A paper tiger in the making?

GUEST COLUMN

Buy. No other single word in the last month has so deeply questioned our value system, investor grain, intelligence and stick-it-out ness.

Just a couple of months ago, when stocks were high, we prayed for some affordability. Our request was promptly acknowledged; we now pray for the courage to acquire.

In these circumstances, the one industry that provokes my ego is paper. Core sector of sorts. Integral to every day living.

And yet I can see the Sirpurs, AP Papers and West Coast Papers of the world mocking the analyst in me:

"I am going for a fraction of the invested value, can you see the value?"

"I might be on the verge of a vigorous take-off, will you dare to buy?"

This is the overview of how the paper industry finds itself in the garbage heap of PE ratios. Three years go, the major players in India's paper industry set out to conform to the global CREP order, which required them to eliminate the use of chlorine in their manufacturing process, invest in environment-friendly equipment and clean up their act. A majority of these investments were not just mandatory; they were prohibitive. A majority of these investments were not just prohibitive, they were non-remunerative.

Result: the nimble analysts moved out of paper stocks, the companies incurred large capital expenditure, projects were extended, commissionings were delayed and return ratios avalanched. If you even mentioned a paper stock to an analyst, she made a value judgment. Pun intended. Until now.

The industry may be on the cusp of a migration for a number of reasons:

December 2008 is the deadline by which the paper companies will have to come clean; some of the major companies have already done so or will be doing so well before the appointed hour

Most major paper companies have not only utilised the opportunity to modernise their plant and equipment; they have also enhanced their capacities

Most major paper companies have incurred low equity dilutions corresponding to the quantum of investments that they have made in their businesses

Most major paper companies have declined significantly in value as a cumulative effect of three years of apathy; when you cross this with the fact that equity dilutions have been modest, what you get are instances of market capitalisation where the top ten manufacturers in the country consolidated can be bought off before breakfast in an elementary stock swap by promoters of large companies in in-fashion sectors

The excise cut from 12 per cent to 8 per cent can widen demand at one end of the possibility spectrum and enhance realisations on the other.

Sirpur Paper

The company had 83,000 TPA of legacy capacity until three years ago; following an extensive overhaul - 60 per cent of the equipment is spanking new "� the company's capacity has been enhanced to 137,000 TPA. An investment of more than Rs 400 crore in modernisation and capacity expansion comprised the following:

A new fibre line with continuous manufacturing process leading to reduced raw material consumption, reduced chemical use, reduced waste, enhanced pulp quality and consistency and increased brightness.

Cleaner environment-friendly process wherein Cl02 is used over chlorine and lime, waste re-burnt and reused and a significant increase in steam water evaporation efficiency

This is what the company expects to achieve: a growing investment in automation, an attractive increase in productivity per person, a relatively steady overhead structure and an increase in production.

This is an interesting inflection point: the company was relatively competitive in conversion costs, but following modernisation cum expansion, the company will now be able to cover its overheads more efficiently. Legacy costs are low with the company sitting on nearly 600 acres of land. Its manufacturing facility is located in the midst of raw material and coal pit head.

Best of all, there is a case that a company with a market capitalisation of Rs 130 crore is considerably under-capitalised when compared to production capacity. Besides, it appears to have been comprehensively discounted when compared to an annual revenue potential of Rs 475 crore and the possibility of generating an EBIDTA margin in excess of 20 per cent.

Andhra Pradesh Paper

One of the first things that strike me about Andhra Pradesh Paper (AP Paper) in 2007-08 is an ominous leaning towards a debt trap. The evidence: across three quarters of the current financial year, EBIDTA declined from Rs 27.97 crore to Rs 25.7 crore to Rs 25.02 crore, while interest increased from Rs 5.58 crore to Rs 8.17 crore to Rs 9.09 crore and net profit declined from Rs 8.33 crore to Rs 2.79 crore to Rs 2.31 crore. Equity: Rs 25.73 crore. That's a market capitalisation of nearly Rs 200 crore for a company with 550 TPD of bleached pulp capacity plus nearly 520 TPD of paper capacity (including nearly 200 TPD of waste paper-based newsprint).

The story at AP Paper is likely to get interesting from this last quarter for some good reasons: there has been a change in the operational leadership and the new managing director has effected some far reaching cost reduction; the addition of a wet lab in the last quarter will enhance pulping utilisation; the commissioning of a boiler will completely replace furnace oil and strengthen plant load factor. Then, there is the proposed 70,000 TPA paper machine addition by July 2009.

A couple of caveats: paper companies move gradually between equipment commissioning and stabilisation, a lag that can try investor patience. Besides, capacity increases are expensive and phased. Investors seeking to add an immediate shine on their portfolios may be temporarily disappointed, but the proximity to commissioning points and evident cost savings may correct valuations.

Mudar responds with speed at mudar@trisyscom.com. Disclosure: Holds stock in Sirpur Paper