Should you invest in... paper and packaging?

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The Independent Online
ONE OF the less dramatic changes that occurred in the recent revision of the FTSE market sector classifications was the splitting of the packaging companies from those concerned with making paper, largely because the packaging industry uses a range of other materials. But the businesses of forestry, paper manufacture and packaging remain closely linked and display similar characteristics - they are all highly cyclical and rarely at the top of investors' buy lists.

Richard Andrews of stockbrokers Greig Middleton, says: "Really, these sectors are a continuum, from forestry to pulp to paper to packaging. You start with the raw commodity and follow it through to the finished product."

He also points out that the combination of forestry and papermaking activities within individual companies is not always a profitable business mix.

"The reason forestry and paper companies are classified together is that companies are often involved in both activities," he says. "Big companies tend to own large tracts of forests to secure pulp for their paper mills. We would argue that they are slightly different business because forestry is a very long-term investment. It takes 15 to 20 years for trees to grow to maturity."

Colin Lombard, of stockbrokers The Share Centre, says: "Forestry and paper is an area people tend to forget. In common with most commodity- based and cyclical businesses, it has had a torrid few years. Prices, especially pulp prices, had fallen dramatically. The big thing in this market is sentiment and I don't think you will see any fireworks in the short term. What you need is a steady increase in demand."

Similar factors affect the packaging companies, says Stewart Methven of Edinburgh Fund Managers. This is another sector where sentiment has not been especially positive. "Packaging is a very difficult business to be in at present. Crown Cork, the US company that took over Metal Box a few years ago is one of the biggest operators in the world, and it has just issued its second profits warning in nine months. In general terms, this is not a great area to be investing in for anything other than trading reasons."

Colin Lombard says the paper business has benefited from a general improvement in global commodity prices. "The whole recovery in interest in commodities was kicked off by the oil price rise, after which investors started to look at steel and paper and the like. Pulp prices picked up nicely and investors discovered there was quite a strong demand for pulp."

Richard Andrews says: "The supply of pulp doesn't change much in the long term. Any long-term trends in price are driven by economic growth, but in the short term it can be much more cyclical. When demand is high, prices will rise and there is scope for recycling, but when capacity is high, prices inevitably fall and companies are better off using their own pulp."

The problem is that given the stage of the recovery in pulp prices, investors have already missed out on some of the bounce. Colin Lombard says: "Prices have already recovered quite strongly so they are not going to run away again. But this will feed through to balance sheets and to profitability."

One of the fundamental problems constantly facing the sector is that paper manufacture is, generally speaking, a low-margin business. Richard Andrews says: "Paper machines are very expensive pieces of kit and paper factories are operationally geared. They have to keep running continuously in order to get a return. This is another reason why paper companies own their own forests, to ensure a constant supply of pulp."

A possible solution is for paper companies to concentrate on high- value niche products, although he believes this strategy may offer only limited help in a downturn. "Smaller companies will try to develop specialist products, but today's specialist product is tomorrow's commodity. When prices turn down, the big mills move into the premium end of the market to keep their presses running."

Although there are seven companies listed under the Forestry and Paper banner in London, most are based in Europe. Stewart Methven says: "When it comes to paper manufacturing, there are really only two UK stocks, Arjo Wiggins and DS Smith. Arjo does not really have a major international presence, compared with its European competitors. This can be beneficial bec- ause that means its share price does not swing as much as it is not so integrated an operation. Arjo is also undergoing a strategic rationalisation, with a new management team that is concentrating on delivering shareholder value." Colin Lombard takes a positive view of both companies. "These are two stocks we are particularly interested in. Arjo Wiggins seems to us like a really world- class business, but one which suffered when demand and prices were low. In turn, that hit its margins and profitability. This meant it was well placed to take advantage of the change in sentiment. Its shares have already run up some way, but I would still be interested if they fell back a bit. The other interesting company is David S Smith, a paper and packaging company which again is well placed to benefit from improvements in pulp prices. We started looking at around 110p to 120p. It is now around 150p and, again, if there was a fallback in prices we would still be interested."

Stewart Methven has reservations. "D S Smith is quite a well-run company but it does suffer in comparison with its bigger competitors. It is quite efficiently run and has quite good cost control, but its corporate earnings are not that wonderful."

The packaging side of the equation displays similar cyclical characteristics, says Richard Andrews. "Packaging is a different business, because it includes plastic packaging as well as paper, but it is also pretty cyclical, partly due to economic factors and partly due to consumer demand. The cycle has turned recently and I reckon that we are right at the bottom at present."

This has led to a high level of activity within the packaging sector. He adds: "We have recently seen quite a lot of consolidation in this sector, both in the UK and Europe. The packaging sector also depends on keeping its factories running at a high capacity and companies try to come up with new specialist ideas that no-one else can make. The idea is that they can charge a premium for something which actually represents a relatively small part of a product's total cost."

According to Stewart Methven, this is due to the fragmented nature of the sector. "Packaging is a lot easier to categorise than paper. There are a large number of fragmented operators all seeking to develop specialist products. So the industrial dynamics are stacked against them. Their customer base is consolidating and the manufacturing businesses are being driven by a concentration on returns.

"The packaging companies are stuck in the middle - when you have a period of deflation customers can drive a very hard bargain. As a result, packaging companies may be getting their high volume contracts, but are having to pay a very high price for them."

So, just as with the paper manufacturers, packaging companies are seeing their margins put under pressure.

Stewart Methven says: "It is very difficult in the sector at present and because of that their multiples have got squeezed. You can justify some interest in the sector at these multiples from a financial trading perspective, but in terms of threats to entry or barriers to competition, these companies are not positioned well."

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