Global outlook: fair to middling.

It's not easy to characterize the state of the global paper industry. Markets are clearly mixed in the established papermaking regions, but the boom continues for newer players in Asia and Latin America. North American companies had a better year in 2004 than in 2003, but much of the recovery was due to contraction in supply, since robust demand growth has failed to return. Even in China, the government is trying to cool off a hot economy by restricting capital and thereby delaying industrial projects, including pulp and paper. In Europe, a base of brand new paper machines has given the region a technological edge, but the soaring Euro has made European exports very pricey.

So, it's safe to say that the global outlook is fair to middling--not great, not terrible, but somewhere in between. In this article, Solutions! examines the market outlooks for North America, South America, and Asia. In related articles, Jim Kenny explores the outlook for Europe (p. 30), and Dorothy Paun, et al, take us through a detailed review of how the North American pulp and paper industry performed in 2002 (p. 42).

BACKDROP

The slow, plodding recovery in 2004, while nothing to write home about, was at least better than the previous year, when the global forest and paper industry endured stagnant growth and profitability well below targets, according to PriceWaterhouseCoopers' Seventh Annual 2004 Global Forest and Paper Industry Survey. Despite an increase in total global industry sales (in U.S. dollars), which were up 8% in 2003 to US$ 319 billion from US$ 296 billion in 2002, return on capital employed (ROCE) indicated only flat growth, said the report. ROCE was static, averaging 4.2%, largely unchanged from 4.3% in 2002. (ROCE measures profitability against capital invested after adjusting for interest expenses.) Global cash flow from operations was also flat at US$ 30.8 billion, compared to US$ 30.6 billion in 2002.

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NORTH AMERICA: MUDDLING ALONG

In North America, the below-average performance in 2003 was a result of currency fluctuations, poor cash flow from operations, and continued issues with oversupply, according to the report. For the 27 U.S.-based companies in the PricewaterhouseCoopers survey, the weak U.S. dollar significantly improved cost structures in 2003. In Canada, this trend was reflected by average gains in net income, revenues, and ROCE for the 11 Canadian-based companies that participated in the survey.

Current trends in the fundamental economics of the North American industry are, at best, mixed, according to market analysts. While market pulp prices have enjoyed a recovery in the 4th quarter of 2004, printing and writing paper demand slowed and newsprint demand remained anemic. Pricing trends were also mixed, according to market observers. Market pulp prices were expected to rise and newsprint price hikes are scheduled, but proposed increases on coated papers and recycled paperboard failed to gain traction, according to trade reports.

While the glacially slow recovery in North America does not appear to be ending, there is very little evidence of stronger demand, which is sorely needed to fuel a robust recovery in pulp and paper. The overall economic recovery in the U.S. has been unsteady, and as a result, paper demand growth has lagged. In this uncertain environment, costs are rising--in some cases sharply--for energy, freight, chemicals, and other inputs. Also, Canadian pulp and paper operations are struggling with the effects of a stronger Canadian dollar, which has hurt this export dependent country. For the moment, analysts appear to be cautiously optimistic, with most predicting a slower, steadier upturn than in years past. At least the North American paper industry appears to be avoiding the wild swings in pricing and capacity that characterized its recoveries--and downturns--in years past.

Returning to the PriceWaterhouseCoopers report, 2004 was at least an improvement for North America over a bleaker 2003. U.S. companies experienced flat ROCE of 4.7% in 2003 compared to 4.5% in 2002, according to the report. Of the 27 U.S. producers in the Top 100, the only companies to achieve a ROCE of at least 10% were Kimberly-Clark (14.0%) and Procter and Gamble (10.1%), both tissue producers. The decline of the U.S. dollar versus most other currencies has, however, significantly improved U.S. companies' cost structures over 2002 figures. Overall, U.S. company financial results were also improved by significant reductions in restructuring charges and accounting changes, said the report. However, cash flow from operations, another key measure of performance, was down 6.3% to US$12.3 billion versus US$13.1 billion in 2002, said the report.

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Over 80% of Canada's forest and paper shipments were exported in 2003, two thirds of which went to the U.S. market. During 2003, the U.S. dollar declined in value 11% against the Canadian dollar, a trend that continued into 2004. The fluctuation in currencies led to lower revenues. As a result, Canadian companies focused on increasing operating efficiencies during the reporting period, reflected in the average increase in ROCE to 3.9% in 2003, up from 2.9% in 2002, according to the PriceWaterhouseCoopers report. Doman and Slocan were the only two companies in the country to beat the ROCE target of at least 10%, with 11.6% and 11.2% respectively. The revenue of the 11 Canadian-based companies in the top 100 in 2003 totaled US$18.7 billion, up 6.5% from US$17.5 billion in 2002. Net income rose 12% to US$266 million in 2003, up from US$237 million the previous year. Only four companies--Domtar, NorskeCanada, Interfor and Doman--reported losses in 2003. Despite these gains, cash flow from operations was down in 2003 to US$0.7 billion from US$1.2 billion in 2002, the report concluded.

ASIA: ENTER THE DRAGON

Growth in the Asian paper industry in recent years has resembled a relay race. One performer starts fast, slows down, and passes the baton to a partner who then sprints ahead. From the 1960s through the late 1980s, Japan's rapidly expanding economy spurred major increases in that country's demand for paper and paperboard. In the 1990s, however, Japan began a decade-long recession and demand growth stagnated. From the late 1980s into the late 1990s, paper and paperboard growth in Asia was driven by three rapidly industrializing nations--Indonesia, Thailand, and South Korea. In the Asian financial crisis of the late 1990s, however, these countries experienced severe financial strain and their paper industries suffered as well. China, which largely escaped the effects of the Asian financial crisis, surged ahead and today is the home for nearly all paper and board expansion in Asia. In addition, India--almost unnoticed in many discussions--is expanding its paper industry, albeit from a smaller base.

Demand growth in China is focused on two principal grades: cartonboard and printing/writing papers. Capital investment of more than US$ 40 billion is expected in the Chinese paper industry from 2000-2010. Consumption of paper and board in China reached 45 million metric tons in 2003, and is expected to grow rapidly, perhaps reaching nearly 70 million metric tons by 2010, according to one estimate. The only other country expected to show strong growth in consumption is India, which should move from about 6.5 million annual metric tons today to about 15 million metrics tons by 2010.

One dark cloud on the horizon is the possible overheating of the Chinese economy. With economic growth roaring along at greater than 9% per year, the Chinese government has taken measures to slow growth rates to a more sustainable pace by restricting access to capital by both state-owned and private companies. Through these measures, the government hopes to avoid an economic crash, which would be a financial and social disaster for the country. In the paper industry, financing restrictions have led to the delay--but not the cancellation--of several major projects.

In recent years, China has grown to become the second largest market for pulp, paper and board in the world (following the United States). As mentioned above, Chinese production of paper and paperboard was about 40 million metric tons in 2003--up from 33 million metric tons in 2002--and demand reached 45 million metric tons. Five-year average annual production growth (1998-2003) was 5.5%, which is lower due to relatively "poor" years between 1996 and 2000. Paper and board demand grew 9.2%/yr during the 1990s and is expected to average 6.0-6.5%/yr during this decade. In 2003, the Chinese paper industry grew by 50 new paper and board machines, bringing 4.1 million metric tons of new capacity on line. The list of 2004 investment projects generated 4.6 million metric tons of additional capacity, with an additional 5.6 million metric tons set to come on line in 2005. The vast majority of current growth in global paper and board capacity is taking place in China.

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There are still two distinct markets in China. One is focused on paper and board that meets international quality standards, produced using wood pulp or high-grade wastepaper. The second market is lower quality paper and board for domestic consumption made from non-wood fibers or locally collected wastepaper. Chinese paper and board production is rapidly converting toward the "international quality" market based on the new, large scale pulp and paper mills built since 1997. Production of lower quality paper and board--typically at mills with capacities less than 50,000 metric tons/yr--is dropping each year but still remains a significant market in China.

INDIA GROWING RAPIDLY

In the shadow of China, the Indian economy has also enjoyed remarkable change over the past five years as economic liberalization and a booming economy set that country on an expansion path. Annual Indian paper and board production is currently 5.6 million metric tons. Imports are 0.9 million metric tons and exports 0.2 million metric tons, according to figures from Jaakko Poyry Consulting. Newsprint and printing/writing papers account for half of the production and the rest is packaging and tissue grades. During the past 10 years, paper and board output has increased steadily, from 2.9 million metric tons in 1994 to 5.6 million metric tons in 2003. Consumption growth has been a bit faster: 3 million metric tons during the same period. Production will grow again in 2004, a trend that should continue throughout the decade, according to Jaakko Poyry. There are several new paper machine projects, expansions, second hand machines, and conversions taking place (for more information, see article on page 88 of this issue).

The Asian share of world GDP growth is expected to be significantly higher than the global average for the next decade. Based on the traditional close correlation between GDP growth and paper consumption, Asian demand for paper and board is widely expected to grow at rates 2 to 3 times that of established Western economies.

One major variable in Asian growth plans is raw materials, since the region is severely deficient in fiber supply. Until the early 1990s, Asian fiber supply was about half recovered paper and half non-wood fiber, with a negligible amount of wood fiber. Since then, the use of recovered paper has grown markedly, reducing the role of non-wood fiber. Most of the increased demand for recovered fiber has been met by imports, largely from the United States and Europe.

Asia has also become an important consumer and importer of wood pulp. Asia currently consumes more than 10 million metric tons/yr of bleached hardwood kraft pulp, a figure that will likely grow to 15 million metric tons/yr by the end of the decade. Latin American market pulp mills may end up supplying a large portion of that increased demand.

LATIN AMERICA

Latin America's pulp and paper industry has enjoyed a remarkable boom in recent years, based largely on its ability to produce high quality, low-cost pulp. Several major market pulp expansions have been completed or are underway, with more on the drawing board.

According to a recent report by Standard & Poor's (S & P), a New York-based provider of corporate credit ratings, low cost structures--based mainly on shorter tree growth cycles--are allowing the principal Latin American pulp producers to profit handsomely from both higher pulp prices and higher production volumes. Latin America is expected to grow its share of the global pulp market as large producers continue to add significant amounts of pulping capacity.

For example, S & P points out that, in Chile, both Celulosa Arauco y Constitucion S.A. and Empresas CMPC S.A. have major expansion programs planned or underway in the next two years (particularly in the pulp sector). Latin American paper and board producers have also benefited from the economic recovery underway in most of the countries in the region. For example, in Brazil, packaging paper producer Klabin S.A., which sells about 67% of its output to the domestic market, has benefited from Brazil's 4.2% economic growth in the second-quarter 2004, said S & P.

"Klabin has improved its capital structure after some important divestments and is now focusing on increasing its exports and capitalizing on the integration in low-cost pulp manufacturing," the report continued. "About half of Chilean Empresas CMPC S.A.'s sales are geared to domestic markets (Chile has about 36% and Argentina about 7%), which have also shown healthy growth (of 5% and 7%, respectively) in the second quarter."

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The following are S & P's assessments of key Latin American producers. Dates represent the period from Oct. 13, 2003, to Oct. 19, 2004, covered by this report.

Aracruz: "As a low-cost producer, Aracruz has benefited from scale gains stemming from increased output due to the Fiberline C learning curve completion and the acquisition of Riocell (400,000 metric tons), both in 2003. Higher output in 2004 should allow Aracruz to maintain financial ratios appropriate for the rating category. The company has worked on smoothing out its debt profile, reducing its short-term-to-total debt ratio to 14% in September 2004 from 34% in September 2003. The company also improved its cash position during this period, and in September 2004 Aracruz's cash holdings (US$ 430 million) covered 2.2x the short-term debt (0.9x in September 2003)."

Klabin S.A. (Brazil): "The divestment of Riocell to Aracruz for US$ 610 million and other asset divestitures strengthened Klabin's liquidity position and significantly reduced debt burden. The ratings were upgraded in July, reflecting the company's commitment to keeping a prudent financial profile. Klabin's cash position as of June 2004 was US$ 300 million, whereas its total debt amounted to US$ 487 million in the same period."

Empresas CMPC S.A. (Chile): "The company's credit measures significantly strengthened in 2004, aided by higher prices and converted product dispatches. Although significant capital expenditures derived from the construction of a new pulp mill in Chile will significantly affect free operating cash flow (FOCF) in 2005, a strong cash generation base should help attain positive FOCF of about 20%-30% of total debt in 2007."

Celulosa Arauco y Constitucion S.A. (Chile): "Arauco's performance over the first half of 2004 compares well with that of the previous year, aided by improved realized prices in most of its product categories, higher volumes, and a relatively stable cost structure. FOCF could come under pressure because of the investment in the pulp mill associated with the Itata project, but it should strengthen quickly in 2006."

RELATED ARTICLE

WHAT YOU WILL LEARN:

* Why the global outlook for pulp and paper is mixed.

* Growth factors fueling the booming Chinese market and the emerging Indian market.

* Why Latin American markets are expanding at a rapid pace.

ADDITIONAL RESOURCES:

* Other articles in this issue covering Europe (p. 30); India (p. 88); and North American paper industry financial performance--2002 (p. 42).

* "China on a hot streak with larger scale, new mills," by Hannu Oinonen and Nie Xiaorong, Solutions!, March 2004. To access this article, enter the following Product Code in the search field at www.tappi.org: 04MARSO24.

* "Zhongzhu Group and Yueyang Group: Building for the future," by Hannu Oinonen and Nie Xiaorong, Solutions!, July 2004. Product Code: 04JULSO39.

ALAN ROOKS, EDITORIAL DIRECTOR

ABOUT THE AUTHOR

Alan Rooks is Editorial Director of Solutions! magazine. Contact Alan at [phone], or by email at: [e-mail].

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