Profit yearning = market churning.

How do you make money in markets that are essentially flat or slowly declining? The North American and European paper industries have been busy trying to answer that question for some time. The first response was to cut capacity while staying in the same markets. The second response was to reshuffle assets, trying to bulk up in profitable areas and down-size in unprofitable areas. The third response seems to be a combination of the first two, which is where we are now.

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The result is a great deal of market churning as paper companies continue to seek their holy grail--consistently profitable operations. Not surprisingly, most of the action is in newsprint and coated paper, two grades being buffeted by major changes in media ad spending (toward the Internet and away from newspapers and to a lesser extent magazines).

The news in recent weeks tells the story well. In Europe, where major capacity additions, a rising euro, and higher costs have put pressure on profits, some companies are cutting capacity and rearranging chairs in the executive suite. The CEOs at Sappi (a major publication paper producer) and Norske Skog (a major newsprint producer) have resigned, and UPM has announced a major capacity restructuring. Last year, Stora Enso announced major capacity shutdowns.

In announcing the resignation of Norske Skog CEO Jan Oksum, the company noted that "Norske Skog has had weak results for a long period. To improve earnings and increase the pace of the current restructuring of the company's business, the board believes that Norske Skog would now be best served by a change of chief executive." No sugar coating it there.

UPM, Helsinki, Finland said it hopes to save EUR 200 million and improve profits by closing inefficient mills. Hmmn--where have we heard that before? Oh yes, in the United States, where newsprint capacity was cut 5% in 2004, and coated freesheet capacity was cut 10% between 2000 and 2003. Now the Europeans are getting in on the act.

By closing several mills in Finland, UPM plans to reduce 17% of its coated magazine paper capacity and 12% of its coated fine paper capacity in Europe. The company will exit the production of brown sack paper. After the restructuring, UPM's average paper machine capacity in Europe will be 320,000 metric tons/yr in coated magazine paper and 420,000 metric tons/yr in coated fine paper.

Meanwhile, in the United States, the churning continues as well. SMART Papers LLC of Hamilton, Ohio filed for bankruptcy in March. Once part of Champion International and then International Paper, SMART Papers is trying to make money from aging coated and uncoated printing paper assets, but so far without success. The company hopes to emerge from bankruptcy with a better plan.

COUNTING ON CHINA

On the other side of the world, in China, things are of course brighter--and for a change a U.S. company is getting in on the act. As part of a plan to narrow its corporate focus to packaging and uncoated paper, International Paper has reached an agreement with Shandong Sun Paper Ltd., China to form a 50:50 joint venture for coated board production in Yanzhou City, Shandong Province. The joint venture includes two coated paperboard machines located in Yanzhou City, as well as construction of a third coated paperboard machine, expected to be completed in late 2007. International Paper's investment in the venture is expected to be approximately US$ 140 million. This amount includes IP's share of the investment in the new paper machine. International Paper currently produces coated board in the United Sates, Poland and Russia.

This is indeed a good move for IP and hopefully others will follow. This is one of the relatively few direct investments by a U.S. paper company in China, the second largest paper producing country in the world. Many other companies--most of them European--have traveled this route before, but better late than never!

Capitalism is, of course, a system that continuously reallocates capital from unproductive to more productive assets. The paper industry is getting a casebook study in this painful but necessary economic rule.

ALAN ROOKS

Editorial Director

Contact Alan at [phone], or by e-mail at: [e-mail]