Canada: singing the blues?

Canada is struggling with a double dose of challenges. First, its forest products industry has been grappling with the effects of the soaring Canadian dollar; stagnant demand for its premier paper product, newsprint; growing competition from South American mills for its other lead product, market pulp; and the long running trade dispute with the United States over Canadian softwood lumber exports.

Then, Canadians suffered through the loss of its national obsession--professional hockey--when the National Hockey League effectively cancelled its 2004-'05 season when team owners locked out the players. While losing hockey for a year (or possibly more) may be tough on the Canadian psyche, the effects of the forest product challenges are likely to be more lasting, in the form of closed mills and job losses.

The current investment situation in the North America pulp and paper industry in general--and Canada in particular--is best described as stagnant due to anticipated low returns on investment. Capital investments have been limited to productivity improvements, and any capital spending is now geared toward productivity gains and cost cutting.

Also, the sinking U.S. dollar and the soaring Canadian dollar have clearly hurt export-dependent Canada. The Canadian forest products industry, particularly the pulp and paper sector, has been one of the hardest hit areas of the economy since more then 85% of production is exported--all denominated in U.S. dollars. In simple terms, the high Canadian dollar has reduced the competitiveness of Canadian pulp and paper mills.

That situation is not improving. The trend for the Canadian dollar has been up, up and away. At the beginning of 2002, the Canadian dollar was at 64 cents against the U.S. dollar. In the fourth quarter of 2003, it was up to 76 cents. On Dec. 13, 2004, the Canadian dollar stood at 81 cents to the dollar, up 27% since the beginning of 2002.

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PAST PERFORMANCE

The past two years reflect the general malaise faced by Canadian producers. In 2002, sales revenue for the Canadian forest products industry dropped 3%, to C$ 52.9 billion, down $C 1.8 billion from C $54.6 billion in 2001, according to a report by PriceWaterhouseCoopers, which was commissioned by the Forest Products Association of Canada. Industry earnings were C$ 2.1 billion in 2002, an 11% improvement over 2001. However, excluding non-operating items, earnings fell 18% to C$ 1.9 billion in 2002, from C$ 2.3 billion in 2001. The drop in earnings was due mainly to reduced prices for the majority of products produced by the Canadian forest industry, according to the report.

Prices were unsteady in the pulp sector, resulting in a further decrease in sales revenues, said the report. The 2002 loss was reduced by a small increase in sales volume along with operating curtailments at high cost pulp facilities, dropping to a loss of C$ 127 million, compared to a loss of C $207 million in 2001.

Newsprint prices dropped sharply in 2002, said the PriceWaterhouseCoopers report, leading to a C$ 2.4 billion drop in sales. While production volumes and cost reductions were implemented by many Canadian producers, these measures did not prevent a drop in net earnings, which were down C$ 929 million. The reduced total net earnings amounted to an anemic C$ 74 million. The "other papers and board" category experienced a 35% decrease in net earnings primarily due to higher raw material costs and reduced margins.

The Canadian forest products industry earned just a 6% return on capital employed (ROCE) in 2002, unchanged from 6% in 2001 and down from 10.7% in 2000. The 2002 ROCE was below the industry's ten-year average, said the report. The industry's average 10-year return on capital employed is only 6.7%, well below estimated cost of capital, which ranges from 9-12%, said the report.

The Canadian forest products industry had C$ 2 billion of capital expenditures in 2002, down from C$ 2.5 billion in 2000 and down sharply from the record 1995 level of C$ 5.1 billion. For the fifth year in a row, depreciation exceeded capital expenditures in 2002.

Profits in Canada's paper industry were down again in 2003, while production figures were mixed. In 2003, shipments of newsprint fell 0.4% to 8.5 million metric tons. All of the decline was in deliveries to customers in North America. By contrast, shipments of mechanical printing papers rose 3.6% in 2003, up 269,000 metric tons. Market pulp exports were also up, rising 1.3% to 10.6 million metric tons. All of the growth was in shipments of high yield pulp, which increased more than 8% from 2003. Shipments in packaging and containerboard fell almost 5% because of a decline in demand in North American and increased competition in the Asian market. Shipments of containerboard fell 5.43% while sales of boxboard and kraft papers declined 0.6% and 8.6% respectively.

BETTER DAYS AHEAD?

While profits in 2002 and 2003 were nothing to write home about, they should almost triple to C$3.4 billion by 2006 if the Canadian dollar stabilizes, according to a report by the Conference Board.

"The stabilization of the Canadian dollar will translate into price increases for exporters, and growing demand for paper products will boost production," according to a Board spokesperson. "The good news for the industry is that profits have passed their lowest point; however, the recovery will be gradual," said Louis Theriault, associate director for industrial outlooks.

Revenues in the Canadian paper industry were expected to rise 8.7% in 2004 and 10.2% in 2005. This growth was expected to offset the increase in material costs, producing profits of C$ 1.2 billion in 2004 and C$2.6 billion in 2005, according to the Board. Profits are expected to climb again in 2006 to C$ 3.4 billion and remain close to that level through the rest of the forecast period, which ends in 2008. Weak selling prices and the rise of the Canadian dollar restricted exports to the United States, the Conference Board noted. As a result, 2003 profits were all but eliminated, with the industry realizing profits of only C$40 million.

The Conference Board noted that the pulp, paper and paperboard segments of the industry have been the weakest and are expected to enjoy the largest rebound. "The Asian market represents the best opportunity for pulp producers," the Conference Board said. "Exports to China now account for 12% of all exports, four times what they were a decade ago."

Of course, this optimistic forecast assumes that the Canadian dollar will stabilize and perhaps drop against the U.S. dollar. A further increase in the Canadian dollar would likely derail this scenario, and higher energy prices also threaten profitability.

HARD TIMES TODAY

While the future may be brighter, today the Canadian industry must deal with the very real and immediate problems of the high Canadian dollar and its negative effect on exports. For example, on Dec. 13 Tembec, based in Montreal, announced a two-week curtailment of operations at its newsprint facility in Kapuskasing, Ontario. The temporary shutdown is scheduled for the second half of January 2005 and will reduce production by 13,000 metric tons and affect 600 direct jobs. Domtar noted that its newsprint operations have been hurt by the stronger Canadian dollar.

Earlier in December, Domtar, based in Montreal, announced that it will indefinitely close part of its operations at its Cornwall mill, including the pulp mill, a paper machine, and a sheeter. The closure is expected to occur on March 8, 2005 and will last "until such time as economic and market conditions allow these assets to operate profitably," the company said in a statement.

Domtar will be curtailing annual production of 150,000 metric tons of pulp and 85,000 metric tons of paper, costing 390 people their jobs. Domtar said 400 additional jobs would be eliminated across the company's operations in Canada and the United States, including management and staff functions, by the end of 2005.

"Our Cornwall mill is significantly exposed to the difficult market conditions facing the Canadian pulp and paper industry," said Raymond Royer, president and CEO. "By using lower cost pulp manufactured at other company facilities as well as closing down one paper machine in Cornwall and redirecting products to more cost effective paper machines in our system, Domtar will improve its overall performance."

Another pulp mill, at UPM's papermaking complex in Miramichi, New Brunswick, began the process of permanently shutting down on December 8, 2004. The closure was part of a plan announced on September 29, 2004 "to secure the facility's long-term viability," said the company.

The litany of mill closures--temporary or permanent--and job losses is likely to continue for the short term at least. Like the U.S. pulp and paper industry, which struggled with a high U.S. dollar in the late 1990s and early 2000s, the Canadian industry is reacting the only way it can--by hunkering down and waiting for better days ahead. Hopefully, both the Canadian forest products industry and the National Hockey League will be able to get out of the penalty box sometime soon.

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WHAT YOU WILL LEARN

* The long list of challenges faced by the Canadian industry.

* Details of the industry's recent performance and prospects for the coming years.

* How companies are dealing with high costs and unprofitable operations.

ADDITIONAL RESOURCES

* "Global Outlook: Fair to Middling" (Related article in this issue. See page 22).

ALAN ROOKS, EDITORIAL DIRECTOR