Europeans look east for the long term: European paper companies are looking to make their mark in Asia, but timing will be crucial for future success.

Senior executives in the larger paper companies like to think of themselves as global players. But the fact is that only a tiny fraction of players at the top echelons of the industry can call themselves truly international in that they both produce and sell their products on several different continents. While this is partly a remnant of the historic fragmentation of the paper sector, the picture is slowly changing as consolidation continues throughout the global pulp and paper industry.

For European pulp and papermakers, global consolidation is focused mostly on opportunities in North America. This has as much to do with financial engineering as it does with a genuine belief among many European managers that they can add value long-term by stepping into the North American arena. But like almost every other business trend, that focus on acquisitiveness and growth will eventually shift back to emerging markets.

The key questions, then, are when and where. For the purposes of this article, we will restrict ourselves to the most interesting of the so-called emerging market regions and potentially the biggest prize of all--Asia.

As everyone and his uncle knows, a combination of demographic expansion and even very modest rises in per capita consumption adds up to massive rises in pulp and paper shipments in countries such as India, Indonesia and China. Still, Western companies' most recent experiences in the region would cause most executives to break into a cold sweat at the thought of tackling the Asian "tiger."

HIGH FLYERS

Before its economic crisis in 1997, Asia was the place to be seen for any ambitious CEO. Markets were opening up, business was booming and paper producers and machine suppliers from the West were building up frequent flyer accounts large enough to take them to the moon and back a couple of times.

Since 1997, the currency crisis has stabilized, Indonesia has witnessed major political wobbles, the world economy has slowed, Japan's economy has be stagnant, and China announced it would join the World Trade Organization. In the paper industry, the main highlight has been Asia Pulp & Paper (APP) posting the largest ever debt default in the sector's history. Indeed, Reuters recently reported that APP's $13 billion debt made it one of the world's biggest distressed borrowers. Added to that, UPM-Kymmene had a short-lived and strained relationship with APRIL. The scale and speed of new machine installations left the region with massive overcapacity.

While everyone still agrees that Asia is a great place to be for the long haul, few are willing to pile in aggressively just at the moment. As Harri Taittonen, analyst at UBS Warburg, pointed out, "If anything, Chinese market demand has developed quite well, not like the situation in the United States or here in Europe, so the thinking [of the paper companies] is still the same. Companies are definitely still thinking about Asia, but I don't think the overcapacity has yet been absorbed. The question is, who announces first and will they all go at the same time? There's quite a lot of capacity that has not been absorbed yet, so I don't think anyone's in a terrible rush."

BIT PART

Among the major European paper companies, UPM-Kymmene, Stora Enso and Norske Skog have the most significant Asian assets. Even so, Stora Enso's operations in the region represent just 1% of the company's total capacity, while UPM-Kymmene's Asian operations contributed just 5% of the group's turnover (sales) in 2001. More significantly for Norske Skog, the group showed 8% of its operating revenue emerging from Asia, with another 15% coming from Australasia.

Stora Enso's main interest in the area is through its interest in the Suzhou mill in China, while UPM-Kymmene's main interest is the Changshu mill, also in China. Both of these are fine paper mills. Norske Skog focuses on newsprint and has substantial interests in Asia through its 50% stake in Pan Asia Paper and 34% share of Malaysian Newsprint Industries (MNI) in Malaysia.

Norske Skog reported that newsprint demand growth was stable last year in countries such as Korea, China and Thailand and the group reported a creditable 25.3% operating margin for 2001, up from 20.3% the previous year. But despite such an apparently good year, the company is far more cautious about future prospects, citing new capacity additions in China in particular.

Certainly, Asia suffered along with other regions in the wake of the recent global economic slowdown, especially with its export exposure to North America. But the downturn was not quite as bad as many feared and there are signs of recovery.

LOOKING UP

According to a recent Morgan Stanley report, Asian cartonboard prices have recovered 30-40% from cycle lows, which could be an early cycle indicator of prices edging upward. As the group pointed out, "Asia is traditionally a largely spot-based market and price increases often anticipate recovery in the more contract-based markets."

Added to that, U.S. consultant RISI recently said it expected Asian demand to grow most for coated and uncoated woodfree grades over the 20022004 period, with Hong Kong and China leading the charge. Whether this turns out to be the case or not, such forecasts do go some way toward explaining the recent rash of rumors that both UPM-Kymmene and Stora Enso are looking to add new paper machines to their Chinese plants. Again, the key question remains: when?

Charles Spencer, analyst at Morgan Stanley, said, "The supply demand balance is getting better. It's not firm, but it's stabilizing."

Other analysts are also cautiously optimistic. Said Taittonen, "Stora Enso is keen to look around, but not too Jar from their existing mill. As for when [any new machines will be built], I wouldn't like to put my head in there."

Lars Kjellberg at Credit Suisse First Boston also believes that European groups will be expanding their Asian presence, though not rapidly. Companies such as Stora Enso and UPM-Kymmene can borrow money much more cheaply than anyone in Asia, he said. It" companies anticipate steady growth over the next three or Four years, it makes sense to add Asian capacity.

"It's definitely risky, though," said Kjellberg. "First, there are the issues with APP and the problems that has thrown up about legal ownership of assets. Beyond that, there is substantial country risk involved in investing in places like Indonesia. Having said that, many companies are looking at the region right now."

Kjellberg also noted that in the larger Chinese cities such as Beijing and Shanghai, quality standards are rising, which could help Western companies penetrate the market.

However, a far more cynical tone was taken by another analyst who noted that Chinese business may not just let Western companies come in and dominate the market. "Look at Lafarge, the cement company. In that case, the Chinese were interested in getting the multinationals in t0r the technology transfer, but then they couldn't expand and the field was open for other Chinese companies to grow."

That point will not be lost on Stora Enso, which is reportedly seeking government approval to expand its existing facilities in China.

China's macroeconomic position seems to be strengthening and, as Kjellberg pointed out, "They are still closing down highly polluting bagasse mills, so the Chinese have been buying a lot elsewhere. The problem is that it's impossible to measure. If consumers start to buy better quality paper, there wouldn't be enough to go around and then there would be an explosion."

At present, cities such as Beijing and Shanghai are leading the charge toward the use of higher quality paper. For the moment, though, that demand is more than being met, especially since APP has installed such a massive amount of capacity.

BY DEFAULT

It is almost impossible to mention the paper industry in Asia without the topic of APP's debt default coming up. As one commentator in the region put it, "Since the APP debacle in Indonesia, I'm not sure too many investors would be putting their money into Indonesia, not so much because of the risk of the investment itself, but more to do with the lack of security and lack of legal recourse to take a company to court. Other examples are the Philippines and, to a lesser extent, Malaysia."

APP hit a major liquidity crisis in March 2001 and unilaterally called a debt moratorium. APP hopes to complete a restructuring of its $13 billion debt in early 2003. But this is the second time negotiations between the company and its creditors have failed and even the prospect of a deal next year may prove to be optimistic.

News reports indicated that APP could face a trial in the United States in May 2002 for allegedly failing to disclose material financial information. The company, several of its top executives, and auditor Arthur Andersen are all listed in the complaint. Also, a class-action suit consolidating several shareholder complaints has been filed in a New York federal court. The suit alleges that APP overstated assets, net worth and ability to pay down debt, and underestimated the group's financial liabilities. Many shareholders, especially in North America, are furious that the Indonesian-Chinese Widjaya family that controls APP is still in charge. As Merrill Lynch's analyst in London, Mads Asprem, put it, "The whole APP thing is confusing for everybody."

Changes are taking place within APP as well. On April 30, APP's chief financial officer and executive director, Hendrik Tee, resigned. Hiroshi Tadano, a former banker with The Sumitomo Bank Ltd and PT Bank International Indonesia, succeeded Tee, who remains a non-executive director of APP. Tee will now head the research and business development division of the Sinar Mas Group. APP also said Franky Widjaja, a member of the Widjaja family, had resigned as an executive director and would devote his time to other Sinar Mas businesses.

Some companies are interested in the group's assets. Store Enso and others have been looking closely at APP's assets in Asia since the company's cash crisis first became apparent, but the main stumbling block appears to be identifying who actually owns what.

As Spencer at Morgan Stanley stated, "Tim problem is that APP is not dead yet. It is not paying any interest on its bonds and if we run into increases in the hardwood pulp price and coated paper, it will be cash generative." in other words, APP's negative influence on the overall market and its need to keep generating cash could depress the situation for some time yet.

ATTRACTIVE STORY

There are many positive signs for demand in Asia. Demand growth is developing reasonably well, prices are starting to creep up again and the impact of China's entry into the World Trade Organization all look to be positive developments.

Timing will also be a key element. Recent history illustrates that Asian paper companies have a large appetite for risk and the overcapacity normally generated under such conditions. But the APP crisis could be just enough to dissuade bankers from funding investments on the scale that has led to the current supply/demand imbalance. If so, long-term profits and growth could prove too attractive a combination for the Europeans to resist taking the considerable risks involved.

IN THIS ARTICLE, YOU WILL LEARN:

* Which European companies are the major players in the Asia Pacific arena.

* What effect China's entry into the WTO may have on its economic climate.

* Whether market trends and forecasts indicate stabilization or continued caution.

* How APP's debt default continues to affect the region.

ADDITIONAL RESOURCES:

* Noske Skog's website: www.norskeskog.com

* Stora Enso's website: www.storaense.com

* UPM-Kymmene's website: www.upm-kymmene.com

Jim Kenny is contributing editor/Europe, for Solutions! magazine, and is based in Brussels, Belgium. He is the former vice president of editorial for Paperloop and today heads his own company, DSI. Contact him by phone at [phone], or by email at [e-mail]