Slim Choices In Paper Buys

Curtailment, consolidation and fuel spikes conspire to hike paper prices.

By Trish Wales, Paper Editor -- Graphic Arts Online, February 1, 2008

The paper industry continues its struggle to balance supply and demand, shutting down inefficient equipment and frequent curtailments. No new machines are on the horizon in the U.S., although new machines are springing up on other continents.

Although overall paper industry research and development spending is flat, some companies have succeeded in providing attractive new products that are low-cost alternatives to traditional offerings.

No. 4 coated groundwood papers benefited from improved optical properties and took some volume from No. 3 freesheet papers as a lower-cost alternative. Higher brightness and more smoothness coupled with yield, opacity and bulk advantage were contributing factors to the robustness of the coated mechanical grades.

Improved SCA papers displaced some coated No. 5 groundwood tonnage as a new category emerged: SCA+.Coated free sheet attributes and the imports in this category are relatively unchanged—bluer papers and more optical brighteners. Other improvements are not category specific but include lower basis weights, forestry certifications and recycled fiber content.

Once again, 2007 was a year for small-town newspapers in the Canadian border states to cover mill closings and paper machines shutting down. Arguably, the 101-year-old paper machine at Baileyville owned by Domtar, the largest uncoated freesheet manufacturer in North America, or the 100-year-old Luke No. 7 machine owned by NewPage, now the largest coated paper manufacturer in North America, were ready to take a rest. Aging assets are commonplace in the U.S and ultimately must be mothballed.

Paper consumption in print markets are squeezed between the pincers of two ever-tightening forces: alternative media, and reduction of run lengths and waste in print operations. The beleagured U.S. paper industry is also trying to maintain pricing and profitability in the face of surging imports from Asia. Yet amid all that, 2007 is the year that domestic paper supply approached balance in the face of declining demand.

A fresh emphasis by paper manufacturers not only on core competencies but on core products is apparent. New companies emerged with larger market shares in smaller markets defined by a more specialized product mix. More focus and streamlining, and less vertical integration, are the hallmarks of these new players. But the jury is out on the viability of their strategies.

Four main grades make up the printing and writing papers segment: uncoated and coated mechanical, uncoated and coated freesheet. North America produces about 30% of the global paper in these categories, and most of it stays at home.

Printing and writing papers constitute a major paper category tracked by various statistical reporting groups and include most papers used in publishing and advertising—principally printed offset or gravure. Newsprint and office papers are tabulated separately.

The U.S. is the largest producer of uncoated freesheet, while Canada leads the world in uncoated mechanical production. Europe leads in the manufacture of both coated freesheet and coated mechanical categories. Manufacturers satisfy needs of their home markets, then search for the most profitable export locations. Currency exchange rates strongly influence the direction paper takes as it moves around the globe.

U.S. print sales kept pace with GDP until the late 1990s. Then, structural changes in the demand curve began to take over. We now bank online; get our news online; order merchandise online. The Internet continues to erode print's market share, shifting paper volume from commercial offset to digital uncoated—“office papers” that pass through digital print engines.

The domestic paper market parallels the print market. RISI, a global forest products information source, reports an average paper demand drop of 4% in 2007 with coated freesheet grades down 9%, mechanical grades down 2%, uncoated freesheet down 4%. The trend is projected to continue into 2008 with some relief from the elections and Olympics, which historically boost print production. Per capita paper usage of the four main grades in the U.S. declined between 1% and 2% to about 735 pounds. But that still amounts to 30 million tons of printing and writing papers consumed in 2007—not a small number.

Supply: less domestic, more imports

Paper manufacturers have learned to constrain supply to avoid inventory builds and price slashing. Curtailment and closures of machines in all paper categories removed almost two million tons of paper from printing and writing grades in 2007. Ten paper companies announced capacity reductions in printing and writing categories, either through closures or retooling.

As a result, paper machine operating rates, which started the year under 90%, had risen well above that mark by year's end. Coated freesheet operating rates rose to 95%, coated mechanical to 98% and uncoated freesheet to 92%. Domestic operating rates at the end of 2007 reflect a reasonable supply of paper, filling 68% of U.S. needs. Rounding out the U.S. market supply were imports, mostly Canadian (20%) and all others (12%), primarily European.

Scandinavia and Western Europe have long produced more coated paper than their local markets require. Much of the excess had shipped to the Far East and, more recently, to the U.S. With the rapid buildup of coated paper production in China, European mills are now facing a similar scenario to the U.S.—excess capacity, curtailment and machine closures. Old Eastern Bloc nations are softening the impact on the Western European manufacturers, providing an alternative to the U.S. market.

Asian paper imports come to the U.S. primarily from South Korea, Indonesia and China. South Korean volume remains constant, the result of well-established distribution channels in the U.S. However, there was a steep increase in coated papers from China in 2007 despite the threat of duties. The reversal of dumping and countervailing duties against Asian imports signals that these papers will continue to be a factor in our markets.

China has invested heavily in coated paper machines and the infrastructure to support the paper industry, even buying U.S. mills. Paper for export is now efficiently manufactured on the latest technology paper machines in China, but the U.S. is not the long-term intended market. Rather, an emerging middle class in China is expected to generate growing domestic demand in the not-too-distant future. (Per-capita paper usage in China, at 65 pounds just one-tenth the U.S. figure, is certain to increase.)

Inventory building was not a factor in 2007. There is no excess supply of paper on merchant, printer or mill floors. Operating rates at the end of the year tell the story.

Tightening supplies

Mechanical categories that include both coated and uncoated groundwood will be in tight supply. In fact, lead times of three months for coated groundwood and supercalendered papers are reported. There's potential for a coated mechanical shortage in 2008, particularly European and Canadian closures, along with a weak dollar that will further reduce imports in this segment.

It's a different story with coated freesheet, where plenty of global capacity meets the increasing global demand. Over one-quarter of imports in this top-of-the-line category come from Europe and South Korea and are well established in the U.S. Despite domestic price increase announcements, average coated freesheet prices actually fell by 3% last year. In the future, higher pricing will be more sustainable because of the concentration of freesheet manufacturers that occurred last year.

Only uncoated freesheet managed to sustain higher pricing in 2007, influenced by consolidation. Overall, 2007 printing and writing prices were up 1% while volume production was down 1.6%.

The cost of making paper is increasing everywhere. Global pulp prices rose 9% in 2007. Chemicals used in the pulp and paper making process also increased in price, as did energy costs. U.S. mills are feeling the pinch and need pricing relief. Only imports stand in the way. Lower cost producers in Western Europe, Brazil, Scandinavia and China may choose more attractive markets because of current exchange rates.

Mergers focus on core products

Mergers and acquisitions are complex in the paper industry. Joint ventures are common, as are partial acquisitions with one corporation buying part of another.

Closing unprofitable mills and inefficient machines along with reduction in administrative expenses are among the first priorities in these newly formed paper companies. As noted, they have a leaner profile and are more focused on a single type of paper. Vertical integration is less common as mills have spun off forestlands and pulp assets to finance acquisitions.

The Domtar/Weyerhaeuser merger was top news in 2006. The deal cleared antitrust in both the U.S. and Canada by July 2007. The new company, Domtar, is now the largest producer of uncoated freesheet in North America. Mill closures were quickly announced in both Canada and the U.S.

Abitibi/Bowater completed its merger of equals last October and now controls about half of the newsprint market in North America. Eight money-losing mills, including one in Lufkin, TX, were closed. The rest, primarily newsprint, were in Canada. The closures will help balance the steadily declining demand for newsprint.

MILL	FACILITY	M/TONS
Boise	Wallula	200
Domtar	Hull et al	200
Fraser	Madawska	70
Georgia-Pacific	Wauna	100
Glatfelter	Neenah	125
International Paper	Pensacola	350
Neenah	Urbana, Housatonic	40
NewPage	Luke	100
Tembec	St. Francisville	325
Wausau	Groveton	105

Paper companies continue to attract private-equity funds comprised of wealthy individuals in search of under-valued companies to turn around, generate profits and find an exit strategy validating the investment. The financial performance of paper companies lags other public companies. However, revenues are increasing and machines continue to produce paper long after amortization. Investors clearly believe paper manufacture can be profitable when mills are purchased at favorable prices and managed effectively.

The sale of Stora Enso's U.S. holdings to NewPage Corp., completed two months ago for $2.556 billion, finally consolidated the coated paper market. NewPage is majority-owned by Cerberus Capital Management, which specializes in working with existing management to transform companies into industry leaders. Cerberus bought the coated fine papers division of Mead Westvaco in 2006, forming NewPage. With Stora Enso's eight mills, NewPage now emerges as the largest manufacturer of coated paper in the U.S. Further capacity optimization and other cost reductions are in the cards.

Apollo Management affiliate CMP holdings snapped up the web coated paper mills of International Paper (IP), forming a new company, Verso Paper, in 2006. Apollo tends to focus on underperforming—or even distressed—companies. Verso booked a loss last September, then filed a registration statement with the SEC for an IPO three months later.

The Plainfield Asset Management Group stepped in to revitalize bankrupt SMART Papers just last month. SMART owns some prior IP assets and remains the largest independent North American manufacturer and marketer of premium cast-coated, text, cover and writing papers. An infusion of capital bolsters their solid brands.

The remnants of the original companies continue with new focus. Weyerhaeuser is concentrating on building products; Mead Westvaco on packaging and specialties. IP is now focused on uncoated freesheet. Stora Enso is delisting itself from the New York Stock Exchange, consistent with its strategy of focusing and simplifying operations, reducing costs and complexity.

Paper industry prospects

We cannot predict the future, but we like to try. The paper industry is a mature capital-intensive industry with a new formula for success. Debt levels limit investment opportunities in the U.S., while foreign paper manufacturers are adding modern, high-speed machines, particularly in Asia. New ways for mills to take advantage of proven cost-cutting methods, yet maintain higher prices and improved profitability, will be tested in 2008.