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Moody’s Releases 2004 Industry Outlook on Paper and Forest Products

Globally, Moody’s rates some 60 paper and forest product companies that have a combined $73 billion US in rated debt outstanding. The newly-published Moody’s Industry Outlook on Paper and Forest Products states that credit ratings in the paper and…

Globally, Moody’s rates some 60 paper and forest product companies that have a combined $73 billion US in rated debt outstanding. The newly-published Moody’s Industry Outlook on Paper and Forest Products states that credit ratings in the paper and forest products sector will remain under pressure in 2004. What improvements there may be in cash flows from better economic conditions will mostly go to shoring up balance sheets stressed by the prolonged cyclical trough.

In the U.S., improved economic activity should lead to increased demand for paper and forest products, with first volumes and then prices for most commodities continuing to improve over time.

However, because rising Asian demand for fibre is pushing up costs, as are increased energy prices, “it is possible that many non-integrated companies will see improved volumes and output prices without experiencing a material increase in realized margins,” says Moody’s Bill Wolfe, the main author of the report. “We are concerned that numerous structural changes are causing uncertainty in the timing and magnitude of the price recovery in some commodities.”

Chief among the structural changes behind the delay in price recovery, Wolfe says, is the impact on global supply and demand resulting from Asian, particularly Chinese demand, although recent capacity investments in Europe and South America are also factors, he says.

Performance varies

In pulp, Moody’s expects prices to increase gradually in 2004. Consequently, returns on capital will not be at levels that can provide funding for significant investment in efficiency or rapidly enough to prevent material dislocation for higher cost participants.

In uncoated freesheet, price improvement will be modest and checked by chronic oversupply. Moody’s expects companies in the sector to focus on cost cutting. Higher costs plants face downtime or closure.

Conditions in newsprint should gradually improve over the near term, but longer term conditions remain uncertain. Moody’s is concerned that despite little new capacity in North America, demand is declining, so pricing pressure will no doubt continue.

In coated paper, recent capacity additions will be limiting the rebound in prices, creating a negative near-term outlook.

While containerboard prices are likely to improve, margin improvement is uncertain because costs are also likely to be increasing, says Wolfe. Paperboard faces similar difficulties in cost, but the outlook is somewhat better because the sector has fewer competitive issues.

Pushed up by strong housing starts and the appreciating Canadian dollar, structural panels are the one sector that has seen impressive price increases. Moody’s expects demand to normalize and for new capacity to come on stream, leading to a return to trend-line prices.

U.S. lumber should show good results this year, but at the cost of the Canadian companies that continue to face stiff anti-dumping duties from the ongoing softwood lumber dispute and an appreciated Canadian dollar. In general, in Canada, companies struggle to adapt to the higher Canadian dollar. In Europe, the outlook is increasingly negative as an expected recovery continues to be delayed. In Asia, outside Japan, the outlook is stable, with some sectors expected to do better than others. In Japan, the outlook is stable as consolidation reduces excess capacity. South America, on the other hand, has a positive outlook, given excellent fundamentals.

Consolidation * higher prices

State-of-the-art newsprint mills are not being built in North America. They are, however, being built in Korea and China, in some cases by North American and European companies. While these mills may not export huge quantities into North America, they act as a barrier against the North American companies being able to export to Asia. This has the effect of increasing the supply trying to find customers in North America.

Some industry observers also point to competition from electronic media as a threat to newspapers and the demand for newsprint, and it is clear that circulation and readership figures are declining over time relative to overall economic activity. This demand-side issue further stresses an already precarious supply balance.

Other observers refer to competition from other groundwood grades. The theme of upgrading a machine from newsprint to calendared or SC or LWC has the affect of increasing the supply of these competing grades. With the rush to “move up the value-added chain,” producers have commoditized the more expensive grades and reduced profit margins to what they used to earn in newsprint. To add to the issue, in order to sell the higher grade output in an environment where the commercial printing industry is stressed, producers have cannibalized their customer base at the expense of newsprint sales.

While North American newsprint and containerboard manufacturers may continue to enjoy a permanent strategic advantage over off-shore competition, the advantage is no longer exploitable in the manner it once was. It now appears that advantage exists only to the extent that North American producers limit their business to North America.

Barriers to exit

Pulp and paper assets are hugely expensive and have extended lives. While a particular asset may not be competitive in periods of muted economic activity, it can be cash positive in those all too brief periods of elevated demand and prices.

A pulp and paper mill is also expensive to de-commission. If that same mill has ready access to fibre, there is a potentially seductive confluence of factors to keep it operating. Too many management teams and investors think there can be positive returns solely because there is an existing mill located close to fibre. These factors combine to create barriers to exit in the form of inertia. High cost capacity will operate, or be idled and therefore capable of operating, long after its relative competitive position makes it an anachronism.

Despite this inertia factor, it has recently become routine to read about companies permanently shutting down particular machines or mills. When aggregated, the numbers some larger players have announced represent capacity that would have represented entire companies 10 or 15 years ago. However, for all the pulp and paper mills that have been idled in North America over the past 15 years, there have been very few bankruptcies, and, unfortunately, very little improvement apparent in the financial fortunes of the survivors.

However, one wonders if the discipline or will to shut down capacity would have existed were it not for consolidation. For smaller, higher-cost companies, the discipline to close capacity would have meant extinction. It would be a brave or foolhardy CEO that would recommend winding-up a company owning long-lived assets with future, albeit cyclical profit potential, as being in the best interest of shareholders.

As companies merged with or acquired incremental capacity, they took on much larger portfolios of controlled capacity. With a large portfolio, shutting down high cost capacity becomes far more palatable. This capacity reduction has become the hidden benefit of consolidation activity. By providing a “politically” acceptable context for management to undertake an exit decision, consolidation has given the industry a largely unnoticed “stealth” ability to close high cost capacity. In conjunction with the “synergy” savings that are often reputed to equal 5-10% of sales, consolidation activity has been a benefit to the industry, even if that benefit is not readily apparent in financial returns.

Conditions may have been much worse were it not for consolidation.

In recent periods, the average price of many commodities has been well below the historic trend-lines that many observers point to. There is the potential this trend may continue. Historically, debt-financed acquisitions have assumed that surplus cash flow realized during a peak period would be used to reduce debt. While the arithmetic of accretion is a powerful motivator, the potential that future commodity prices may be l
ower than historic averages suggest that the risks associated with debt financing may be greater than had previously been thought. Recent debt-financed (unintended) exit of uncompetitive capacity has resulted in continued pressure on credit ratings. Despite this however, Moody’s anticipates that further consolidation activity will occur and views it as an essential aspect of the viability of many North American companies. The above-noted lack of apparent financial returns may, however, cause a reduction in valuation multiples and an increased potential of future M&A activity involving something other than debt-financed cash consideration.

Balance varies by grade

Including China, world-wide kraft pulp demand has grown by approximately 2.5% per year over the past six years after having grown by approximately 4% per year over the previous six years. Supply, on the other hand, grew by 4% per year from 1990-to-1997 and by nearly 3% from 1998-to-2003. Growth in supply is estimated at 4% for 2004. The figures point to an over-supply situation.

Europe continues to be the biggest market, consuming 45% of the world’s market pulp output. The Asian numbers are increasing over time, and now total 25%, having eclipsed North America at 20%.

Current world-wide market pulp capacity is estimated to be approximately 40 million tonnes per year. The top ten producers account for 45% of overall capacity. Despite the over supply, price volatility and economic uncertainty often observed in this market, it continues to attract new investment. Consequently, despite increasing concentration over time, this is still a commodity market where no producer has pricing power.

Canada outlook

Canadian companies, other than those whose primary activity is producing OSB, face some of the most difficult conditions ever seen. First, there is the very rapid appreciation of the Canadian dollar. This has the impact of reducing revenues and profitability. The benefit of lower Canadian dollar equivalent of U.S. dollar denominated debt may not fully off-set. Then there is the impact of increased foreign competition form China and South America. Add to this the impact of increased energy costs and conditions are not at all positive. The softwood lumber dispute further complicates matters. With some balance sheets having been stressed from debt-financed acquisitions, the misalignment of all factors is complete.

Moody’s expects to observe a significant amount of fundamental restructuring activity in the Canadian landscape in 2004, not in an effort to preserve ratings, but in an effort to maximize shareholder value. Those companies that take active steps to remain competitive, and have the necessary access to liquidity to pay the bills until the impact of their actions is realized, will dramatically improve their opportunity of preserving their ratings.

Summary Opinion

In general, ratings in the paper and forest products sector remain under pressure. While North American producers will begin to see improved cash flow in 2004 as general economic activity is relatively strong, many balance sheets, especially those of companies that debt-financed their growth, are stressed as a consequence of the prolonged trough that they are slowly leaving behind.

While paper and forest products’ commodity price movements usually lag general economic activity, the delay for this cyclical recovery has been especially prolonged. Moody’s is concerned that numerous structural changes are causing uncertainty in the timing and magnitude of the price recovery in some commodities.

The leading structural factor behind the delay of the price recovery is the impact on global supply and demand resulting from Asian, particularly Chinese, economic activity. Higher and more volatile energy prices are also a factor. Recent capacity investments in Europe and South America are also factors. So too is the ongoing softwood lumber dispute. Lastly, variations and volatility in currency exchange rates may be changing the arithmetic of relative advantage.

The evolving environment necessitates that companies adapt in order to maintain their credit ratings, and that they have access to liquidity to allow them to initiate change and operate until the impact of any change is internalized.

Moody’s Investors Service is a subsidiary of Moody’s Corporation. Additional information is available at www.moodys.com.