• JULY 1, 2011

Identifying paper stocks: Do's and don'ts

Some of the recent deals in the paper sector have once again induced some investor interest in this old economy sector. European newsprint manufacturers are making a lot of enquiries for potential buyouts in India as almost 50% of the country's newsprint consumption is imported. As per the CII, the consumption of paper and paperboard will increase to 20 m tonnes by 2020 and 40 m tonnes by 2030 with an annual average growth rate of 8%.

There are four segments in paper industry: writing and printing paper, newsprint, fancy paper and paper used for packaging purposes. Each segment has different growth drivers. While the growth in corporate spending is driving demand for coated and copier paper (which falls under writing and printing paper category), the pickup in industrial activity has led to an increased demand for industrial packaging, paper and paperboards. Besides higher demand for paper in the packaging sector, the fact that environmental concerns has led to replacement of plastics with paper augurs well for the industry.

Let us discuss a few things that we need to consider while buying a paper stock.

Revenues drivers

Growing organized retail: There is increased preference for branded goods in India nowadays. With more income in their hands, people are willing to spend more in return for quality and exclusivity. The situation is not different in the case of paper products as well. Consumers these days buy more of branded notebooks, paper bags and of course branded greeting cards and gift items. This has intensified the competition in the paper industry and the need of the players to innovate. Increased competition in any field always brings the best out. Although there are many unorganized and unorganized players, only a handful of them are able to actually generate decent business and earn good returns.

Government support - A major catalyst: As discussed in the earlier article, government support by way of funding the flagship literacy scheme has been a major catalyst for growth of the sector.

Increasing purchasing power of Indian middle class: Increase in per capita income impies that people are more willing to spend now. The demand for consumer goods, FMCG and textiles has been increasing. With this is increasing the demand for packaging paper such as Kraft paper.

Cost drivers and margin analysis

Input costs: Paper requires wood as raw material which is not so easily available. Thus the paper companies are planting more trees to source wood for pulp : Also, these days companies prefer to use waste paper. The prices of waste paper have been on the rise. Paper making also requires water for processing which may not be easily available at all places. Also, the land required to set up the plant has to be procured.

Near zero wastage of raw material: One good thing about the paper making process is that all that is produced as a by-product can be sold in the market in one form or the other to realize some additional money. In fact many companies are actually following this practice. They are using fly ash to make bricks, plastic waste to make plastic sheets which are used as thatched roofs. Paper board is made out of the sludge which is produced in the manufacturing process.

Increasing margins with the focus on value added products: Times have been changing fast for the paper industry. Paper is the same but the way it was used earlier is very different from the way it is being used now. Paper is being used to make notebooks, bags, newspapers, food boxes, publicity material, packing purposes and industrial reasons. With the introduction of e apers, newspapers demand has been adversely affected. But, the need for fancy and coated paper is driving the industry. Players too focus on these newer forms that help them earn better profits. Newsprint as such was not really earnings additive for the paper companies.

Key financial parameters

Capex intensive industry: The paper industry requires huge investments in land and machinery. Also, there are a few environmental clearances that have to be obtained from the government. All this implies that it is capex intensive in nature i.e. it involves huge capital outlay. This acts as a deterrent for newer players to enter the industry. Hence it is important to take a close look at the free cash flow for the company.

Working capital requirements: Decent amount of inventory has to be maintained at all levels to satisfy the round the year demand for paper. This means that cash is blocked in the form of inventory. This particularly poses a problem in the third quarter when the old inventory has to be sold off so that new stocks can replace them in the coming quarter. Typically, the fourth quarter is the best one for the industry because of start of a new academic session.

Debt equity ratio: Paper consumption is expected to grow at an average annual growth rate of about 9% over the next couple of years. The industry players are ramping up their production capacities to meet the growing demand for paper. While some have issued more equity, mostl of the companies have resorted to borrowings. Thus, debt equity ratio for Indian paper companies is slightly high at the moment at 1.2 times.

Return ratios: Return ratios for players in the paper sector are not particularly attractive when compared to other commodity linked sectors. On an average a paper company earns 9% return on equity and slightly higher 10% return on capital employed. The profit margins are different for different players. A lot depends on the kind of paper that the company produces. For example, a company producing traditional forms of paper like newsprint and writing paper will tend to earn lesser margins than one who is producing more of fancy and coated paper.

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