FINANCIAL OUTLOOK

Forest product companies and market challenges

Article by Dirk Steinicke, Analyst at Moody’s

Forest product Moody’s predicts that 2020 will be a difficult year for companies are likely most paper and forest products companies in Europe, to focus on executing especially the first half of 2020. Firstly, demand for capital spending projects communications papers is continuing to decline, especially and cost-cutting given for coated woodfree paper, which calls for ongoing production market challenges capacity reductions. Secondly, the pricing level for hardwood and softwood pulp grades is currently relatively low and we believe it is below the cash cost of production for a significant portion of global production capacity. Slower economic growth in major economies also puts pressure on paper packaging mainly because the growth in demand becomes insufficient to fully absorb capacity additions, which leads to lower corrugated container prices. In our view, flat consumer packaging and tissue prices will not offset pricing pressure in the corrugated container segment.

Following a prolonged period of deleveraging, the rating agency thinks that many companies across the pulp, paper and paper-packaging sector in Europe are likely to turn their attention to executing recently announced new investments and reducing costs in response to the currently challenging demand and pricing situation in most market segments. The coronavirus outbreak has diminished optimism about prospects of an incipient stabilization of global growth this year. While logistics disruptions may temporarily slow paper and forest product exports from China and other areas of significant outbreaks like Korea and Italy, the impact on global demand is likely to be far worse (than the impact on global production), resulting in oversupply across many regions, which will also drive prices lower.

Moody’s expects consolidated operating income for the 42 paper and forest product companies that we rate globally to decline by 5%-7% over the next 12-18 months. However, many Moody’s rated European companies in this sector, in particular UPM-Kymmene (UPM), Progroup, Smurfit Kappa (SKG), Mondi and Metsä Board, have built up financial flexibility to execute their capital investments in new projects without putting significant pressure on their credit quality.

Over the past few years the companies have benefitted from a fairly benign operating environment that has supported volume growth in all segments aside from graphic paper, where demand is structurally declining owing to the shift to digital media. Investments to optimise the level of vertical integration, increase productivity and reduce the overall cash costs of production have also played an important role. Even companies with graphic paper exposure, such as UPM, Sappi and Stora Enso, have increased their earnings. Despite declining graphic paper volumes, these companies have continued to shift their business mixes away from margin-dilutive paper operations towards structurally growing and more profitable segments, such as pulp (Stora Enso, UPM), paper-packa-

ging (Stora Enso, Sappi), and labelling or other specialty papers (UPM, Sappi).

The EBITDA of the vast majority of companies in Moody’s peer group of European Ba and Baa-rated pulp, paper and paper-packaging companies has grown since 2012. For example, the combined EBITDA of this peer group increased by 12% between 2012 and 2017. Moreover, for the 12-month period ended September 2019 EBITDA was even 32% above the 2012 level, as companies benefitted from structurally better positioned paper businesses. However, as trade tensions increased, global growth slowed and the demand for pulp significantly deteriorated during 2019. As a result, the average EBITDA margin has started to decline (see Exhibit 1), reflecting the more challenging market environments.

Aggregate EBITDA margin of Moody’s rated European pulp, paper and paper-packaging companies is declining

Exhibit 1 Source: Companies financial reports

European pulp, paper and paper-packaging companies rated by Moody’s have started to increasingly focus on cost reduction programmes and more selective growth investments in order to protect profitability and financial flexibility. Many of these companies, in particular those with structurally declining paper operations, have remained focused on strengthening their balance sheets. This has enabled them to keep investing in strengthening and diversifying their operations while staying free cash flow positive. In addition to investments, companies have used excess cash to reduce debt by roughly one-third to an equivalent of around $20 billion in the 12-month period ended June 2019 from an equivalent of almost $30 billion in 2012. Such debt reductions combined with increased EBITDA generation have resulted in a Moody’s-adjusted debt/EBITDA leverage ratio of around 2.1x for the 12-month period ended September 2019 down from 4.1x in 2012 on average.

Moody’s thinks that because these companies’ balance sheets are stronger on average there is some capacity for growth investments, even though the rating agency has a negative industry outlook for the global paper and forest products industry. As Exhibit 2 shows, the average debt level for the Moody’s rated European peer group is close to a record low.

Moody’s rated European pulp, paper and paper-packaging companies’ aggregate debt is much lower than in 2012

Exhibit 2

Source: Companies financial reports

However, Moody’s thinks that the companies’ balance sheets are likely to weaken further over the next 12-18 months. This development is mostly driven by our expectation of declining EBTIDA generation and to a lesser extent by increased debt loads used to fund strategic growth investments. Nevertheless, Moody’s observes that most companies are still within the range of their self-imposed leverage targets (see Exhibit 3), which they have tightened during the last couple of years, or will take measures to do so if the market Most rated European pulp, paper and paper-packaging companies’ reported remains challenged for a leverage is within their own ranges prolonged period. Therefore, Net leverage target/ Reported net leverage for 12-month the rating agency further ex- ceiling [2] period to December 2019 pects that the current market Stora Enso Metsä Board below 2.0x below 2.5x 2,1x 1,1x situation will compel compa- Mondi [1] none 1,3x nies to optimise their cost Sappi below 2.0x 3,0x structures in order to remain SKG UPM 1.75x - 2.5x below 2.0x 2,1x -0,2x compliant with their respec- ENCE (Pulp) below 2.5x 1,8x tive financial policies. ENCE (Energy) below 4.5x 4,3x Progroup 2.5x - 3.0x 2,6x

For example, Stora Enso has extended its cost savings programme to €275 million

Exhibit 3 Source: Companies financial reports

(1) Mondi does not have a specific target, just a commitment to maintaining an investment-grade ratingper year from €200 million

(2) These are internal self-imposed targets/ceilings

from 2021 onwards. Sappi is currently working on the Vision2020 programme aimed at reducing its operating costs by a total of $140 million per year by 2020 compared with 2018. Sappi’s management already realised $87 million of savings during fiscal 2019, which ended in September 2019. At the same time, the company is continuing its transformational strategy by adjusting production capacities in graphic paper and newsprint with the closure of 620,000 tonnes of graphic paper and 240,000 tonnes of newsprint production capacity. Sappi has also cut its dividend to protect its cash flow.

Meanwhile, UPM continues to gradually optimise its cost structure and has announced plans to build a new 2.1 million tonne pulp mill in Uruguay for around €2.8 billion (including infrastructure investments) to strengthen its market position in a structurally growing product. Furthermore, Metsä Board is also going to revamp its Husum mill for about €320 million in order to reduce production costs so that it can continue to offer competitive products.

Elsewhere, SKG currently plans to invest as much as €1.6 billion between 2018 and 2021 on projects aimed at generating additional volumes, improving the level of vertical integration and reducing cash costs. Similarly, Progroup has started building a new 750,000 tonne testliner mill in Germany at a cost of around €465 million and four additional corrugated plants in Europe. A number of other companies, such as ENCE, Mondi, and Sappi are planning to debottleneck their pulp and packaging operations as well as make investments in renewable energy in a response to continued increases in demand. Although pulp prices are currently at a low level, Moody’s expects that they will start to increase again over the next two quarters given that global demand is still robust and major production capacity additions will not enter the market before 2021.