While this and other similar European paper mergers have been mooted for the past five years, nobody has previously made as compelling an argument for the imminent likelihood of such a deal as Karri Rinta, an equity analyst with Handelsbanken Capital Markets, in his September Pulp & Paper sector update.
The title of the paper, ‘Shotgun marriage made in Heaven’, says it all. The formation of a joint venture (JV) that would encompass 92% of UPM and Stora’s combined European paper capacity is a forced marriage, yes, but it is one that fulfils the strategic ambitions of both parties.
UPM, 65% of whose business is in paper, would get the undisputed leadership position in Europe that it needs to maintain paper prices in a declining market (something it failed to do with its acquisition of Myllykoski for the simple reason that it still had a strong competitor in Stora Enso to hoover up the volume it tried to take out of the market). This would allow it to stabilise and maintain its cashflow from paper, buying it time to grow its nascent biofuels, bioplastics and fibre-based chemicals interests.
Meanwhile, Stora Enso would benefit by reducing its exposure to the volatile paper market to just its interest in the merged entity, while also increasing its future cashflow from paper and gaining an injection of funds from the sale of assets unnecessary to the merger that could be used to finance the investment in its Asian packaging operation.
Paper partners
The scenario Rinta proposes would see the formation of a joint venture that would house all of UPM’s Paper Europe division (annual output 10.3m tonnes) together with Stora Enso’s European newsprint and fine paper assets (annual output 5.7m tonnes). Based on their respective contribution to the JV, UPM would take a 65% controlling interest, while Stora Enso would own the remaining 35% minority shareholding.
Stora Enso would then sell (assuming it could find a buyer) its remaining European paper assets – namely the Kabel and Maxau mills in Germany and its Corbehem mill in France – while the JV would be faced with 1.5m-2m tonnes of capacity closures, such as 450,000 tonnes of magazine paper capacity at Stora’s Veitsiluoto mill in Finland.
This would create a European paper giant with clear market dominance in newsprint (41% based on 2012 market shares) and magazine grades (52% including the assets Stora Enso would have to divest) and a strong position in coated fine paper (26% market share to Sappi’s 30%). The JV’s nearest competitor in newsprint and magazines would be Norske Skog, says the report, with just 10% market share in the former and 15% in the latter. "It’s a reasonable and rational thing to do – if they can get it through Brussels," said one paper source.
While it could be argued that this level of dominance in specific grades might scupper the merger from a regulatory point of view, Rinta points out that Brussels took a flexible view to the UPM/Myllykoski deal, partly due to its desire to sustain the industry. "The distance between the number one and number two competitor is a potential problem, but if it gets to that stage [regulatory approval] I’d say there is less than 10% likelihood a merger wouldn’t happen."
Time to act
Rinta’s hypothesis, that there is now a "50% likelihood" that we will see a merger between UPM and Stora Enso within the next six to 12 months is founded on two facts. Firstly, the structural decline in European paper demand is moving faster than the mills’ ability to offset it; and secondly, this merger is the only one that could create an entity strong enough to maintain prices in a declining market and salvage cashflow generation from paper (to the benefit of both).
Evidence for this decline can be found in the annual statistics from the European Association of Graphic Paper Producers (Euro-Graph), according to which European demand for graphic papers plummeted 15.8% in 2009, rebounded 4.6% in 2010 (largely thanks to strong exports on the back of the weak Euro), before dropping 3.9% in 2011 and 6.4% in 2012. In the first half of 2013 demand is already down 5.7%, with the worst drops being recorded in coated mechanical reels (down 7.9%) and coated woodfree (down 8.2%). Time is running out.
"All of the paper companies are looking for solutions that will stop future cash haemorrhage," said one industry insider. "UPM have depreciated their paper assets – cashflow is decreasing very quickly – so there’s an increasing urgency to sort out the paper problem. It’s the same with Stora and certainly the case with Sappi."
Rinta agreed, adding: "Cashflow from paper is drying up faster than expected – the biggest risk to a merger would be for the European economy to suddenly recover faster and stronger than expected."
UPM is well aware of the need for action, as evidenced by recent statements from chief executive Jussi Pesonen, who said following the group’s Q2 earning’s report that UPM would "seek to simplify its business portfolio" and that this "may involve ownership changes". In addition, Rinta points to structural changes such as UPM’s decision to split its paper operations into Paper Europe (2% EBITDA margin) and Paper Asia (15% EBITDA margin) – thereby disclosing the weak margins in Europe – and Stora Enso’s decision to separate its growth units (packaging and pulp) from its challenged paper and sawmill units, as "laying the foundation for consolidation".
"After Q2, all the stars started to be aligned to take this step," said Rinta. "All that is left is for UPM to convince Stora Enso."
