Forest products companies may fail to earn their cost of capital, but investors have hardly been strict in cutting off the industry's cash supply

Overcapacity abounds, but mills can still secure funds

Money doesn't grow on trees, or so the saying goes. But the forest products industry has had few problems attracting capital in the past and looks unlikely to suffer any great difficulties in doing so in the future. Debt capital markets, either private, public or governmental, have always been a major supporter of the industry in both the peaks and troughs of its cycles.

Equity capital, on the other hand, has been scarce and very cyclical. Equity investors in general tend to support the pulp and paper industry in anticipation of the next cyclical peak. Whether this traditional split is set to change remains to be seen, but before future financing sources for the pulp and paper sector can be identified, it is first necessary to establish a medium to long term outlook for the industry.

Overall, the global outlook for the pulp and paper industry is highly favorable. In the short to medium term, price deterioration is expected to continue as the global economy slows down. In the longer term though, the impact of increased merger and consolidation activity, coupled with limited capacity expansion plans, will result in improved profitability for the industry. On a global basis, the forest products industry continues to enjoy an average demand growth rate of 3-3.5%/yr, in line with global GDP growth. But the supply side has been notoriously volatile and was the principal driver of the industry's poor profitability during the past decade. With the exception of 1989 and 1995, the industry has not earned the cost of its capital in the last 10 years.

The sector continues to suffer from a high level of global fragmentation. Even the largest forest products company in the world, International Paper, combined with its newly merged partner, Union Camp, represents less than 7.5% of global capacity. The industry is at the bottom of the consolidation pile, with the top five companies in the paper and board sector accounting for slightly over 12% of worldwide sales.

This fragmentation is significant, particularly in comparison to the media sector. As one of the major end-use markets for the paper industry, media has a consolidation ratio of close to 40%. Given the current state of the industry, merger and consolidation activity will accelerate in the near term, creating global companies with a worldwide presence. These mega-players will have access to capital markets at the most competitive prices. Today, companies such as International Paper, UPM-Kymmene and Stora Enso are a few of players that enjoy this status.

Going global
On a global basis, capacity concentration in the industry is forecast to increase three-fold on 1985 levels by 2005 (Figure 1). This means that the top five companies would have an average capacity of 22 million tons by 2005, compared to just 7.8 million tons in 1997. Increased concentration will further promote the creation of global, geographically diverse companies operating in a more disciplined market place. These factors will result in increased profitability and the attraction of capital at more competitive costs.

North America remains the least consolidated of all the regions. But there are a number of initiatives under way which should improve the situation.

Several companies have carried out transactions to realign their product focus, including deals between Tenneco and Madison Dearborn, Bowater and Weyerhaeuser, Champion and Donohue, as well as MacMillan Bloedel and Pacifica Papers. Paper producers are also opting to monetize non-core assets and reassess the value of their timber holdings. Strategic alliances and partnerships are very much in vogue among North American paper companies, along with larger scale consolidation moves such as the mergers between International Paper/Union Camp, Stone Container/Jefferson Smurfit and Bowater/Avenor, to name but a few.

In Europe, a fair amount of consolidation has already taken place. The industry has emerged with a number of regional and international players now seeking to enhance their global presence through strategic alliances and joint ventures. For example, UPM-Kymmene hooked up with APRIL, Stora Enso and Odebrecht joined together to form Veracel, and Norske Skog teamed up with Abitibi-Consolidated and Hansol. Geographical expansion is also on the European agenda. One only need look at Norske Skog's purchase of Shin Ho Paper, UPM-Kymmene's takeover of Blandin in the USA, or SCA's acquisition of tissue companies in both Latin America and Asia.

Latin America has also attracted a fair amount of capital from the northern hemisphere, using the region's growth potential, labor and fiber assets to its advantage. Some consolidation has taken place on an intra-regional basis and further rationalization is expected, particularly in Brazil. The trends in Latin America include privatizations, strategic alliances and consolidation moves. Among the most notable of these are Klabin and Kimberly-Clark's strategic alliance in tissue and Riverwood and Suzano's partnership in containerboard, Igaras.

Asia has witnessed the most dramatic changes, moving from aggressive expansion to struggling to maintain independence. Capital is scarce and there has been little new money available for investments in the so-called tiger economies of Thailand, Malaysia, Indonesia and the Philippines. Japan and Korea are beginning to see some signs of recovery though, and the region promises significant increases in per capita consumption as the economies return to prosperity. In the short to medium term, Asia will continue to offer opportunities in the form of strategic alliances, acquisitions, country specific and regional consolidation, as well as restructuring programs.

Big spenders
Given the current outlook for the forest products sector, it is now possible to examine potential financial sources for the future. In North America, the industry has focused on improving earnings. As a result, overall profit margins have trended upward during the last few years. At the same time, the industry has focused on investing only the capital needed to maintain its competitiveness instead of expanding capacity. As a result, CapEx (capital expenditure) to PPE (property plant and equipment) ratios have been trending downward so that 1998 became the first year in history that the industry had higher depreciation than CapEx.

Further cuts in CapEx levels are also expected shortly, especially once the details of the US Cluster Rules (environmental regulations) have been finalized. Despite the reduction in capital spending, debt levels have remained high due to continued poor profitability and share repurche programs. The latter resulted from a desire to bolster equity values and the availability of buying opportunities. There has been virtually no new equity issuance since 1995, with the exception of a couple of IPOs (initial public offerings) and de-mergers, such as Pacifica Papers in 1998 and Crown Vantage in 1995. On average, debt ratios in the North American forest products industry have remained at about 48% of total debt to capitalization.

Over $30 billion was raised for the forest products industry in North America in 1998 (Figure 2). Some 97% was debt financing compared to a 3% contribution for equity. Over 71%, or almost $20 billion, of this debt was raised in the bank market. Figure 2 is also representative of the rest of globe, where debt financing accounts for over 90% of the total capital raised for the industry. The balance of North American debt in 1998 was split between high yield (almost $4.0 billion) and investment grade debt ($3.5 billion). High yield spreads indicate the yields demanded by investors in this market. Due to the emerging market crisis that began in the third quarter of 1998, investors demanded more yield to carry out transactions in the fourth quarter of 1998 and on into 1999.

Europe has witnessed similar trends, but with one major difference. The overall gearing levels at 38% are about 10% lower than US levels. This is also true across other industries as European companies tend to be less leveraged than their US counterparts.

Emerging funds
In Latin America, and Brazil in particular, the industry's debt levels remain high. This is due to a number of factors, including a shift in monetary policy earlier in the decade as well as recent capacity expansions. More specifically, looking at the current and near term financial environment in Latin America, the devaluation of the Brazilian real has thrown the country's economy into recession. And since Brazil accounts for over 40% of the region's GDP, this is of fairly major significance.

Other factors have contributed to high debt levels in Latin America too, and they will continue to do so. Brazil's economic contraction will affect its neighbors, especially Argentina, through reduced trade flows.

Additionally, low commodity prices will hurt many Latin countries and the financing crunch is set to slow investment spending. Political developments could impact growth in countries such as Brazil, Mexico, Argentina, Ecuador and Venezuela. As a result, aggregate growth in Latin America should be flat in 1999, compared to the 2.3% growth seen in 1998.

Last, but by no means least, comes Asia. Given the competitiveness of the region, the industry has enjoyed high profit margins while overall leverage levels have also soared to new highs. This trend resulted from the significant expansion plans carried out over the last five years and the region's financial crisis that began in 1997. Equity financing has been extremely limited following the crisis. A prime example of this is the Changshu deal between UPM-Kymmene and APRIL in China. APRIL teamed up with UPM-Kymmene to finalize the mill¹s construction, which ultimately allowed UPM-Kymmene to put up its own equity capital to help finance the project.

Last December, Chase and other banks refinanced this equity contribution in the bank market.

At present, there is also very limited debt financing in the region, particularly in the so-called tiger economies. The little financing that does exist is limited to the support of export credit agencies or other multilateral support. Equity values on average are at about 10-30% of the industry's four-year peak. In the medium term though, Asia's hesitant recovery should continue, driven by loosening macroeconomic policies throughout the region. On the down side, a Chinese devaluation could potentially spark renewed regional contagion, while an abrupt collapse of the yen would hurt the region as most Asian currencies are pegged to the currency.

Capital markets have been closed to emerging markets for most of the past 18 months. Many banks reduced their exposure to Latin America and Asia, cutting back credit lines. Clearly, this poses a challenge to such a capital-intensive industry as the forest products sector. However, there is and continues to be structured financing available to the emerging markets, including traditional and structured trade finance, development banks and equipment finance. Development banks can provide alternative long term financing sources for players in these markets. In this area, the Brazilian national development bank (BNDES) is a leader, providing long term, low cost local currency loans (an emerging market rarity), equity and good advice.

Despite all the negative news surrounding the availability of emerging market financing, there is a glimmer of hope to be found in the many capacity expansion plans that have been put on hold and/or deferred. This temporary delay should help the industry to correct the supply/demand imbalance and improve its overall health through increased profitability and enhanced shareholder value.

Stocks in favor
Most of the major acquisitions that have been carried out over the last few years have been done on a stock-for-stock basis, but smaller transactions have tended to be carried out on a cash basis. Given the friendly nature of such mergers, tax-free stock deals are the preferred route. There are rarely hostile transactions in the industry with the exception of one or two deals that were debt financed - for example, the Georgia-Pacific/Great Northern Nekoosa transaction earlier in the decade.

In stock transactions, there is basically no new equity as the target company's equity is rolled up under the acquiring company's equity. And on the debt side, existing debt levels are refinanced under the new company plus any incremental debt needed to consummate the transaction. Pure stock deals commanded the lion's share of the mergers undertaken over the last three years (Figure 3) and this trend is expected to continue as long as tax authorities allow the tax-free benefit of such deals to continue. Another source of financing that is beginning to creep into the sector can be found in private equity capital. Increased M&A activity has attracted a class of investors that has traditionally shied away from cyclical plays due to the lower return on investment. Some recent transactions of this kind include Madison Dearborn's acquisition of Tenneco's containerboard business and CD&R's purchase of Riverwood.

Looking ahead, the consolidation pace will continue to accelerate in the near term, creating global companies with access to capital at the most competitive costs. Financing for the larger merger transactions will be dominated by stock for stock and/or stock and cash transactions, while smaller deals are expected to be debt financed. Greenfield expansions will be limited and mainly focused in the southern hemisphere. Financing will continue to be scarce for these expansion plans and probably dominated by structured trade finance, government agencies and support from development banks.

North America and Europe are expected to dominate the capital markets in terms of liquidity, access and efficiency. On a more positive note, the turbulence in emerging markets is likely to diminish in the medium term, but there will be some lag in the restoration of capital markets in these economies and the return of investor appetite. In the near term, financing in emerging markets will remain scarce and expensive.

Debt markets will continue to dominate the financing of the global forest products industry in the near to medium term through commercial banks, capital markets, export credit agencies and other multilateral agencies. Equity capital will also be used to support the industry, albeit as a very small percentage of the total.

The bank market has always been a key supporter of the industry, viewing the sector very positively. When all public markets have shut down, the bank market remained open to the industry, as witnessed during the crisis in the third quarter of 1998. As a result, many companies rely on this market as it provides the deepest, most liquid and most diverse form of capital available. But even the bank market is expected to become more cautious in the future when asked to finance non-integrated, stand-alone mills. These types of projects will become very difficult to finance, particularly given the recent experience with projects such as the Celgar pulp mill in Canada.

The outlook for the forest products industry is favorable, but the sector needs to work more closely with governments and financial institutions to ensure a disciplined approach toward further expansion and the promotion of the industry. Given the fragmented nature of the sector, it would be a lot easier for each company to focus on its own individual interest. But the world is becoming a lot smaller and actions taken by any sizable company in Brazil, Indonesia or even in the USA, will affect the fortunes of others in Europe and elsewhere. The industry needs to work together with its constituents toward the common goal of improving the health of the industry and enhancing shareholder value. With improved profitability, financing, be it debt or equity, will always be there to support the industry.

Foad Tamaddon managing director of Global Forest Products at Chase Securities Inc., gave this speech at a PPI Forum in April 1999.

Note: This story has been revised from an earlier version.

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