How Mondi and Sappi proved everyone wrong and reinvented themselves

Written off a decade ago as redundant in the new digital world, the paper industry has gone back to the drawing board to defy its predicted demise. Now, it is in robust health: Mondi's market cap has grown fourfold since 2007, largely as a result of its focus on packaging, while Sappi's stock is at a record high. This is how they reinvented themselves

David Hathorn’s last AGM as Mondi CEO was a low-hype affair: all four of the shareholders who posed questions about the R124bn company seemed more concerned with the complex accounting valuations of its forestry assets than the future prospects for such an old-world asset as paper.

Perhaps that is testament to the fact that under Hathorn, Mondi has delivered anything but wafer-thin margins since it was spun out of Anglo American in July 2007.

Hathorn, a chartered accountant who joined Anglo American 26 years ago before becoming Mondi’s finance director in 1991, has officially retired (he turned 55 on Sunday). But he presided over a company whose stock quadrupled from R76.77 then, to around R340 today, a total return of about 620%.

It’s been a windfall for investors too, many multiples more than the 141% rise in the JSE’s top 40 since then.

That’s no mean feat for a paper industry company, largely considered "dead" by sceptics ahead of its listing on the Johannesburg and London stock exchanges. But Mondi’s steep rise — 85% gain over the past three years, while the JSE inched up only 9% — suggests paper is back.

There is nuance to this. While you may associate Mondi with your office photocopier, the real game for traditional paper firms now is packaging — or, in the case of Mondi’s rival Sappi, pulp.

In an interview with the Financial Mail after his last AGM, Hathorn says investors need to understand the radical metamorphosis of the industry over the past decade.

"People look at this industry and write it off. When we listed in London in 2007 it was a mission to get anyone to talk to us," he says.

"The industry had a shocking reputation. Scandinavia destroyed value for years and years, and people looked at (Mondi) as ‘paper’. Only when we got people to understand that this was a packaging business we were talking about, not a conventional old paper business, did they look at it differently."

A company that focuses on providing coated fine paper used in magazines is a different entity to one providing packaging. "They’re both paper, but the applications are totally different," says Hathorn.

Mondi took a crucial strategic decision, 20 years ago, to focus on packaging. That led to it breaking away and reaping the dividends.

"We were pretty much like every other group: we had a wide spread of products, a huge amount of printing and writing stuff. But from the late 1990s, we started focusing on packaging particularly and we built structural advantage in those big primary industries," he says.

It was a savvy move. It led to Mondi’s return-on-capital shooting north to around 20% — way ahead of the wider industry’s figure, which is between 13% and 15%.

If the SA paper industry is a tale of two companies — Mondi and Sappi — it is instructive to compare Sappi’s strategic thinking at the time.

Under former empire builder Eugene van As, Sappi decided it wanted to be the "biggest and best" in the glossy paper universe. It was a decision that hobbled the group for over a decade as the digital era ate its lunch.

It took until 2009 for Sappi to rethink its plans, and shift its focus to pulp.

Steve Binnie, who was appointed Sappi CEO in 2014, tells the Financial Mail it was a difficult time. "It’s easy now to judge that with the advent of smartphones, but at the time it was a good sector to be in and it was making good margins," he says.

Clearly, the market likes Sappi’s change in direction: its stock is up 264% over the past five years. That takes some of the sting out of the fact that since 2007, Sappi’s stock has risen only 35% — a speck in the distance against Mondi’s 622%.

Sappi’s salvation has been not packaging, but rather dissolving wood pulp — the sort that is mainly used to make textiles.

It’s somewhat fitting that a company that bet the house on providing the glossy paper for Vogue magazine has now hitched itself to the fashion industry in another way. But the fact is, demand for the fibres is soaring, as it can be used to make rayon yarn, creating high-quality fabrics.

More than 50% of Sappi’s profit now comes from dissolving pulp — which has been growing more than 10%/year in recent years.

Is there still value? What is the investment case for Mondi and the recently resurgent Sappi? Is the market finally waking up to the fact that diagnosis of the death of paper was premature?

Again, it depends on which corner of the paper market you’re in.

"If you take coated paper," says Hathorn, "I agree, there are some major demand challenges. If you take uncoated fine paper, the stuff you photocopy with, that has demand challenges, but packaging paper – that is a structural growth industry."

The reason for this isn’t hard to find: e-commerce has led to a surge in companies like Amazon, which package products for delivery. And Amazon’s sales for the three months to March soared 23%.

Also, better packaging extends the lifespan of products — a boon for every retailer.

While GDP in Europe rose only 1% last year, growth in corrugated packaging grew at three times that rate. At Mondi its consumer packaging is growing between 3% and 5%.

Says Hathorn: "A third of the world’s food goes to waste before it hits the dining room table. (So) everything you can do to enhance the quality of packaging to sustain longer shelf life – like bringing plastic into paper, and multibarriers, which Mondi is now very big in — makes a huge difference to the value chain."

The shelf life for red meat, for example, can be extended threefold. Tactile beauty is part of the draw, too. High-quality printed boxes have become an advertising medium in themselves, says Hathorn.

While the traditional brown box (known as containerboard) remains the mainstay, companies like Mondi have become much more canny about how they package goods. "There’s really intelligent packaging now, where you have measures that tell you whether that product ever dropped below or [went] above a certain temperature, in which case it’s rejected before it gets onto the shelf," he says.

Steep growth in high-end packaging has also played into Sappi’s hands.

Sappi was able to parlay its skills as a glossy paper maker to more lucrative ends — producing cosmetics packaging and boxes for cellphones, whisky and champagne as well as high-end food.

Binnie says that business is growing at between 2% and 3% per year.

While retailers bemoan the growth in e-commerce and the resulting closure of many stores, packaging companies are loving it.

Hathorn says Amazon doubled the number of Mondi packages it used last year. "The reason we’re big with Amazon is not because we were smarter than the rest of the pack but because we happened to end up with a packaging facility adjacent to the major Amazon plants in Poland, so of course we became the preferred supplier," he says. A stroke of luck, but shareholders won’t complain.

At the moment, Mondi’s supply to e-commerce agents like Amazon represents less than 5% of its corrugated packaging volumes. But the growth potential is immense.

Says Hathorn: "It’s growing at (about) 15%/year and e-commerce is projected to get up to 30%-40% of retail distribution, so there’s huge growth opportunity there for us."

Mondi has other, less stellar growth areas too. Its industrial packaging business — which makes kraft paper principally for cement bags as well as high-margin packaging for auto parts, supplying BMW and Mercedes-Benz — is one such area.

Nonetheless, waxing lyrical about boxes is clearly part of Hathorn’s DNA.

"They’ve got to have a fender that needs to be pristine when it arrives somewhere in India, say, and the box around that is quite a nice box, full of protective capacity — so the margins there are highly attractive."

One worrying factor for those who are looking for signs of Mondi slowing down is its weaker-than-expected first-quarter trading update, which emerged last week.

This showed its underlying profit was down 6% year-on-year, partly because costs of its supplies rose. But Mondi’s response shows times have changed in the paper industry: it hiked the prices of its kraftliner products, which analysts from JPMorgan believe will add 5% to its full-year profits.

Being able to hike prices is a big deal for an industry that has spent the past two decades chasing its tail, struggling with excess supply and rampant indiscipline when it comes to spending. Much like most commodity suppliers, it must be said.

So what has changed? Supply, says Hathorn.

"The big difference now in Europe is that [wood] is a constraint. If you go back to the 1990s, Scandinavia was producing a huge amount of fibre, it was incentivised to beneficiate it and you saw an endless array of capacity coming to market. And every time prices went up, they got clobbered again and came back down," he says.

In about 2000, it all changed. The European Union encouraged green energy and energy plants to burn raw timber.

"That programme has now stopped but the plants are there," he says. "Any surplus timber in Europe got sucked into this green energy structure and they burnt it up."

The second big factor that changed the paper industry was the global financial crisis of 2008. Though it began with Lehman Brothers going bust, paper companies also collapsed when they couldn’t repay their debts.

Mondi’s competitors who hadn’t diversified into packaging were unable to cope with the interest payments at a time when they realised people no longer wanted their product.

"In the virgin-based packaging industry – kraft paper made from timber – there is no new capacity, absolutely none, on the horizon. So that market got tighter and that’s why people have been getting excited and our share price has run up the way it has done over the past six months," says Hathorn.

But investors will want to know, does this mean Mondi’s stellar run can continue?

Avior’s Wade Napier, who has a "hold" rating on Mondi, says it’s unlikely it will enjoy the same level of growth it produced over the past decade.

Napier says that after the financial crisis, "Mondi didn’t have so much debt – and post 2010 was in a very strong position to capitalise. So that’s why we’ve seen this earnings growth."

But now, says Napier, "a lot of competitors have sorted themselves out and are on an equal footing" with Mondi.

He adds that Mondi is still in a "very strong financial position and is still the lowest-cost producer of various products in Europe, so will still generate lots of cash over the next 10 years."

Of the 14 analysts who cover Mondi, there’s an equal split between "buy" and "hold". Their 12-month target price is R356/share, only marginally above its current level of R337/share.

For Sappi, half the analysts call it a "buy", a third say it’s a "hold" and there’s only one "sell", from Barclays analyst James Hutchison. But the stock has already hit its 12-month share price target, putting it at a record high.

For those eager to put their money on the resurgence in paper, which is a better bet?

Until now, Mondi has been the favourite for its rand-hedge qualities, as 90% of its operations are in Europe. But Sappi may well be the purer option.

Between 70% and 80% of all Sappi’s costs are rand-based, even though its pulp and magazine paper revenues are earned in dollars or other hard currency. Its only rand earner is its SA tissue paper, which is less than 10% of the business.

Mondi has no plans to exit its SA investments, even though all its recent acquisitions have taken place outside the country.

Asked if the increasingly hostile business environment could prompt a rethink, joint chairman David Williams says SA is still a "core" part of the group’s operations.

Hathorn adds, however, that "policy uncertainty is not good for business — it inhibits investment, it inhibits the desire to take a risk with capital".

But Mondi’s SA business doesn’t have much room to grow by taking market share. Its kraftliner business already has 100% of the market, and the balance is exported.

It is also the only hard-wood pulp producer in SA, and while it could try to export any extra, timber resources are limited because of the scant rainfall in the country in recent years.

"We’ve invested sensibly in our businesses in SA, we’ve kept it competitive. But you’d have to look at [political] issues in terms of allocating future capital, and that would obviously be a drawback."

So why is Mondi keeping its SA assets?

"If you break our business down," says Hathorn, "we’ve got the primary upstream [forestry] business and the downstream converting business. The logic in the upstream business is structural cost advantage and low-cost production; in the downstream it’s about close proximity to the customer."

In the forestry business, Mondi’s advantage is that it has a cost advantage in places like SA, Russia, Slovakia, the Czech Republic and Poland.

"SA has low-cost timber that grows quickly, it’s fully integrated, we make the pulp, we turn the pulp principally into packaging paper. It still makes sense — it’s a competitive business," says Hathorn.

Sappi also has plans, including adding another 1Mt to its wood pulp capacity by 2025, which requires a capital investment of around $600m.

Binnie says SA remains "extremely profitable" for his company. But he says there are other dynamics at play: "With a lot of product going to the Far East … if you could be close to customers that may have cost benefits. Also, do you put all your eggs in one basket?"

Finally, Sappi is now in a position to expand: it has halved its net debt over the past four years, to $1.33bn, and the weaker rand has created the opportunity to grow.

Clearly both companies, after the jitters which have rocked the industry over the past two decades, seem well aware of who they are. Both seem solid long-term bets.

The man tasked with expanding Hathorn’s success is Peter Oswald — a paper lifer too, who seems equally enthused by the role. Since 2008, he has headed Mondi’s Europe & International division.

"Peter and I have worked together for 26 years so there’s a huge amount of experience and knowledge in the senior team," says Hathorn. "I’ve been CEO for 17 years which is too long in my view, it’s time for someone else to go and do it."

When asked what he’s proud of from his career, Hathorn is keen to stress candour.

"There are a lot of organisations that are not good at getting the real answers as to what’s happening [in their business].

"Too much upward reporting … we’re very honest when we get something wrong and why we got it wrong and we learn from it," he says.

Asked whether Mondi can quadruple its value again over the next decade, Hathorn skirts the issue.

"The bottom line is that the group is very well-positioned. We’ve still got some projects to exploit, the footprint in the downstream business is becoming better and better, we can add on and expand," he says.

If you look at the trendline over a 15-year period, Hathorn says Mondi is only just above the mid-point. "Those shareholders who believed in it and bought it made a hell of a lot of money, those who didn’t missed a great opportunity," he says.