MARK CONNELLY is director and senior equity analyst at Credite Suisse First Boston Corp., New York, N.Y.

Newsprint: A positive spin on consolidation

by MARK CONNELLY

The following was excerpted from a speech given at the Southern Pulp and Paper Industry Labor-Management Council (SPPILMC) Conference on Industry Best Practices.

THE PAPER INDUSTRY HAS MANAGED ITS affairs very poorly over most of the last two or three decades. However, we are starting to correct some of those excesses. There's been a change in mindset, and investors are extremely encouraged by what they're seeing from paper industry CEOs. We like the new discipline, but nobody's convinced us that the industry has got it right yet. The biggest grades of paper are the least consolidated grades, with the exception of uncoated free-sheet. This suggests that the benefits are going to the smaller grades. Until we get those bigger grades - like containerboard - cleaned up, that's going to continue to be true.

CONTAINERBOARD VS. NEWSPRINT. The containerboard industry is talking about production restraint. Top producers, such as International Paper (IP), have embraced marginal economics, where machines are run at less than 100% of capacity. It's a complete change of mindset that dramatically impacts the industry at the operating level.

It's a really good thing, and it's going to make the industry better at the margins, but it is not a dramatic shift. When you introduce logic and better operating methods, they tend to trickle through an industry pretty quickly. They also tend to get heeded away pretty quickly, too. If you introduce a new way of doing business in a healthy business, you're going to get more out of it than if you introduce it in an unhealthy one. So, I would argue that the kind of supply discipline that we're seeing from Bowater in the newsprint business is far more significant in the long run than what we're seeing in containerboard, even though containerboard is far bigger. Good businesses benefit faster than bad businesses, and containerboard is still a fairly lousy business.

In containerboard, there are still more than 50 North American producers of a relatively undifferentiated, low value-added commodity product that hasn't made money in the last ten years. You've got an industry structure leading to conclusions that look good for one company, but are not good for the whole group. As an industry consolidates, that gets better, but containerboard has not consolidated, and production discipline at the margin by Smurfit-Stone, IP, and Georgia-Pacific is not going to get you anywhere in the long run. What has it done to the earnings of these companies? Earnings have tanked. Just as soon as the shipment numbers went down, earnings went down with it. The only benefit we're getting, though it's relatively small in the current scheme of things, is that we are coming into some kind of economic recovery with lower inventories, which means we can snap back faster.

In newsprint, though, we've seen a dramatic shift in behavior. For example, several large producers, like Bowater, have become a huge believer in downtime. It's also particularly interesting to me what's happening globally in newsprint. Ten years ago, the top five producers globally had about 20% market share. If you look across all grades, that's not really a terrible number, except that not all grades are global and newsprint is. Now, the top five producers have 48% market share. However, where that tonnage is produced is equally interesting. For example, Norske Skog produces on five continents, and Bowater produces on two and operates on three.

In fact, if you look at the top seven newsprint companies, there's only one that operates within one continent. This means that companies not only care about those import/export flows coming into North America, but that they can also do something about those flows. And, if one of your competitors is doing something you don't like, you can retaliate. What's happened in newsprint has happened both in North America and globally, and the combination of the two is extremely powerful. We're seeing producers on a global level thinking the same thing - we've got to shift the way we do business.

What's the first thing that started to happen? We're keeping tonnage where it belongs, in local markets. In pulp and paper, the value is not so high that we can put products from Asia on boats and ship it over here. That's not going to create a low-cost, efficient structure. There is a place for local representation in almost every market, although maybe not for every grade. However, in newsprint, we're seeing it happen.