SHARES

Sappi, ENX, Northam, Hyprop, Emira Property Fund

It takes nerve to embark on the radical repositioning of a business. Sappi did just that five years ago when it started a process to end its heavy reliance on printing paper by increasing the importance of chemical cellulose, or dissolving wood pulp (DWP), in its product lineup.

To do so, it ramped up DWP production at its Ngodwana mill in SA and Cloquet mill in the US at a cost of US$460m.

DWP is used to produce textiles, quality fabrics and rayon. Other applications include cigarette filters, pharmaceuticals, cosmetics and cellophane.

Sappi had little choice in the matter. Demand for newsprint and glossy, coated paper for magazines and catalogues had been in decline for years.

The strategy to increase the importance of DWP has met with great success. In Sappi’s year to September 2016, DWP contributed $294m (60%) of group operating profit of $487m, while at the earnings before interest, tax, depreciation and amortisation (Ebitda) level, its contribution was $339m (46%) of a $739m total.

DWP’s contribution of 1.11Mt in volume sales in Sappi’s past financial year was only 15% of total group volume sales of 7.25 Mt. Its Ebitda profit margin was an impressive 36.5%.

Expanded DWP production has been a major contributor to Sappi’s robust performance, lifting headline EPS (HEPS) from US7c in financial 2012 to 57c in financial 2016, which itself had an increase of 67.4%.

In the process, return on capital employed rocketed from 5% to 20%, and return on equity (ROE) from 6.2% to 26.7%.

Sappi’s returns put it in front of its major competitors. These include the world’s largest paper producer by volume, International Paper (US), with a 17.7% ROE, Stora Enso (Finland) with 7%, WestRock (US) with 2.4% and Japan Paper Company with 11%.

With a 20% market share, Sappi is now the DWP market leader. It is a position Sappi CEO Steve Binnie says the company is determined to retain, adding that it will add 500,000 t of DWP capacity over the next five years. Of this, 100,000 t is set to come from “debottlenecking” projects at the Ngodwana and Saiccor mills in SA in 2017 and 2018.

Sappi is not looking only to DWP to drive profit growth, but also to “moderate investments in areas that offer growth and improved margin”, says Binnie.

Here Sappi has a number of tricks up its sleeve, including growing sales volumes of higher-margin speciality paper used for high-end packaging.

“Speciality paper now contributes 15% of our Ebitda, compared with virtually nothing five years ago,” says Binnie. “We want [it] to contribute a quarter of Ebitda by 2020.”

To that end, Sappi is converting a mill each in the US and the Netherlands to produce speciality paper.

Sappi is also shifting into “adjacent markets”. The group is thinking big, targeting new businesses to add $100m (about 14%) in Ebitda by 2020.

One of a number of inno- vative projects involves better use of timber resources. Paper makers, says Binnie, use about 50% of the tree to make paper. Sappi is investing in technology and processes to extract highvalue chemicals and materials from the remaining 50%.

Binnie does not expect such projects to require Sappi to increase its net debt to above its self-imposed limit of two times Ebitda. It currently stands at $1.32bn, or 1.7 times Ebitda.

Sappi is set to deliver another positive set of results in its year to September. However, HEPS growth will fall far short of that of the previous year.

Among factors working against Sappi is a stronger rand, which has put the brakes on SA operations’ profit growth in dollar terms. Sappi generates about half of its Ebitda in SA.

Another negative is a weaker DWP price, which peaked in October 2016 at $975/t but fell 14% to $835/t in June.

But Binnie does not believe this reflects a market moving into oversupply. “Worldwide capacity will grow at 5%/year, in line with demand growth of 400,000 t/year,” he says.

The prospect of muted HEPS growth has resulted in Sappi’s share price retreating 15% from its May high. But the group’s solid medium- to longer-term prospects make it an attractive buying opportunity.