The failure of consolidation
by Henry Poole
The earnings of the five principal listed European forest products companies in 2002 should be on average 64% below the 2000 level. Observers should expect the rate of earnings decline to accelerate sharply in 2002 with the unwinding of the late cycle publication paper price increases and the erosion of added value in integrated fine paper operations.
Consolidation cannot artificially create a profitable balance between supply and demand. Although it has reduced the number of suppliers, it has still left an industry that has over-estimated the level of demand and under-estimated the strength of supply. Customers have rebelled by using less paper and finding new sources of supply. The rigidity of the framework adopted by listed companies for cutting production and sustaining selling prices has given the private companies an opportunity to expand at low risk. Despite the consolidation of Haindl, for example, publication paper capacity in private ownership has grown by some 30% since 1999 to 5 million tonnes/yr.
The debate about consolidation has assumed such a dimension that it obscures the vital point of how dependent the industry has become on the weakness of the euro. Each Euro 0.01 change relative to the dollar has affected the average cost base of publication/integrated fine papermaking by some $7/tonne. This was at a time the value of the euro was $0.89 compared with $1.31 in 1995. It is not surprising that, despite high wood costs, even in eucalyptus pulp production, Europe's cost disadvantage has narrowed from some $200 to just $25.
The real situation
Despite reassurances from the industry, the far more serious question of why the earnings collapse is happening in the first place must be asked. What is the point of believing in consolidation if it has been accompanied by damage to the consumption trend, the continued growth in capacity and the alienation of customers?
Customers resent deeply the arrogance of papermakers, which has sprung from misplaced belief in producers’ power to control markets. In Europe, the fine papermakers cannot understand consumer resentment at being forced to pay 25% more for fine paper than in 1999, when pulp costs less.
Vigorous pursuit of consolidation can only release forces that are destructive to those who try to control the markets. Paper buyers are determined to seek new sources of supply, barriers to entry are falling and new entrants profit by advances in papermaking technology. The consolidators are no longer at the cutting edge of the industry in contrast to the brilliance of Myllykoski, the ascent of Papierfabrik Palm and the increasing audacity of both Leinfelder and Cartiere Burgo.
For example, place a price of $1,500/tonne on the so-called consolidation of European capacity in the context of Russia. International Paper's ownership of Svetogorsk and Mondi's participation in Syktyvkar proves that western investment can be successful. Expect more of the same, given the availability of both hardwood and softwood fiber at low cost and the value placed on capacity. The figure bruited for Syktyvkar, which has achieved impressive returns, was $500/tonne, a third of what has been paid in western Europe.
In the listed part of the European forest products sector there are only two substantial companies, which have both thought correctly in strategic terms and acted in time. These are Norske Skog, which has been transformed, and Holmen, which has emerged from a long period of relative decline.
Enthusiasm for buying market share by acquisition is not being accompanied by sufficiently rigorous mill rationalization. It is dangerous to accumulate a long tail of weak mills and then be forced into compromises over re-investment, whereby aging facilities are downgraded in size instead of being closed and the full potential of low cost sites is not realized. Study by contrast the approach of Holmen, which has focused on a small number of sites and divested the remainder.
The fate of the paper industry is to believe in impossible dreams and to apply with vigor conclusions drawn from lessons painfully learned long after they have had any relevance. Consolidation might have worked, had it happened in the early 1990s. It has little place in today's changed economic environment, which is about the vulnerability of consumption trends and the strength of deflationary pressures. Customer alienation, falling barriers to entry and the opportunity of new entrants to exploit artificially imposed constraints on the normal working of the market are somber portents for those who advocate consolidation.
Henry Poole is an analyst at Credit Lyonnais Securities based in London
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