offset by an unrealized loss of €0.6 million on the mark to market adjustment of our Stendal mill’s interest rate derivative during the nine months ended September 30, 2012, compared to an unrealized derivative loss of €0.6 million in the same period of 2011. We did not incur a foreign exchange gain or loss on our foreign currency denominated debt in the nine months ended September 30, 2012, compared to a gain of €1.3 million in the same period of 2011.
Our current tax expense increased to €7.2 million, compared to €3.9 million in the same period of 2011, primarily relating to changes in uncertain positions as a result of certain ongoing tax audits during the current period. Accordingly, we also reversed certain valuation allowances during the nine months ended September 30, 2012, resulting in a deferred tax recovery of €2.3 million, compared to a deferred tax provision of €3.7 million for the comparative period of 2011.
QUARTERLY REPORT - PAGE 34
In the nine months ended September 30, 2012, the noncontrolling shareholder’s interest in the Stendal mill’s income was €2.9 million, compared to €5.2 million in the same period last year.
We reported net loss attributable to common shareholders of €7.0 million, or €0.13 per basic and diluted share, for the nine months ended September 30, 2012, which included a total non-cash unrealized gain of €0.8 million on the fixed price pulp swaps and Stendal interest rate derivative, more than offset by a non-cash charge for stock compensation of €1.8 million. In the nine months ended September 30, 2011, net income attributable to common shareholders was €51.9 million, or €1.07 per basic and €0.92 per diluted share, which included a non-cash unrealized loss of €0.6 million on the Stendal interest rate derivative, a €1.3 million non-cash foreign exchange gain on certain of our foreign currency denominated debt and a non-cash charge for stock compensation of €2.8 million.
Operating EBITDA in the nine months ended September 30, 2012 was €85.7 million, compared to €150.1 million in the same period of 2011. Operating EBITDA is defined as operating income (loss) plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the three months ended September 30, 2012 for additional information relating to such limitations of Operating EBITDA.
Net income attributable to noncontrolling interest
QUARTERLY REPORT - PAGE 35
Liquidity and Capital Resources
The following table is a summary of selected financial information at the dates indicated:
As at
September 30,
December 31,
Financial Position
Working capital
As at September 30, 2012, our cash and cash equivalents and short-term German federal government bonds increased to €126.2 million from €117.3 million and working capital had decreased to €220.5 million from €247.2 million compared to the end of 2011.
Sources and Uses of Funds
Our principal sources of funds are cash flows from operations, cash on hand and the revolving working capital loan facilities for our Celgar and Rosenthal mills. Our principal uses of funds consist of operating expenditures, payments of principal and interest on the project loan facilities relating to our development of the Stendal mill (“Stendal Loan Facility”) and for its Project Blue Mill, capital expenditures and interest payments on our outstanding 9.5% Senior Notes (the “Senior Notes”).
In October 2012, we extended our €25.0 million Rosenthal revolving working capital facility to October 31, 2016.
Debt Covenants
Our long-term obligations contain various financial tests and covenants customary to these types of arrangements.
Our Stendal mill has established the Stendal Loan Facility and a project loan facility for Project Blue Mill (collectively the “Facilities”) which require Stendal to maintain a similar leverage ratio of total debt thereunder to EBITDA (the “Stendal Ratio”). An aggregate of 80% of the principal amount of the tranches under the Facilities are severally guaranteed by German federal and state governments, and the Facilities are without recourse to the “Restricted Group” which is comprised of Mercer Inc., the Rosenthal and Celgar mills, and certain holding subsidiaries. Because of volatility in foreign exchange rates and pulp prices we can give no assurance that the Stendal mill will be in compliance with the Stendal Ratio as of December 31, 2012. We have entered into discussions with the Stendal mill’s lenders and currently expect to receive, if required, a satisfactory amendment or waiver. Additionally, we have the right to cure any breach of the Stendal Ratio by providing additional equity to Stendal. In the event that the Stendal mill is not in compliance with the Stendal Ratio, we are not able to acquire a satisfactory amendment or waiver of such covenant, and we do not undertake to cure the breach by providing additional equity to Stendal, the Stendal mill would be in default under the Facilities and the Stendal mill’s lenders would be entitled to pursue their remedies thereunder. This would have a material adverse effect on the Stendal mill, our business and our consolidated results of operations.
QUARTERLY REPORT - PAGE 36
As at September 30, 2012, we were in compliance with all of the covenants of our indebtedness.
Cash Flow Analysis
Cash Flows from Operating Activities. We operate in a cyclical industry and our operating cash flows vary accordingly. Our principal operating cash expenditures are for labor, fiber and chemicals.
Working capital levels fluctuate throughout the year and are affected by maintenance downtime, changing sales patterns, seasonality and the timing of receivables and the payment of payables and expenses.
Cash provided by operating activities decreased to €62.5 million in the nine months ended September 30, 2012 from €107.7 million in the comparative period of 2011, primarily due to our weaker operating results. An increase in accounts payable and accrued expenses provided cash of €13.1 million, compared to €24.9 million in the same period of 2011. A decrease in inventories provided cash of €9.3 million in the nine months ended September 30, 2012, compared to an increase in inventories using cash of €27.9 million in the same period of 2011. A decrease in receivables provided cash of €0.9 million in the nine months ended September 30, 2012, compared to €3.2 million in the same period of 2011.
Cash Flows from Investing Activities. Investing activities in the nine months ended September 30, 2012 used cash of €14.8 million, compared to using cash of €25.4 million in the same period of 2011. Capital expenditures in the nine months ended September 30, 2012 used cash of €27.5 million, compared to €26.1 million in the same period of 2011. Capital expenditures in the nine months ended September 30, 2012 primarily related to the recovery boiler upgrade project at our Rosenthal mill and Project Blue Mill at our Stendal mill. Proceeds on maturity of marketable securities provided cash of €12.2 million, compared to purchases of marketable securities using cash of €4.0 million in the same period of 2011.
Cash Flows from Financing Activities. In the nine months ended September 30, 2012, financing activities used cash of €27.3 million, primarily for scheduled Stendal loan facility principal repayments. In the comparative period of 2011, financing activities used cash of €53.5 million, primarily as a result of cash of €15.2 million used to redeem our 9.25% Senior Notes due 2013, €23.2 million used to repay the principal amount under the Stendal loan facility and €14.7 million used to repay borrowings under the revolving facility at our Celgar mill.
Capital Commitments and Future Liquidity
As at September 30, 2012, we had approximately €17.1 million of capital commitments related to our €40.0 million Project Blue Mill at the Stendal mill and deposited €7.1 million in a separate investment account to manage Project Blue Mill’s costs and funding. Project Blue Mill has also received an investment decree, determining that it qualifies for up to €12.0 million in governmental grants, comprised of €9.2 million of investment incentives and €2.8 million of tax grants. The actual receipt of such grants is subject to the Stendal mill satisfying all governmental rules including verification. The investment decree is a condition of our accessing the Project Blue Mill loan facility. The Stendal mill, based on expenditures to date, has currently applied for €1.2 million in grants and is awaiting approval and receipt.
QUARTERLY REPORT - PAGE 37
Based upon the current level of operations and our current expectations for future periods in light of the current economic environment, and in particular, current and expected pulp pricing and foreign exchange rates, we believe that cash flow from operations and available cash, together with available borrowings will be adequate to meet our liquidity needs in the next 12 months.
Other than commitments relating to Project Blue Mill, we currently have no material commitments to acquire assets or operating businesses. We anticipate that there may be acquisitions or commitments to capital projects in the future. To achieve the long-term goals of expanding our assets and earnings, additional capital resources may be required. Depending on the size of a transaction or project, the capital resources that will be required can be substantial. The necessary resources will be generated from cash flow from operations, cash on hand, borrowing against our assets or the issuance of securities.
Contractual Obligations and Commitments
There were no material changes outside the ordinary course to any of our material contractual obligations during the nine months ended September 30, 2012.
The collective agreement with our hourly workers at our Celgar mill expired on April 30, 2012. Initial collective agreement discussions with the union are currently underway. The Union has received a strike vote from the hourly workers and can effect a strike at the mill upon 72 hours’ notice. We continue to work toward a satisfactory new agreement with the Celgar work forces. However, currently we can provide no assurance that we can achieve such an agreement without a work stoppage or other disruption. A significant work stoppage or disruption at the Celgar mill could have a material adverse effect on our consolidated results of operations.
Foreign Currency
Our reporting currency is the Euro as the majority of our business transactions are denominated in Euros. However, we hold certain assets and liabilities in U.S. dollars and Canadian dollars. Accordingly, our consolidated financial results are subject to foreign currency exchange rate fluctuations.
We translate foreign denominated assets and liabilities into Euros at the rate of exchange on the balance sheet date. Equity accounts are translated using historical exchange rates. Unrealized gains or losses from these translations are recorded in our Consolidated Statement of Comprehensive Income (Loss) and impact shareholders’ equity on the Consolidated Balance Sheet but do not affect our net income.
In the nine months ended September 30, 2012, accumulated other comprehensive income increased by €7.8 million to €29.1 million, primarily due to the foreign currency translation adjustment.
Based upon the exchange rate at September 30, 2012, the U.S. dollar has strengthened by approximately 5% in value against the Euro since September 30, 2011. See “Quantitative and Qualitative Disclosures about Market Risk”.
QUARTERLY REPORT - PAGE 38
Results of Operations of the Restricted Group under our Senior Note Indenture
The indenture governing our Senior Notes requires that we also provide a discussion in annual and quarterly reports we file with the SEC under Management’s Discussion and Analysis of Financial Condition and Results of Operations of the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, referred to as the “Restricted Group”. The Restricted Group is comprised of Mercer Inc., our Rosenthal and Celgar mills and certain holding subsidiaries. The Restricted Group excludes our Stendal mill.
The following is a discussion of the results of operations and financial condition of the Restricted Group. For further information regarding the Restricted Group including, without limitation, a reconciliation to our consolidated results of operations, see Note 11 of our Interim Consolidated Financial Statements included herein.
Restricted Group Results — Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011
Total revenues for the Restricted Group increased to €119.7 million ($149.9 million) in the third quarter of 2012, compared to €117.8 million ($166.3 million) in the third quarter of 2011, primarily due to higher pulp and energy sales volumes and a stronger U.S. dollar relative to the Euro, partially offset by lower average pulp realizations.
Pulp revenues for the Restricted Group for the three months ended September 30, 2012 increased marginally to €112.8 million from €111.6 million in the comparative period of 2011, primarily due to higher pulp sales volumes and a stronger U.S. dollar relative to the Euro, largely offset by lower average pulp realizations. The U.S. dollar was approximately 13% stronger versus the Euro in the third quarter of 2012 compared to the third quarter of 2011. Energy revenues increased by approximately 15% in the current quarter to €7.0 million from €6.1 million in the same period last year, due to increased energy sales at our Celgar and Rosenthal mills.
List prices for NBSK pulp in Europe were approximately €620 ($777) per ADMT in the current quarter, compared to €694 ($980) per ADMT in the same quarter last year. In the third quarter of 2012, average pulp sales realizations for the Restricted Group decreased by 14% to €502 ($629) per ADMT from €587 ($829) per ADMT in the same period last year due to lower pulp prices, partially offset by a stronger U.S. dollar relative to the Euro.
Pulp production for the Restricted Group marginally decreased to 204,124 ADMTs in the third quarter of 2012 from 206,907 ADMTs in the same period of 2011, primarily due to lower production at our Celgar mill.
Pulp sales volumes of the Restricted Group increased by approximately 18% to 224,696 ADMTs in the third quarter of 2012 from 190,013 ADMTs in the comparative period of 2011, primarily due to increased sales to China. During the current quarter, our Celgar mill ramped up sales volumes to realize upon increased demand from China and re-balanced its inventory levels.
Costs and expenses for the Restricted Group in the third quarter of 2012 increased by approximately 25% to €124.5 million from €99.4 million in the comparative period of 2011, primarily due to an approximately 18% increase in sales volumes.
QUARTERLY REPORT - PAGE 39
In the third quarter of 2012, operating depreciation and amortization for the Restricted Group was €8.3 million, compared to €7.4 million in the same quarter last year. Selling, general and administrative expenses for the Restricted Group were €6.4 million, compared to €6.1 million in the same period of 2011.
Transportation costs for the Restricted Group increased to €14.6 million in the third quarter of 2012 from €11.6 million in the same quarter last year due to increased volume of sales, including increased sales to China.
Overall, per unit fiber costs of the Restricted Group in the third quarter of 2012 decreased by approximately 4% compared to the same period in 2011, due to lower fiber costs at our Rosenthal mill resulting from reduced demand for fiber from other residual fiber users.
In the third quarter of 2012, the Restricted Group reported an operating loss of €4.8 million compared to operating income of €18.3 million in the third quarter of 2011, primarily due to lower average pulp sales realizations, partially offset by a stronger U.S. dollar relative to the Euro.
Interest expense for the Restricted Group increased to €6.0 million in the third quarter of 2012 from €5.5 million in the same quarter last year, primarily due to the foreign exchange impact on the interest expense of our U.S. dollar denominated Senior Notes.
In the third quarter of 2012, there was no foreign exchange effect on the Restricted Group’s foreign currency denominated debt, compared to a loss of €0.2 million in the third quarter of 2011. The Restricted Group also recorded a gain on derivative instruments of approximately €0.3 million related to a fixed price pulp swap contract entered into in the second quarter of 2012.
During the third quarter of 2012, the Restricted Group recorded €1.2 million of income tax expense, compared to income tax expense of €2.6 million in the same period last year.
The Restricted Group reported a net loss for the third quarter of 2012 of €10.0 million, compared to net income of €11.4 million in the same period last year.
In the third quarter of 2012, the Restricted Group reported Operating EBITDA of €3.6 million, compared to Operating EBITDA of €25.8 million in the comparative quarter of 2011. Operating EBITDA is defined as operating income (loss) plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our consolidated results for the three months ended September 30, 2012 for additional information relating to such limitations of Operating EBITDA.
QUARTERLY REPORT - PAGE 40
The following table provides a reconciliation of net income (loss) to operating income (loss) and Operating EBITDA for the Restricted Group for the periods indicated:
Restricted Group(1)
Gain on derivative instruments
Restricted Group Results — Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011
Total revenues for the Restricted Group decreased to €347.8 million ($445.9 million) in the nine months ended September 30, 2012, compared to €369.8 million ($520.2 million) in the same period of 2011 due to lower average pulp realizations, partially offset by higher energy revenues and a stronger U.S. dollar relative to the Euro.
Pulp revenues for the Restricted Group for the nine months ended September 30, 2012 decreased to €326.4 million from €352.1 million in the comparative period of 2011, primarily due to lower pulp prices, partially offset by higher sales volumes and a stronger U.S. dollar relative to the Euro. The U.S. dollar was approximately 10% stronger versus the Euro in the nine months ended September 30, 2012, compared to the same period of 2011. Energy revenues increased by approximately 21% in the nine months ended September 30, 2012 to €21.4 million from €17.7 million in the same period last year, primarily due to increased energy sales at our Celgar mill.
List prices for NBSK pulp in Europe were approximately €637 ($817) per ADMT in the nine months ended September 30, 2012, compared to €701 ($986) per ADMT in the same period last year. In the nine months ended September 30, 2012, average pulp sales realizations for the Restricted Group decreased by approximately 14% to €514 ($659) per ADMT from €596 ($838) per ADMT in the same period last year.
Pulp production for the Restricted Group increased marginally to 616,837 ADMTs in the nine months ended September 30, 2012 from 611,139 ADMTs in the same period of 2011.
Pulp sales volumes of the Restricted Group increased to 634,687 ADMTs in the nine months ended September 30, 2012 from 590,448 ADMTs in the comparative period of 2011, primarily due to increased sales to China.
Costs and expenses for the Restricted Group in the nine months ended September 30, 2012 increased to €345.0 million from €312.1 million in the comparative period of 2011, primarily due to higher sales volumes.
QUARTERLY REPORT - PAGE 41
In the nine months ended September 30, 2012, operating depreciation and amortization for the Restricted Group was €23.8 million, compared to €22.4 million in the same period last year. Selling, general and administrative expenses for the Restricted Group increased slightly to €18.3 million from €17.6 million in the comparative period of 2011.
Transportation costs for the Restricted Group increased to €40.3 million in the nine months ended September 30, 2012 from €35.1 million in the same period last year due to increased shipments to China.
Overall, per unit fiber costs of the Restricted Group in the nine months ended September 30, 2012 were flat, compared to the same period in 2011.
In the nine months ended September 30, 2012, the Restricted Group reported operating income of €2.8 million compared to operating income of €57.7 million in the same period of 2011, primarily due to lower average pulp realizations.
Interest expense for the Restricted Group decreased to €17.8 million in the nine months ended September 30, 2012 from €19.2 million in the same period last year, primarily due to the conversion of our convertible notes in 2011.
In the nine months ended September 30, 2012, there was no foreign exchange effect on the Restricted Group’s foreign currency denominated debt, compared to a gain of €1.3 million in the nine months ended September 30, 2011.
The Restricted Group recorded a gain on derivative instruments of approximately €1.9 million related to a fixed price pulp swap contract entered into in the second quarter of 2012, compared to €nil in the same period last year.
Other income for the Restricted Group decreased to €3.4 million in the nine months ended September 30, 2012 from €3.8 million in the same period of 2011, primarily as a result of the net costs of our take-over bid for Fibrek Inc.
During the nine months ended September 30, 2012, the Restricted Group recorded €3.3 million of income tax expense, compared to income tax expense of €5.9 million in the same period last year.
The Restricted Group reported a net loss of €12.8 million for the nine months ended September 30, 2012, compared to net income of €37.6 million in the same period last year.
In the nine months ended September 30, 2012, the Restricted Group reported Operating EBITDA of €26.8 million compared to Operating EBITDA of €80.2 million in the comparative period of 2011. Operating EBITDA is defined as operating income (loss) plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our consolidated results for the three months ended September 30, 2012 for additional information relating to such limitations of Operating EBITDA.
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The following table provides a reconciliation of net income (loss) to operating income and Operating EBITDA for the Restricted Group for the periods indicated:
Liquidity and Capital Resources of the Restricted Group
The following table is a summary of selected financial information for the Restricted Group at the dates indicated:
Restricted Group Financial Position(1)
At September 30, 2012, cash and cash equivalents and holdings of short-term German federal government bonds for the Restricted Group decreased to €55.0 million from €57.0 million at the end of 2011.
We currently expect the Restricted Group to meet its interest and debt service obligations and meet the working and maintenance capital requirements for its operations for the next 12 months with cash flow from operations, cash on hand and available borrowings.
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Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect both the amount and the timing of the recording of assets, liabilities, revenues, and expenses in the consolidated financial statements and accompanying note disclosure. Our management routinely makes judgments and estimates about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the probable future resolution of the uncertainties increase, these judgments become even more subjective and complex.
Our significant accounting policies are disclosed in Note 1 to our annual report on Form 10-K for the fiscal year ended December 31, 2011. While all of the significant accounting policies are important to the consolidated financial statements, some of these policies may be viewed as having a high degree of judgment. On an ongoing basis, using currently available information, management reviews its estimates, including those related to the accounting for pensions and post-retirement benefits, provisions for bad debt and doubtful accounts, derivative instruments, impairment of long-lived assets, deferred taxes, inventory provisions and environmental conservation and legal liabilities. Actual results could differ from these estimates.
We have identified certain accounting policies that are the most important to the portrayal of our current financial condition and results of operations.
For information about both our significant and critical accounting policies, see our annual report on Form 10-K for the fiscal year ended December 31, 2011.
New Accounting Standards
See Note 1 to the Company’s interim consolidated financial statements included in Item 1.
Cautionary Statement Regarding Forward-Looking Information
The statements in this report that are not reported financial results or other historical information are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended.
Generally, forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, or words of similar meaning, or future or conditional verbs, such as “will”, “should”, “could”, or “may”, although not all forward-looking statements contain these identifying words. Forward-looking statements are based on expectations, forecasts and assumptions by our management and involve a number of risks, uncertainties and other factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. These factors include, but are not limited to, the following:
the highly cyclical nature of our business;
our level of indebtedness could negatively impact our financial condition and results of operations;
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a weak global economy could adversely affect our business and financial results and have a material adverse effect on our liquidity and capital resources;
cyclical fluctuations in the price and supply of our raw materials could adversely affect our business;
we operate in highly competitive markets;
we are exposed to currency exchange rate and interest rate fluctuations;
increases in our capital expenditures or maintenance costs could have a material adverse effect on our cash flow and our ability to satisfy our debt obligations;
we use derivatives to manage certain risks which have caused significant fluctuations in our operating results;
we are subject to extensive environmental regulation and we could have environmental liabilities at our facilities;
Project Blue Mill might not generate the results we expect;
our business is subject to risks associated with climate change and social government responses thereto;
we are subject to risks related to our employees;
we rely on German federal and state government grants and guarantees;
risks relating to our participation in the European Union Emissions Trading Scheme and the application of Germany’s Renewable Energy Resources Act;
we are dependent on key personnel;
we may experience material disruptions to our production;
we may incur losses as a result of unforeseen or catastrophic events, including the emergence of a pandemic, terrorist attacks or natural disasters;
our insurance coverage may not be adequate; and
we rely on third parties for transportation services.
Given these uncertainties, you should not place undue reliance on our forward-looking statements. The forgoing review of important factors is not exhaustive or necessarily in order of importance and should be read in conjunction with the risks and assumptions including those set forth in reports and other documents we have filed with or furnished to the SEC, including in our annual report on Form 10-K for the fiscal year ended December 31, 2011. We advise you that these cautionary remarks expressly qualify in their entirety all forward-looking statements attributable to us or persons acting on our behalf. Unless required by law, we do not assume any obligation to update forward-looking statements based on unanticipated events or changed expectations. However, you should carefully review the reports and other documents we file from time to time with the SEC.
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Cyclical Nature of Business
The pulp business is highly cyclical in nature and markets for our principal products are characterized by periods of supply and demand imbalance, which in turn affects product prices. Pulp markets are highly competitive and are sensitive to cyclical changes in the global economy, industry capacity and foreign exchange rates, all of which can have a significant influence on selling prices and our operating results. The length and magnitude of industry cycles have varied over time but generally reflect changes in macro-economic conditions and levels of industry capacity.
Industry capacity can fluctuate as changing industry conditions can influence producers to idle production or permanently close machines or entire mills. In addition, to avoid substantial cash costs in idling or closing a mill, some producers will choose to operate at a loss, sometimes even a cash loss, which can prolong weak pricing environments due to oversupply. Oversupply of our products can also result from producers introducing new capacity in response to favorable pricing trends.
Demand for pulp has historically been determined by the level of economic growth and has been closely tied to overall business activity. From 2006 to mid-2008, pulp prices in Europe steadily improved. However, in the latter half of 2008, a global economic crisis resulted in a sharp decline of European pulp prices from a high of $900 per ADMT to $635 per ADMT at the end of 2008. Pulp prices began to increase in the second half of 2009 and continued to increase to record levels through June of 2010, before declining slightly in the fourth quarter of 2010. Pulp prices again rebounded to record levels in the first half of 2011 but declined sharply in the latter part of the year, primarily due to economic uncertainty in Europe and credit tightening in China. Despite continued economic uncertainty in Europe, European pulp prices stabilized, averaging approximately $837 per ADMT in the first half of 2012, before declining to $760 per ADMT at the end of the third quarter of 2012.
Prices for pulp are driven by many factors outside our control, and we have little influence over the timing and extent of price changes, which are often volatile. Because market conditions beyond our control determine the price for pulp, the pulp price may fall below our cash production costs, requiring us to either incur short-term losses on product sales or cease production at one or more of our mills. Therefore, our profitability depends on managing our cost structure, particularly raw materials which represent a significant component of our operating costs and can fluctuate based upon factors beyond our control. If the prices of our products decline, or if prices for our raw materials increase, or both, our results of operations could be materially adversely affected.
Costs
Our production costs are influenced by the availability and cost of raw materials, energy and labor, and our plant efficiencies and productivity. Our main raw material is fiber in the form of wood chips and pulp logs. Fiber costs are primarily affected by the supply of, and demand for, lumber which is highly cyclical in nature and can vary significantly by location. The state of lumber markets affects both the amount of sawmill residuals, such as chips, produced as a by-product of lumber and the level of timber harvesting, which provides us with pulp logs. Production costs also depend on the total volume of production. Lower operating rates during periods of cyclically low demand result in higher average production costs and lower margins.
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Currency
The majority of our sales are in products quoted in U.S. dollars while most of our operating costs and expenses, other than those of the Celgar mill, are incurred in Euros. In addition, all of the products sold by the Celgar mill are quoted in U.S. dollars and the Celgar mill costs are primarily incurred in Canadian dollars. Our results of operations and financial condition are reported in Euros. As a result, our revenues are adversely affected by a decrease in the value of the U.S. dollar relative to the Euro and to the Canadian dollar. Such shifts in currencies relative to the Euro and the Canadian dollar reduce our operating margins and the cash flow available to fund our operations and to service our debt. Conversely, an increase in the U.S. dollar versus the Euro and the Canadian dollar positively impacts our revenues by increasing our operating margins and cash flow.
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We are exposed to market risks from changes in interest rates and foreign currency exchange rates, particularly the exchange rate between the Euro and the U.S. dollar and the Canadian dollar versus the U.S. dollar and the Euro. Changes in these rates may affect our results of operations and financial condition and, consequently, our fair value. We seek to manage these risks through internal risk management policies, as well as the use of derivatives. We use derivatives to reduce or limit our exposure to interest rate and, from time to time, currency risks. Additionally, we, from time to time, use derivatives to reduce or limit our exposure to fluctuations in pulp prices. We also use derivatives to reduce our potential losses or to augment our potential gains, depending on our management’s perception of future economic events and developments. These types of derivatives are generally highly speculative in nature. They are also very volatile as they are highly leveraged given that margin requirements are relatively low in proportion to notional amounts.
Many of our strategies, including the use of derivatives, and the types of derivatives selected by us, are based on historical trading patterns and correlations and our management’s expectations of future events. However, these strategies may not be effective in all market environments or against all types of risks. Unexpected market developments may affect our risk management strategies during this time, and unanticipated developments could impact our risk management strategies in the future. If any of the variety of instruments and strategies we utilize are not effective, we may incur significant losses.
All of our derivatives are marked to market at the end of each reporting period, and all unrealized gains and losses are recognized in earnings for a reporting period. We determine market valuations based primarily upon observable inputs including applicable yield curves.
During the nine months ended September 30, 2012 and 2011, we recorded an unrealized loss of €0.6 million on our outstanding interest rate derivative.
We entered into a fixed price pulp swap contract in the second quarter of 2012. The contract fixes the price of 5,000 tonnes of pulp each month between May and December 2012 at $915. We recorded a gain of approximately €1.9 million related to this swap contract in the nine months ended September 30, 2012.
We are also subject to some energy price risk, primarily for the natural gas and the electricity that our operations purchase.
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Disclosure Controls and Procedures
Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Based on such evaluation, our principal executive officer and principal financial officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act.
It should be noted that any system of controls is based in part upon certain assumptions designed to obtain reasonable (and not absolute) assurance as to its effectiveness, and there can be no assurance that any design will succeed in achieving its stated goals.
Changes in Internal Controls
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
We are subject to routine litigation incidental to our business, including those described in our latest annual report on Form 10-K for the fiscal year ended December 31, 2011. We do not believe that the outcome of such litigation will have a material adverse effect on our business or financial condition.
Other than as listed above, there have been no material changes to the factors disclosed in Item 1A. Risk Factors in our latest annual report on Form 10-K for the fiscal year ended December 31, 2011.
None.
Exhibit
No.
Description
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ David M. Gandossi
Date: November 2, 2012
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