Asia's recovery appears to be laying the foundation for not only a sustained pricing upcycle, but also significant share price increas

By Norman Waite

Paper tigers hit the recovery trail

Asia's recovery appears to be laying the foundation for not only a sustained pricing upcycle, but also significant share price increas

by Norman Waite

Asia's economic crisis wreaked havoc on the share prices of Asian paper companies, but it also played a large part in creating the extremely favorable pricing environment that the paper and forest products industry now enjoys. Although economic and political risks have outweighed the competitive advantages of Asian companies over the past two years, the region's budding economic recovery should begin to expand operating margins and free up the valuations that many of these shares deserve. We believe names like Asia Pacific Resources International (APRIL), Asia Pulp & Paper (APP), Tjiwi Kimia and Siam Pulp & Paper (SPP) still hold compelling value at current prices.

Recovery rolls on

Rebounds in the region's growth rates and rising consumption across the board should continue to boost recuperating demand for pulp and paper in Asia. Pulp prices have already moved up by over $150/ton since January last year and every grade of paper and board has either already shown upward price movement or announced a pending price increase. We are confident that non-Japan Asia can resume its position as the fastest growing region of paper and forest products consumption within the next two years.

Regional demand now appears to be on the rebound following the financial crisis. Forward integration and the beginnings of an economic recovery have put pulp imports by the big three importing countries - China, Korea and Japan - on track to increase by over 10% year-on-year. China looks poised to import more pulp this year than ever before and Korea's recovering paper industry is on schedule to raise imports to levels last seen in 1997. While Japan's pulp imports are likely to show another contraction in 1999, we believe its pulp and paper industry has stabilized and could start to recover in the near future. Pulp inventories now stand at their lowest level in over three years and the appreciation of the Japanese yen has significantly lowered the cost of imported pulp. The combination of lower inventories and higher operating rates signals the beginning of a recovery in Korea and Japan

Chinese imports of paper and board also continue to grow at an encouraging rate. After year-on-year growth of just 5% in 1998, the country's paper and board imports are set to top more than 6.5 million tons in 1999 - a 13% increase on the previous year. We estimate that 3-4% of this increase is a result of the country's crackdown on smuggling. Nonetheless, this leaves China with 9-10% real growth in demand for higher-end products.

Figure 1 - Asian Paper & Forest Products Industry Stock Performance
Source: Reuters, Salomon Smith

China cuts capacity

The Chinese industry is notorious for its small, outdated, inefficient and highly polluting nonwood mills. However, Beijing's efforts have significantly reduced the country's capacity over the last three years. Through an environmental clean-up campaign that began in 1996 and an ongoing economic rationalization program, the government has brought about the closure of more than 3,000 mills. Salomon Smith Barney estimates these actions have decreased China's overall paper and board capacity by 4.5-6.0 million tons/yr (almost 2% of global capacity)

Once finalized, China's entry to the World Trade Organization (WTO) should lead to even more closures as local players become exposed to greater competition. The majority of China's mills are unlikely to survive as most of them have no competitive advantages other than their proximity to customers. China ranks at or near the bottom in terms of capacity per mill. So much so in fact, that even Cuba and North Korea have average capacities that are double those of China. Average capacity utilization and labor productivity in China are also very low in comparison to countries such as Thailand and Indonesia.

Attractive fundamentals

Asia has been home to the majority of the world's capacity expansion in five out of the last 10 years. However, the region's growth in downstream capacity between 1988 and 1998 was almost seven times its growth in pulp supply (integrated and market). This compares with an average of less than four times outside of Asia. This trend has increased demand for market pulp by non-integrated companies and removed the supply of market pulp from integrated producers.

When this declining pulp supply is added to the 7.5 million tons or more of Asian net imports of pulp averaged between 1996 and 1998, Asia's pulp market should significantly contribute to higher global pulp pricing going forward. A rising pulp price should eventually push up downstream product prices, expanding operating margins among the vertically integrated Indonesian and Thai players.

The region's paper and board capacity growth rate looks set to slow significantly going forward. Even if we include projects categorized as "undecided", paper and board capacity growth should slow to just over 1%/yr in 2000 and 2001. This should contribute to one of the most attractive global capacity outlooks in recent history.

The lowest growth rate of global paper and board capacity in the last 15 years was in 1994, immediately prior to one of the steepest price increases the industry has ever experienced. While we do not expect growth rates in 1999, 2000 and 2001 to be the lowest over the past 15 years, our forecasts indicate that these three years should rank second, third and fourth (not respectively) on the list. This would be one of the most sustained lulls in capacity expansion the industry has seen.

In a bid to reduce debts or focus on core competencies, Asian companies have begun to solicit buyers, boosting merger and acquisition (M&A) activity across the region. Continued regional consolidation would improve the Asian industry as decreased fragmentation could stifle opportunistic competitive behavior and reduce pricing volatility. In some cases, M&A activity might also unlock asset values held back by poor execution or financial stress.

Although Japan's top five producers make up over half of the country's capacity, the top five in non-Japan Asia hold little more than 10% of that region's total. The need for capital and restructuring on the seller's side, matched by the strategic imperatives to enter Asia on the buyer's side, suggest that international transactions should continue. However, a lack of regional capital suggests that intra-Asian deals are unlikely to be on the cards

Figure 2 - Global Paper Induxtry P&B v Pulp Capacity Expansions 1988-1998 (tons in thousands, downstream/pulp capacity multip
Source: RISI, Salomon Smith Barney

Leverage is key

While we do not anticipate a price rise of the trajectory seen in 1994 and 1995, there is little reason to doubt that the industry is at the beginning of a cyclical price upturn. The question now becomes how to take advantage of these attractive industry fundamentals. We believe the key is to find the players with the most leverage against this recovery.

The first key factor to consider is a company's exposure to the Asian market. Virtually every Asian player possesses this advantage to a certain degree. APP's wide-ranging product line and comprehensive geographic exposure, for instance, offers the largest exposure to the Asian recovery of any stock we cover. Other stocks might offer more specific exposure either to pulp (APRIL), specific grades of paper (Tjiwi Kimia), or one country or region's recovery (SPP)

A second factor worth looking at is the quality of the company's assets. Asian players have leapfrogged in technology to modern machines designed to produce higher quality products from lower grade raw materials, allowing many players to compete with their more established peers on quality as well as price. Aside from some of the older capacity in Taiwan, most of Asia’s listed companies possess this advantage to varying degrees.

The third factor would be a company's cost structure. Thai and Indonesian companies boast some of the lowest labor rates and raw material costs in the world. We believe this lower average cost of production justifies a further premium for an Asian company's value per/ton of capacity when compared with its international peers.

Finally, we believe it is imperative to consider a company's financial management. Asian paper companies have varying degrees of financial leverage due mainly to either recent capacity expansions or, in the case of non-dollar based accounting, currency devaluations.

All in all, Asian companies look set to enter 2000 on an upswing. The pricing and demand situation is beginning to play in their favor and should translate into expanding operating margins and improved share price performance. We believe that companies such as APRIL, APP, Tjiwi Kimia and SPP are well leveraged against this recovery and offer compelling upside

Norman Waite is the Paper and Forest Products Analyst for Asia (ex-Japan) at Salomon Smith Barney. This is an extract from his November report, "Asia Paper & Forest Products - After the Fall…the Recovery". The report covered APRIL, APP, Indah Kiat, Tjiwi Kimia, AA and SPP, as well as two Malaysian plywood companies

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