The big two restructure but will it do the trick?

Two of the world's biggest pulp and paper companies have announced far-reaching restructuring programs for their businesses. In Europe, Stora Enso unveiled a long list of closures as the company looks to revamp its profitability profile, while International Paper (IP) has gone even further and targeted a whole new focus on a key grade strategy.

The big question for investors though, is whether these reappraisals will achieve the desired effect. After all, returns have been consistently disappointing in an industry beset by an almost endemic lack of pricing power. At the same time, costs, especially in the form of energy, appear to be heading in just one direction-up.

In terms of the two restructurings, there are some similarities and a few key differences. For example, both groups clearly recognize that pricing power is an issue in terms of ongoing profitability. Of course as truly global players, both companies are seeking to enhance their strengths in key geographical areas where there is a growth premium. Conversely, while IP is set to streamline its asset portfolio along key grades, Stora Enso is taking a different path, opting to take a hit by closing some of the older assets on its books.

Much has already been written about IP's revamp since it was announced in September, but it is probably worth going over the main elements again. IP's chairman and CEO John Faraci explained that the group's overall strategy would involve improving profitability, strengthening the balance sheet, and returning value to shareholders. In other words, selling off assets, returning some cash to investors and trying to create a smaller, more effective business through selective investments.

According to the U.S. giant, the group has reviewed its existing capabilities and resources, as well as industry fundamentals and its competitors' strategies, to come up with a plan that keeps the business focused in two main areas--uncoated woodfrees and packaging.

In the uncoated woodfree market, IP notes that it is well positioned in the global market with 6.6 million short tons of capacity ranged across the south and east of the United States and strong strategic footholds in Eastern Europe, Russia and Brazil. The company also has a prime distribution asset in xpedx. As such, the company argued that it "can earn the cost of capital returns" as a "low-cost producer," especially as it indefinitely closed three paper machines in the United States in the first half of this year. Indeed, as the group pointed out "[Today] over 70% of IP's uncoated paper machines are in the first or second global cost quartile."

On the packaging side, IP noted that it holds strong positions in containerboard and corrugated box businesses in the United States, as well as an expanding presence across Europe, Asia and beyond.

More interesting for shareholders and concerned workers, IP also announced $8-10 billion in asset sales. Out go:

* IP's majority stake in New Zealand's Carter Holt Harvey, which was taken up by the Rank Group for just over US$ 1.1 billion

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* the group's coated paper and SC assets, including the Inpacel mill in Brazil

* the beverage packaging business, including the Pine Bluff mill

* Arizona Chemical

* the kraft paper business, including the Roanoke Rapids mill in North Carolina 

* selected U.S. forest holdings (some 6.4 million acres will be affected)

* and, by extension, business lines focused on wood products, since IP will no longer be a natural owner if it is divesting its forest lands.

IP believes that the most of the divestments can be achieved by the middle of next year, although it could take until the end of 2007 to offload the forest holdings and associated wood products lines.

If all goes to plan, the moves should unlock US$8-10 billion, half of which will go to reducing the company's debt, which should help IP solidify its investment grade status. Another 30% or so will be returned to shareholders through share repurchases or dividend payments, leaving somewhere between US$ 1.6-2.0 billion for reinvestment.

At this stage, the company is "taking a cautious approach," but it is actively looking at a number of opportunities, including:

* building up its uncoated/pulp platform in Brazil

* investing in packaging projects in China

* expanding the Svetogorsk operation in Russia

* and finally, looking at bolt-on corrugated businesses in Eastern Europe and the Mediterranean areas.

In the meantime, the group will look for operational cost savings throughout the organization, as well as reorganizing the uncoated paper operations it intends to keep to ensure that the plants are cost-effective.

STREAMLINING OPERATIONS

In Europe, Stora Enso is also looking at a sizeable streamlining program that will see at least 5% of the company's workforce (approximately 2000 people) leave by the middle of 2007.

Six operating units are also set to go as part of a divestment initiative, reducing the company's paper and board capacity by 530,000 metric tons/yr, pulp capacity by 305,000 metric tons/yr and sawing capacity by 340,000 m3. In financial terms, this will reduce sales by some EUR 490 million.

In addition to the six units up for grabs for potential buyers, several closures have also been announced, so the full list looks something like this:

* in France, PMs 3 and 4 at Corbehem are set for closure, taking 250,000 metric tons/yr of LWC out of the equation

* more publication paper production will also go as the Wolfsheck Mill in Germany is up for divestment

* on the fine paper side, PM 1 at the Varkaus mill in Finland is earmarked for closure, taking out 95,000 metric tons/yr of woodfree coated capacity

* another 280,000 metric tons/yr of woodfree coated capacity will also go with the divestment of the Grycksbo mill in Sweden

* in Portugal, the Celbi mill has been identified as a potential divestment candidate (the plant can produce around 305,000 metric tons/yr of short-fiber pulp)

* at the Hammarby mill in Sweden, there is a planned closure on the packaging board operation

* in the United States, PM 31 at the Stevens Point mill is to close, taking 25,000 metric tons/yr of coated specialties off the market

* more packaging board capacity will go in Finland with the divestment of the Pankakoski mill, which produces some 95,000 metric tons/yr of FBB, WPB and SBS 

* Finland will see the Veitsiluoto Sawmill divested

* and staying with forest products, the Linghed Sawmill in Sweden is also on the divestment list.

And in case that is not enough, the company has already announced that the thinning process may well continue with another four plants already "under review":

* the Summa mill in Finland (MF, newsprint, improved newsprint, 405,000 metric tons/yr)

* the Reisholz mill in Germany (215,000 metric tons/yr of SC)

* the Uetersen mill in Germany (woodfree coated, coated specialties 270,000 metric tons/yr)

* the Berghuizer mill in the Netherlands (uncoated woodfree, 235,000 metric tons/yr).

As Stora Enso's CEO, Jukka Harmala, pointed out, "These four mills under special review are fairly big where the total headcount is about 2000 people and we have given one year for the final decision to be made. All options are open for the future of these mills. Performance will be evaluated using a range of financial and operational measures, with long-term profitability the key criterion."

Of course, Stora Enso is not just closing capacity. It has a number of schemes in the pipeline already, some of them rather large. For example, the group is well advanced with the Veracel startup in South America and the massive investment in a new 420,000 metric ton/yr SC machine at Kvarnsveden in Sweden is about to bear fruit.

Elsewhere, the company has just signed a letter of intent to go ahead with a joint venture in China in liquid packaging board and in Europe it has completed the EUR 450 million acquisition of the German paper merchant, Schneidersohne.

The really big news, though, is that Stora Enso has made major land purchases in Brazil and Uruguay, where it plans to establish around 200,000 hectares of plantations that will feed the company's fiber supply needs for years to come and could well see the Veracel pulp mill expand even further.

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Overall, in fact, the company is committed to investing in growth markets around the globe.

SHIFTING SANDS

Major restructuring programs such as these serve to highlight the constant changes that are always taking place in the global pulp and paper market. And with two of the world's biggest paper companies leading the charge, it seems clear that the industry is facing some fundamental shifts as corporations target low-cost fiber supplies, efficiency gains, economies of scale and growth markets in an era of rising costs, overcapacity and relatively weak pricing.

However, a positive initial market reaction to the announcements from both companies has been matched by a small degree of skepticism since. Some commentators have asked the reasonable question that if the entire sector is set to suffer poor returns for the foreseeable future, why would these restructurings make any difference to their investment portfolios.

Harri Taittonen at Nordea is fairly typical when he points out that IP will raise some funds, but goes on to ask what will be left when major profit drivers such as wood products get sold off "EPS" dilution could be quite significant if they sell of their higher margin assets," he explained.

Then, there is the problem of structural overcapacity in the United States. "The problem is the supply/balance. It doesn't really help if assets are simply being moved around," Taittonen points out.

And indeed, he makes a similar point about Stora Enso. "The headline closures announced were probably a bit more than the market was expecting, but it is over an 18-month time period and when you bear in mind that a lot of new capacity is coming on stream over that period it could dilute the effect."

On a more positive note, one analyst at least gave IP credit for taking a bold step in the face of some fairly intractable long-term profitability problems. "I can understand why they've stuck with packaging, but on the face of it uncoated freesheet doesn't look like the greatest market to concentrate on with so much extra capacity coming out of low-cost countries. What they do have though, is the distribution channel, which any competitor would find hard to replicate, so maybe that does make sense."

Another market watcher was rather excited about IP's prospects in Europe if Anglo American does indeed go ahead and sell off its Mondi unit, which has long been nurturing the growth markets of Eastern Europe where IP also has a strong presence.

"I don't know if the timing is going to work given that it will take some time to raise the cash from their forests or even if IP is currently strong enough to take it on, but it's certainly an interesting prospect and I'm sure they'll be taking a look at it," noted another analyst.

Clearly though, some commentators believe there is value in the stock, as witnessed by the buy signal sent out from Citigroup. The Citigroup team points out that IP's refocus could well be earnings dilutive, but with the share price at a relatively low level and a stronger balance sheet making the stock less risky, the shares could deliver value.

This though, is some way short of a rousing endorsement of the company's strategy and even IP's own presentations lack any sense of an imminent return to great profitability as a result of its action plan. For example, the document notes that "low cost producers can earn cost of capital returns". In other words, it's possible that we may not actually destroy shareholder value.

On the other hand, if IP were to undertake any major investment plans, this could well spook the investment community. That should not prevent the company from continuing to expand around the globe with smaller bolt-ons, though.

For instance, the company has completed the acquisition of a majority share of Compagnie Marocaine des Cartons et des Papiers (CMCP), a leading Moroccan corrugated packaging company. At the same time though, IP has reportedly deferred a decision on a major pulp/paper investment in Brazil until later next year.

The rating agency Fitch seems less convinced that the changes will enhance IP's attractiveness and has kept a negative outlook on the group after the restructuring announcement. As Fitch explained, "The portfolio of businesses that will be sold have garnered revenues of around $6.9 billion and turned an operating profit of just in excess of $900 million by company calculations. The challenge for IP will be to replicate these operating margins in the uncoated papers and packaging markets. Part of that challenge comes from the high returns that will be jettisoned with IP's substantial timberland operations, which have been a significant earnings contributor and which will account for a majority of business sales proceeds.

"The risk in the transformation strategy is that with the new capital structure, cost savings fail to sustainably improve margins and create a sufficiently large earnings stream," Fitch continued. "This places increasing emphasis on the success of expanding operations into opportunistic emerging markets. Fitch will continue to monitor IP's progress but will not change its ratings or outlook at this juncture."

NEGATIVE OUTLOOK

In Europe, Moody's downgraded Stora Enso's debt from Baa1 to Baa2, while S & P reaffirmed its BBB+/A-2 rating, but it did adjust the company's corporate rating outlook from stable to negative, reflecting the challenge of maintaining profitability.

Among the issues cited by the agencies were rising costs, overcapacity and weak demand, but one analyst noted that Stora Enso was far from being the only company coming under somewhat negative scrutiny.

"Yes, Stora Enso did get that downgrade, but the outlook for most of the industry is pretty much the same," he said. "For me, the more problematic issue is who buys these assets. In many cases the capacity is not being taken out and trade buyers could lose out to private equity firms or venture capital groups who will look to sweat the assets for cash and that won't help the pricing environment one bit."

However, as a leading industry consultant noted, "There is a risk of that, but to be honest everyone is running the machines flat out these days."

Another analyst was less optimistic, though. "A lot of the companies in this sector are trading at book value," he said. "That means no-one is expecting them to add any shareholder value and that is not encouraging. There's going to be even lower earnings in 2006 with costs going up. The only hope of an earnings recovery will depend on pricing and the trigger is not there."

All in all, this is not the best endorsement for the sector, but there's no doubt that there is good news simply in the fact that companies such as IP and Stora Enso are at least trying to boost profitability and facing up to very real issues in the marketplace.

ABOUT THE AUTHOR

Jim Kenny is international editor 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].

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JIM KENNY, INTERNATIONAL EDITOR

WHAT YOU WILL LEARN:

* How the industry's two biggest players are trying to restore profitability.

* How IP's restructuring is creating risks as well as potential rewards.

* How Stora Enso is targeting growth markets and low cost materials.

ADDITIONAL RESOURCES:

* "North America: The European Connection," by Jim Kenny, Solutions!, December 2004. To access this article, enter the following Product Code in the search field on www.tappi.org: 04DECSO23. Or call TAPPI Member Connection at 1 800 332-8686 (US); 1 800 446-9431 (Canada); [phone] (International).

* "Stora Enso Looks Forward to a Resurgent 2004," by Jim Kenny, Solutions!, June 2004, Product Code: 04JUNSO31.

* "Leading the Giant: An Interview with John T. Dillon, CEO and President, International Paper, TAPPI JOURNAL, June 1998. Product Code: 98JUN50.