The sector has carried out a more or less ordered retreat cutting its production capacities. The most recent financial figures however show that this solution alone may not be enough.

Problems that existed well before the recession

For once the environment was supplanted in the analyses by more directly economic considerations during the roundtable in which a number of senior managers from the sector took part. No one can as yet say when the recession is going to end but it is now possible to draw up an initial assessment. Some sectors, like tissue, are holding up much better whilst others face increasing difficulties… around issues that in many cases existed already.

The difficulties facing the paper sector appeared well before the eruption of the financial crisis. Share prices for the sector began slipping at the beginning of 2008, and even before this for some companies, whilst other sectors continued to advance significantly until the end of summer 2008. Even from that moment, the share values in the sector lost value faster than other industrial sectors, and they have been subject to even more dramatic movements than their sales: some shares have lost more than 90% of their value since the start of the crisis.

At the moment, the indebtedness of most major European papermakers is greater than their market capitalization, which even further reduced the ardor of investors. Among the leading companies, one of the most exposed is Smurfit Kappa. Its net debt is twelve times its stock market capitalization. All groups are actively working on refinancing their debts, and most have secured their debt servicing for 2009. However, some companies could find it very difficult to make their debt payments in 2010 and 2011 if sales do not pick up to a satisfactory level, as shown by the case of Stora Enso.

Investments on hold

Even before the start of the financial crisis, papermakers were applying two types of solutions for their declining earnings: increasing cash flow and reducing costs.

One of the favorite weapons used by the groups to increase their cash flow has been the postponement or even cancellation of investments. They also decided, by a large majority, not to pay dividends to their shareholders. As well as being hazardous, these methods may not even be enough. Peter Berg, McKinsey, therefore recommended, among other solutions, “reducing buffer stocks, applying for subsidies from governments or other entities”!

All companies have frozen some of their investment programs and are only investing when the return on investment is equal to or less than one year. Those embarked on costly programs, like Mondi in Russia, have struggled to justify in their annual reports the impact of these on their cash flow. In addition cutting back on investments has an immediate knock-on upstream in the value chain. Some equipment manufacturers like Metso have been very hard hit. Restarting the investment will be long and costly once the end of the crisis is reached, notably because of the obsolescence of some equipment.

According to Peter Berg, the optimization of operating capital, by reducing stocks and negotiating payment times, represents almost 10% of turnover for the cash flow. The impact of optimized investments is estimated at between 15% and 25% of total expenditure.

Reducing costs is the second major solution being implemented by companies. Their main tools here are debt refinancing, procurement policies and the restructuring of the workforce. Restructuring is in itself insufficient to resolve the crisis the industry is going through. Stieg Andersen, Nordea, believes that consolidation has not yet reached a level at which relevant pricing and procurement policies can be applied. It is, also, a very long and costly process. The increasing numbers of these “non-recurring elements” on the balance sheets of the companies in the end weigh heavily on indebtedness and cash flow.

And then?

In the longer term Peter Berg sees innovation by companies as the answer. In products, obviously, with packaging mixing board and plastic as well as in the reorientation of the companies. UPM is gambling on the development of new activities such as biofuels and new markets, Stora Enso is expanding its own eucalyptus plantations, etc. The sector could thus reinvent itself through “a vertical integration with companies specializing in information and knowledge, with others focused on a market segment and a third group of companies producing commodities”.

Nordea is looking to the development of “biocombines”, companies capable of selling wood based products in the fields of biochemistry, paper, etc. The bank is mainly present in Scandinavia, where papermakers have long experience in managing forestry stocks. In addition to paper and wood, bio-fuels are an increasingly attractive alternative in deriving value from the assets of these companies.

Above all this area offers a more certain profitability. It will be possible for new entrants to build a new machine and upset the consolidation of the sector. However investment in new energies and biochemistry is much more difficult to duplicate. The knowledge is relatively restricted and, because of the novelty, it is generally much better protected. Finally, it is a sector with strong growth prospects in regions in which the markets for paper are reaching maturity.

Following the initial agreements signed by many of the papermaking groups, Nordea calls for the creation of “constellations” bringing together the paper/forestry, the energy and the chemical sectors. The energy specialists have huge expertise in the field of energy distribution and processing, and the “chemists” are making increasing use of biochemical products to replace oil-based products. For instance, in 2007 Stora Enso signed an agreement with Sweden’s Neste Oil for the construction of a demonstration plant in Varkaus. In the United States, Weyerhaeuser set up a joint-venture with Chevron, Catchlight Energy, in 2008.

For Peter Berg, the competitiveness curve for the companies in the sector will resemble a “forced smile” rather than a “Mona Lisa smile”. With further concentration upstream, that is in controlling the raw materials, and downstream, the applications and leading products for customers, companies will make up for the lack of profitability in production (the bottom of the “smile”) and a simple access to the market.

In any case, analysts remain skeptical on the ability of the sector to return to strong growth when the recovery comes. This will not however prevent some companies from achieving good earnings by focusing on niche markets and/or innovative products.

How the sector’s management sees things

A roundtable brought together a number of senior managers from companies operating in various market segments, and including one working in the Middle-East and North Africa.

Salim Karadsheh heads Nuqul Tissue, a company in the Nuqul group, a Jordanian based conglomerate. Operating in several North African and Middle Eastern countries, the group has benefited from the boom in tissue consumption in these regions and it produces almost 160,000 tonnes of tissue. It also has interests in packaging and non-woven products, and a joint venture with SCA. His optimism balances out the dramatic statements of Dermot Smurfit, CEO of Powerflute. According to him: “There will be further bankruptcies in the pulp and paper industry, as there will in other business sectors. I am very pessimistic and I think that this is going to last for two to three years and lead to protectionism and social disturbances”.

What possible solutions are there for this crisis? Here again the answers vary. For Norske Skog, specialized in press papers, Christian Rynning-Tønnesen is preparing his group for an ongoing downwards trend in newsprint consumption in the mature markets. No one however was predicting the disappearance of the press! According to Barry Wiersum, CEO of Sappi Fine Paper Europe, the current crisis shows that individuals always want more information, as the Internet increases the need for printing. In getting through the recession, Christian Rynning-Tønnesen aims to make use of the possibilities of short-time working such as allowed by legislation: “The options vary by country, which is somewhat unfair. Some countries pay the wages in the event of short-time working, others do not. Some factories have been closed not because of higher costs but because the State pays compensation for wage costs”.

Such distortions of competition are a source of concern for the participants. Dermot Smurfit complained of the subsidies received by some German papermakers in the regions of the former East Germany. The market itself is not necessarily any fairer than public policies. The variations in exchange rates of countries outside the euro zone provide relief for English and Swedish producers to the detriment of their neighbors. Finland has been very hard hit, especially as the price of wood there, according to Dermot Smurfit, remains much too high.

There are still opportunities of course… for those able to finance them! Given the struggle to obtain finance for their everyday business activities, acquisitions would seem to be reserved for companies outside the sector. The only bright spot in the storm, some groups such as Norske Skog are taking advantage of the low stock prices to buy back their shares.

The environment is nevertheless still on the agenda. It is a constraint but one that is increasingly seen as an opportunity. According to Barry Wiersum, “environmental postures are softening at the moment”, but this is only momentary. He believes that the influence of environmental associations will increase again once the crisis is over. Salim Karadsheh, who acknowledged that the environment is not such a significant factor in the regions in which Nuqul operates, is watching what happens in Europe closely.

In the medium term, energy businesses are on everyone’s lips. Salim Karadsheh “spends half his time considering energy factors”. Papermakers are not actually giving up production. Some sectors, such as tissue, remain very profitable, which led to the question from Salim Karadsheh who noted “that no one has mentioned the customers”. The companies in the tissue segment consider themselves as producers of consumer products, for which distribution, innovation and image are of critical importance.

In other paper industry segments however, the producers tend to ignore these aspects. In effect, for Barry Wiersum, “the role of innovation is underestimated. This will be a much more satisfying way of earning money as of 2010-2011”… for those that will have made it through.

The point of view of Michal Jarczynski, CEO of Artic Paper

Artic Paper reported a 27% growth in net earnings for the first three quarters of 2008. With the completion of the acquisition of Grycksbo Paper in Sweden, the group will have a total production capacity of 805,000 tonnes of fine and publication papers.

Michal Jarczynski is worried about the future if the management of paper groups do not take care to maintain their resources for running their mills once the recovery turns up. This was a leitmotiv adopted by others, like Barry Wiersum: “Many facilities are in rural locations, or at least some way outside cities, which creates problems of recruitment. There is a real danger of losing experienced manpower that it will not be possible to get back once the recovery gets under way”.

“Reducing costs makes sense but we created the fat on our structures in the past and it is now time to get rid of this, but we need to ensure the future for our facilities, we need to keep the muscle. The industry depends on its people; we need to retain the best teams for the future!” He also raised the issue of the intentions of investors, whether financial or industrial, from Asia or the Middle-East. Those with liquid reserves are ideally placed for acquiring European groups, suffering because of the bank credit limitations.

“The bottlenecks and the hidden reserves are already settled, but there is still room for improvement. Our employees are the driving force for these improvements. They know how to increase the speed by 5 meters a minute, to reduce the changeover time by 2 minutes, how to increase the yield by 0.1%. Lots of small improvements, most of them costing nothing, helping to give us a chance of surviving”.

The environmental dilemma for papermakers

Papermakers are under increasing pressures and a degree of disinformation from environmental pressure groups. Associations are being set up to offer responses to the general public and to work with industry bodies such as Cepi. The National Association of Paper Merchants has created TwoSides for this purpose.

Martyn Eustace, its Director, presented data enabling a better understanding of public opinion. The Boston Consulting Group carried out a survey that showed that paper and packaging are the most “environmental” products purchased by consumers. 27% said that they always buy eco-products, and 41% do so occasionally. Of all product categories, it was the strongest statement of eco-buying. However, paper is the product for which consumers are least inclined to pay more for its environmental credentials… The quality of eco-papers is seen as being more or less comparable to that of non eco-papers, although there are very many non eco-papers in Europe.