The two Finnish groups have been trying their best to counter unfriendly industry fundamentals like weak global demand for newsprint, high fuel costs and excess capacity. Both companies have been restructuring their manufacturing operations and closing down as much as capacity as they can.

But they are getting jammed from two ends - their euro-denominated output is too expensive in a global paper market - and U.S. manufacturers are taking advantage of the weak dollar to flood European markets with their own produce.

The result? Stora and UPM are in danger of a credit crunch. Don't be surprised if their debt is downgraded to junk at some point this year.

The currency-related dynamics are stark. International Paper, a U.S. manufacturer and a competitor of Stora and UPM has seen its European sales rise 25% in two years, 12% in 2007 alone. Stora's have risen 17% in two years but only 3.2% in 2007. As for UPM, sales in the U.K. fell 2% in 2007. In Finland, its backyard, they fell 6% and in France they were down 8%.

Apart from the currency disadvantage, high wood prices have also eaten into their operating earnings.

What's hurting the credit profiles of both UPM and Stora is that they are committed to generous cash returns to shareholders through share repurchases and dividends. While this is positive for investors in the short term, it could increase financial risk if fundamentals don't improve as both companies have significant debt in their books.

UPM's 2007 operating cash flow fell to EUR867 million from EUR1.2 billion, but net capex rose to EUR425 million from EUR314 million. It kept the dividend payout at EUR392 million. It's a similar story at Stora.

Another problem is the sensitivity of paper demand in a slowing economy. According to UBS, demand for graphic paper fell 7% in the last economic slowdown in 2001-02. Graphic paper is vulnerable as publications are hit by lower advertising spending.

The Finnish paper makers also face a possible 80% duty scheduled to be imposed on Russian wood exports by the Russian Federation from 2009.

Stora and UPM's shares have underperformed the Euro STOXX index by 30% in the last one year yet many sell-side analysts remain bullish. Only 13 out of 39 analysts covering Stora has a sell recommendation, 10 have 'strong buy', according to Thomson Financial.

That contrasts with the rating agencies' agreement on the companies' worsening balance sheets. The cost of insuring against Stora's 5-year debt default has risen from 134 basis points at the start of the year to 435 bps. UPM's up from 111 bps to 436 bps.

While in these nervous times, it would be wrong to read too much into credit default swaps, the trajectory of the companies' CDS suggests investors going long on the stock are do so at their peril - at least until there's a clear sign of the dollar's recovery against the euro.

(Arindam Nag, a Senior Writer for Dow Jones Newswires, has covered business and finance for 16 years in Asia, Europe and the United States. He can be reached at +44 207-842-9289 or by email: arindam.nag@dowjones.com)

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