SFK Pulp Fund: Not Pulp Fiction 4/12/10

SFK Pulp Fund (SFK-U CN) is a small cap Canadian income trust which operates three mills
that manufacture two types of market pulp: Northern Bleached Softwood Kraft (NBSK) and
Recycled Bleached Kraft (RBK) – these are the primary ingredients for most of the paper grades
we consume today. A relatively high cost producer, SFK suffered from the perfect storm in 2009
as an appreciating Canadian dollar exacerbated a rapid decline in pulp prices, and the termination
of a favorable wood chip supply agreement effectively increased wood chip prices (50% of cash
cost) by 15%. To make matters worse, SFK had a leveraged balance sheet, and was forced to
negotiate a waiver for a breach of its financial covenants.

In a remarkable turn of events, the pulp market over the past 12 months has gone from bust to
boom, yet the market has yet to recognize what a dramatic increase in pulp prices can do for a
company with such high operating and financial leverage to this commodity. SFK now benefits
from a rare combination of tailwinds: 1) the global market pulp market has moved from a surplus
to a shortage, resulting in a near vertical ascent in prices, 2) SFK’s cash flow generation is set to
massively deleverage the balance sheet, and 3) SFK is converting from an income trust to a
corporation, which creates a strong technical backdrop. As detailed below, I believe
conservative fair value for the stock is C$2.90, a 132% gain from the C$1.25 close on April 12,
2010. For those investors who are more risk averse and look for yield, SFK’s convertible
debentures (ticker SFKCN on Bloomberg) could provide both, they rank higher than the equity
in the capital structure and pay a 7% coupon (price of $88 for a 15% yield to maturity on
12/31/11).

Investment Thesis
Strong leverage to the global pulp price recovery cycle. Pulp prices have increased 45% from the
trough in May 2009 (11% year-to-date in 2010) and are highly likely to continue the positive
momentum throughout 2010 due to supply constraints, global demand recovery and unexpected
disruptions (more detailed discussion below). SFK is in a great position to benefit directly from
this robust tail wind:
• Product mix: 60% of its EBITDA over the cycle comes from the Saint-Felicien,
Quebec virgin-based NBSK pulp mill (66% in FY10E) with high fixed costs (ie high
operating leverage). The annual capacity of this mill is 360K tonnes. The remaining
40% comes from the spread-based business of RBK pulp, whose margins tend to
increase with higher NBSK prices. For every USD $50/tonne price hike in NBSK,
SFK EBITDA will increase by about C$33M, though the move could be partially
offset by a strengthening Canadian dollar and/or high fiber cost (annual contracts on
the latter mitigate volatility, however). The capacity of the two RBK mills (both in
the US) is 385K tonnes.
• High quality asset portfolio: SFK’s Saint-Felicien NBSK pulp mill historically has
been regarded as one of the highest quality mills in the Northern Hemisphere. Recent
balance sheet woes and the spat with wood chip supplier Abitibi-Bowater have taken
some of the shine off this asset, but it is indeed high quality.
• Committed customer base: SFK has a very committed core customer base for all
three of its mills (its top five customers contributed more than 50% of its revenue).
During the recovery phase of a market cycle (where we are now), these core

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 customers tend to provide a more stable production schedule and more visible
earnings power.
• Street underestimates the pulp price momentum: So far in this cycle, the Street
has been behind the curve and is still playing catch-up in terms of judging both price
and earnings power – we may soon see rounds of pulp stock re-ratings over the next
several months as 1Q10 earnings hit the tape.

Pulp Prices in Context

1,000

900

800
$/tonne

700

600

500

400
8/ /03

5/ /05

2/ / 06

2/ / 09
2/ / 02
5/ /03

/1 3

5/ /04

8/ /06
/1 6

5/ /08

/1 8
5/ /07
2/ /03

8/ /04
/1 4
2/ /04

8/ 05
/1 5
2/ /05
5/ /06

8/ /07
/1 7
2/ /07

8/ 08

2/ /08
5/ /09
8/ /09
/1 9

10
11 /0

11 1/0

11 1/0

11 1/0

11 1/0
11 1/0

11 1/0
1/

1/

1/
1

1
1
1
1

1
1

1
1

1
1

1
1
/1
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NBSK pulp price ($/tonne) BHK pulp price ($/tonne)

Technical boost from conversion into a corporation. The upcoming conversion will most likely
lead to additional technical support for SFK stock price. Company management has already
received feedback from various interested shareholders who are unable to purchase shares until
after the conversion.
• Minimal shareholder defection: Management has communicated with its major
shareholders about the conversion and they are effectively all on board, i.e. there
should be minimal “forced selling” from existing shareholders after the conversion
becomes effective in July.
• Diversifying investor base: Some of the institutional investors that are not allowed
to invest in the income trusts can now buy into SFK post conversion. In addition, US
investors may become shareholders as they are more comfortable with a
“corporation” structure. US investors currently account for 30% of SFK shares only.

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 SFK-U CN Top 10 Unitholders
Shares % of
Firm (mm) Total
Mackenzie Financial 8.8 9.7%
Fairfax Financial 8.7 9.7%
Odyssey America Reinsurance Co 6.2 6.9%
US Fire Insurance Co 2.8 3.1%
Israel Brokerage Investments 2.1 2.4%
TIG Insurance Co 2.0 2.2%
TD Asset Management 1.5 1.7%
Chou Associates 1.0 1.1%
Arkansas Blue Cross & Blue Shield 0.3 0.3%
Pennsylvania Trust Company 0.1 0.2%
Top 10 unitholders 33.6 37.2%

• Making the company more comparable to its “corporation” peers: The

conversion will make it possible to compare SFK with its sector peers on a more
apples to apples basis and thus demonstrate that SFK is the best name in the sector to
play the pulp market recovery (see valuation section for more details).

Significant balance sheet improvement potential. As a reminder of the market carnage in 2009,
SFK is currently rated CCC+ with a negative outlook by S&P and B3 (B2 for bank debt) with a
negative outlook by Moody’s – both at the low end even in the high yield ratings spectrum. At
this point, increasing shareholder value is really dictated by balance sheet improvement. SFK
management has set that as a top priority in 2010. The change will stem from two fronts:
• Refinancing: In July 2009, SFK amended the credit agreement to obtain a waiver of
the interest coverage covenant until June 30, 2010. As part of the amendment, the
company had to pay higher interest rates and live with more restrictions on its
debt/liquidity levels, capex, and cash distributions. SFK’s C$55M revolving credit
facility will mature on Oct 30, 2010, and it is highly likely that SFK will refinance
and restructure this credit facility during 2Q10 to push out the maturity, obtain a more
lenient covenant package and a lower interest rate. The CFO says “you’d be
surprised at how much the credit market has changed, from our perspective, in a year.
People are now lining up to give us loans.” Refinancing the converts may also be in
the cards as the 7% coupon is high given the strong rally in the credit markets.
• Debt reduction: Unlike its asset-rich rivals such as Fibria Celulose (FBR) in Brazil,
which can easily sell off non-core assets for debt reduction, SFK will need to rely
primarily on internally generated cash flow. SFK has approximately C$146M NOL
to offset future taxes and the cash flow savings (from NOL and potentially lower
interest payment after refinancing) can be applied to debt reduction.
With the strong rally in the high yield market and overall improvement of general market
conditions, SFK should have little difficulty achieving these goals during the next three to six
months and thus eliminating the liquidity overhang. Note that management just spoke with both
rating agencies last week and sounded pretty optimistic that they’re about to change their
outlooks to “positive”. Actual upgrades will probably come after a couple quarters of solid debt
reduction. In my model I have net debt/cap falling from 30% at 4Q09 to 15% by 4Q11 (note that
the debt in the debt to cap covenant calculation excludes converts).

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Takeout candidate. High and rising pulp prices will most likely lead to restarts of higher cost
mills and/or M&A activities. SFK has high quality manufacturing assets and one of the smallest
market caps among its peers, making it an ideal takeout candidate. Note that SFK purchased the
Saint Felicien NBSK mill from Abitibi in August 2002 for US $400M. The enterprise value of
the whole company today is around US $300M, which incidentally meshes with the median
transaction value of US $416/tonne of capacity (745K tonnes divided among the 3 mills). To get
a sense for replacement value, Fibria’s Guaiba mill, which was sold to CMPC will cost $2.2B to
expand its capacity from 450K tonnes to 1.75M tonnes, or roughly US $1,700/tonne. In
addition, Ilim, Russia’s largest pulp & paper company, is building a 720K tonne softwood pulp
mill in Sibera for US $700M (US $970/tonne).

Market Pulp Transactions over the past 15 years

Transacti Annual
on Value Capacity
Buyer Target Date (US$M) 000 mt US$/MT

Paper Excellence Tembec (French pulp mills) Apr-10 $136.0 565 $241

Wayzata Investment Partners Halsey Pulp mill (Pope & Talbot) May-08 $32.0 180 $178

Asia Pulp & Paper Meadow Lake Pulp Mill Jan-07 $32.0 325 $98

Mercer Celgar Pulp Feb-05 $210.0 430 $488

Koch Industries Georgia Pacific's Pulp Mills May-04 $610.0 1,300 $469

SFK Pulp Fund (Public) Abitibi's - St. Felicien mill Aug-02 397.0 355 $1,118
Cenibra (remaining 51.48%
Sep-01 1,542.4 820 $1,881
Japan Brazil Paper Resources interest)
Georgia-Pacific's 4 UFS and pulp
Aug-01 200.0 450 $444
Domtar mills
Pope & Talbot NorskeCanada's Mackenzie mill Mar-01 100.0 240 $435

Tembec La Rochette Pulp Sep-00 158.0 550 $287

Asia Pulp & Paper Celgar Pulp Company Jun-00 400.0 420 $952

Sodra Norske Skog's Tofte mill May-00 200.0 480 $416

Tembec / Kruger Fort James' Marathon mill Dec-99 74.2 200 $371

Tembec Donohue Matane Nov-99 33.2 175 $190

Canfor Northwood Nov-99 540.3 535 $566

Tembec Tartas (remaining 50%) Oct-99 23.2 165 $281

Oct-99 62.9 380 $416
Pope Talbot Harmac Pacifc (remaining 39.8%)
Jan-99 181.9 225 $414
Tembec Crestbrook
Harmac Pacific (interest upped Dec-98 6.5 380 $233
Pope & Talbot 60%)
Mar-98 261.8 550 $1,190
Mitsubishi & Oji Al-Pac JV (remaining 40% interest)
Dec-97 83.2 380 $297
Pope & Talbot Harmac Pacific (initial 53.5%)
Kimberly Clark's Pictou & Terrace Nov-97 540.0 700 $771
Harmac Pacific (failed) Bay
Dec-96 600.0 663 $437
Alliance Forest Products KC's Coosa Pines

Average $529
Median $416

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Cheap valuation. Using pulp price increases that have already been announced, and flatlining
prices through 2010, I get a base case 2010 EBITDA of C$75M for SFK, which is above Street
consensus of C$55M. SFK’s peer group is currently trading at 7.2X EV/EBITDA. Using a
conservative 6X forward multiple, I get a base case price target of C$2.90, 132% above the close
of $1.25 on April 12. (More detailed discussion on valuation below)

The pulp market in context:

Pulp markets are getting extremely tight, as an already tight market was further squeezed by the
Chilean earthquakes, which curtailed 8% of the global supply of pulp, potentially for months.
Pulp was already benefiting from a structural vortex into China (which is building a number of
non-integrated paper mills that will require high quality virgin pulp), and there is no significant
pulp capacity coming on before 2012.

Global nameplate capacity of pulp is about 52M tons, and current production is pretty much
maxed out at 50M tons. In 2009, demand actually grew by 2% because China’s 55% growth
soaked up all the excess supply caused by a slowdown in the developed world (North America
down 11%, W Europe down 11%, Japan down 17%, Oceania down 13%). China’s share of
global shipments is now 21%, up from about 10% in 2002-2008. This is not a one-time shift,
rather a structural shift, in my opinion.

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So while global production (largely in Europe) was cut by about 3-4M (6-8% of global supply)
tons in 2009, demand actually grew, causing a depletion of inventories from 50 days in Jan 2009
to 25 days in November 2009. We’re back to a “balanced” market at 30 days supply, but that
assumes Chile gets back to full production immediately (which is unlikely). European producer
pulp inventories are still at extremely low levels of 24 days.

Pretty much all of the 3-4M tons of capacity has returned to production, and a 1M ton plant in
China is starting this year. So what’s the problem? News to no one, but an earthquake hit
Chile’s pulp operations dead on on 2/27/10, disrupting all of Chile’s mills (4M tons, or 8% of
supply). While the damage to the mills is fairly easy to fix, the roads and ports will take longer –
these mills may not return to full production for months. At a minimum, we have lost roughly
1M tons of supply for 2010 that cannot be recouped, because the mills were running flat out
before the earthquake.

In addition, Finnish dockworkers recently had a two-week strike (ended on 3/19/10). Finland is
a net exporter of pulp to other parts of Europe. Its supply is roughly 2M tons (4% of supply). It
may be a conspiracy, or it may be dumb luck, but the pulp market has never seen a disruption of
this magnitude, and with the market already extremely tight, each disruption is magnified
tremendously.

So what next? The extreme tightness will likely subside once Chile is up and running (some
restarts have already been announced), but China is not suddenly going away – there has been a
structural shift in the pulp market – very similar to the one that has affected the iron ore and met
coal markets. Chinese environmental initiatives have forced the permanent closure of some of
their non-wood pulp lines. And with a number of non-integrated paper mills starting in China
over the next few years, their demand for virgin pulp is likely to grow. China is also learning a
similar lesson from its experience in the steel markets – when you shift from non-wood pulp to
virgin wood pulp, your paper mills run more efficiently and you actually drive down cost. It is
unlikely that they will shift back to their nonwood pulp in a significant way.

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Trust to corporation conversion in Canada:
Before the tax law change in 2006, a Canadian income trust paid little to no corporate income tax
because it distributed essentially all the pre-tax earnings to its unit holders. The income trust was
once a very popular investment vehicle in Canada and the sector alone was worth over C$160B
by the end of 2005.

On October 31, 2006, however, the Canadian federal government announced a plan to change
the tax treatment of income trusts. Under the new plan, the government would apply a tax at the
trust level on distributions of certain income from most publicly traded income trusts and
partnerships in Canada (referred to as specified investment flow-through or SIFTs) at a tax rate
comparable to the combined federal and provincial corporate tax rate and treat such distributions
as dividends to unit holders. These tax changes will apply to income trusts at the beginning of
the 2011 taxation year.

Stocks of the Canadian income trusts reacted negatively on the announcement as expected – by
the end of 2006 TSX Income Trust Index had tanked by 20% from October. The announcement
also triggered waves of M&A deals involving income trusts. In 2008 as the Canadian
government published more details on SIFT conversion rules, the pace of income trusts
converting into corporations also accelerated. There were 9 income trust conversions in 2008
and approximately 23 conversions in 2009. SFK announced its conversion plan in 2009 and is
expected to complete the process in June 2010. The new company will be called Fibrek Inc.

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Upcoming Catalysts
• First quarter earnings release around mid May, 2010
• Annual meeting on May 19th, 2010 to approve the conversion
• End of waiver period on June 30th, 2010
• Maturity of revolving credit facility on October 30, 2010
• December 31, 2010 and after, the company is free to call 7% converts at par.

Valuation

Trading Comps Analysis

With net debt of C$184M, and 90.5M fully diluted units, the enterprise value is roughly
C$300M. The company posted negative EBITDA in 2009, therefore the key to its valuation is
really its forward EBITDA in 2010. My base case EBITDA forecast is C$75M (using average
NBSK pulp price of US $905/ton), implying a forward EV/EBITDA of 4.1X. If the pulp price
increases to $955/ton, the multiple will drop to 2.8X.

SFK’s peer group is trading at 7.2X EV/EBITDA, if we use a conservative 6X multiple, SFK
should be worth C$2.90/share, or 132% above the close price on Apr 12. Incidentally this would
be a P/E of If pulp price assumption is increased to $955/ton, a 6X multiple will imply a target
price of C$5.10/share, or over 4X the closing price on Apr 12t.

Global Market Pulp Comparables

% 2008 EV/EBITDA EV/EBITDA
Ticker Company Pulp Sales Price (local) EV (US $M) (FY10E) (FY11E)
CFX-U CN CANFOR PULP INCO 84% 11.96 424 2.6X 3.4X
CMPC CI CMPC 30% 22200.00 11,774 12.5X 11.0X
FIBR3 BZ FIBRIA CELULOSE 80% 37.65 14,125 8.2X 7.5X
MERC MERCER INTERNATI 100% 5.78 1,290 6.0X 6.6X
SUZB5 BZ SUZANO PAPEL-PRA 35% 23.23 6,332 7.5X 6.9X
TMB CN TEMBEC INC 53% 2.43 636 6.5X 6.9X
WFT CN WEST FRASER TIMB 35% 42.05 2,279 7.4X 6.8X
SFK-U CN SFK PULP FUND 100% 1.25 297 4.1X 3.6X

Average excluding SFK 5,266 7.2X 7.0X

SFK-U CN Sensitivity of 2011E EBITDA to pulp prices, exchange rate

NBSK pulp price ($/tonne)
$830 $880 $930 $980 $1,030
(CAD/USD)
Exchange rate

0.93 55 68 82 95 108
0.98 58 72 86 100 114
1.03 61 76 90 105 120
1.08 64 79 95 110 125
1.13 67 83 99 115 131

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Distressed liquidation analysis
SFK has a top heavy capital structure, typical for companies with high yield credit ratings.

Capital structure (maxed out) (C$M)

Debt
Senior secured revolver (max) 55
Senior secured term facility 177
Capital lease and PSIF grant 8
Convertible debentures 48
Total debt 288

Market cap of equity 118

Total capital 406

In order to get a sense of the potential downside for shareholders in this capital structure, I did a
quick liquidation analysis assuming SFK is liquidated based on its 2009 year end balance sheet
data. The analysis, which by no means is scientific or comprehensive, suggests that equity value
will NOT be entirely wiped out even SFK maxed out all the borrowing capacity under its credit
facilities. Using my base case EBITDA, the residual equity value ranges from C$0.55 to C$1.38,
a max 56% discount to the current share price.

SFK-U CN Distressed Liquidation Analysis

Enterprise Value (C$M)

EV/EBITDA (2010E) multiple
4.0X 4.5X 5.0X 5.5X 6.0X
2010E EBITDA

55 220 248 275 303 330

65 260 293 325 358 390
75 300 338 375 413 450
85 340 383 425 468 510
95 380 428 475 523 570

Less Total Debt Obligations (C$M)

EV/EBITDA (2010E) multiple
4.0X 4.5X 5.0X 5.5X 6.0X
2010E EBITDA

55 0 0 0 15 42
65 0 5 37 70 102
75 12 50 87 125 162
85 52 95 137 180 222
95 92 140 187 235 282

Implied Equity Value Per Share

EV/EBITDA (2010E) multiple
4.0X 4.5X 5.0X 5.5X 6.0X
2010E EBITDA

55 0.00 0.00 0.00 0.16 0.46

65 0.00 0.05 0.41 0.77 1.13
75 0.13 0.55 0.96 1.38 1.79
85 0.58 1.04 1.51 1.98 2.45
95 1.02 1.54 2.07 2.59 3.12

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7% Convertible unsecured subordinated debentures (ticker SFKCN)
The 7% converts due 12/31/11 are a decent yield product but upside may be capped at 22% due
to possible refinancing.

SFK issued the 7% converts back in August 2006 to finance its acquisition of AFR Mills.
Compared with SFK common stock which no longer makes cash distributions (or dividend
payments after conversion) due to the covenant restrictions, the converts provide both capital
appreciation potential and a more likely coupon payment – as part of the credit agreement
waiver, SFK can not pay converts interest unless it meets a cumulative EBITDA test which is not
publicly disclosed. According to the company’s 4Q09 earnings release, SFK paid the scheduled
converts coupon on Dec 31 2009 (confirmed with management) implying that it was at least in
compliance with that covenant at year end and may continue to pay the coupon in June 2010.
The converts are currently quoted at C$88 and yield over 15% (yield to maturity), which is even
higher than SFK’s comp Canfor Fund’s (CFX-U CN) dividend yield of 11.6%.

However, SFKCN’s total return could be capped due to a high likelihood of a refinancing during
2010. Management has indicated that it may refinance its high coupon converts as part of their
efforts to improve SFK’s balance sheet. So for a C$88 investment in SFKCN, the most likely
upside (maybe also the max upside) by year end 2010 is the $7 coupon payment plus another $12
of premium (not necessarily in cash) if the company calls, or tenders for the converts at par
and/or refinances it with debt of a lower interest rate, implying a combined expected return of
approximately 22%. If there is a change of control event, investors may get an additional C$1
upside due to the 101% change of control put.

Call/redemption feature in its prospectus:

“The Debentures will not be redeemable prior to December 31, 2009. On or after December 31,
2009, and prior to December 31, 2010, the Debentures may be redeemed, in whole or in part,
from time to time at the option of the Fund on not more than 60 days and not less than 30 days
notice, at a price equal to the principal amount thereof plus accrued and unpaid interest, provided
that the Current Market Price is at least 125% of the Conversion Price. On or after December 31,
2010, the Debentures may be redeemed in whole or in part from time to time at the option of the
Fund on not more than 60 days and not less than 30 days prior notice at a price equal to the
principal amount thereof plus accrued and unpaid interest.”

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 SFK-U CN Stock vs 7% Converts due '11
140 6

120 5
Converts price (7% due '11)

100
4

Stock price
80
3
60
2
40

20 1

0 0
9/7/06 9/7/07 9/7/08 9/7/09

Converts price Stock price

Variant View
SFK is not well liked by the Street – of the 6 analysts who cover it, 4 have “Holds” and 2 have
“Sells”. Each analyst has conservative (ie stale) pulp prices in their model and seems to
underestimate (or ignore) the deleveraging ability of this company in a rising pulp price
environment. I also believe the Street is underestimating the favorable technicals post trust to
corp conversion.

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