Secular Headwinds to Paper Profits

Paper is ubiquitous in our everyday life. In any given day, consumers use paper products to read, to publish, to clean, and to package. Indeed, paper has been with us for over two millennia, and while consumption of certain kinds of paper faces undeniably stiff headwinds, society's demand for paper isn't likely to vanish overnight. In fact, for certain categories of paper and in certain corners of the globe, the outlook for paper seems downright bullish.

China versus the United States
For the most part, paper and paper products are disposable products. As a nation's middle class grows in size, the convenience and need for paper products likewise expands. Figure 1 shows how American paper and paperboard consumption grew steadily from the 1960s through the 1990s and how just recently, China has surpassed the United States in terms of total paper and paperboard consumed.

Looking at total tonnes consumed is one thing, but understanding the per capita trends in paper and paper consumption is critical in understanding where new capacity is likely to be built and where capacity is likely to be removed. Figure 2 shows per capita paper and paperboard consumption since 1961.

Two trends are evident in Figure 2. First, per capita consumption of paper and paperboard in the U.S. is on the wane--from over 340 kg/person/year in 1999 to less than 270kg/person/year in 2008. Meanwhile, China's per capita consumption is less than one fourth of that seen in America. We believe that paper demand in North America will continue to decline and that demand in China will continue to see steady growth.

How Much Growth Is in Store for China?
A quick history lesson helps us get a sense of where Chinese paper consumption may be headed. Figure 3 shows per capita consumption from 1961 to 2008 versus GDP per person for the U.S., Japan, and China. We believe that when Chinese per capita GDP crosses $20,000 per year, the average Chinese citizen could consume 150-200 kg/person/year. This would translate into a staggering 200 million-275 million tonnes/year of paper and paperboard, or roughly 2.2-2.9 times larger than the peak consumption seen in the U.S. during 1999.

Important Trends Impacting the American Paper Market
Paper and paperboard consumption has been on the decline in America for about a decade. Much of this is due to declining newspaper and magazine subscriptions, weakening amounts of print advertising, a decline in mail volumes, and more manufacturing moving overseas. We see little reason to believe the trend will slow anytime soon. In fact, several developments could precipitate an increase in the rate of decline.

Data from the U.S. Postal Service, depicted in Figure 4, paint a clear picture of recent trends.

Periodical volumes have been in steady decline for a decade. Over 800,000 fewer tons per year of periodicals have been shipped since the start of the decade, due largely to the growing share of Americans that now rely on the Internet and 24-hour news stations for information and opinions they once obtained from magazines.

Looking ahead, changing demographics will only exacerbate the decline of magazines and newspapers. Figure 5 shows the percentage of American adults that read the newspaper. Slicing these data by age cohort paints an even bleaker picture.

 

The decidedly negative trend isn't isolated to the U.S. Stora Enso (STERV), one of Europe's largest producers of publications papers, noted in a recent presentation that in 1980 over 60% of 20-29 year old Germans had print subscriptions, but by 2008 fewer than 30% had subscriptions.

First class mail and standard mail, like periodicals, have suffered from the continued ascendance of electronic media. Volumes for both are both down about 15% (in terms of weight) since 2000. First class mail has been, and will likely continue to be, impacted by email and electronic bill-payment options offered by banks. Standard mail, which includes junk mail and catalogs, has been impacted by advertising budgets and also a shift to web-based demand.

We also note that the cost of postage in the U.S. is less than other developed nations. Given the persistent financial woes of the USPS, we would not be surprised to see continued postage rate increases--which, on the margin, would further impede the volume of mail sent--and hence further reduce the demand for paper.

The X-Factor of the iPad
 Apple (AAPL) recently announced that it had sold over 2 million iPads worldwide and over 5 million eBooks have been downloaded; this news should have paper producers trembling. Consumer adoption of e-readers like the iPad, Kindle, and Nook is likely to further accelerate as competition and innovation among the big players lowers the cost of ownership and improves the quality of the customer's experience. The potential consequences for paper are staggering. Newspaper and magazine subscriptions could further shift from print to electronic; book aficionados could go from needing to store hundreds of pounds of literary works on many bookshelves in their homes to having all that content stored in a slim, lightweight gadget; and office workers could forego needing to print out hundreds of pages of documents by downloading them onto their device.

The iPod's impact on the music industry provides an instructive example of just how devastating an easy-to-use digital device can be for an established medium. Data from the RIAA show how various forms of media for music rose to prominence and then fell once a better option was unveiled (see Figure 6).

We expect a similar phenomenon to manifest as e-readers gain consumer acceptance. Data from the Association of American Publishers, which tracks book sales in the U.S., offer a glimpse of the early stages of this transformation. From 2002 to 2009, revenues from e-books have grown from nothing to 3.3% of the market (Figure 7). And this is at a time when the monochromatic Amazon Kindle controlled the e-reader market. We believe that the pace of this shift will only accelerate once Apple's iPad and iBookstore take digital reading to the mainstream.

Capacity Utilization
What will it all mean for U.S. paper producers? The outlook, obviously, is far from rosy. Paper is a commodity product, and profitability is greatest for the low-cost producers. Economics would suggest that when there is overcapacity in the marketplace marginal revenue will equal marginal cost, thereby generating losses for the high-cost producers and limiting profitability for the low-cost manufacturers.

According to data from the Federal Reserve, capacity utilization for the U.S. Paper Industry has been on a multiyear downward trend (see Figure 8). We do not believe that demand will rebound enough to raise utilization rates above 85%; rather, we believe that eventually the high-cost capacity in America will need to be shuttered.

While America's paper capacity is being shuttered, idled, or aged, China is continually installing the latest paper machines. These new machines are frequently larger and more efficient than many of the machines found in the rest of the world. A growing risk for paper makers in North America is that if China's capacity grows too fast and outpaces domestic demand, Chinese producers could look to start exporting more paper (produced on the latest and greatest machinery) into the already overserved developed economies. Fortunately for American manufacturers, China is fiber-poor. The Chinese must import fiber in order to run their mills; this added logistical cost helps to slightly protect American producers from Chinese imports--but we are concerned that this will not always be the case.

Summary
Companies who compete in the paper and paperboard industries compete in a no-moat industry. Switching costs for customers are low and profitability is dictated largely by supply and demand. We believe that demand for printing and publication papers will continue to weaken in developed economies as consumers and workers increasingly consume information digitally rather in print form. This will lead to continued overcapacity in North America and Western Europe. Meanwhile, the growing middle-class in much of Asia will continue to increase their per capita consumption of paper and paperboard--this growing demand will cause new manufacturing capacity to be added in the East. This new capacity will utilize the latest technology and likely be in the low-cost end of the cost curve. North American paper producers should be wary that Asian producers could increasingly turn to the U.S. market to find a home for any excess supply.

The financial consequences of declining developed market paper demand and surging emerging market paper demand will be very uneven. Companies who focus on industrial and consumer packaging should not be impacted as much as the companies who produce printing papers. Items still need to go in boxes, and as the globe's population continues to grow and trade continues to expand in the coming years, box demand should also tend to increase. For this reason, the secular headwinds faced by corrugated box producers like  Temple-Inland  and  Packaging Corp. (PKG) aren't nearly as daunting as those facing firms like  Domtar , UPM (UPM1V), and Stora Enso, for whom printing and publication papers account for a majority share of total sales.