Are the paper tigers crouching?

SPECIAL FEATURE

Steady demand growth, price hikes and recent institutional investor interest in paper stocks suggests some bullish sentiment for the sector.

The paper industry has been operating at full capacity over the past few years as the growing economy fuels demand for the commodity.

Paper prices have seen about three hikes in the current fiscal year each one ranging from Rs 500 to Rs 750 per tonne across all categories and yet another increase of about Rs 1000 per tonne is imminent in the month of January 2007.

The rise in prices rides on the back of rising input costs and the deadlock of high demand and stagnant supply. Large players are expanding capacities to meet the rising demand.

In spite of this, the paper stocks have significantly under-performed the broad market over the past year. The under-performance is attributed largely to rising input costs, thus trimming margins. However, new acquisitions, investments in building capacity and price rises may spur new interest in paper stocks in the coming year.

Rising demand, stagnant supply
The demand for paper has been rising steadily over the past few years in the wake of the booming economy, as consumer spending on education, newspapers and packaged consumer products increases.

India has a per capita consumption of paper of about 7 kg as compared to more than 30 kg of China, and the enormous 300-plus kg of the United States.

Collectively, the Indian paper industry amounts to approximately 6.5 million tonne with an annual growth of 6-7 per cent historically.

Some analysts expect this growth rate to continue, whereas others are more optimistic and suggest that the industry is expected to grow at over 10 per cent in FY08. Even with a conservative estimate of about 6 per cent growth annually, the demand would rise by about 390,000 tonne next year.

The supply of paper on the other hand has been stagnant, in spite of the outlays of capital expenditures by almost all the players in the industry.

According to Rohan Gupta of Emkay Research, "The investments in building capacity will lead to a rise in the supply by about 1 million tonne over two years."

Looking at the current scenario, this rise in capacity will be completely absorbed by the demand for paper. "There is no over-supply or excess capacity expected in the paper sector, and thus, it is a healthy demand-supply scenario," adds Gupta. This creates a climate where the price hikes can be passed on to the consumers safely.

This year, the excise duty benefits awarded to the industry too were not passed on to the consumer, thus allowing for some leeway with manufacturers.

Where are the margins?
Despite the steep price hikes, the margins of the paper makers do not seem to be rising proportionately. The collective price hike across all categories of paper products over the past year was almost 20 per cent after factoring in the four price hikes and excise benefits to the manufacturers.

Against this rise in prices, the operating profit margin for the industry rose from 16 per cent in FY05 to 18 per cent in FY06. Almost all the major players reported similar margins, except for Ballarpur Industries and Tamil Nadu Newsprint which reported about 23 per cent and 25 per cent margin, respectively.

The reason: a large part of these price rises is absorbed by the raw material, power and fuel for the industry, the prices of which have risen incessantly. The paper industry is raw-material oriented and fuel-intensive.

Input costs, comprising of raw materials, fuel and power, add up to more than half of the total expenditure of all the major players in the industry. The main input for paper industry is wood pulp.

Due to the stringent environmental control and climatic restrictions, it is increasingly difficult for paper manufacturers to source inputs from within India.

There are no greenfield expansion plans in the offing in the near future, which would fulfill the rising demand for pulp and stabilise the prices of pulp. As a result, pulp prices have witnessed a rise of about 8 per cent whereas waste paper prices rose by 5-7 per cent over the last four months.

The way out
An option for the manufacturers is to use non-conventional inputs such as recycled fibrous waste. However, it is highly capital intensive to produce large quantities of paper from recycled waste.

The paper industry in India is highly fragmented, with only about 45 per cent of the market controlled by organised players.

In order to feed the hungry paper mills with pulp, larger players are opting for brownfield expansions such as Andhra Pradesh Paper's increase in capacity from 160,000 tonne per annum to 194,000 tonne per annum by March 2007.

Other players like ITC, one of the largest paperboard manufacturers have also announced increase in capacity to raise production from 300,000 tonne per annum to 400,000 tonne per annum by April 2008. Besides, in order to source pulp, Ballarpur Industries has also made an acquisition of Sabah Forest Industries in Malaysia.

Why size matters
Considering the demand-supply deadlock, and the rise in input prices, scale seems to be an answer to control the input costs, as well as meet the demand more efficiently.

The smaller, unorganised paper manufacturers suffer from high production costs, uneconomic operation, low quality, inability to produce premium and branded paper, and negative impacts on the environment. This has led to the situation of low productivity, low efficiency, excessive resource consumption, obsolete technologies, and low scale of operation.

Even the large players would shy away from acquiring these players because it would not make any significant addition to the existing capacities of the organised manufacturers. The larger players have an advantage here, with sophisticated technologies, and economies of scale.

According to Gupta, the smaller unorganised players will therefore, be forced out of the industry over time. 
 

FINANCIALS
Rs crore	Ballarpur	TN  Newsprint	Orient  Paper	AP  Paper
Net Sales	2162.65	820.80	1136.34	482.01
Y-o-Y Growth (%)	7.39	10.50	48.10	-4.91
Operating Profit	512.39	206.73	180.84	70.16
Y-o-Y Growth (%)	10.34	34.15	122.40	70.10
OPM (%)	23.70	25.19	16.00	14.56
Net Profit	226.06	91.29	61.90	26.47
Y-o-Y Growth (%)	5.71	55.80	664.20	-20.61
NPM (%)	10.45	11.12	5.45	5.49
EPS	11.85	13.95	47.09	8.46
CMP (Rs)	108.70	91.25	539.50	92.05
Note: Figures are for trailing 12-month period ending Sept 2006

The markets' response
Although paper industry stocks have significantly under-performed the markets over the past year, mutual funds and private equity funds have increased their investments in the sector over the last couple of months.

Even smaller players like Rama Pulp and Paper have been successful in securing funding from foreign private equity players.

Stocks such as Orient Paper, Ballarpur Industries, Tamil Nadu Newsprint have attracted attention of a number of mutual funds of late. An underdog over the past one year, the sector seems to be promising for the coming year, says Mr Gupta, and recommends a buy on Ballarpur, TN Newsprint and AP Paper.

At the current price, the Ballarpur stock trades at 7.5 times estimated FY08 earnings, Tamil Nadu Newsprint at 5 times, J K Paper at 6.7 times and Andhra Pradesh Paper at about 3 times.