Paper stocks - Wrap it up

SECTOR REVIEW

Valuations of paper stocks are looking cheap compared to several other sectors.

With the vertigo inducing heights that the Sensex is in, it may not be easy to find stocks that are really cheap.

But if you are looking for a sector that has the potential to grow steadily and is available at a price cheaper than the Sensex, here we have something to write about. Paper stocks which have not really been in the forefront of the recent stock market rally, trade at an average price-earnings ratio (P/E) of 10, way below the Sensex P/E of 17x.

Over the past one year ending September 22, 2005, while the Sensex gained 46.4 per cent, the BS Paper Index somewhat lagged behind with a return of 42.4 per cent. To be precise, among the major paper stocks, Ballarpur Industries and West Coast Paper Mills gave a return of over 40 per cent. Star paper has been a star performer delivering a return of about 140 per cent.

Analysts feel that valuation of the overall industry is cheap and this can be a good time to buy paper stocks as they have corrected sharply last week amid the overall correction in the market.

Analysts are bullish on Star Paper Mills and JK Paper given their low valuations and are positive on Ballarpur Industries and West Coast Paper Mills, too. Ballarpur is trading at a P/E of 11 times, while the valuations for Star Paper Mills and JK Paper are 6.9 and 10.7 respectively.

However they feel valuations of Tamil Nadu Newsprint (TNPL) look a bit stretched at the current levels (15.2). Going forward they expect paper companies to post good results on account of high demand and better realisations. Even in FY05, all the major players posted decent sales growth. Except TNPL and JK Paper, all of them recorded good profit growth too.
 

Profit margins
Company name	PAT margin  (%)		PAT margin (%)
	FY05	FY04	Q1FY06	Q1FY05
Ballarpur Industries*	9	7	8.60	7.00
Star paper Mills	11	7	9.30	11.90
TNPL	6	9	7.30	1.10
Andhra Pradesh Paper Mills	6	6	7.10	5.90
West Coast Paper Mills	6.60	6.60	7.20	3.40
JK paper*	6.20	6.40	9.90	6.10
* Year ending June

Improving fundamentals
The reason for the optimism is of course that the industry fundamentals still hold good. The Rs 15,000 crore Indian paper industry, which mainly comprises of paper, paperboard and newsprint had been plagued by low demand, declining realisations, spiralling raw material costs and squeeze on margins due to poor pricing flexibility. Yet over the last three years, the industry grew at 5.47 percent per annum.

Going forward, the scenario for Indian paper manufacturers is expected to change for the better as India's paper consumption is growing at 6 per cent p.a. which is fairly high.

Star Paper Mills, in its Annual report for 2004-05, said the global paper and paperboard consumption (mainly dominated by N America, Europe and Asia) is estimated to grow from the current 340 million tonnes to 402 million tonnes by 2010 largely led by the spurt in the consumption in Asia.

India is also expected to contribute substantially to total Asian consumption as it is one of the fastest growing economies in the world. However, the consumption in other parts of the globe like North America and Europe are expected to come down during the period.

While North American Consumption is slated to come down from 31 per cent in 2004 to 28 per cent in 2010, European consumption is expected to slide from 28 per cent to 22 per cent. Meanwhile Asian consumption is expected to move up from 32 per cent last year to 34 per cent in 2010.

Fortunes of paper industry is directly related to growth of GDP of a country. According to a senior company official of a reputed paper manufacturer, "Demand for paper grows faster than the growth in GDP and the same is expected to continue in the medium term. Demand for paper could grow in the range of 7-10 per cent if the GDP growth is about 6-8 per cent". Analysts expect overall demand for paper to grow at around 8 per cent CAGR over next 2-3 years.

Further per capita consumption of paper in India is low at around 6 kg, way behind the global industry average (53 kgs) and below the other emerging economies like China (28 kgs), Indonesia (22 kgs) etc.

Tamil Nadu Newsprint said in its Annual report for last fiscal that India's per capita consumption of paper is likely to reach 8 kg by 2010. This will obviously enable Indian paper companies to cash in on the opportunity in terms of better growth in sales and profitability.

The growth segments
The question is what kind of paper will sell more? Analysts expect all the three segments of the paper industry namely Writing & Printing (W&P), Industrial and Newsprint segment to post equally robust growth.

The government's increased thrust on education for one would aid growth in W&P paper. Demand for W&P paper is expected to grow at a CAGR of 5.5 per cent upto 2008-09.

Increasing industrial activity and more demand for better packaging across the sectors will help industrial paper like Duplex and Kraft paper to grow at over 7 per cent. Increasing number of players and the anticipated boom in the newspaper circulations is expected to boost demand for new sprint too.

Increasing capex
But it is not just about the rising demand for paper. According to Indian paper manufacturers Association, while demand for paper is expected to grow at 6.1 per cent, capacity expansion is estimated to grow at only 3.1 per cent upto 2008-09.

No greenfield expansion projects are expected in the medium-term due to entry barriers like high capital costs and strict environment regulations. However there are certain capacity expansion plans lined up by major players. By fiscal 2006-07, eight significant paper companies are set to invest over Rs 6100 crore and hike the capacity by 7.96 lakh TPA.
 

Paper capacities are set to go up
Company	Current capacity (TPA)	Post  expansion  (TPA)	Capital outlay (Rs crores)*
ITC	277500	400000	2500
Ballarpur Industries	400000	800000	1200
Star Paper	71350	100000	85
TNPL	230000	245000	565
West Coast Paper Mills	163750	253750	620
Andhra Pradesh Paper Mills	153700	193700	635
JK paper	150000	200000	235
Sirpur Paper	83000	133000	294
* Figures are approximate numbers; additional capacities will come up by FY07 Source: Asian CERC

In fact the demand-supply gap has been narrowing over the years and has nearly halved from 15 lakh tonnes in FY98 to an estimated 8 lakh tonnes in FY05. According to analysts, the gap is expected to narrow further to 0.5 mn tonnes by FY 2007.

Thus the capacity utilisation of players is expected to improve from around 89 per cent in FY05 to 93-94 per cent in the medium term till the expansion projects of the existing players get commissioned.

Most of the larger players are already operating at full capacity and will maintain the rates even if there are capacity additions in future thanks to strong demand.

Could imports be a worry?
Analysts say that imports form around 3 per cent of the production of the industry. Thus imports are not a major threat for Indian paper manufacturers particularly in W&P and industrial paper segments as domestic players are equally competitive.

However imports of newsprint paper are higher as the raw material required for the manufacture of newsprint is not easily available in India and also relatively newsprint consumes a lot of power whose costs are higher in India than abroad. Exports of Indian paper are also not significant as domestic demand is adequate enough to exhaust the domestic supply.

Firm price trends
Prices of paper especially W&P and industrial paper have been rising since mid-2004 on account of stable demand and better capacity utilisation.

Paper prices are expected to continue to remain firm in the medium term due to increasing demand for paper and relatively low growth in capacities.

Also rising prices of raw material (mainly wood) and energy (coal, fuel) prices which form a majority of the total cost of production of manufacturing paper (about 75 per cent) are expected to drive prices up.

Analysts expect average realisations of Indian paper companies to improve on account of higher capacity utilisation and better pricing flexibility. However sustained availability of raw material is a key concern and will have its impact on profitability.

Off-late there has been a steep inflation in coal, fuel oil, chemicals and raw material costs. According to industry sources, fuel oil and raw material costs are expected to rise further. However companies having captive pulp and power plants are in a better position to control their raw material costs.

Most of the players exhibited expansion of margins in FY05. For instance, Ballarpur's net margins for FY05 was 9.4 per cent, up from 6.5 per cent in the previous fiscal. Similarly, Star Paper saw its net margins surge to 11.1 per cent from 6.8 per cent.

Analysts expect the overall margins of the industry, specially players like Ballarpur Industries, JK Paper and Star Paper to improve further in the medium term. However according to industry sources, this will depend on the raw material and energy costs and the ability of these companies to pass on the increase to consumers. However they are expected to remain under pressure if costs rise substantially.

Based on forward earnings, many of the paper companies are trading at even lower valuations, which makes a good case for investment in these companies. Ballarpur Industries has a forward (FY06) P/E of 8.9, while that for Star Paper Mills and JK Paper are 6.4 and 8.4 respectively. Considering the growth prospects of the sector, those are attractive, say analysts.