Paper shares: a lower than average risk, Solutions! Online Exclusives, June 2003

 

Paper shares: A lower than average risk

by Håkan Rylander, SCA

(Editor’s Note: This story is available on the SCA website, www.sca.com, and appears here in a slightly edited form.)

The SCA Investor Report brought together three leading pulp and paper analysts for a roundtable discussion about the paper industry’s economic situation, acquisition strategies and the valuation of paper shares.

Roundtable participants: Catarina Ihre, Nordea Securities; Mattias Sjödin, Carnegie; and Lars Kjellberg, Credit Suisse First Boston.

SCA Investor Report (IR): How do you view the economic situation for paper products companies?

Ihre: During the summer (of 2002) there were a number of leading indicators that began to look positive, but since then the economy has declined again. Suddenly the world looks a little uncertain. However, paper products companies in general feel quite stable.

Sjödin: All of the leading indicators have declined, especially in the U.S.

Kjellberg: The paper products industry needs greater demand, but this has disappeared. Advertising investments are extremely important for graphic paper, but basically these are currently at zero. And there is no indication of them increasing.

Ihre: Generally, this means that I am adopting a cautious approach to 2003. It’s possible that we could see reasonable profitability during the second half of next year. We analysts will be able to maintain our forecasts, but change the year from 2003 to 2004.

Sjödin: I don’t believe that volumes will fall (during 2003). On the other hand, what will happen to prices is uncertain. Volumes won’t increase so much that they offset any falling prices. I’m not talking about hygiene products, but about traditional forest industry products.

Kjellberg: A critical factor is that the industry continue with its disciplined approach to the way it uses capacity. If this is not done, there is a 20 percent downside on prices.

Sjödin: And even more on share prices.

IR: To what extent does this gloomy picture also apply to other sectors, such as hygiene products and packaging?

Ihre: Hygiene products, and to a certain extent packaging, are affected more by private consumption and therefore have a different cycle.

Kjellberg: The greatest uncertainty is for newsprint, less for packaging and even less for hygiene products, which are nearly independent of economic cycles.

Sjödin: For newsprint, much depends on the advertising economy, but for hygiene products and packaging, it is more company-specific factors that have an impact. These include technological developments, marketing and having the appropriate structure.

IR: Currency rates are another factor that companies are unable to control, but that can have a major impact on results.

Ihre: Yes, many analysts foresee a structural weakening of the dollar. However, many of the companies now have a better balance between their production facilities and sales than they had 10 years ago. Therefore, currency exposure is not as high. But the strength of the dollar is an important indicator of the U.S.’s ability to be the engine of the world economy.

Sjödin: If the dollar falls, there is normally a directly negative effect on European shares.

Kjellberg: However, many of the historical connections have now been discarded. For example, the variation of pulp prices according to share prices is something you can forget.

Sjödin: Absolutely. What we have also seen is that paper products companies’ shares have kept their value rather well when the rest of the stock market has been in sharp decline. Particularly all of the companies that focus on consumer products, such as SCA. An explanation is that the companies generate strong cash flow.

Kjellberg: The balance sheets are also generally in good shape. In addition, the price structure is excellent despite the weak economy.

Ihre: The fact that the prices have held their position is partly a result of consolidation. With fewer players in each segment, there is less risk of a senseless price war. Another extremely positive trend in recent years has been that the paper products companies have become more efficient.

IR: Is there major potential for further increases in efficiency?

Ihre: There is always work to be done on the margin, but I believe the major shift in level has already been implemented, at least in Europe. Now it is more the details that must be considered.

Kjellberg: However, we still haven’t seen the results of the increased efficiency. This will happen when the mills can work at full capacity.

Sjödin: And if prices can then remain the same, there is enormous leverage for profitability.

IR: Do you primarily regard an aggressive acquisition strategy as a factor that raises the risk (for a) company?

Sjödin: Normally, it raises the risk. In the traditional forest products industry, it is difficult to prove that acquisitions add value for the purchasing company’s shareholders.

Ihre: If you look at the profitability of SCA, for example, over the past 10 years, it is clear that it has sold low-performance units, like fine paper, and secured quite high payment for them. Capital has instead been invested in packaging and hygiene products, in which it has increased its profitability in pace with its acquisitions. It really is a textbook example of how this should be done.

IR: Does a history of successful acquisitions hold a strong forecast value for the future?

Kjellberg: Yes, I think so. SCA has established a reputation whereby the share price reacts positively when it makes a major acquisition. For a company with a poor acquisition history, the price would fall correspondingly.

Sjödin: At the same time, it can be presumed that the companies that failed in their acquisitions have probably learned from the experience and will be more cautious next time.

IR: Would a major failed acquisition have a strong impact on confidence, even for a company with a favorable track record?

Kjellberg: Yes, reputations are sensitive and it only takes a little to destroy them.

Ihre: And they can take years to repair.

IR: Listening to you, it almost sounds as though the interesting aspect is not actually what strategy a company has, but the ability to implement it. How do you assess this ability?

Kjellberg: Companies must create trust, which, after all, is rather fragile. But there is also another interesting purchasing trend in the industry. Since paper companies generate strong cash flow, they attract new investors who buy out companies from the stock market. This has happened to three rather large paper companies in Europe.

Sjödin: And with the prevailing valuations, more buyouts would have occurred if they had not been blocked by deadlock among the owners.

Kjellberg: If we go back to where we began, with market outlook, we can see that uncertainty is extensive today—much greater than a few months ago. It really isn’t possible to make a reasonable assessment of the economy. In a situation like this, it is important to try to see beyond the current problems.

Ihre: Uncertainty makes investors look more at stable key data linked to the balance sheet and sales, which vary much less than key data linked to profits.

Kjellberg: Yes, there has been a change in how companies’ values are regarded. We also believe that the European paper companies now have a higher earnings capacity over an economic cycle compared with a few years ago.

Ihre: It can be debated whether individual transactions were positive or not, but the general trend toward a more concentrated market has led to improved profitability.

Sjödin: From a share perspective, paper is no longer regarded as a high-beta industry, meaning that it swung more strongly than the stock market in both directions. Now it is more a case of the risk being lower than the average in the stock market.