Ind-Ra Revises Paper Sector's Outlook to Negative to Stable

India Ratings & Research (Ind-Ra) has revised the sector outlook to negative to stable for FY15 from negative based on an expected moderation of supply side pressures with gradual absorption of the overcapacity created during the past few years. Improved ability to hike prices along with benefits from the recent capex should help sector companies in improving profitability amid moderating cost pressures.

Ind-Ra has also revised the Outlook on most of its rated paper manufacturers to Stable for FY15 from Negative. This is based on the completion of their capex programme in 2013 and the expected operational benefits from capex in FY15.

The agency expects the overall sector demand to grow around 7%-8% yoy in FY15 with certain sub-segments witnessing higher growth rates than the overall industry. This will be on the back of changing lifestyles and strong growth in consumer-oriented sectors such as FMCG.

Inventory levels have been stabilising among industry players and reducing at distributors indicating moderating demand-supply imbalance. Ind-Ra's analysis of major sector companies indicate that despite high capacity use by paper companies, cumulative inventory levels grew at a meagre 2% yoy in FY13 (FY12: 31% yoy, FY11: 14.7% yoy).

Ind-Ra also expects minimal capacity addition over the next two to three years. Announcement of new projects (by value) in the industry reduced to INR37bn during FY12-9MFY14, with almost one-seventh of the projects announced during FY07-FY11. With no significant capacity addition in the next few years and gradual absorption of past over-capacity, demand supply dynamics is likely to become favorable for paper manufactures.

Sector companies are likely to register a rise in operating margins in FY15. However, managing input costs would be the key for domestic paper manufacturers. Their profitability has suffered in the past due to rising domestic wood prices. Also, rupee depreciation has increased the imported cost for raw materials such as pulp and coal. Paper companies have taken several measures to increase wood availability including focusing on farm forestry and importing wood to reduce dependence on domestic wood sources. Although rupee depreciation has minimised benefits from the latter measure, wood import by paper companies is likely to keep domestic wood prices in check.

Around 15% depreciation of the rupee during 2013, although increased the imported cost of raw materials, benefitted certain segments such as coated paper and packaging board, where domestic prices are determined by import price parity. Sustenance of the rupee at the current levels (INR61/USD) is likely to reduce competitive pressure from imports as witnessed in FY13 with the overall sector imports declining 8.3% yoy (in USD terms).

What Could Change The Outlook

Rise in Cost Pressures: The rating Outlook could be revised back to Negative on any significant rise in domestic wood prices or pulp and global coal prices which would increase raw material costs, thereby reducing profitability and deteriorating credit metrics of paper manufacturers.

Unexpected Capex: Ind-Ra expects that any fresh capex plans by the sector companies would only be announced post complete benefits from the recent capex come in. Any unexpected capex announcement would further stretch the already leveraged balance sheet of sector companies and could lead to a negative sector outlook.

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