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11 June 2019, Sweden | Mutual Funds | News

Forest - the new green gold

Forestry is one of Sweden's most traditional industries, and today's ever-growing demand for sustainability is gradually turning the sector into an experimental workshop for modern technology.

New products can mean higher margins, and the valuation of forest products companies is generally low - which offers security for the investor.

The most important regions globally in this sector are the Nordics, Latin America, with a number of pulp producers, and North America. Beyond these areas, Asian countries are becoming more and more relevant, especially in packaging and tissue.

The two largest Nordic companies in the sector are UPM-Kymmene and Stora Enso, which both have annual sales of around EUR 10 billion. These are followed by SCA, Holmen, Billerud Korsnäs and Finnish Metsä Board. The rest of Europe also has a number of packaging companies such as Smurfit Kappa, DS Smith and Mondi.

Catella Fonder has chosen to dedicate this month's podcast to the forest products sector, and has invited representatives from different angles: Mikael Jåfs, forest products analyst at Kepler Cheuvreux; Mikael Hannus, Vice President Group R&D at Stora Enso; and Martin Nilsson, who manages Catella's small cap Småbolagsfond.

The big traditional products manufactured in this sector are timber, pulp and packaging materials. Paper was previously a very large and important product, but demand has steadily declined over a number of years.

"We had peak paper in Europe around 2005-2007, and the average annual volume decline for all grades is around 3 percent. This will probably continue," says Mikael Jåfs, adding that the industry has done a good job of adapting to the changes – surplus machinery has been decommissioned and some paper mills have been converted to other manufacturing like packaging materials.

The ongoing technological transition has contributed to the development of Stora Enso, with more and more reading being done on electronic screens rather than paper. The increased focus on sustainability is also contributing to its achievements.

"The process of change is one of our drivers. Another is seeking our growth in our other segments. The knowledge integrated into what we can achieve with the raw material has increased, and is leading to new products. For example, woven textiles have grown well," says Mikael Hannus.

Around 400 people work in research and development at Stora Enso, and about 1.5 percent of the group's sales are invested in this area, which is broadly equivalent to SEK 1.5 billion every year. "A lot of money," says Hannus, adding that the company tries to focus its efforts on commercially relevant products.

According to Jåfs, Stora Enso is currently investing the most of the Nordic companies in terms of research and development, although there are many other companies trying to develop their products in a similar way.

A harvested tree gives rise to a number of different products and possible uses. First, you get rough sawn timber that is taken to a sawmill to be made into planks and boards. Some of the material may be glued and become components for windows or doors. According to Hannus, almost half of the harvested volume in Sweden goes to sawmills, where the square pieces are put to one side. The bark is mainly used to create energy for drying planks and boards. Sawdust is made into energy pellets, and chips go to the fibre industry to be made into cardboard or paper, hygiene products or textile pulp.

The remainder from harvesting is pulpwood, which is mechanically or chemically made into fibre for paper or cardboard. The major groups are either a thin, effective printing surface or a rigid and durable cardboard product. A number of social drivers are contributing to growing demand for cardboard: Firstly, the increase in online shopping requires more and more boxes for shipping; and secondly, the food industry wants to package more goods, which generally means less food waste.

The residual products are used to produce cellulose and lignin binders. The lignin is boiled out of the wood pulp in the pulp mill and much of it is used to drive chemical recycling, but some can be made into other products, including a component in glue. Lignin can also be used to develop phenol-based coatings, instead of the fossil-based phenolic coatings that exist today.

That must be a big area for the future?

"The phenol market is huge compared to the volumes of lignin produced today, so there is clearly an opportunity here. There are also other applications for lignin that will compete. And the lignin field contains a large amount of knowledge that needs to accompany the material," says Hannus.

He expects that, during the next decade, new combinations of substances will be discovered that can be used to modify the properties of, for example, the surface of cellulose fibres. This would give it other properties that can compete with fossil solutions. "Surface modification knowledge will open new opportunities," he says.

The margins in the old traditional production segments are around 6 to 8 percent. They are much higher in new product areas, although Hannus does not want to put any figure on it. However, he emphasises the importance of developing more new products on the one hand, and quickly upping their volume on the other.

"There might be lower margins initially, which is why we are focusing on getting volumes in the segments for new products very quickly. We measure the share of sales for new products, and have got it up to 9 percent, but do not intend to let it stay there," he says.

Hannus says that the search for new products takes place in a kind of collaboration with their customers, since they have a positive expectation of getting access to more and better sustainable solutions.

"Sometimes the amazing happens. That we can cross-fertilise between different divisions and segments and get exciting new applications that our customers could not even have wished for," says Hannus.

A huge number of plastic bags and bottles disappear every year, and extremely few are recycled. Around 2 percent, it is claimed. It must be a world-saver to find a degradable replacement.

"Yes, preferably a naturally degradable material that does not require special industrial composting. There are various biodegradable plastics, but some of them require industrial composting to break down," says Hannus.

Vehicles have become an application for the technology in several ways. Some vehicles now have fibre-based components, such as dashboards. Hannus says that cellulose fibre is useful as it can be produced in large quantities with reliable quality, but another area is biocomposites, where some of the plastic can be replaced with wood fibre to create the same function as before. This reduces the need for fossil raw materials by combining plastics with forest materials.

Tall oil is already mixed with diesel to some extent, but Hannus is not convinced that this raw material will be used for fuel to any great extent - there is simply too little tall oil for it to be possible, and the oil is already used in a number of other areas.

"The global availability of tall oil is limited so it cannot replace fossils. There are less than 3 million tons of tall oil worldwide per year from the pulp industry, with about 1 million tons in Europe. The chemical industry has long used the special molecules in tall oil for washing detergents, paints and adhesives. If you shift the tall oil to the fuel sector, there will be more fossils in the chemicals industry instead," says the R&D chief.

How about clothing? Viscose is a forest raw material that was developed as an alternative to cotton.

"We do not produce viscose ourselves, but our customers produce it from our dissolving pulp. There have been some dirty process steps in the past in this area that have been ended, and there has been a lot of process development for viscose and alternative solutions. The lyocell process is a competitor to some types of viscose products. The Tree to Textile initiative that includes H&M and Ikea now hopes to scale up the process," says Hannus.

Looking at the companies in the sector, after an upswing phase earlier this year they have fallen back in recent weeks and the share price levels are relatively low compared to last summer. However, Jåfs expects that the forest sector's inflow of new products going forward will affect the shares positively.

"Looking ahead, I think the new products will provide new revenue streams that investors will probably be willing to pay higher multiples for. But at the moment, it is concern about demand and the economy that is depressing these stocks," says Jåfs.

Many of the sector's shares currently have a p/e ratio between 7 and 8, he notes. This is low - but on the other hand, this is how things often are in periods when the stock market seems to see an approaching recession.

But you do get a decent yield.

"Yes, about 5 percent for several of them," says Jåfs.

Catella Fonder's portfolio manager Martin Nilsson is also upbeat about the sector. He points to the hunger for sustainable products, and also the fact that many of the companies are 'financially sustainable', as he puts it.

"We believe that the substitution we envisage for these products will lead to better earnings going forward for the companies," he says.

Nilsson describes the forest products companies as very attractively valued, well-managed, and with strong balance sheets, and, in the case of the companies that own forest, with hidden values.

"As far as sustainability investments are concerned, we have seen substantial multiple expansion in the companies that benefit from the ongoing trends, but in this particular sector we have not experienced the tendency yet," says Nilsson.

Among the companies that fit into the small cap universe is actually SCA, which qualifies with a market capitalisation of approximately SEK 55 billion. He is an enthusiastic shareholder.

"They own 11 percent of the Swedish forest, which is a fantastic asset, and also have an industrial arm that has made large investments that we are positive about," says Martin Nilsson.

We are also positively inclined towards investments in forest products companies for Catella's other funds, and we have holdings in companies including Stora Enso, Holmen and Billerud.

Catella Småbolagsfond

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Martin Nilsson

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