Need to know – Market dynamics from Moodys

1 June 2015



Need to know – Market dynamics from Moodys
Converting Today reached out to Moodys to find out more about what’s driving the market and the ratings for the key EMEA paper and forestry companies.


Need to know - Market dynamics from Moodys

In place of individual viewpoint and lastword articles, Converting Today reached out to Moodys senior analyst Matthias Volkmer to find out more about what's driving the market and the ratings for the key EMEA paper and forestry companies.

More diversified players posted solid EBITDA growth in 2014
Moodys rates 11 European paper and forest products companies in EMEA. Among the nine rated companies that have so far reported their preliminary financial results for 2014, six (Metsa, Mondi, Sappi, Smurfit Kappa, Stora Enso and UPM) posted solid single-digit to low double-digit percentage EBITDA growth (see Appendix B for more details) and strong free cash-flow generation. Although the financial performance of those companies with traditional paper operations was helped by the decline in demand for European graphic paper of about 3%, which was less than the 5% drop we had previously expected, we think the improvement in their results mainly reflects their efforts to reposition or broaden their business profiles away from the mature European paper market.
These companies have made, and continue to make, sizeable investments in related segments, such as specialty paper, paper packaging, liquid packaging, chemical cellulose and biofuels, and/or have lowered their fixed and variable costs across their operations. Exhibit 1 provides an overview of the companies' profitability in 2014 relative to the highest margin that each company has achieved.

Challenges persist for players with narrower product focuses
Ence, Norske Skog and Portucel all reported declines in EBITDA for 2014. These companies, which have narrower product focuses than the other six rated companies that have reported their results, still face substantial challenges and execution risks as they seek to improve their business prospects in 2015 and beyond. To do this they are executing their restructuring plans (Ence), addressing cost inefficiencies (Norske), or expanding their business profile into new product areas of higher growth (Portucel).
In 2014, the industry made capacity cuts totalling 1.2 million tons across paper grades in the European graphic paper market through permanent plant closures or paper machine conversions. Reductions of a further 1.5 million tons of paper capacity in Europe are planned so far for 2015 (see Graph 2). These capacity closures include the equivalent of more than 5.5% of estimated existing European newsprint production capacity. However, while smaller industry players hope to benefit from the market rebalancing effects and relief on pricing, larger industry players, such as Stora Enso and UPM, will only take out capacity permanently to avoid
greater inefficiencies and potential operating losses. As corresponding sales volumes can frequently be absorbed by their existing production sites, this may result in a more limited rebalancing effect on the wider market.

Most corporate strategies remain unchanged, despite recent management changes
Following a number of years of management continuity, with initial strategy realignment followed by a prolonged period of business restructurings and transformations in most cases, seven of the 11 rated European paper and forest products companies have made changes to senior management over the past 12 months. While the relatively high number of new senior management appointments during 2014 could indicate that a corporate strategy refocus is about to take place, the initiatives most companies have subsequently announced are in line with their existing strategies. For example, Metsa Board is still aiming to replace traditional paper volumes by expanding its paper board production by the end of 2017. Sappi is still concentrating on transforming itself into a diversified wood fibre group focused on specialised cellulose and its profitable paper business, and Stora Enso on its transformation into a renewable materials company. Meanwhile, WEPA Hygieneprodukte GmbH (WEPA, Ba3 positive) is continuing to pursue organic growth and opportunistic external growth.
The only exception appears to be Portucel, which initiated a strategic review of its business model following the appointment of its new CEO in the spring of 2014. The review concluded with the company's management announcing a three-year restructuring plan to recover profitability. This primarily involves a substantial increase in its capex plan, aimed at diversifying its current business profile by investing in new growth areas such as tissue and pellets, given the poor long-term growth prospects in the increasingly challenging uncoated wood-free (UWF) market.

Expansion plans continue to drive capital expenditure (capex) in 2015
Metsa, Mondi, Sappi, Smurfit Kappa, Stora Enso and UPM have announced they will maintain or increase their (in some cases) already sizable capex programmes compared with last year. As can be seen in Graph 3, Metsa will increase its capex fourfold in 2015 compared with 2014, which includes the expansion of its folding boxboard production capacities. With the exception of Smurfit Kappa and UPM, capex incurred by these companies will be at least equal to, and in some cases significantly above, their depreciation levels.
Among the other three rated European paper and forest production companies that have reported their 2014 results so far, Portucel is also set to increase its capex significantly in 2015 compared with last year, while Ence is likely to hold its capex steady, albeit at a relatively low level on a historical basis. Meanwhile, we expect Norske Skog to only selectively allocate capex, including for necessary maintenance purposes, owing to the company's continuing efforts to strengthen its cash flow.

Some companies such as Mondi, Smurfit Kappa, Stora Enso, and UPM, which have sufficient financial flexibility on account of their profitability improvements, have confirmed their progressive dividend policies in the interests of continuity, including, in some cases, dividends that are based on a percentage share of their operating cash flow. Despite its recently completed refinancing, Norske Skog needs to focus on preserving sufficient liquidity to meet its substantial
debt obligations in 2017 in the face of challenging conditions in the European paper market. Based on weak earnings and the company's financial position, the company's board recommended that no dividend be disbursed for the financial year 2014.

Euro's slide is driving up input costs for non or partially integrated players
The substantial new pulp capacity ramping up in Latin America during 2014, mostly in hardwood pulp, was favourable for non or partially integrated players such as Norske Skog and Lecta during the first three quarters of last year. However, pricing pressure increased during the fourth quarter of 2014, owing to the euro's weakening against major currencies, including the US dollar.
Companies whose sales are mainly in euros, while their main input (material and pulp) is traded in US dollars, experienced cost increases.


The cost pressure was further exacerbated by announcements on hard wood pulp price increases in the first quarter of 2015, following substantial European pulp capacity reductions mainly related to the closure of Ence's 410,000-ton pulp mill in Spain in October 2014.


Conversely, European paper and paper-based packaging companies that generate most of their sales in a currency that is stronger than the euro, either via exports (as is the case for Metsa Board and Portucel) or through products that are globally priced in US dollars (such as pulp producer Ence) but have the majority of their cost bases in the euro, could moderately benefit for some time to come, as we do not see any major recovery of the euro before 2017.

ENDS



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