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Paper Tigers catching fire at last?

26 November 2014 Paul Whitburn, RECM
Paul Whitburn, a portfolio manager at RECM.

Paul Whitburn, a portfolio manager at RECM.

The shares of global paper companies were hit hard by changing patterns in media consumption and reduced business activity following the financial crisis. But certain companies enjoy good strategic positioning or inherent competitive advantages and have managed to prosper while their peers have struggled.

While the advent of the internet age and the global financial crisis had a big influence on paper consumption, according to Paul Whitburn, a portfolio manager at RECM, some of the paper industry’s woes were of their own making. “For many years paper companies had easy access to debt and therefore overinvested in capacity. The resulting oversupply could take decades to take up in a lower growth environment.”

The paper companies that have managed to survive the difficult trading conditions have been those that invested in more efficient plants and those able to fully vertically integrate by owning their own timber resource and pulp manufacturing plants. “Companies focused on coated wood-free paper, which is used in glossy magazines, have struggled,” says Whitburn. “As consumers have switched to digital channels, demand for coated wood-free paper has declined, leaving companies like Sappi with excess capacity and declining product pricing. Their strategy of trying to consolidate the coated wood-free market backfired and they had to later impair and close these operations leading to substantial capital destruction.”

Mondi’s diversification away from South Africa proved a shrewd move when their acquisitions in Eastern Europe and Russia benefitted from fundamental shifts in the European paper market. “These regions were seen as high risk at the time Mondi bought into them,” says Whitburn. “But they acquired the assets cheaply and then modernised them to make them more cost competitive. When these regions became the manufacturing and packaging hubs for Europe, Mondi were well positioned and went on to grow strongly. But from an investor point of view, their good positioning is already very evident in their high valuation.”

RECM visited Portugal shortly after the global financial crisis in search of quality companies that might have been oversold. “At the time, the southern European countries were known as the PIGS (Portugal, Italy, Greece and Spain) and were heavily out of favour,” says Whitburn. “We found a paper company – Portucel – that has consistently generated higher returns than its European paper industry peers despite the low growth environment.”

Portucel has a number of competitive advantages that make them the lowest cost global producer of printing paper, says Whitburn. “They’re fully vertically integrated and have access to a rare variant of timber that grows faster, yields more and requires substantially fewer chemicals in processing pulp to paper. They have minimal gearing, are close to their main market in Europe and they sell a higher proportion of premium paper giving them a higher average price per ton. They’re also developing a timber plantation in Mozambique that will be roughly the same size as their Portuguese timber operations and will serve demand in the Chinese market.”

Portucel is 81% owned by Semapa, a family-owned industrial conglomerate. “Semapa also owns 100% of Secil Cement, the second largest cement manufacturer in Portugal, with operations in Brazil, Tunisia, Lebanon and Angola,” says Whitburn. “At current prices, an investment into Semapa not only provides investors access to Portucel’s compelling competitive advantages at an attractive valuation, but you also get the entire cement business for free, including the equivalent of seven million tonnes of global capacity.”

Even with the shift to digital, paper demand is still closely linked to economic activity. As economic activity picks up again in Europe, paper consumption should increase and RECM expects Portucel to benefit, especially if it has fewer well-funded competitors.

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