Capacity expansion plans are few and far between these days, but this should spell good news for producers and investors alike

By Mark Wilde, Catarina Ihre and Peter Stroble

Capacity cuts lead to better conditions

A lack of investment, and consequently new supply, points to tighter markets, higher prices and stronger earnings, perhaps for an extended period. With large new paper machines projects typically taking three years to complete, paper companies could be entering a three to four-year window of prosperity. The industry could enjoy a replay of the 1986-1989 upturn.

Capacity squeeze

All the indicators suggest that a global capital squeeze is under way in the paper industry. The trend is apparent in individual company numbers as well as industry-wide figures. There is also anecdotal evidence to support the trend. In June last year for example, the parent company of one of the world's leading manufacturer of paper machines filed for protective bankruptcy. Harnischfeger's collapse into Chapter 11 and Beloit's subsequent struggle under the weight of the financial uncertainty underscored the difficult environment facing equipment suppliers to the industry.

Capital spending in the USA and Canada remains well under depreciation and amortization (D&A) levels. In the USA, the American Paper & Forest Products Association's (AF&PA) 1999 capacity survey pointed to the lowest three-year forecast growth rate on record. The survey showed just 0.7%/yr growth rates through 2002. Moreover, as it began to reflect the shutdown of marginal capacity, the AF&PA survey showed a net decline of 0.5% in the industry capacity in 1999. This is the first year-to-year capacity decline in the survey's history.

In Europe, capital expenditure rates are running at, or below, depreciation rates for the first time in many years. Consolidation remains the order of the day in Europe. The major players are all looking for growth through acquisitions, not only regionally, but also in Asia and North America. New machine expansions are low on the agenda. The biggest Scandinavian companies have also initiated stock repurchase programs.

In both regions, the industry has been widely criticized for over-investing capital and underperforming for shareholders. The market has punished firms with new projects. In addition, CEOs are squarely focused on the long term threat from low cost, southern hemisphere producers. For example, for the first time in many years, there are no market pulp or uncoated white paper projects under discussion in North America. In Europe, there are very few new projects coming on stream as companies recall how the market was destroyed in the early 1990s through excessive capacity growth.

The impact of the capital squeeze on "higher growth" portions of the global industry is just as striking. In Latin America, several major projects have also been deferred. And in Asia, which was the center of much capital spending during the 1990s, 1999 marks the last big year of new machine startups - for the near term at least. Several prospective projects have been shelved due to Asia's economic crisis and funding lines for $1-2 billion mills in Indonesia are likely to remain closed for the time being, despite improving market conditions.

Operating status

Long project lead times mean that much of the industry's new supply can be predicted out to 2002. In most grades, there is just not much new capacity in the pipeline. The implications for the industry's supply/demand balance and profitability are powerful. If global demand strengthens over the next couple of years, operating rates in the industry are poised to rise.

Operating rates are presently in the 95% range in North America and 93-96% in western Europe for most major grades. Historically, operating rates have been among the best indicators of the industry's health. Rates in the mid-to-upper 90% region have been indicative of good times. Higher operating rates in the future should produce higher prices and improved profitability.

Saying that the industry is sensitive to operating rates is just another way of pointing out the importance of supply and demand in this business. On the demand side, consumption of most paper products tends to be economically sensitive. However, the year-to-year demand swings are relatively modest - typically just a few percentage points. For example, consumption of containerboard is driven by the production of boxes for durable (25% market share) and non-durable goods (75% market share). Stable demand for non-durables such as food, beverages, soap and detergents means a relatively steady need for corrugated containers. Although export demand represents a much smaller piece of the market, it too can represent a critical element in the demand equation. Exports are particularly important for US producers in markets such as containerboard and newsprint.

Over time, surges in new supply have probably had a greater impact on the market than declines in demand. Typically, paper companies have responded to the same factors (high commodity prices, inexpensive capital) at the same time and in the same fashion, ie building new capacity. As a result, capacity has come in waves. Due to the long lead times on big capital projects, companies have little leeway to adapt to changing markets. Once new machines are under construction, they are pushed to completion. And once completed, high fixed costs dictate that they run, often flat out. The result has been disastrous for pricing as can be seen from Table 1, which highlights four recent rounds of overbuilding in the paper industry.

New capacity does not come just from new mills and machines though. Debottlenecking represents a highly cost-efficient means of boosting capacity for papermakers. While some debottlenecking occurs every year, strong markets and higher prices make the returns on these incremental projects look even more attractive. As a result, the pace of machine speed-ups and rebuilds tends to accelerate during strong markets.

Global supplies

It is increasingly important to consider capacity increases, in whatever form, within a global context. A growing number of paper commodities are traded globally, rather than on a regional basis. Added to that, the companies themselves are increasingly becoming global in their operations. As a result, capacity additions on one continent can produce a ripple effect around the world.

The Asian economic crisis drove this point home with a vengeance in 1997 and 1998. Asian demand collapsed just as a wave of new capacity across the region was coming onto the market. What could no longer be sold locally was forced into global markets. Suddenly, newspapers on the west coast of the USA were buying Korean newsprint. Western European producers, already suffering from the falling demand in Russia, were hit by lower exports into Asia. Office supply superstores found themselves stocking Indonesian copy paper and prices of virtually all paper and paperboard commodities collapsed. For many US paper companies, the Asian collapse marked a fitting close to a miserable decade. When looking back in 20 years, we may find that it marked the end of an era for the industry.

For the first time in memory, every region of the world

is experiencing a drop-off in new capital investment. Our research suggests that new capacity for all paper grades will grow at a rate of just 1.4% from 1998-2001. Moreover, a good deal of the industry's highest cost capacity in North America has been shut down. Some of these closures have yet to be included in capacity estimates. For example, over the past year, 2.0-2.5 million tons of containerboard capacity, or 6-7% of the North American supply base, has been shut down. Similarly, an estimated 2.5-3.0 million tons of pulp capacity have been mothballed. Although the dynamics vary from region to region, the underlying reasons are similar - poor financial returns and an inability to attract new capital.

North American numbers

Most North American paper companies have experienced horrible financial returns for nearly a decade. With the exception of a short-lived boom in 1995, the 1990s have been a lost decade. Plagued by overcapacity and low commodity prices, the industry has failed to earn its cost of capital throughout most of the decade. Paper stocks have missed the stock market boom of the mid to late-1990s. Poor returns and a growing recognition of the erosion in their global cost position forced US and Canadian producers to reassess their positions and reconsider investment opportunities.

The AF&PA’s 1999 capacity survey predicts that new capacity growth in the USA will average just 0.7% in the 1998-2001 period - the lowest three-year average on record. The one exception to the general trend is illustrated by the inclusion of six new tissue machines in the survey, indicating that this is one segment of the industry where producers are clearly on a capacity binge.

The capacity numbers are also reflected in the financial projections of individual companies. The North American pulp and paper industry has brought capital spending to levels well under depreciation and amortization, effectively pulling capital out of the industry. Since most of the numbers include investment figures for both paper and building products operations, they understate the shortfall in pulp and paper investments. Many companies continue to put new capital into building products operations, even as they under-invest in their paper operations.

North American companies have also been consolidating and rationalizing their operations in response to increased global competition and poor financial returns. From a capacity standpoint, the most important result has been a rationalization of marginal mills, further reducing the capacity base.

The most striking example has been the closure of 1.1 million tons of containerboard capacity in the wake of the Smurfit-Stone (SSCC) merger. The company's recent move to take control of the closed Florida Coast Paper mill boosts the capacity that SSCC has under wraps to 1.6 million tons - or roughly 4% of North America's containerboard industry. While the SSCC merger has been the most dramatic example of consolidation accompanied by capacity rationalization, virtually every other recent merger has had much the same result. Indeed, SSCC's call to "consolidate, rationalize… repeat the process" is becoming the industry mantra in the USA.

European moves

The pace of consolidation has been even more striking in Europe, especially in the Nordic region. UPM-Kymmene and Stora Enso, both the result of several mergers over the past decade, now constitute two of the world's three largest paper companies. Most European producers are financially healthy because of extensive cost-cutting and rationalization programs undertaken in the early and mid-1990s.

Figure 2 highlights the aggregate level of capital spending for the leading European paper companies relative to their D&A costs. Since Europe still accounts for approximately 30% of global pulp and paper capacity, the impact of lower capital spending levels on the global market is substantial.

There is also a strong commitment among the blue chip companies in Europe to grow through acquisitions and to play active roles in further consolidation. Apart from the woodfree and waste-based containerboard sectors, western Europe is already well on the way to becoming a consolidated business segment. Consequently, producers are now starting to look outside Europe rather than continuing to expand within the region.

There are some risks of further European capacity growth, particularly those associated with privately-owned companies. For example, the family-owned German group, Haindl, is starting up a lightweight coated machine in 2000 and has declared a strategy of continued growth. Other sources of potential capacity include government-sponsored projects such as those proposed by the Baltic States, notably in the market pulp segment.

However, as in North America, the good news clearly outweighs the bad. Positive developments include recent moves by leading Nordic paper companies to return cash to shareholders through stock repurchase programs and extraordinary dividend payments.

Until very recently, stock repurchase programs were not permitted in the Nordic countries. These programs are important, not only because they highlight the increasing shareholder focus among Nordic producers, but also because they provide an alternative use for free cash flow during strong markets.

Latin flavor

The big story in Latin America is the lack of news - there are practically no major projects under construction in the region. Although there are still plenty of proposals in both Brazil and Chile, very little new capacity is currently being built.

Estimates suggest that the capacity base across Latin America will rise by 1.3 million tons over the next three years. In Brazil, several proposed pulp mill projects have been stalled by weak markets as well as repeated bouts of economic and political upheaval. Eventually, some of these projects will move ahead though.

With an extremely advantageous climate for growing hardwood and softwood fiber, Brazilian mills enjoy some of the world's lowest production costs per ton. The next time the industry goes on a construction binge, Brazil may be the epicenter. For the moment though, there is little firm progress on projects, so new capacity is at least two years from the market.

A similar situation exists in Chile where the two big players, Arauco and CMPC, have repeatedly delayed large capital projects in favor of acquiring competitors at home and in neighboring countries. Arauco has repeatedly postponed a 500,000 ton/yr pulp mill project in southern Chile. Instead, the company acquired the only large pulp producer in Argentina - Alto Parana. Similarly, CMPC bought the 280,000 ton/yr Santa Fe pulp mill at Nacimiento in Chile in November 1997 from Shell and Citicorp, rather than building more capacity.

Magnetic force

Over the past few years, Asia has been the biggest magnet for capital in the paper industry. Even as North America and European paper companies began taking a more judicious approach to capital during the 1990s, non-Japanese Asian paper companies pushed ahead with plans for huge new pulp and paper mills.

Asian consumption grew by 48% from 1990 to 1996. Fed by rapidly growing Asian demand for paper, generous timber concessions and plenty of low cost capital, the Asian pulp and paper industry headed out on an aggressive growth track. Indonesia attracted much of the new capital in the region. At a conference in London in December 1996, the head of the Indonesian Pulp & Paper Association outlined plans for 10 million tons of market pulp capacity. It was heady stuff, since Indonesia was only exporting 1.13 million tons of pulp at the time and the total world production of market pulp was just 37.9 million tons. Other countries with significant capacity growth were China, South Korea and Thailand.

The economic crisis that swept through the region in the summer of 1997 caused a sharp drop in local demand and dried up much of the cheap capital for the region. Unfortunately, it did not mean an immediate end to new capacity additions.

While many projects still in their early stages were shelved, those already under construction continued to move forward, often in a delayed or scaled-back fashion. As capital projects in the industry are so large and carry such long lead times, there was a lag between the economic crisis and the end of new pulp and paper mills in the region.

Most of the new capacity in Asia (mainly woodfrees) will be running by the end of 1999. However, the new supply pipeline has been largely bled out and very little additional new capacity is slated to start up from 2000-2002. After adding 3.3 million tons of woodfree capacity from 1997-1999, Asian producers are projected to add less than 0.5 million tons from 2000-2002. Will Asian pulp and papermakers return to the capital bottle again if industry conditions improve over the next year? We think there are some significant reasons to believe this will not happen. Firstly, concerns over continuing economic and political risk in countries like Indonesia, Malaysia and Thailand are likely to slow the investment of new capital, even as industry conditions improve. A good example is the failed fine paper joint venture between UPM-Kymmene and APRIL (Asia Pacific Resources International). Secondly, granting timber harvest concessions on government land in Indonesia has become a more contentious issue since the fall of the Suharto regime. These concessions were a critical element in most projects built in the 1990s.

Korea represents another major center for new capacity during the 1990s. However, the past two years have seen much of the new Korean capacity fall under the control of western paper companies including Abitibi-Consolidated, Norske Skog and Bowater. These companies are likely to be much more sensitive to the global implications of any further capacity additions.

Forward thinking

The supply news from each of the regions, or rather the lack of it, points to slower global capacity growth over the next two to three years. In major producing regions like the USA, projected growth is at its lowest level in at least 40 years. If demand growth returns to the traditional historic rates of 3.5%-4.0%, the industry should see operating rates rise and pricing improve.

With the supply outlook relatively fixed, the real key to the industry's future is demand. For pricing initiatives to be sustained, more evenly balanced global growth is essential. Demand must pick up in Europe, Latin America and Asia. Europe and Asia are particularly important since they are such large pieces of the total global market. In 1997, the two regions accounted for 59% of total worldwide paper and board consumption.

Economic laws should not be forgotten. Supply is elastic as prices improve and strong markets will bring new capacity. The most obvious source is debottlenecking. Under normal conditions, we estimate that these incremental improvements boost capacity by roughly 1% per year. In a stronger market, the pace of debottlenecking could reach 1.5-2.0%.

"As global demand growth improves, operating conditions are poised to tighten. For a disciplined investor, we believe there is a solid opportunity in this sector"

Mothballed capacity, much of it in North America, is apt to restart as prices climb. But just how much mothballed capacity will come back, and how quickly? Firstly, much of the shuttered capacity is controlled by large players such as SSCC - firms with an interest in avoiding oversupply. Secondly, in sectors such as pulp, significant pieces of this capacity would require considerable new capital investment to meet tightening environmental standards.

A review of new capacity growth on a grade basis also reveals some significant variations. The only notable capacity growth over the next few years is to be found in the tissue industry, where capital spending is strong on a global basis. Even without factoring in debottlenecking, tissue companies are slated to add approximately three million tons of new capacity on a base of 19 million tons. Although tissue companies have enjoyed the best long term returns in the paper sector, the combination of new capacity additions and rising fiber costs are likely to put pressure on margins over the next one to two years. Other segments with above-average capacity growth include meaningful additions to coated mechanical grades in Europe and newsprint in China. On the other hand, there is very little in the way of new bleached board or containerboard capacity anywhere in the world.

The medium term supply/demand dynamic for the pulp and paper industry is positive. There simply is not much new capital flowing into the industry and the global supply curve is flattening as a result. As global demand growth improves, operating conditions are poised to tighten. For a disciplined investor, we believe there is a solid opportunity in this sector over the next 1-2 years. Whether the industry can ever again become a solid longer term investment is an issue in the hands of executives, directors and shareholders. Put simply, the industry must collectively do a better job of managing the flow of new capital into the sector.

Mark Wilde and Peter Stroble work for Deutsche Bank in New York, while Catarina Ihre is based in Stockholm.

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