Paper money is real

SECTOR UPDATE/ The Paper Sector

The paper sector seemed to have missed the broad-based rally in 2004. The Business Standard Paper Index, comprising listed paper makers, was up 3.12 per cent y-o-y while the Sensex was up 13 per cent.

Shares of leading player Ballarpur Industries (BILT), which commands close to 9 per cent market-share in the domestic paper market, were up 8 per cent. Smaller players like JK Paper, AP Paper and Sirpur Paper Mills were all in the red.

The only exception was Star Paper which saw its share price soar 43 per cent. But this year may be quite different. Signs are already visible with stock prices showing a recovery over the last couple of months.

The reason is simple: the price of pulp, which is the main ingredient for paper, is set to decline even as paper prices may remain steady given the strong domestic demand.

Paper companies will, thus, see their bottomline grow this year. In the long run, paper makers will benefit from growing demand, thanks to a burgeoning economy.

The price factor
Paper prices mirror international price trends which in turn depend on pulp prices. In 2004, international paper prices moved up, resulting in domestic paper prices rising by about 5 per cent on an average.

The increase was largely driven by rising demand for pulp in US, Europe and China apart from increasing fuel costs, which surged 30-40 per cent.

Internationally pulp (soft wood) prices moved up 7 per cent last year.

However, in the past few months, global pulp prices have been declining due to higher inventory levels emanating from increased production. NBSK (Northern Bleached Softwood Kraft - soft wood pulp which is a benchmark for pulp prices) has declined by 20 per cent to around $510 per tonne (December 2004).

Analysts expect pulp prices for domestic manufacturers also to decline in line with international trends. However, this may not necessarily lead to a fall in paper prices as demand for paper is expected to be buoyant. 

Financials, valuations and capacity expansions
Companies	Sales (Rs cr)	Operating margins (%)	Net (Rs cr)	Trailing 12-m P/E (x)	capacity expansion*	Total capacity post-expansion*
BILT	507.77	22.81	43.31	9.45	3.00	7.50
TNPL	180.64	12.56	34.90	20.30	0.50	2.80
JK Paper	154.37	18.49	10.67	7.50	0.50	2.00
West Coast Paper Mills	113.67	13.06	5.11	8.00	0.36	2.00
Andhra Pradesh Paper Mills	107.10	15.37	6.72	5.80	0.45	1.99
Sirpur Paper	56.19	12.30	3.73	5.20	0.55	1.38
Star Paper	49.32	18.86	5.51	4.70	-	-
Financials are for nine months ended December 31, 2004.                                                                                                              * Lakh tonnes per annum

Analysts expect paper prices to increase in the US, driven by a revival in the economy. In Asia, demand is mainly fuelled by China. Domestic demand for paper, too, is expected to continue and we are slated to witness some renewed demand in April-March 2005 as corporate results start pouring in and educational institutes restart.

This might see some increase in paper prices in the near term. Given the kind of demand growth, paper companies will gain by sheer growth in volumes, leave alone prices.

The growth story
The long-term story looks even more enticing. The sector is known to have a 1:1 correlation with the economy. With the GDP (gross domestic product) is expected to grow at 6-6.5 per cent as per the Reserve Bank of India's (RBI) projections, the paper sector is expected to mimic that growth.

Low per capita consumption of paper will also spike demand (the per capita paper consumption of paper in India is estimated at around 5 kg per annum, which is below the world average of 54 kg per annum). "This bespeaks that demand growth lies in India in the years to come," says Abhijeet Kundu, analyst with Angel Broking.

Domestic paper demand is at around 55 lakh tonnes and has grown at around 5.5 per cent CAGR (compounded annual growth rate) during the last five years.

The growth rate in demand expected to accelerate to 6-6.5 per cent per annum in the next two-three years.

Supply of paper (now around 51 lakh tonnes), on the other hand, is expected to grow at a lower rate of 3-3.5 per cent per annum on the back of lower capacity additions, leaving a supply gap of nearly 10 lakh tonnes in the next three years.

Why aren't companies adding capacities? Analysts cites the the sector's high capital intensity. A project in sector requires an investment of around Rs 1-1.2 lakh per tonne.

So to add about one lakh tonne of capacity a firm needs to spend about Rs 1,000 crore. However, most big players plan to add capacity in the year to come, the result of which will be visible after 12-18 months.

BILT is planning to expand capacity by 3 lakh tonnes which will raise its total capacity to 7.5 lakh tonnes per annum. Smaller players are, however, likely to raise capacities only marginally through de-bottlenecking.

With paper plants already producing 80-85 per cent of what they are capable of, demand for paper will supersede supply.

Valuations look attractive
Since the sector entered in the market rally a little late in time, valuations in the segment still look attractive. Most paper companies are trading at a discount to both the Nifty and the CNX Mid-cap Index (both are trading at a P/E range of 14-16).

BILT and Tamil Nadu Newsprint trade at forward P/Es of 7 times and 10 times for FY06 earnings respectively.

BILT is the leader in the high-end coated paper segment with around 45 per cent market-share.

The high-end coated paper segment is witnessing a growth of 10-12 per cent per annum. This coupled with the capacity expansion plan is expected to drive BILT's prospects.

The company has also managed to keep up its profits despite a rise in raw material costs - net profit increased 31.7 per cent to Rs 43.31 crore.

TNPL is also engaged in expanding its capacities and has undertaken cost cutting measures. Its earnings for trailing nine months suffered as a result of a rise in raw material costs which percolated to the bottomline (net profit was down 78 per cent to Rs 34.90 crore).

This was because of the water supply problems that it faced. All said and done, paper manufacturers, small and big, are also expected to benefit from firm prices. And by the end of this year, it looks like the paper sector will be worth writing home about.