The Forestry & Paper sector might, on first glance at least, appear to be the market’s unloved ginger step-child but the truth is investors continue to warmly clasp this tiny grouping to its bosom. In the year to date, it can point to gains of 30.2% compared to the FTSE All-Share’s still-generous 9.8% return, enough for a second ranking overall (see table, Sector Report, page 38).

This rosy picture is slightly deceiving all the same. Only Tobacco, with just two constituents, is formed of fewer names than Forestry & Paper which has five members. Moreover, Mondi (MNDI) represents £2.7 billion of the grouping’s aggregate £2.9 billion market cap. At least we believe this South African behemoth can maintain its excellent run, especially if risk appetite remains elevated and signs of a nascent economic recovery become stronger. Finnish packaging group Powerflute (POWR:AIM) also looks a sensible portfolio pick but to get a more rounded view of the industry, a detour into the General Industrials’ sub-sector of Containers & Packaging is also required. Irish Smurfit Kappa (SKG) looks to be well and truly on a roll.

Tough times

Moody’s Investor Service warned last month (28 Feb) that European paper producers were ‘likely to see their operating income decline in the next year or so due to lower prices and demand for paper. European paper volumes should decline because of persistent euro area macroeconomic weakness and the structural decline in demand for paper. Similarly, Latin American pulp producers’ operating income will decline due to weakening prices for market pulp.’

As such, investors must stick to the basics and target the firms with healthy balance sheets and good cashflow. Powerflute’s strong finances and its 30% global share of the semi-chemical fluting market give the Finnish company a decided edge over many of its rivals and every chance to widen the competitive moat which surrounds its economic castle. Investment in the modernisation of facilities at its Kuopio semi-chemical operation slowed production growth in 2012 but should this year add significantly to both output and quality with a telling effect on the bottom line.

Smurfit Kappa is highly cash generative and it is therefore expected to continue to increase its dividend and pursue acquisitions in emerging markets. September 2012’s $340 million deal for Orange County Container Group (OCCG) is typical of the group’s acquisition strategy. OCCG is a corrugated and container board manufacturer with operations in Northern Mexico and the southern United States. It is a strong strategic fit with Smurfit’s existing businesses and is expected to deliver at least $14 million of synergies within 24 months of its purchase.

Higher distributions are also on the agenda at Mondi. The FTSE 250 firm told investors at its full-year results (21 Feb) it would be focussing on the integration and optimisation of recent acquisitions in the consumer packaging space. Management expressed confidence it would make further progress in the year ahead prompting Dublin-based Davy Stockbrokers to say ‘these deals should be accretive and will support the company’s progressive dividend policy.’

Mondi cut its distribution to €0.095 a share in 2009 but had rebuilt it to €0.28 by 2012. Further increments, to €0.32 (27.4p) this year and €0.356 (30.4p) next are the consensus expectation, figures which put the stock on respectable yield of 3.1% for 2013.

Smurfit Kappa did not pay a dividend at all in 2009 or 2010 but payments have been resumed. The market forecast of a €0.303 payment implies a 2.5% yield at the time of writing.

Unpacking the sector

The General Industrials’ sub-sector of Containers & Packaging is also germane to this niche and UK-based recycled packaging specialist DS Smith (SMDS) merits a closer look.

With a market cap of £2.1 billion, DS Smith is one the UK’s biggest suppliers of corrugated packaging products with customers in every major commercial and industrial sector. The group’s main focus throughout 2013 is likely to be the integration of its SCA Packaging acquisition. It is on track to deliver the targeted €100 million of annual cost savings and €130 million of cash savings earlier than previously expected, according to the group’s interim management statement (7 Mar).

DS Smith is in the only stock capable of matching Mondi for its market cap influence and James Cropper (CRPR:AIM), forestry investor Cambium Global Timberland (TREE:AIM) and micro-cap Ceres Media (CMI:AIM) are generally left in the shade of their larger counterpart.

Cumbria’s James Cropper is a three-division paper manufacturer. The specialty papers division produces bespoke speciality paper in a wide variety of colours and finishes for sale in over 50 countries. The group’s technical fibre products division makes high-performance, non-woven materials with applications in a wide variety of fields including fire protection, power storage and cryogenic super insulation. The third division is a converting business that produces specialised products such as inkjet board, mountboard and luxury packaging materials. At the time of writing the shares trade on a pretty full rating of 18.3 times earnings for 2013.

Cambium Global Timberland has seen its net asset value (NAV) has fallen by more than a third since the fund was launched five years ago. One of the main drivers of the £43.5 million cap fund’s southbound stock price seems to have been the parlous state of US housebuilding. With signs the American housing market is starting to look up Cambium may be able to turn its fortunes around. At January’s interims, the company’s net asset value (NAV) came to 62p per share so at 42.25p the shares trade at a thumping 32% discount.

A market cap of just £400,000 means Ceres Media is the baby of the sector. Listed in September 2011, it is the holding company of Natural AdCampaign which identifies and develops natural, sustainable and environmentally friendly advertising and marketing products for companies who wish to promote their products and brands through the use of natural materials. Ceres’ final results (31 Jan) saw the group post losses before tax of £1.7 million. Management blamed challenging trading conditions ‘with performance having been impacted by the poor general economic conditions and specific structural issues impacting the print material distribution sector, especially in the United Kingdom.’

All wrapped up

To give a broad-stroke pen picture of the industry we should look at two different paper types. White paper, also known as graphic paper, is used for publishing; from newspapers and magazines to the annoying restaurant brochures that clog your letterbox, they all have their origins as white graphic.

Of greater financial interest may be brown paper, which drives the packaging side of the industry. The majority of packaging paper is made from recycled fibres; the remaining 10% to 20% is derived from virgin fibre or, in layman’s terms, wood.

The raw material for recycled paper-based packaging comes from a grade referred to as OCC (old corrugated containers). Prices have been largely driven by robust Chinese demand over the past decade and after a setback in late 2011, when recycled product volumes softened somewhat, they have started to rise again.

Powerflute’s chief financial officer David Walton estimates recycled paper prices have gone up around 80% since 2007. ‘China doesn’t have its own supplies so it imports waste paper by filling up containers that have delivered goods to the Western world,’ he explains.

Further price increases are expected at the end of the first quarter. The kraftliner market is likely to remain tight and with the spread between European kraftliner and recycled at almost historic highs, interest in recycled material should only increase. Weaker demand from Europe remains a key risk.

Package deal

Corrugated packaging comprises of two components; linerboard (the heavy outer layer) and fluting (the wavy bit in the middle which acts a little like a shock-absorber).

Linerboard can be made from virgin fibres (often referred to as ‘kraftliner’) or it can be constituted from recycled materials. In this case it is described as testliner. Containerboard is the generic term used to describe the paper types that go into corrugated packaging.

The choice of linerboard will depend not just on costing considerations, but also on the application of the packaging. Fruit and vegetable packaging is made using virgin fibres on account of their higher resistance to moisture. Dry goods such as textiles can be packaged using recycled containerboard because protection from damage during transit is the primary concern as opposed to maintaining a stable environment for perishables.

Powerflute makes fluting out of birchwood. This high-quality virgin product commands a better price than recycled fluting and typically sells at a 10% or 15% premium.

As recycled product increases in price, so too does the virgin fluting. ‘Recycled packaging prices have been forced up because recycled raw material costs keep rising. This is pushing up our selling prices yet our costs are staying the same, so we are much more profitable,’ explains Walton.

White paper

The market for white or graphic paper has fallen off a cliff owing to the inexorable rise of the internet over the past decade or so. Once a booming industry, companies had invested heavily in extra capacity only to find themselves very much caught in possession by a dramatic reversal in economic conditions, not to mention a major threat to their whole business model.

Historically, the media sector had been notoriously reliant on paper but as the online world has evolved, the industry has increasingly shifted much of it focus to web-based delivery of its products. The fully supplied paper industry, which had previously assumed steady growth in demand, rather suddenly found itself all at sea when it market collapsed almost overnight.

In spite of these vicissitudes, UK paper manufacturer James Cropper is still in the black. Half-year results in November saw pre-tax profits edge up to £1.2 million from £1.1 million in the same period a year earlier. Cropper’s technical fibre products (TFP) division was the group’s star turn amid healthy demand from the aerospace, defence and energy sectors.

COMPANY PICKS

Mondi (MNDI) 885p

Mondi is an international packaging and paper group with production operations across 30 countries with key operations and interests in central Europe, Russia and South Africa and other emerging markets. Originally part of the diversified Anglo American (AAL) mining group, Mondi (MNDI) became an independent dual-listed business in mid-2007 after it successfully demerged from Anglo American and listed on the London and Johannesburg Stock Exchanges. Amid difficult and even cut-throat trading conditions, the group posted a 19% drop in pre-tax profits to €371 million in its full-year results (21 Feb). Consensus expects earnings per share (EPS) growth of 19% for this year and 8% next, so a forward price/earnings multiple of 12.4 looks reasonable enough. On the downside, net debt looks high at €1.9 billion.

Smurfit Kappa (SKG) €12.32

Irish packaging giant Smurfit Kappa (SKG) has paper-based packaging operations in Europe and Latin America. When the group posted its final 2012 figures (6 Feb), profit before tax rose 11% to €331 million, while basic earnings per share rose 20% to €1.11. Last year the group acquired OCCG for €260 million, the first such deal since its initial public offering 2007. The purchase is an integrated paper-based packaging company with significant corrugated and converting operations in Mexico, and two corrugated plants and a paper mill in the United States. A 9.4 times PE for 2013 reflects historic earnings volatility, as the firm plunged in to loss in 2008 and 2009, but earnings per share are expected by the market to surge by 26% this year and 16% next to €1.36 and €1.58 respectively.

Powerflute (POWR:AIM) 23p

The Finnish £64.8 million market cap was admitted to Aim in May 2007 with the intention of buying, repairing and selling paper-mills. The group’s main operations centre on the Kuopio paper mill in Finland and Powerflute controls a 30% share of the global market in semi-chemical fluting.

The group’s preliminary results for 2012 saw profit before tax come in at €6.3 million, down from the previous year’s €12.3 million. The drop was largely attributable to weak economic conditions and a competitive trading environment leading to downward pressure on selling prices.

A lowly nine-times earnings multiple for 2013 is testimony to how Powerflute’s earnings can swing around, as earnings per share plunged by 65%, 90% and 53% in 2008, 2010 and 2012, while they rebounded hugely in 2009 and 2011. Consensus is looking for an 86% EPS surge to 2.54p for this year and some comfort is provided by a balance sheet with net cash at year-end of €10.9 million.