2008 Paper Recycling Supplement - Consolidated Containerboard

What I’d like to talk about today is something that is very germane to me, and that is consolidation in the containerboard industry and the impact on recovered fiber.

Some of you may not be aware that Solvay Paperboard, Syracuse, N.Y., and Southern Container, Hauppauge, N.Y., had grown a very successful, privately owned business that had gone under the radar screen for many years. We were doubling our size every five years for the last 30 years or so. Our challenge as a privately held company was that we had a large equity base held by a small number of people. We concluded that we had better put together a succession plan. Over 18 months we did that; we went to the market and really tried to engineer who would be the best successor company for us to merge with and, in fact, we really handpicked Rock-Tenn Co., Norcross, Ga.

Rock-Tenn has grown substantially in the folding carton and display segment of the business and is looking to corrugated packaging as the new platform for its growth. The company has pledged to support our endeavors in continuing to expand in the containerboard packaging segment, and we’re very excited about that merger. We’ve got a great management team and we’re looking forward to a lot of things in the future.

The market was a little excited about this merger as well. I think that our paper industry peers’ composite share price from October 2007 through January 2008 was mirroring the stock market at the time because there was a downward trend generally. Interestingly on Jan. 10, when we announced the merger of Rock-Tenn and Southern Container, there was a pretty dramatic divergence. If you followed the peer industry, they continued to decline approximately 23 percent during the following three months, while Rock-Tenn took off, going up 40 percent over the next three months, creating a 60 percent spread in the market.

This is a pretty radical representation of what a good merger can do in the eyes of the marketplace.

We’ll talk a little bit about the economy that overlays our industry and how that relates to the containerboard packaging business. We’ll talk about the consolidation trends that I’m sure you are seeing in our industry. Lastly, we’ll look at how consolidation affects recovered fiber markets and what we might see as we look at containerboard packaging moving forward.

First of all, I suppose the most pervasive thing we see today is the crazy price of oil. You can’t turn on the TV, turn on the radio or open a newspaper without being bombarded by the impact of oil on the global economy. Whether it’s $5 per gallon gas at the pump, the doubling or tripling of heating oil prices, the price of your freight to haul your fiber across the land, oil is permeating everything we do. Clearly it’s an issue that this country has to address, but it’s not just oil.

If you look at the weak U.S. dollar and the strong global demand that’s imparting itself on the materials that are part of the North American landscape, and you see nothing but very steep upward trend lines, from gold to steel to soybeans.

This trend is also beginning to translate itself into a variety of commodities, not just specialty materials, and the "inflation" word is rearing up and staring us square in the face.

The Federal Reserve has done a great job of controlling the interest rates. It’s kept the economy moving along at very low demand, but we’re now starting to see it get a little scary. The last two periods the Consumer Price Index (CPI) has gotten up into the 4 percent range. In May the CPI peaked above 4.2 percent, and that’s getting into the problematic area.

If we look back over the last decade or so, the 2.5 percent area is a far more comfortable place to be. As soon as we start to eek up into the 4-plus percent range, it has a radical impact on our economy.

We’re also seeing a time when our overall industrial demand is declining, as represented by the Purchasing Managers’ Index, which has tipped below 50 percent for the first time in a while, an indication of industry contraction.

From the good news standpoint, as we’ve seen a decline in U. S. domestic consumption, we’re seeing a pick up in export demand. I know you’re all keenly aware of that, particularly in this industry. Particularly during the last 18 months or so, we’ve seen a pretty dramatic increase in export demand across the manufacturing economy, not just in the paper industry. It’s really helped to buffer in the overall impact of the declining U.S. demand.

While GDP (gross domestic product) continues to be relatively healthy, it’s largely being bolstered by export demand. While the economy is still holding its own from a GDP standpoint, it’s a little bit of a nervous situation further exacerbated by data indicating the industrial economy is further sloping. Clearly the economy will be labeled tenuous at best. I don’t think we’ve tipped into this recessionary period that we were all talking about—and maybe there are economists in the room that would debate that—but it seems like we’re hanging on by a thread.

On the other hand, from a containerboard standpoint, things are not so bad. From ’05 on we’ve seen a very nice upward slope of operating rates on both linerboard and corrugated medium. Why is that?

First of all, box demand has been reasonably constant. Corrugated packaging is one of those industries that is maintaining itself, which is fortunate.

Secondly, we have an environment with a weak U.S. dollar, rising export demand and declining imports. In fact, linerboard exports are up 9.2 percent year over year, and corrugated medium exports are up 37 percent year over year. The low dollar is helping our industry dramatically.

As you know, though, we are starting to get some pressure from ocean freight costs and container availability, which is a threat to containerboard as well as to recovered fiber markets.

Another big driver in that operating rate slope that is going up radically into the 96 percent range is capacity demand. It’s a phenomenon everybody is familiar with. The offshore effect of North American manufacturing moving principally to Asia over the last decade has put a substantial burden on the containerboard packaging industry. It absolutely required rationalization of capacity, taking plants out of the system. Capacity has shrunk by 3.5 million tons during the past seven or eight years.

I’m sure you can go through the list of mill closings one by one, thinking, "I remember that one." Those were your customers, I’m sure, to some extent. You had to replace those customers with Asian customers. Clearly you have, but the containerboard industry had to go through this radical capacity downsizing.

Also good news is relatively low new capacity creep. While there are a couple projects on the board, specifically International Paper’s conversion to lightweight liner board, fortunately the company shut down its Taraho, Ind., medium mill. That took a couple hundred thousand tons out of the market. So, net, it was about a 300-ton addition, and most of that is going to export, so we really haven’t seen the impact of that domestically.

This climate of capacity rationalization and supply and demand balance is very clearly in effect in the containerboard industry. That’s best evidenced by inventories. Inventory has declined steadily over the last seven or eight years, while we were driving capacity down and demand was relatively flat.

Recovered fiber, on the other hand, is going straight up. It’s easing a little bit; that’s good news. But it’s not just wastepaper costs that are impacting our industry. Thanks to the decline in the housing market, we’re also seeing it on the wood side of the business, as well, which is about 60 percent of the North American containerboard fiber supply. As the saw mills that were producing the lumber to build all these houses that are no longer being built close, we are no longer seeing the residual chips that were part of that manufacturing process and are a huge feedstock for the containerboard packaging industry and our virgin pulp. Therefore, the cost of wood is also going up dramatically, as well as energy, as well as freight, as well as chemicals, as well as literally every other commodity in our industry.

We’ve seen pretty steep upward trends in costs for both recycled fiber as well as for virgin material. Significantly in the area of recovered fiber, we’ve seen recovered fiber prices increase from $48 per ton in 2002 to $154 per ton in 2008. Energy costs have gone from $30 to $100. There are lots of big drivers for cost increases in the industry.

The good news is that all of those other economic slides I showed about capacity being balanced with supply have allowed operating rates to go up. Net, even though it is a tenuous time, the containerboard packaging industry is about as healthy as it can be.

Now, it’s not great. I’m not up here bragging about how wonderful it is to be in the containerboard packaging business. Although we’ve done pretty well over time, as you look at the benchmark of the publicly traded companies, it’s not exceptional. Yet, it is getting a little bit better. There have been some improvements in earnings and operating margins. It’s not good enough, but the trend is positive.

What are we working on? Pretty much the same old stuff: vertical integration. You studied it in high school economics. Our industry is the perfect case in point of trying to get that right. It hasn’t quite gotten it right yet. It’s still working on it. We see most all the integrators working on rationalizing capacity, trying to take plants out of the system to reduce the overall capacity of the industry. Secondly, we’re increasing asset utilization—operating the assets we have installed more hours per day, more days per week, more months per year. Thirdly, we are trying to, in some cases, upgrade the operating infrastructure to have more efficient, more productive, higher technology machines. This is difficult to do in an industry that’s not producing huge returns.

That, frankly, has been the cornerstone of Southern Container’s existence over time as we plowed most all of our cash flow back to our assets. We tried to maintain a very state-of-the-art mix of manufacturing equipment. It’s tough to do, but that’s what the industry is trying to do.

The second bullet that we have to be worried of is the traditional integrated model of chasing volume. You’ve got to install the assets and fill them up, so let’s go get volume. The only problem is that when you do that, you’re just taking volume from other people, and the margins get tighter. That’s the big threat that the industry has. It’s getting better, but it still has to be something that is in the back of all of our minds.

Finally, the real story is manufacturing costs. As a capital-intensive industry, we have to have low costs. It’s a commodity product; that’s the way it is, low cost wins.

Consolidation is another big dimension in our industry today. There have been four mergers this year, frankly. MeadWestvaco is selling its Charleston, S.C., mill to Roger Stone and Matt Kaplan of KapStone Paper and Packaging Corp. You’re all I’m sure aware of the International Paper and Weyerhaeuser transaction, which we understand is going to close third quarter. Of course, there’s the Rock-Tenn/Southern Container merger. You are also aware, I’m sure, of Cascade buying out Domtar’s stake in Norampak. These are all here-and-now kinds of containerboard consolidation plays.

Since 1999, $37 billion worth of containerboard packaging mergers have occurred. That amounts to 31 million tons of containerboard that has changed hands in the last seven or eight years. That’s a huge amount of change in the industry, and I would say it’s not the end.

Looking at it a different way, back in 1995 you had the top two companies—Stone Container and Georgia-Pacific—represent 20 percent of the market share of our industry. Today, following the International Paper/Weyerhaeuser merger, the top two companies represents almost 50 percent of the market share, and the top four companies account for nearly 70 percent. I would say this march is going to continue further.

Let’s take a look at that for a minute. The top players in terms of market share in the containerboard packaging industry are International Paper (IP), Smurfit-Stone, Georgia-Pacific (GP), Temple-Inland, Packaging Corp. of America (PCA), Norampac (Cascades), Rock-Tenn and Visy Industries. It will take some time for IP and Weyerhaeuser to rationalize their merger, so I have to say that IP is going to be out of the acquisition game for awhile. But clearly the company has a major amount of work to do to truly affect the strategy it deployed of creating $400 million in synergies, bringing these two companies together, shedding assets and building new management teams.

Smurfit-Stone, the second largest company in the space, is clearly interested in growth. Although its primary interest right now is in rationalizing capacity within its own plants, retooling its plants to try to upgrade its assets, reduce costs and bring shareholders value. Smurfit-Stone would like to be part of firm consolidation, in my opinion, however it has to get its balance sheet in order.

GP clearly is capable of pulling off any acquisition in this industry worldwide. The company has huge amount of cash, strong commodity players and very capable operators, and I clearly would look for them to be at the front of whatever consolidation occurs going forward.

Temple-Inland is probably in the game, as well. The company has completed its transformation, spinning off the banking side of the business. It’s focusing now on the corrugated packaging and building products segments, and I think it’s a player going forward either to acquire or be acquired.

PCA is a great company and best performer on the list when we looked at the earnings of all the containerboard packaging companies. As it has become part of the private equity space in our industry, it’s been very focused on lowering operating costs and running the business in a very effective way. So I think PCA is a neutral player in terms of acquisition. It would only acquire if it was truly an outstanding value and the company could continue to drive its earnings upward. I don’t think it’s going to go backwards just to get bigger.

Norampac, I clearly think is looking for more, as is Rock-Tenn. And, Visy is clearly committed to the recycling side of the industry and is putting its money where its mouth is with new machine capacity as we speak.

I think there is a lot of enthusiasm among the top eight to try to rationalize capacity. Globally, there are some big players as we look at some of the Asian and European companies, and I think you are going to see consolidation as the landscape going forward.

Let’s shift gears a minute to the impact of industry consolidation on the recovered fiber markets.

First of all, let’s take a look at the containerboard fiber source to begin with. I think everybody in the room is clearly aware of the substantial increase in the use of recovered fiber in containerboard over the last couple of decades. Recovered fiber use has increased from approximately 50 percent to a little more than 70 percent since 1990, hence the decline in virgin fiber from the 55 percent range to 30 percent. I don’t think that’s a surprise to anybody.

The industry has invested in nearly 25 million metric tons of additional capacity driven by non-wood fiber from 2005 through 2009. This is rapidly changing everything we do.

New capacity expansion projects in Asia from ’08 and ’09 represent an additional 10 million tons of containerboard capacity. Expansions are planned for Nine Dragons, Long Chen Paper and Lee and Man, to name a few.

Imports of recovered fiber to China grew from 3 million to 6 million tons per quarter, doubling over the three-year period from 2004 through 2007. The increase in U.S. recovery rates for old corrugated containers (OCC) from 59 percent in 1993 to 78 percent in 2007 has been driven by this kind of demand.

Asia imports nearly 20 million tons from the U.S., a little bit from Europe and a little bit from Japan. That is just radical, revolutionary, transformational, whatever other adjective you want to put on it. This has a huge impact on your business.

Let’s go back to recovered fiber in North America. Today’s North American recovered fiber consumption, about 60 percent of it is OCC, 12.5 percent is high grades, 15.4 percent is news and mixed paper is 13.1 percent.

There are some demand upticks. We’re going to see a 400,000-ton, or 2 percent, demand increase for OCC from 2008 to 2010. We’re going to see roughly a 500,000-ton increase in demand for mixed paper. There is North American domestic consumption growth on the drawing board.

Containerboard represents about 59 percent of all the recovered fiber consumed in 2007. OCC consumption increased by 1 percent in 2007. Over the next two years, consumption of OCC is projected to increase by 2 percent, with 76 percent of the OCC to be used in containerboard grades, and 25 percent to be used in paperboard grades. Our strength is that we have strong demand and a favorable currency balance. The challenge is what is going to happen to shipping containers and the cost of export freight. Frankly, I cannot forecast what that’s going to do to the balance of Asian demand for North American recovered fiber.

What will the impact of containerboard industry consolidation on recovered fiber markets be? There won’t be much. The players will be fewer, but the voracious demand for recovered fiber and the fact that there are going to be no virgin pulp capacity additions means that all the demand is going to fall onto your industry. That doesn’t mean there is not going to be some tactical change. Obviously, each of these integrated containerboard packaging companies have to feed their recovered fiber needs and, as they merge, have to consider strategies.

As we look back at the consolidation of the industry and the containerboard packaging marketplace, I guess the punch line of my remarks today is that consolidation is going to continue, no question. This capacity-demand balance that has been happening over the last five years, which has increased operating rates and decreased inventories, allowing us to recover costs, I believe will continue. We will see fourth quartile paper machines shut down. Those high-cost machines have got to close. And yet we will see a few more machines being built using modern state-of-the-art technology.

Recovered fiber will continue to be very strong with no virgin pulping capacity installed. In the end, those companies that execute a low-cost strategy are going to win.