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Ruminations on the Abitibi-Bowater merger

With both Abitibi and Bowater still up over 20% on their announced merger, obviously the market loves this deal. We don’t, plain and simple! In our defense, we note the following issues:

Market Share: The combined company would represent 46.8% of North American newsprint capacity. We expect that both the Competition Board in Canada and its Anti-trust cousin in the U.S. will have trouble with the lack of regional newsprint supply alternatives. This is especially a concern on the Eastern seaboard in the U.S. and Canada. We suspect that government anti-trust officials will demand significant asset sales, lowering the resulting synergy savings, and ability of AbitibiBowater to manage future newsprint supply. We also point out that there are few buyers for these assets, so top dollar, or even market prices are unlikely.

Opposition: We point out that newsprint buyers are not without resources of their own. Major publishers have been very successful over the past five years on limiting newsprint price increases.

Sales Volumes: It is typical that post-merger sales to key customers are less than the sum of the sales from the individual firms before the companies got together. Customers, rightly fearful of putting too much reliance on one supplier, will usually attempt to further diversify their suppliers. In North America, we believe that major publishers will actively support AbitibiBowater’s newsprint competitors by accepting preferential terms and price. This will likely accelerate the shipment of Chinese newsprint to the North American market.

Newsprint Capacity Closures: With this announced merger, both companies were quick to point out that the deal did not anticipate mill rationalizations. With the expected closing of this potential transaction in Q3, we believe that this statement limits either company’s ability to shut newsprint mills in the interim. It also sends a signal to the rest of the industry that supply management responsibilities are clearly on the shoulders of AbitibiBowater, effectively relieving them of any curtailment pressure. We point out that over the last five years, both Abitibi and Bowater have taken the vast majority of closures/conversions, leaving them with few high cost facilities to shut down. With publishers aiding higher-cost producers, AbitibiBowater will likely be forced to close lower-cost mills than those of the marginal producer.

Consumption Decline: The main problem facing North American newsprint producers is the fact that domestic consumption dropped by 7% in 2006, with little expectation of this rate leveling off. If anything we believe that newsprint publishers now understand that their future lies in their transition to an electronic medium and not in hard copy sales. We expect that further conservation measures on the part of publishers including web width reductions and the elimination of newsprint content made redundant by the World Wide Web. In addition, North American demographics continue to point against producers, as their customer base has failed to attract young readers, suggesting that circulation declines may be a given.

Newsprint Pricing: With the move to 6-month contract pricing, we expect that publishers will be able to force near-term newsprint prices lower still. We understand that many of these contracts were recently renewed at price discounts from US$25 to US$35 per tonne. Without additional newsprint capacity closures, we think that the decrease in pricing will accelerate. We note that Foex Indexes Ltd. report a US$31 per tonne price drop since the recent high was established in early June 2006. Pulp & Paper Week list prices describe a US$35 per tonne drop since August 2006.

Financial Flexibility: Merging Abitibi and Bowater does little to change the financial strength of the resulting company. AbitibiBowater will still be heavily leveraged with little wiggle room to convert newsprint capacity to higher-value groundwood paper grades. We also believe that there is a good chance that AbitibiBowater comes to the market for a potentially-dilutive equity infusion.

The previous is an excerpt from Paper & Forest Products: Weekly Industry Digest. For more information, please visit www.salmanpartners.com