The somewhat self-effacing acceptance that “a box is simply a box” and that, ultimately, the products that paper and packaging group Mondi manufactures will, as with any other commodities, experience a decline in real prices over time, could, CEO David Hathorn believes, eventually differentiate the company from its global peer group.
Arguably, such a mentality was de rigueur while Mondi was still positioned within a commodity-centric mining group such as Anglo American. But it did not necessarily hold that it would automatically remain the main guiding principle once the group was unbundled, particularly given that many of its competitors still insist that the market remains differentiated.
Hathorn argues that perceptions of ongoing differentiation are, “with respect, nonsense”. While, in South Africa, the corrugated packaging sector is still somewhat differentiated, owing to its geographical distance from other markets, increasingly, packaging and office paper, its two principal products, are perceived as pure commodities in territories such as Europe and North America.
In other words, when fast-moving consumer goods giants such as Procter & Gamble tender for packaging, specifications are spelt out, and those firms able to meet the requirements compete on price, and price alone. “Once you adopt such a mindset, it changes the way you run the business and you start running it the way we do,” Hathorn asserts.
Principally, it translates into an unrelenting cost focus designed to sustain margins, rather than attempting to conjure up some “nonexistent differentiation” to boost the top line.
At Mondi, at least 2% of cost reductions is budgeted for yearly, and over the past three years, it has achieved more than 3% a year on average, equating to a reduction of more than 10% of its cash-cost base.
Some of this has been achieved through asset rationalisation, with the group having closed over 30 plants and disposing of 36 over the last few years. The balance has been realised through a $2-billion investment into its low-cost emerging-market footprint, as well as through operational improvements. Hathorn says that some rationalisation will continue, with one mill closure planned for 2008, but that the future lies in the simplification of product lines, slimming down sales forces and cutting out overheads.
Two major optimisations are also under way, with Mondi spending €525-million on the modern- isation and expansion of the Syktyvkar mill, in the Komi region of Russia, and a further €350- million on a containerboard and box-plant expansion at the Swiecie mill, in Poland.
A STEEPENING FIBRE COST CURVE
Associated strongly with a drive towards lower- ing costs, the Johannesburg-domiciled group has a near fixation with a geographical migration to the world’s lowest-cost fibre growing, or harvesting, regions. This also means entrenching fibre self-sufficiency for it operations, currently in 35 countries.
This strategy is being pursued in the context of a fast-steepening timber cost curve, which is driving Mondi to narrow its forestry presence to two of the world’s three lowest-cost regions – South Africa and Russia. It also continues to eye opportunities in the third, Brazil, but corporate activity in that territory is being constrained by the very high trading multiples of South American forest-product companies, many of which are selling market pulp into fibre-hungry China.
The timber advantage in South Africa comes from the fact that it is a fast-growth, high-rotation region. Eucalyptus trees take between seven and ten years to grow to maturity, while hardwood in the northern hemisphere takes up to 70 years to 100 years to reach the same point. This means that the cost of timber delivered to the mill in South Africa is low, at about €22/m3.
And, despite the slow growing conditions in Russia, the fact that a third of the world’s timber grows in Russia, and is relatively unexploited, is creating real opportunity.
Mondi operates in the Komi Republic, a region the size of France, where 70% of the surface area is planted, and less than a third of the available cut is felled yearly.
“That means that there is a staggering surplus of timber,” Hathorn enthuses, adding that it can buy timber from the State, on a 25-year leasehold title, at €1/m3. This eventually translates into €24/m3 to the mill, given the logistics constraints in the Komi region. “It is basically swampland, so you have to build your own roads and you also generally have to fell during the frozen periods.
“So, while it is a very different set of dynamics to South Africa’s, the fundamental issue is that the surplus timber in Russia means you can procure a sustainable, low-cost timber base.”
By contrast, “timber prices are going through the roof” in other traditional territories. Timber prices delivered to the mill in Scandinavia were calculated at €40/m3 a year ago and have since risen to €60/m3. Similarly, the price in Portugal has risen from €40/m3 to €55/m3.
LAND CLAIMS WON’T affeCT STRATEGY
Mondi is also adamant its commercial and strategic interests, particularly its backward integration into a low-cost timber base, are not threatened by the fact that some 48% of its South African land is still subject to claims by previously disadvantaged communities.
Mondi’s forests occupy some 1,3-million hectares, mostly on the eastern side of the country, and the group harvests some 22-million cubic metres of timber yearly for use as pulpwood, sawlogs, mining timber and poles.
Hathorn says that the company is working with more than 100 communities, the Land Claims Commission and government to resolve the matter as soon as practically possible.
“We will receive full-value compensation for the land from the State and will still have the right to retain the trees,” Hathorn explains, adding that Mondi has developed five settlement models, which it is in the process of presenting to affected communities.
These five models were premised on variations on two main kinds of settlement: • A sale and leaseback, whereby a community seeking an annual income flow would take ownership of the land, while Mondi would be compensated for the value of the land and then pay rental to the community, which would also allow it to continue to grow trees.
- An alternative model could involve Mondi contributing its timber into a joint-venture company, with the community contributing the land. Mondi would be compensated for the land value, and would take up to 75% of the equity in the joint venture, owing to the fact that the timber is worth about 75% of the total costs. That also meant that it would continue to receive 75% of the timber at cost.
“Therefore, we do not see it as a major commercial issue for Mondi, but as an opportunity to deliver a sustainable working model in engagement with communities that will enable us to grow timber on that land for a long time to come,” Hathorn insists. But he acknowledges that the process is absorbing much management time and attention.
LEVERAGED BUT RESILiENT
Ultimately, the idea behind its backward inte- gration and its geographical spread is to leverage the business to the upcycles and build countercyclical resilience for the inevitable downturns.
Hathorn notes that, across the previous price cycle, from 2001 to 2006, which contained “three good and three bad years”, Mondi was able to sustain a return on capital that was 50% better than the industry average.
In 2007, its maiden year as an independently listed company, the group reported a strong rise in operating profit to R4,8-billion, from R3,2-billion, and a 97% rise in earnings a share to 453c, from 229,7c a share in 2007.
“We had a good year and we even had a good fourth quarter, while our European competition, by and large, reported their worst fourth quarters in their respective histories. So we feel the differentiation is starting to show through in the financial numbers,” Hathorn enthuses.
The company is also entering a possible sweet spot as the prices for paper and packaging, which have been lagging the surge in timber prices, begin to show green shoots of strength.
“What has really changed in this industry over the last few years is that fibre has become a constrained commodity for the first time in the history of the world. The fact is that Europe has now run out of fibre, Scandinavia is now 30% short and the Russians are now placing export duties on their fibre that used to flow into Finland. This is why there is this rapid fibre escalation in Europe,” Hathorn explains.
Add to that the fact that China is in pulp deficit, and the surge in pulp prices becomes even more understandable. “That is fundamentally good news for our industry, because the biggest problem that our industry has faced historically has been overcapacity.”
This said, that surge in upstream prices has not fully been converted downstream and the outlook is mixed.
Corrugated paper prices rose 10% last year, but Hathorn expects these to flatten off in 2008, given that the euro:dollar exchange rate is beginning to attract product from North America into Europe.
However, other prices are firming. Sack-craft prices rose 12% in 2007, and rose by a further 5% in January. Office paper prices rose 7% last year and the further rationalisation under way in 2008 could provide another kicker.
Mondi is also considering swinging some of its sales from end products to market pulp, which it is able to produce at Richards Bay, to take advantage of the upstream prices.
Having said this, the group’s share price has by no means set the market alight since the listings, trading in the upper R60-a-share range during the latter half of March, down from a high of R72 a share, recorded earlier in the month.
In fact, at the time of writing, the R34-billion market-capitalisation group was only slightly up for the year so far on the JSE, and was down, year-to-date, on the London Stock Exchange.
Hathorn is sanguine about the performance, noting that it is still a new market participant, and that it is still experiencing some “overhang” from the Anglo American shareholding – a number of funds with mining-related mandates are having to dispose of their interests in the paper company.
“The resister is tightening nicely, the flow-out from Anglo is probably 85% behind us with only some of those inherited shareholders, who are not natural paper shareholders, still needing to make the move.”
He adds that the focus of investors appears to be shifting from the overhang threat to the fundamentals of the business.
“We believe what we are saying is different about us is being displayed in the financial performance. But these things take time,” he concludes.