Weak signals for Europe, but a positive 2004 beckons.

Next year could prove to be the start of an upturn in the fortunes of the European paper industry, but it's far from cut and dried. A sense of deja vu pervades the conversation when canvassing opinion about the prospects for the European paper industry in 2004. The consensus appears to hover around "extremely cautious optimism."

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Inevitably, like the broken watch that's right twice a day, predictions of an upturn will come to pass eventually. The question remains though, will 2004 finally mark a turnaround in the paper industry's fortunes after a prolonged slump?

As UBS analyst, Harri Taitonen, concedes, "Yes, we've heard this story already, but this is the third year we've been going through this, so it has to end sometime. As such, we're looking now for real market signals and on that basis the October stats were the best surprise for us. They were very positive."

Of course, in many respects 2003 was not entirely typical as was underlined by Lars Kjellberg at Credit Suisse First Boston. "Yes, we heard this same story last year, but I am very positive for next year. You have to remember that there was a war in between [in 2003] which didn't help. Personally, I don't think things will be flat at all. I think things will pick up in the paper industry as the economy picks up. The data from German industry has surged and we're definitely going to get stronger markets."

Bullish comments from some of the financial analysts then. But interestingly, the pulp and paper companies themselves seem far more reticent about near-term market developments.

President and CEO of the M-real Corporation, Jouko Jaakkola, is fairly typical when he says, "The key economic indicators are still not showing any clear signals for the future. Nevertheless, there are signs of a pick-up in the United States. In Europe, we are seeing a seasonal upswing in demand for coated paper in September to November. Our previously announced [euro]295 million savings programs are moving ahead and will for the most part reach completion by the end of the year [but] weak demand will dampen their effect to some extent. The recession in Europe is still continuing and an upswing is not expected over the next few months."

With M-Real's capacity utilization rate standing at 87% for paperboard in the third quarter and just 80% for the group's paper machines, it is not hard to see why prices have been slipping and management have been left feeling defensive. But M-real is certainly not alone in viewing the short-term outlook with a degree of caution.

Announcing the latest quarterly results at UPM-Kymmene, president and CEO, Juha Niemela, noted, "In Europe, there are some positive but still rather weak signals pointing to improving growth. In North America, economic recovery appears more likely. The demand for paper in the company's main markets continues to grow slowly, and we do not foresee a significant market turnaround this year."

Meanwhile, Stora Enso's CEO, Jukka Harmala, said, "The long-awaited recovery in demand for forest products in Europe is still not clearly apparent. The macro-economic environment has not provided the conditions for sustained improvement in advertising spending, so demand for advertising-driven paper grades remains moderate. Demand for the group's packaging board products, which depends on general economic activity, remains stable. The outlook for product prices in Europe is largely stable, except in fine paper, where downward price pressure persists."

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Sappi, meanwhile, reported "difficult market conditions", although the group did say that there were early signs of improvement in Europe amid an improvement in coated fine paper orders. SCA was less bullish, saying, "A change in the advertising market, which could result in an improved demand situation for publication papers, was not discerned."

ODD TIMING

Not exactly a bright and breezy tone from the corporate headquarters. However, that has not stopped Europe's bigger players from announcing price hikes for everything from SC grades to newsprint. Stora Enso, for example, has already said that it aims to raise prices for magazine grades by [euro]40/metric ton early in 2004, with a [euro]25/metric ton increase for newsprint.

Given the apparent lack of supporting evidence to justify such increases, less sophisticated folks might be left scratching their heads as to why the companies were so intent on setting themselves up to fail. But several executives believe that by drawing a line in the sand now, the groups hope to stabilize the prices they already have, rather than harboring any realistic belief that the prices will stick. As one consultant said, "It's the Christmas present they would give themselves if they could."

Even the likes of Harmala concede, "In fine papers, there are some areas that are more problematic, especially in uncoated woodfrees, but at least in coated hopefully we've seen the bottom [of the cycle]. Certainly the situation has not changed dramatically, but talking to our sales people in the last few weeks there are some positive signs. We're going out with these prices increases but there's no doubt we're going to have a hell of a fight."

Marciano Alarco, analyst with Deutsche Bank, is not among those who believe that the prices will stick. "These guys have all announced rises for magazine paper, fine paper, newsprint and so on, but I don't really feel they'll go through," he says. "Operating rates are still at less than 90% in some cases, although the order books are okay. Prospects may improve in mid-2004, of course, but it's possible you could see pulp prices falling at the beginning of the year so that's not going to support any price increases if that happens."

Taitonen at UBS points to the lack of any real conviction in the announcements. Even so, he believes it still represents a positive signal. "There is certainly a debate as to whether these prices will go through. But whether you think they will or not, at least the sentiment is a lot better because European volumes have been seasonally better than expected."

Charles Spencer at Morgan Stanley is yet another skeptic. "Pricing announcements have begun to be made, first in publication papers where producers are pushing for a 5% increase from January 2004, and some producers have even announced increases in fine paper. However, producer inventories remain excessive, especially in fine paper, and very few industry players can foresee a powerful demand recovery in 2004 that would tighten industry operating rates enough to allow strong pricing power."

Spencer is far from being totally pessimistic though. Like other analysts, he may not believe that the January increases have much real bite, but he does feel that 2004 will prove to be a better year overall. Morgan Stanley believes that the cyclical trough has been reached and is forecasting around 5% for demand growth with a 3% boost on the pricing side. And it seems that even better news could be in store if things go really well.

"Our new 2004 forecasts could be too conservative if we do get the typical cyclical recovery when GDP growth accelerates and paper demand grows at a 2-3 times multiple of GDP. Such a powerful cyclical recovery in demand last occurred in 1994 (+10% year-on-year growth), which also followed a three-year industry recession, and operating rates, pricing and profits surged in 1995. If this were to recur our estimates for 2004 would likely be 50% too low."

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Kjellberg at CSFB certainly feels that there is some upside to come in 2004, even if the January increases do not prove realistic. "There's a small chance of something going through I suppose, especially for the grades that are not one year contracted, but possibly not yet. January is traditionally a weak period and the industry has historically never been able to raise prices ahead of an upturn in volumes. Unlike other industries, demand in the paper industry moves up or down and the price follows. If you look at the second half of 2000, for example, it was really quite good, but prices didn't go up until the end of the year and then by the time they went through the market had fallen back. As a result, I think there's still a bit to go before we actually see any price increase, but if we get another 2% on the utilization rates we may see some changes."

BANANA SKINS

Of course, the European paper industry does not exist in splendid economic isolation. Even if Euro GDP growth does stimulate demand and lead the paper companies out of the cyclical trough, there are enough banana skins spread along the path to make anyone but the boldest investor pause for thought before diving wholeheartedly into the sector.

For example, energy prices have been steadily creeping up across Europe and it looks like they will rise further. That translates into a large cost increase for some companies. Tomas Eriksson of Swedbank Capital points out that energy prices comprise 20% of the variable cost for newsprint and mechanical grades. And Peter Nygen, who is responsible for energy procurement at SCA indicates that it represents [euro]400 million/year to the company--some 10% of the company's purchasing costs. "We are now seeing a clear trend of electricity prices in this area rising as overcapacity declines and consolidation progresses," he says.

Even more important is the huge currency effect as the U.S. dollar sinks against the Euro. This factor is already having a major impact on the containerboard market in Europe where it has created a dampening effect, but according to some commentators it could herald a upward price movement for the pulp and recovered paper markets.

As one Finnish specialist reported, "If there are further cost increases they will come from any combination of pulp prices, energy or freight rates and all of them could have a sizeable impact next year. So whatever happens it's highly unlikely that either costs or prices will be flat next year."

Economists at Morgan Stanley predict a US$/[euro] exchange rate of US$1.20/[euro] for 2004, reflecting a further US$ depreciation against the euro. This is likely to be felt most negatively among exposed companies such as M-real or Norske Skog, says the company, but it will also reduce the global competitiveness of European producers in export markets and could attract imports of some packaging grades. Again, another factor that might scupper hopes of a significant price increase even if volumes improve.

On the other hand, some observers believe that a strengthening euro could be helpful on other grades. "Anywhere that the United States is more dependent on imports, for example, coated woodfrees and even coated mechanicals to a certain extent, European exporters would be best placed to 'export' their price increases," said one Nordic analyst.

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PROBABLY MAYBE

So, 2004 looks as though it could in fact be the year of the upturn. According to the market watchers, the indicators look good for pulp, recovered paper and coated fine paper grades, although packaging may trail behind slightly and the annual nature of newsprint supply contracts means that any really positive moves may well have to wait until 2004 has shown a real and steady volume increase.

RELATED ARTICLE: IN THIS ARTICLE YOU WILL LEARN:

* Why next year could be the beginning of an upturn in Europe--but maybe not.

* Why price increases for European paper products may be problematic.

* How pulp, recovered paper and coated fine paper have better prospects than other grades.

ADDITIONAL RESOURCES:

* "Southern Europe moves toward even greater integration, Jim Kenny, Solutions!, Sept. 2003

* "Top 10 global paper companies," Jim Kenny, Solutions!, June 2003

* "Do currency fluctuations impact earnings?, Jim Kenny, Solutions!, June 2002

* All of the above features are available free to TAPPI and PIMA members. Go to www.tappi.org and click on Solutions!

JIM KENNY, CONTRIBUTING EDITOR/EUROPE

ABOUT THE AUTHOR

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].