Stormy times lie ahead for coated woodfree producers in western Europe as the business gets hit by capacity problems

by Heikki JW Salonen

Dark clouds on the horizon for European coated woodfrees

Western Europe is clearly the world's leading marketplace for coated woodfree (CWF) paper. In 1997, total demand in western Europe reached 6.5 million tons, but capacity exceeded demand by 3.2 million tons. With annual exports from western Europe running at 1.5 million tons, this represents close to 15% of the region's total capacity. As a result, European suppliers are also the world's leading exporters of CWF paper.

To make profits in these circumstances, producers need rapidly growing global demand for paper and, of course, better than average cost-competitiveness if they are to beat the competition on the local and export markets. Unfortunately, market prospects look somewhat alarming and industry leaders are worried.

One of the main problems is that prices for CWF and market pulp are decreasing. According to CEPI (the Confederation of European Paper Industries), CWF production in Europe increased by 15.8% on the previous year during the first quarter of 1998. Europe has suffered from significant price erosion, especially in southern Europe and the UK. The luster of the USA and Far Eastern export markets has also vanished. Global inventory levels and highly competitive supplies from Asia rather suggest a decline in pulp prices. Under these circumstances, it is highly unlikely that CWF suppliers in western Europe will be able to expect much price support from increasing market pulp prices in the future.

Specialization and concentration

Given the predicament that the industry finds itself in, European coated woodfree producers will certainly need to focus on consolidation as well as achieving a continuous improvement in productivity and cost reduction. According to cost simulations carried out by the consultant ÅF-IPK, the average weighted total cost of delivered coated woodfree paper was $1,071/ton in the fourth quarter of 1997. Total costs among the key suppliers ranged from $916/ton to $1,405/ton. Stora Enso's Kaukopää mill in Finland had one of the lowest costs, while the Gorsmühle mill in Germany owned by Zanders (a subsidiary of International Paper) exhibited the highest cost (Figure 1).

At the same time though, European CWF was priced at $970/ton in the fourth quarter of 1997. On this basis, only 12% of European coated woodfree paper capacity was able to cover total costs. Even if all the capital charges are eliminated from the cost simulation, that still leaves 18% of European CWF capacity above the average European price level for the period. Based on these figures, it is easy to predict that concentration and specialization in the European coated woodfree sector will continue to accelerate.

Another point that comes out of the study is that integrated Nordic suppliers have demonstrated a clear competitive edge over non-integrated producers. During the review period between 1988 and 1997, integrated suppliers - mainly from the Nordic countries - have continuously outperformed non-integrated suppliers (Figure 2). Total weighted average costs among the integrated suppliers for the time period was $1,040/ton, while non-integrated suppliers recorded a total cost figure of $1,175/ton. Comparing the figures, the average cost advantage in favor of the integrated producers is 11% - clearly a significant difference.

Taking the industry as a whole, lean average EBIT (earnings before interest and tax) margins have been running at between 5%-11% of sales, it is self-evident that integration has been one of the biggest strategic assets for suppliers that have had access to integrated pulp.

Staying economical

Parallel to the tendency to increase the share of integrated production, economy of scale has also been used effectively to achieve cost benefits for suppliers. Cost simulations for units with a production capacity of between 50,000-70,000 tons/yr show that the rough mean total production cost reached $1,150/ton for European suppliers during the fourth quarter of 1997. In the same period, production lines in the 220,000-300,000 ton/yr range show a similarly costed mean price dropping down to $1,020/ton - a difference of $130/ton. In extreme cases, the cost advantage favors the larger units by some 30% (Figure 3).

Based on this, it is little wonder that the nature of the coated woodfree business is changing. The average unit size has seen a rapid increase during the last decade and modern production lines are now scaled at 300,000-500,000 tons/yr.

These huge machines undoubtedly cause significant market turbulence when they come on stream. But despite this, it is very hard to imagine any large-scale player turning the wheel back to start building less productive paper machines. So in the future, smaller units will only be able to survive by increased specialization, while a major part of total coated woodfree paper sales will gradually turn into a commodity business.

The restructuring also comes at a time when the quality of European CWF paper is on the increase as modern paper machines are not only capable of producing at very high speeds, but also to exacting specifications.

Seven major groups control the bulk of European coated woodfree paper capacity. The smallest of these has around 400,000 tons/yr, while the largest has 1,385,000 tons/yr. Stora Enso will be the biggest supplier when the two companies formally merge and at the other end of the scale is Spain's Torraspapel, which is the smallest of the major suppliers. The combined CWF capacity of the major suppliers is 5.8 million tons, but there are also nine medium-sized suppliers in western Europe, which have an aggregate total capacity is about 1.6 million tons/yr, or 21% of the European total.

Best up north

Within the seven leading supplier groups, the Nordic companies - SCA/PWA, Stora Enso and UPM-Kymmene - had the lowest total production costs, ranging from $986-$1,031/ton during the fourth quarter of 1997 (Figure 4). The cost spread for the four other large suppliers was $1,068-$1,129/ton. The four in this range comprise South Africa's Sappi, Burgo of Italy, Metsä-Serla in Finland and Spain's Torraspapel, which had the highest average cost among the leading suppliers.

The total cost spread for the eight medium-sized suppliers runs from $1,040-$1,405/ton, which indicates that there are still some relatively efficient units among these suppliers, such as Jefferson Smurfit's Papeteries de Condat mill in France. But overall, the mid-ranking suppliers suffer from higher costs. Relatively small market shares and the cost base of the mills in
question make these companies likely targets for potential acquisitions and mergers as the European coated woodfree industry restructures.

What is also becoming clear is that the Asian financial crisis will hit European CWF exports hard and in time, the US dollar exchange rate may create havoc throughout the business. Traditionally, Europe and Japan have been net exporters of coated woodfree paper worldwide. Most of the volumes have been directed to markets in the Far East, Latin America and North America. But since the end of 1995, the US dollar appreciated almost continuously against the German mark up to the third quarter of 1997. The gain was 28.5%, an increase that has been alleviated by the slow European economic recovery, the collapse of the Asian economies and, of course, a lengthy upturn in the USA. The stronger the US dollar has become in the wake of devaluations elsewhere, the greater the attraction has been for exporting countries.

Now, however, the global economy is on the verge of seeing an opposite wave. First, there is the danger that the Japanese yen may keep depreciating further. If that happens, other major Asian currencies - including the Chinese yuan - may have to follow suit and devalue.

So far, the impact of the Asian economic crisis has only marginally affected North American economies. But as the crisis rumbles on, so will the increase of its influence on North America. This may well coincide with slowing domestic demand in the USA, and in these circumstance the Federal Reserve may have no other option than cutting interest rates to support the economy.

The first obvious result of such a measure will be a slump in US stock markets, while further on a depreciation in the international value of the US dollar is likely. This scenario would be especially harmful for most of the integrated coated woodfree suppliers in Europe, as they would be forced to price their exports based on an appreciating Deutschemark.

The potential impact on cost-competitiveness is obvious and considering the financial starting point many producers find themselves in, the future does not look particularly bright for the moment.

This article is based on ÅF-IPK's study
of the European coated woodfree business
from 1987 to 2005. Further details are
available from Heikki JW Salonen, consulting manager at ÅF-IPK in Finland. Tel +358.9.46.97.802, Fax +358.9.46.97.801 or email: heikki.salonen@ipk.af.se