/ 13 April 2009

In the woods

If there is a company that has been badly affected by the economic maelstrom, it is paper giant Sappi, which lost 80% of its market value.

Declines in global demand for its products have hit its bottom line, with local competitors such as Mondi also seeing losses of about 60% in value.

Market sentiment has turned against paper companies because recessionary conditions have seen a strong downturn in demand for paper products.

But Sappi’s is the kind of performance associated with, for instance, American banks, not South African-headquartered companies, most of which have done an altogether better job of weathering the worst of the storm.

Year on year Sappi has seen more than an 80% drop, with its market capitalisation declining to about R9-billion from more than R21-billion in mid-2008.

The all-fall-down was enough to see the company kicked off the JSE’s list of its top 40 companies.

But amid the global economic crunch Sappi has taken flak from investors who view some recent key strategic decisions with scepticism, particularly its decision to buy the coated graphic paper business of Finnish paper company M-real for €750-million.

The deal, argues shareholder activist Theo Botha, did significant damage to the company’s share price and strategically made little sense at a time when it was clear the global economy was headed south. M-real has been a poor performer, recording losses for two consecutive years.

Then Sappi produced less than stellar first quarter results, which showed a significant reduction in demand for its products. The share price has since continued to flounder, falling sharply in late February.

In the case of M-real the company took the decision to declare a rights offer to raise the €450-million it required to make the acquisition.

The rest of the purchase was made with a €220-million loan from M-real to Sappi and 11-million newly issued Sappi shares and assumed debt.

The new shares were issued at a deep discount of about 65% — R20.27, from the then share price of R58.

Botha has described this as ”destroying the value of the share”.

At the same time the final number of shares issued — 286 886 270 — severely diluted shareholders.

Two large local institutional investors — the Industrial Development Corporation (IDC) and the Public Investment Corporation (PIC) — frowned on the decision. The IDC abstained from voting whereas the PIC voted against the deal.

The company met with even more negative PR following a report released by Goldman Sachs, stating that Sappi was likely to breach its debt covenants by 2010. These are agreements between a company and its creditors that the company will operate within certain financial limits.

Similarly a downgrading of its South African-based business by ratings agency Fitch because of weakening debt ratios caused by continued difficult trading conditions has been another blow.

Other shareholders, however, namely Allan Gray and RMB Asset Management, signed irrevocable agreements to support the deal in exchange for accepting a reported 0.75% portion of the proceeds for underwriting the deal.

Put to the vote 80% of Sappi’s shareholders approved the deal with M-real.

Although the PIC and IDC refused to comment to the Mail & Guardian on the transaction, Allan Gray’s Delphine Govender sticks by its decision.

Given the condition of the European coated paper industry — plagued by over-capacity and significant fragmentation — Allan Gray believed that the deal would reduce capacity in that market, allowing for price increases, and give the company €120-million cost savings through synergies created by the deal. The move would also allow for consolidation of the European market, boosting Sappi’s performance.

”We believe the reasons — are all still valid and compelling,” said Govender.

”Unfortunately — given the subsequently tough and rapidly worsening trading conditions — the swift value unlocked through significantly improved pricing power has been somewhat hindered, but we do not believe irretrievably so.”

Despite all of this Govender said she’d still buy the shares, especially on the anticipated restoration of profitability in the European operations.

”We are also bullish on the prospects for the chemical cellulose operation [a South African business], which we believe is an outstanding asset, but has been recently and temporarily hit by significantly reduced levels of demand because of the global economic climate,” she said.

”Hampered by short-term negative news flow and sentiment, the current share price of Sappi does not reflect the intrinsic value of the business under normal operating conditions.”

Ultimately, Sappi’s recovery from the knocks to its public profile depends on a global economic turnaround.

Sappi’s response
Sappi chief executive Ralph Boëttger is adamant that the company’s strategy, particularly with regard to its European markets and the purchase of M-real, will pay off.

Boëttger argued that to consolidate the European market and reduce capacity, M-real was the best bet.

The deal saw the elimination of 630 000 tons of capacity in the European market, Boëttger told the M&G.

At the time of the deal Sappi also announced the closure of operations at its Blackburn mill, which further decreased capacity by 180 000 tons. The combined effect gave other players in the market the confidence to shrink operations.

”By the end of this month 1.3-million tons of coated wood-free [paper] capacity will have been reduced,” he said, which amounts to 11% of total capacity in the European market.

This has resulted in the ability to increase paper prices in the European market, the first in seven years, and increase the company’s market share by 30%.

”In a market that’s down by — we think 16% to 17% as stocks have been drawn down, in a world economic slow-down — we got prices up,” he said.

Boëttger argued that there was no cost to shareholders who followed their rights or who decided to sell their rights through the M-real deal.

And when it comes to market performance, compared with competitors in the industry, such as Stora Enso and UPM in Europe, Sappi has not under-performed the industry, said Boëttger.

He acknowledged that the coming quarter is expected to be extremely tough, given current market conditions, but the company is expecting to be cash positive for this financial year.

Regarding Sappi’s debt covenants, he said that although it would be arrogant and misleading to guarantee that the company will not breach its debt covenants, the company does not believe it is in danger of doing so.

It will be tough to renegotiate any debt renewals, he said, but the company is making progress raising money both locally and internationally.

”We are confident that we will renew our facilities and have sufficient liquidity. We are very aware of the fact that we are going to pay more, but I think that’s realistic.”

The company is ”so lean” after a tough few years and, having ”done all the necessary restructuring”, it is well positioned to take advantage of any upturn in the economy, said Boëttger.