There is a future on the cards

The odds are stacked against the industry at the start of 2002. But if observers' predictions come true, the bad vibes will fizzle out in the second half of the year, bringing good fortune to all those who survive the walk on the dark side

Like most other companies, PPI would like to wish every reader good health and happiness for the future. That goes without saying. But no matter how hard industry players wish the same for the pulp and paper sector, the outlook remains gloomy. The overwhelming response to PPI's outlook survey has sadly painted a bleak picture for 2002. The best that observers can hope for, according to the survey results, is that 2002 turns out to be a year of two halves, with July-December bringing some respite.

Last year ended on a low with the bulk of the industry's analysts, CEOs and consultants feeling less positive about the future than they were in the middle of the year. This pessimism can be traced back to well before the terrorist attack on New York on September 11, when the slowing world economy took another blow. But there are other, industry-related, reasons for the lack of joviality throughout the pulp and paper sector. Oversupply, low prices and weak demand have all played a part in tarnishing the industry outlook.

Producers may have had a tough time over the past 12 months with little to look forward to in the immediate future, but Christian Georges, financial analyst at Crédit Lyonnais Securities, does little to cheer them up, saying that the biggest hurdle that companies will have to face this year is "their own stupidity", referring to the "totally unrealistic newsprint price increases imposed this year". On top of that, Ken McEntee, publisher of The Paper Stock Report - Paper Recycling Online, is only a little more restrained when he says, "The industry, like all other industries, needs to stop making decisions based on the desires of Wall Street analysts."

Some observers can only see a "blind leading the blind" scenario in the industry as sales, profits, output and demand continue on a roller-coaster ride that seems to contain more dips than climbs. But others including Javier Ortiz, general director of ConsultUS based in Mexico, come to pulp and paper producers' rescue saying that, "The pulp and paper industry is a slow and late learning industry." Ortiz maintains that companies have made a start on the road to self-improvement, but they still have a long way to go. Now comes the difficult part, according to Ortiz. "So far, the job [of modernizing and reengineering] has been easy through mergers and acquisitions and shutting down inefficient mills," he says. Drawing a parallel with the automobile industry, Ortiz continues, "The new generation of Hondas, Chevys, small Mercedes and BMW is beginning to emerge. The big cars running at 4-5 km/l are still operating, but the breed which can achieve 12-15 km/l with lots of conveniences and technologies is starting to appear."

Georges at Crédit Lyonnais is less benevolent toward manufacturers and attacks the global phenomenon of oversupply, saying that excess production will continue in 2002 with the possible exception of the cartonboard and tissue sectors. Producers may have worked hard over the past 12-24 months to cut back supply in line with demand, but areas such as pulp, fine paper, magazine paper and newsprint will continue to come under the axe as the year unfolds, he maintains.

One European securities broker also believes that the newsprint sector will lag behind this year. "Newsprint may be weak as some new machines start in Europe. Newsprint and SC [supercalendered] will probably under perform in 2002 as they are the late cyclicals," he maintains.

But not every response to the survey is a harbinger of doom. On a positive note, Stora Enso's CEO, Jukka Härmälä, says, "European demand for SC paper and uncoated fine papers should stay healthy despite the general weakening of these markets." But even Härmälä sees a downside. "Even newsprint will start showing some weakness," he comments. On the basis of the company's forecast, Stora Enso plans to make some cutbacks during the year. "Market uncertainty has increased and the outlook is being affected by world events. Stora Enso will continue to adjust its capacity to market demand."

The giant producer is sure to be in good company, though, when it comes to trimming output. "There is going to be [general] oversupply in the pulp and paper industry in 2002," according to Lauri Hetemaki, senior researcher at the Finnish Forest Research Institute. "New production capacity is coming to the market and the rather weak demand is not absorbing it with current prices. [This] is likely to lead to downtime," Hetemaki says.

Predictions of oversupply and downtime are not restricted to Europe either. President and CEO of Paprican, Joseph D Wright, represents many North Americans when he says, "We remain in an excess supply position although companies have been more serious about taking downtime and this will help. Newsprint in particular will remain slow, though."

While producers in North America and Europe in particular are making a great show of slashing capacity to bring supply in line with demand, a rather different story is unfolding in Latin America. Equity analyst, Marcelo Falcone Hanan of Fator Doria Atherino Brokerage House in Brazil, says, "Suppliers are really investing to increase their capacity and will continue [in 2002] in order to enhance their position in the global market."

Lucas L Godinez, managing director of Klabin Embalagens, echoes Hanan's comments and says, "In Brazil, there has been a 20% increase in recycled paper capacity added in 2001. That is hardly responsible."

One equity research analyst says that suppliers have acted responsibly in 2001, but not all of them. "As expected, the larger companies are taking the hit when it comes to downtime and smaller producers continue to maintain high capacity utilization figures. This is expected to continue into 2002, but even with suppliers taking the downtime, we still need to see a recovery in demand in order to see a recovery in prices." According to the analyst, suppliers are likely to increase capacity utilization in 2002, which does not bode well for price increases. "As prices start to stabilize, I think producers will try to increase capacity utilization, but this will simply put more downward pressure on prices."

Bruce Kopkin, president of Lorentzen & Wettre USA, simply states, "Supply must not increase. Individual company greed must be held in check for the sake of the industry. Mothballed mills cannot be sold and restarted."

The negative effect of oversupply reaches the far corners of the world, but the country that is cited most for contributing to the excess, particularly in the containerboard and newsprint sectors, is China. McEntee of The Paper Stock Report, says, "Unless an international crisis occurs involving China, China will continue to grow as [one of] the major world producers, particularly in packaging grades. Major US producers will adapt by further investments and perhaps a great deal of control over Chinese production. There will be repercussions in the US beyond the tunnel vision of Wall Street."

But for every pessimist, there is always an optimist, and Ray Curran, president and CEO of Smurfit-Stone Container, is one of them. "There is some reason for cautious optimism due to a sizeable amount of policy stimulus in the pipeline in most major economies, even more than had been anticipated before the September 11 attack," he says. According to Curran, "Economic fundamentals across the globe are considerably stronger than they were a few years ago, reflected in lower inflation, stronger fiscal positions and greater monetary policy credibility."

While no sector stands out as being a "dead cert" for this year, the newsprint industry, along with packaging, is set to endure the roughest ride. One reason for this is the fact that the grades' popularity is so closely linked to the economy. The global macro economic outlook is dark for at least the first six months of the year. Consumer spending is down, major financial institutions have been forced to cut interest rates and many companies are struggling to keep afloat. Toward the end of last year, companies were spending less on advertising, which resulted in a reduction in pagination in the newsprint sector. The knock-on effect is that newsprint consumption has also been pulled down. According to industry analysts, Hawkins Wright, the newsprint growth rate in the eurozone was likely to hit 1.6% in 2001 before dipping to 1.5% this year.

In the US, domestic media spending by advertisers was expected to drop by 6% last year to $192 billion, according to the Jack Myers Report in USA Today (Pulp & Paper Week). The drop would be the largest one-year ad spending reduction since 1942, when the figure fell by 4%. The report also said the US media spending by advertisers would slump by 7.8% in 2002 to just $177 billion.

There may be a light at the end of the tunnel, though. While sources are unanimous that January-July will be a difficult time for the industry with a real likelihood of recession deepening around the globe, the middle of the year may turn out to be a pivotal point. In the US, analysts at Morgan Stanley say that the combination of sluggish demand and the strong dollar seen at the end of 2001 undermined commodity prices, but economic recovery in the second half of 2002 should drive the next up-cycle. The European picture is not so bright, though. Toward the end of last year, Morgan Stanley forecast total European paper demand to decline in 2001 by 4% and to grow by a below trend 1% this year. A recovery is forecast in the second half of 2002, but this optimism is partially derived from the company's US economists' view that a sharp rebound in US economic growth will develop. If the US recovery proves not as powerful, there are downside risks for the European July-December recovery forecast as well.

While many observers forecast a negative outlook, mainly for newsprint, at least one equity analyst is most upbeat about the sector in 2002 believing that newsprint is a relatively consolidated grade with little or no new capacity due to come on stream.

Packaging is, of course, another grade whose popularity goes hand in hand with the economy. Commenting on paper-based packaging grades, as well as pulp, Curran of Smurfit-Stone Container says, "Like 2001, [2002] will be difficult and will require discipline management within the global industry. US capacity growth is at record low levels. However, capacity gains in China and Europe are driving global containerboard grade increases to 2.2-2.5%/yr."

According to Curran, there is unlikely to be an increase in demand in the near term to reduce the demand-supply gap. He points out that while capacity increases in Asia and Europe will certainly hit the US in terms of fewer exports, the overall effect will be no different to the impact of the overly strong US dollar of the past few years.

To limit adverse effects and stabilize market conditions, many producers have made considerable effort to participate in merger and acquisition (M&A) activity in the last couple of years. On the surface at least, companies have worked hard to increase their market share on a global scale with the intention of providing a more stable pricing environment for customers, as well as improving shareholder value. According to the outlook survey, M&A activity is widely expected to continue in the coming months, but there is a mixed response as to which regions and segments. Overall, observers anticipate that consolidation will continue around the globe and across all the grades. "The big boys have to settle down first, though," one source says.

But has past M&A action actually brought any benefit? Again, there is a mixed response to the question. At one extreme, an observer comments, "Mergers are not the answer to shareholder value. We need fewer paper machines and no new capacity. Paper and print are dead." But at the other end of the spectrum, Reid Carter, paper and forest products analyst at National Bank Financial, says, "Yes, prices for most commodities could have been expected to be much worse if consolidation in newsprint, containerboard and fine papers had not taken place."

M&As are traditionally seen as a positive step. But as the number of deals increases, so does observers' awareness of the end result. So far, the majority agrees that M&As bring short term benefits. However, unless CEOs adjust their spectacles and display more long sightedness, the benefits will be lost, players say. Comments such as, "mega mergers never work as advertised", "you end up with debt ridden, bloated organizations" and "it has a concrete financial impact on the wallet of the CEO" do little to boost morale among consolidators past and present. But if there is doubt over the sustainability of financial returns, what else can companies expect?

Despite the negative image of M&As, there are many supporters of corporate moves to expand and consolidate. "[M&A activity] has not yet affected margins, but it will," one source says. On top of that, "There will only be four to five large players covering 80-90% of the market in two to three years." Once that situation has been reached, "Then we will see a difference," another observer comments.

Focusing on paperboard and packaging grades, Curran of Smurfit-Stone Container says, "M&A activity will continue in the next couple of years, particularly in North America. The industry is starting to bring more predictability to shareholders and is adjusting more quickly to cost reduction needs. The real issue is growth and allocation of capital." Curran explains how companies should proceed to maintain a solid financial framework and comments, "Greater focus must occur on the needs of the customer within their ever changing environment. Innovation and speed-to-market are essential qualities for producers that must be stepped up to new levels." Curran is confident that shareholders will benefit from consolidation, if they are not already. "Shareholders look for producers that have great enthusiasm for their business and are focused on a couple of key grades where they are market leaders. Continued consolidation will eventually produce these results," he adds.

Mark Wilde, managing director at Deutsche Banc Alex Brown, is another believer in the continuing M&A trend. On top of that, he says there is a 50% probability of seeing the biggest ever trans-Atlantic deal in the coming months. "The industry does need to consolidate much more dramatically and we won't get there 'hitting singles'," he says.

The prospect of a mega-merger to beat all others will bring readers either delight or just another turn of the screw, depending on their industry position. Many aspects of the outlook survey may have conjured up a picture of hell fire and brimstone for the industry's future. But producers may find comfort in the responses from people in high places, who anticipate better times to come later in the year. A few observers have tried to dampen the glimmer of hope on the horizon by saying that an upturn will only come in 2003 and beyond. But be that as it may, it will still come.