October 15, 2018


In 2007, Amazon released an e-reader called the Kindle. In 2010, Apple launched the highly successful iPad. These, and similar technological innovations, reduced demand for printing. Paper and pulp companies Sappi and Mondi appeared to be in long-term decline.

Source: Bloomberg

But they have bounced back strongly. In the last three years to the end of August 2018, Mondi plc has delivered a total shareholder return of 53% and Sappi 146%, ranking them both in the top ten of JSE performers. We expect this outperformance will continue, for various reasons.

Sappi and Mondi, which are now in the “forest products” sector and have grown from their South African roots into global operators, have stepped up to the challenges and transformed their businesses. As a result, both companies have a significantly better long-term return, profit margin, and growth prospects.

Return on Equity (ROE %)

Source: Bloomberg

3 Year estimated sales growth (% p.a.)

Source: FACTSET

They have made the following company-specific changes:

  • Closed higher cost, smaller or non-integrated plants
  • Made efficiency improvements to produce more wood pulp and generate their own energy from waste products
  • Changed the sales mix away from paper towards higher margin growth products such as packaging and Dissolving Wood Pulp (DWP). DWP is used as a substitute for cotton or polyester in clothing
  • Strengthened their balance sheets and refinanced debt at much lower interest rates

Mondi earned 50% of profits from paper production in 2009, but with its repositioning to packaging, this declined to 19% by 2014, with packaging reaching 81%. Sappi’s profit margins are about 9% for paper but 14% for packaging and 30% for DWP. Although demand for paper has been declining by 1-4% p.a., pulp and packaging demand is growing in line with global GDP at 2-3% p.a. and DWP as high as 5-6% p.a. Both Mondi and Sappi should grow faster than the industry by increasing market share through both organic growth, mergers and acquisitions. These benefits will be seen from 2019 onwards, with Mondi targeting organic growth of 9%.

Having repositioned with better-quality, higher-margin assets in their portfolios and strong balance sheets, both companies are ready to take advantage of the tailwinds provided by several improving fundamentals in the industry.

The first industry driver is that e-commerce sales are growing around 10% a year, which will add additional volume growth for packaging due to increased demand for boxes and additionally related packaging for transit and security.

The second is that tightening environmental legislation is forcing retailers and consumer goods companies to switch from plastic packaging to paper. For example, only 10% of shopping bags are made from paper, indicating the huge potential to grow market share. These trends are in the early stages of growth and it is difficult for the companies involved to make forecasts. But the potential for paper-based packaging to grow its market share is clear when one considers that 52% of consumer packaging uses plastic, and 15% is paper-based. What is clear as well, is that the trend is going back in favour of paper-based packaging. Europe is leading the way by banning plastic bags completely by 2023.


Source: Ocean Conservancy

Global Consumer Packaging Market (units sold)

Source: Citi Research, Flexible Packaging Association

The third driver is that the recent Chinese ban on waste paper imports has added to upward momentum for prices of both recycled and virgin packaging material. As China switches to importing more packaging or pulp to satisfy domestic demand, the costs of both materials have risen to levels not seen in decades, suggesting we are in a similar supercycle to the one we saw in metals a decade ago. Mondi and Sappi, as integrated producers, are in a prime position to benefit.

Kraftliner

Source: RISI

Related to that trend is the fact that China is still in the early stages of pulp consumption, consuming only 30% of global pulp supply compared to 50% for most metals. We expect demand from China to be strong for years to come as it pivots towards a consumption economy.

Finally, both companies strive to lead in product innovation and technology, from nanocellulose and barrier technology for packaging to wood-related products such as Xylitol and bioenergy. Mondi claims to have developed the world’s first fully recyclable flexible packaging product, with commercial launch proposed for 2019. Sappi is using its waste wood as biomass to produce and sell energy (budgeting 19% returns) and has started to produce Xylitol, a healthier substitute for cane-based sugar.

The company-specific drivers of both Sappi and Mondi’s improvement to a high-quality asset base with more integration (pulp, energy), lower cost, faster growing and higher margin products have significantly improved their returns. This, together with industry tailwinds such as e-commerce, tightening environmental legislation and China’s ban on waste paper imports, leads us to believe that all these benefits are still to accrue to these companies and are not fully factored into their share prices. STANLIB Equity has a significant overweight positioning in both shares.

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