How to do Business Analysis of Paper Manufacturing Companies

The current article focuses on the analysis of the business of paper manufacturing companies. The article aims to highlight to an investor what she needs to analyse while assessing the strength in the business model of paper manufacturing companies.

After reading this article, an investor would know the key parameters that differentiate one paper manufacturer from another. Additionally, the investor would also get to know the key strengths and challenges of the paper manufacturing industry that any company has to face.

Whenever an investor comes across any paper manufacturing company, then the first thing that she should try to find out is what kind of raw material it uses to produce paper. This is because; the business dynamics, challenges, strengths etc. for paper-manufacturing companies depend a lot on the kind of raw material they use to produce paper.

Segments of paper manufacturing companies

Paper manufacturing companies mainly use three different kinds of raw materials to produce paper:

1. Wood (also classified as chemical pulp)
2. Recycled paper
3. Agricultural residue (Sugarcane bagasse, rice straw, wheat straw etc.)

The kind of plants required to produce paper, the investment requirements, the competitive strengths, barriers to entry, financial needs etc. all differ a lot between the paper manufacturers using wood as raw material and those who use recycled paper and agricultural residue as raw material.

The business challenges faced by the two primary segments of paper manufacturers i.e. wood and non-wood (recycled paper & agro-residue) are so different that both set of players have their separate industry organizations:

• Indian Paper Manufacturers Association (IPMA) represents wood-based paper manufacturers who are the largest of paper-manufacturers and
• Indian Agro & Recycled Paper Mills Association (IARPMA) represents non-wood paper manufacturers i.e. recycled paper and agro-residue-based paper manufacturers.

Therefore, throughout this article, while analysing the dynamics of the paper industry, we would see how paper manufacturers from each of these segments differ from each other.

Let us now attempt to understand the key business dynamics of paper manufacturers.

Factors affecting the business of paper manufacturers

1) Shortage of raw material

All the paper manufacturers in India whether wood-based or non-wood-based, face a shortage of raw materials to manufacture paper.

Wood-based paper manufacturers face a shortage of wood due to many reasons:

• Environmental concerns on the cutting of natural forests for getting wood,
• Limit on the land that a company can own to grow trees for getting wood,
• The hesitation of farmers to opt for farm-forestry to produce wood is because; it is a long-gestation period process taking 3-5 years to get earnings.

Rating Methodology for Paper Industry, ICRA, November 2015 (Click here), page 3:

The domestic paper industry irrespective of the nature of raw material being used suffers from significant fibre shortage. The wood based paper mills suffer from constraints via government policy to restrict land holdings and the ability to source wood from captive plantation.

…constraints of longer cash-flow cycle in farm forestry as it can take upto 3~5 years before farmer generates cash by undertaking farm-forestry.

Therefore, whenever the paper industry witnesses capacity addition by wood-based paper manufactures, then the shortage situation becomes acute and the prices of wood increase and the industry has to rely on expensive imported wood, for example during 2009-2014.

Rating Methodology for Paper Industry, ICRA, November 2015, page 3:

Simultaneous capacity expansions during the last few years (2009-2014) lead to severe competition among mills for wood procurement and consequently an increase in wood prices leading to requirements for importing wood without a corresponding increase in product realisation.

This shortage of raw materials to manufacture paper is not limited to wood. Other manufacturers using recycled paper as well as agro-residue also face raw material shortages.

In India, the collection of waste paper for recycling is low; therefore, the industry is not able to meet its requirement from domestic sources. As a result, paper manufacturers have to import waste paper.

Rating Methodology for Paper Industry, ICRA, November 2015, page 3:

Similarly, due to low collection rate of waste paper, ~50% of the waste paper requirements are imported by the industry.

Paper manufacturers using agro-residue face challenges because; the raw material is available in specific seasons and in addition, it can be used for purposes like burning sugarcane bagasse in power plants for generating electricity.

Rating Methodology for Paper Industry, ICRA, November 2015, page 3:

Also due to the alternate use of agri-residues as fuel and their seasonal availability, the ability to source them at competitive prices also remains a challenge for the mills. As a result, the prices of all the raw materials have consistently increased over time.

Therefore, an investor would notice that all the paper manufacturers whether wood-based or non-wood based, have faced continuously increasing raw material costs.

In light of a continued shortage of raw materials for producing paper, the mills that can use multiple types of raw materials are in a better position than others that rely only on one form of raw material to produce paper.

Rating Methodology for Paper Industry, CARE, November 2020 (click here), pages 3-4:

The companies who have the ability to use different raw materials and whose mills are located closer to raw material sources are viewed favourably.

However, whenever a company shifts from wood-based paper production to non-wood-based paper production, then usually, the quality of products suffers.

Rating Methodology for Paper Industry, CRISIL, February 2021 (click here), page 20:

However, a high usage of non-forest-based fibre resources limits production capabilities to the lower end commodity grades of paper.

As a result, an investor would have to understand the trade-off faced by the paper producers when they choose between using wood-based pulp and non-wood-based pulp e.g. from recycled/waste paper and agricultural residues.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

2) No pricing power and intense competition due to low value-adding, undifferentiated commodity products:

The products made by paper manufacturers are without any significant differentiation i.e. a customer can easily switch from the products of one company to another without any impact on her business.

For example, a person can easily switch a notebook made from the paper of one manufacturer with a notebook made from the paper of a different manufacturer and she will not face any challenges in writing. Similarly, a person can easily switch using tissue papers made by different manufacturers without any problems. The same is true for almost all the paper products like copier paper, newsprint, paperboard packaging boxes etc.

Therefore, an investor would appreciate that when manufacturers in any industry made products, which are undifferentiated and easily switchable, then the manufacturers lose their negotiating power with the customers.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan (click here), a subsidiary of Nikkei Inc., page 5:

Because many pulp and paper products are by nature highly general, however, achieving differentiation based on product quality is difficult. Consequently customer continuity and stability are somewhat low on the whole.

As a result, the paper manufacturers have very low pricing power over their customers and most of the time, the players compete with each other based on lower prices to get business.

For example, while reading the order of the Competition Commission of India (CCI) against the non-wood based paper-manufacturers dated November 17, 2021 (click here), an investor notices that for one of the orders, Century Pulp and Paper, a division of Century Textiles and Industries Ltd quoted a very low price below the market price. The company quoted a price of ₹39.80 per kg for a product, which is being sold in the market for a price of ₹44-46 per kg.

CCI Order, Nov. 17, 2021, pages 36-37:

Presently the said products are sold in market in the range of Rs. 44.00/- per Kg to Rs. 46.00 per Kg. All condemned unilaterally about the unethical pricing policy of Century paper & pulp who quotes abnormally low rate. Citing the recent example for 1800 MT order from Star Educational books, Delhi the said firm has quoted Rs. 39.80/- per kg which is inclusive of all tax, transportation component, F.O.R. Delhi. Such moves give negative feedback in the market, and traders demand such deals from Agro based mill that are already in loss.

The credit rating agency, Standard and Poor’s in its guidelines for rating paper manufacturers (click here), also highlighted the price-based competition in the paper industry:

S&P rating guidelines for the paper industry, page 4:

Highly competitive industry, with competition based primarily on price

Therefore, an investor would appreciate that in the paper industry, the players compete on pricing because most of the products are a commodity in nature, which are undifferentiated from each other.

Moreover, in the case of selling paper products, the manufacturers rely on the channel of dealers in addition to selling some quantity directly to corporate customers and govt. departments via tenders.

Rating Methodology for Paper Industry, ICRA, November 2015, page 2:

Paper is largely consumed by many small printers who work on behalf of various publishers/FMCG companies; hence most of the sales of the paper mills are typically through dealers/indentors who source orders from these printers and act as an interface between the mill and the customers.

The dealer channels deal with the final customers and in turn, have a high negotiating power over the manufacturers. When an investor analyses the developments in the paper industry around the world, then she notices that in foreign locations, the dealers have come together to collaborate with each other and in turn further increase their negotiating power over the manufacturers. As a result, in foreign countries like Japan, many paper manufacturers have started to create their own agencies/supply networks.

Rating methodology for the paper industry by Japan Credit Rating Agency, May 2020 (click here), page 2:

Companies in the paper distribution market have also merged, in response to the intensified competition, into three large agencies selling the products of multiple large paper manufacturers and having strength in broad product lines. In addition, some large paper manufacturers have been strengthening their direct agencies

Therefore, an investor would appreciate that the products of the paper-manufacturing companies are primarily undifferentiated-commodity products where the customers/dealers have a high negotiating power over them.

Only a few products of paper manufacturers are directly purchased by end consumers, which offer an opportunity for building a brand and gaining some pricing power like the copier paper.

Rating Methodology for Paper Industry, ICRA, November 2015, page 2:

Within all the paper product segments, copier paper is the main product, where it is directly consumed by the end customer and hence product branding in this segment provides some pricing power.

The credit rating agency, S&P in its guidelines for rating paper manufacturers also highlighted that paper products are commodities and creating a brand with a pricing power is very difficult. Therefore, primarily, the players compete on pricing.

S&P rating guidelines for the paper industry, page 4:

Paper and packaging products are essentially commodities and producers are subject to intense price competition with barriers to entry from meaningful product differentiation and brand identity generally difficult to achieve.

S&P highlighted that only for a few products like tissue paper, a manufacturer may create a brand and have some competitive power.

S&P rating guidelines for the paper industry, page 6:

…in some cases–such as the tissue papers segment–issuers may be able to build up significant barriers to entry (depending on products and markets) through branding.

Therefore, from the above discussion, an investor would appreciate that in the case of paper manufacturers, most of the products are undifferentiated-commodity products where a customer can easily switch between the products of different companies. Moreover, the sale channel is focused primarily on large dealers.

As a result, the paper manufacturers are not able to gain pricing power for most of their products like writing & printing paper, paperboard, kraft paper and packaging products. The paper manufacturers are able to create a brand and in turn, gain pricing power only in the case of a few products that are directly purchased by the retail customers.

Rating Methodology for Paper Industry, CARE, November 2020, page 2:

Paper and paper products have very limited scope for product differentiation which limits the pricing strategy. This in turn results in intense price competition with low barriers to entry.

While assessing the factors leading to the competitive strength of the existing players or barriers to entry to newer players, an investor notices that the factors are capital intensiveness, closeness to sources of raw material and customers and economies of scale etc.

S&P rating guidelines for the paper industry, page 4:

However, new entrants may be discouraged by the substantial capital investments needed to build new mills and from access to raw materials (such as wood or recycled fiber). In addition, economies of scale are important because larger mills are often more efficient than smaller ones.

An investor would note that in the barriers to entry for new players, she does not see the mention of factors like technological intensity, customer stickiness etc., which are present in industries where the quality of the product is paramount and switching costs for the customers may be high.

As a result, the paper producers have low pricing power over their customers and find it difficult to pass on the increase in their input costs to their customers.

S&P rating guidelines for the paper industry, page 4:

High volatility among key input costs such as energy, pulp, and transportation costs, with limited possibilities to pass these on to customers in terms of higher prices.

During 2009-2014, when India witnessed a significant increase in the capacities of wood-based paper manufacturers, the wood prices increased sharply; however, the mills could not pass on the same to the customers.

Rating Methodology for Paper Industry, ICRA, November 2015, page 3:

Simultaneous capacity expansions during the last few years (2009-2014) lead to severe competition among mills for wood procurement and consequently an increase in wood prices leading to requirements for importing wood without a corresponding increase in product realisation.

The inability of paper producers to pass on an increase in input costs is a global phenomenon. In Japan, the credit rating agency, Rating and Investment Information, Inc. highlighted that the profitability of the paper manufacturers is poor and they face the risk of losses if input costs increase.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan, page 10:

The profitability of print media, packaging materials and materials for daily living is generally low, partly because of their relatively low added value and intense completion. Manufacturers face a risk of failing to achieve profitability and making losses when product markets deteriorate or raw material and fuel prices rise.

Therefore, an investor would appreciate that paper manufacturers make low-value-added, undifferentiated, commodity products. As a result, they have very low pricing power and, in turn, face a lot of challenges in passing on any increase in their input costs.

In light of undifferentiated commodity products, the paper mills, which are able to produce products from different segments like writing paper, newsprint, paperboard, packaging, Kraft paper, tissue paper etc., are better placed as they can handle the slowdown in any one product category without a lot of difficulties.

Rating Methodology for Paper Industry, CRISIL, February 2021, page 19:

The ability to alter the product mix (to shift between NP and WPP (writing and printing paper), for instance, or within the various commodity grades in WPP) according to market trends will be a crucial factor, especially in a highly cyclical industry.

The ability to produce different types of paper products is also essential because different segments of paper are currently facing different types of demand dynamics.

An investor would appreciate that a shift of information distribution to electronic medium has impacted the printing paper demand for newspapers, magazines and other information brochures.

S&P rating guidelines for the paper industry, page 4:

Publishing paper products face high substitution risks and long-term demand declines because of shift away from printed to electronic sources.

On the contrary, paperboard products used in packaging are witnessing an uptrend in consumption because of demand from e-commerce players who use it extensively in the shipping of products.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan, page 3:

Packaging materials, which are used for the transportation and storage of various products including foods, beverages and daily necessities, enjoy steady demand even during economic slowdowns.

An investor would appreciate that the paper manufacturing companies have a low pricing power due to intense competition, fragmented industry and commodity products. However, the situation is complicated further by the threat of competition from imports faced by the market with a growing paper consumption like India when many paper manufacturing companies around the world are facing a decline in paper consumption in their home countries.

Further advised reading: How to do Business Analysis of a Company

2.1) Threat of competition from imports:

While analysing the different product segments of the paper industry, an investor notices that in the case of value-added products, domestic mills face competition from imports from overseas paper producers. As a result, in the current scenario of declining import duties, it becomes essential for domestic paper mills to be very cost-efficient.

Rating guidelines for the paper industry by ICRA, November 2015, page 9:

product segments because of their high-value added nature are also the most vulnerable to import threats especially during periods of declining international prices. Hence the ability to maintain competitive prices vis a vis imports, while maintaining a competitive cost structure to compete with imported products amid declining import duties remain the key driver of the profitability for the companies in these product segments.

An investor notices that in the past, Indian paper manufacturers benefited from high import duties and were protected from the threat of imports.

Rating guidelines for the paper industry by CRISIL, 2007, page 1:

The domestic manufacturers have been able to operate profitably in the past despite these inherent constraints; this is owing to factors such as the high degree of tariff protection that has helped keep the threat from imports negligible.

However, now the import duties have declined and the threat from imports has increased.

The threat of imports from overseas producers becomes more apparent when an investor analyses the situation of paper industries of other countries.

In developed countries like Japan, the paper industry is facing a troubled time where the domestic demand is constantly declining. As a result, looking at business opportunities in the international market for Japanese paper producers has been an essential survival strategy.

Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, page 1:

Business environment is severe in the domestic market where demand for paper mainly printing and information paper has been declining. In these circumstances, major paper manufacturers have been seeking opportunities in overseas markets with high growth potential and focusing on businesses other than pulp and paper for growth.

From the above paragraph, an investor would also note that the business environment is so stressed in the Japanese market that the paper producers are also looking at businesses other than paper manufacturing.

The stress in the Japanese paper market is leading paper producers to cut down capacities in order to lower their fixed costs.

Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, pages 2 and 3:

A reduction in production capacity and reviewing sales strategies are in progress centering on large paper manufacturers

It is necessary to keep capacity utilization at above a certain level through reduction of production capacity and expansion of exports in order to maintain and improve the competitive strength of factories over a medium term in the face of declining demand mainly for printing paper.

Rating guidelines for the paper industry by Japan Credit Rating Agency, June 2018 (click here), page 2:

In this situation, a reduction in production capacity, including the shutdown of paper machines, is progressing. It is assumed that it will take time to eliminate the oversupply and that fierce competition will continue for the time being

The fear of overcapacity in the Japanese paper market is so severe that when the paper mills go for modernization of the plants to be cost-competitive, then such decisions are seen cautiously because they increase the plant capacity, which further complicates the oversupply problem.

Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, page 3:

The installation of new machines is an optional measure to resolve the obsolescence of facilities, but this often leads to increased production capacity. When installing new machines, therefore, attention must be paid to the effect on domestic demand and market conditions.

In Japan, it is estimated that a reduction in the domestic paper demand is inevitable and the development of overseas markets is essential for paper manufacturers to sustain.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan, pages 3 and 11:

In the medium to long term, however, demand contraction will be unavoidable in the domestic market, making the development of overseas markets an imperative issue for sustainable growth

For medium- to long-term growth, a manufacturer needs to have advanced manufacturing facilities, expand into overseas markets

Even if an investor looks at other developing economies, she notices that the paper industry of countries like Indonesia is also finding international markets more attractive than their domestic market.

Rating guidelines for the paper industry by Pefindo, Indonesia, page 1:

In general, the export market offers higher consumption and product diversity than the domestic market

In light of the above-discussed scenarios, when an investor looks at the Indian paper products market, then she notices that in India, the consumption of paper products is increasing. This is because of the current low per capita consumption of paper in India as compared to global averages.

Rating guidelines for the paper industry by ICRA, November 2015, page 2:

Given the low per capita paper consumption in India in relation to global averages as well as compared to various other peers, India has witnessed steady growth in paper consumption, which is in contrast to many developing countries, which have seen demand contractions.

Rating guidelines for the paper industry by CARE, November 2020, page 1:

With the per capita paper consumption in India being low at around 13 kg when compared with the global average of 57 kg, the growth is expected to be higher in the domestic market when compared with the world growth rate.

Therefore, an investor would appreciate that a growing market like India will always attract competition from overseas paper producers who are facing declining paper demand in their home countries.

An investor would now understand that the paper industry faces intense competition from numerous players in the fragmented domestic industry as well as from paper producers overseas. In such a severely competitive environment, it becomes difficult for any company to earn a respectable return on its capital because the pricing-based competition would always drive the prices of paper products lower.

However, an analysis of the history of developments related to competition in the paper industry in India as well as overseas shows that on numerous occasions, the paper manufacturing companies have resorted to cartelization and price-fixing so that the competing paper mills coordinate their pricing strategy and increase prices as a group.

2.2) Price-fixing cartelization by paper manufacturers:

From the above discussion, an investor would appreciate that the paper industry is highly fragmented and intensely competitive, which produces undifferentiated commodity products. As a result, none of the companies has any sustained competitive advantage to command a higher price or higher margins.

An investor would appreciate that in such an industry, the lowest-cost producer survives.

The credit rating agency, S&P, has highlighted in its rating guidelines that the paper industry produces commodity products wherein the long-term, product prices are determined by the cost of the most efficient producer.

S&P rating guidelines for the paper industry, page 8:

…most forest and paper products are commodities and the price of a commodity is determined in the long run by cost levels of the most efficient producers.

Therefore, the companies with the lowest cost of production set the market prices and others have to follow; otherwise, the rest of the companies would lose business to the lowest-cost producer and in turn, they will have to go out of business.

To survive the continuous pricing pressure, the paper companies have attempted to form a cartel where the competing firms sit together and mutually decide the prices of their products.

The Competition Commission of India (CCI) recently concluded its investigation and hearing for the price-fixing by non-wood-based paper manufacturers. CCI found that many paper manufacturers mutually decided on the prices and put pressure on their peers to increase their prices. As a result, the CCI put a penalty on some of the non-wood-based paper manufacturers and their industry association, the Indian Agro & Recycled Paper Mills Association (IARPMA), for their anti-competitive business practices.

CCI order, November 17, 2021, page 61:

Commission concludes that OPs had indulged in cartelisation in fixing prices of writing and printing paper as detailed in this order, by participating in the meetings convened under the umbrella of the platform provided by their trade association and discussing prices and the roadmap for coordinated increase, besides monitoring the decisions taken in such meetings.

CCI also found that due to cartelization, some of the players like Ruchira Papers Ltd increased their product prices even when their cost of production had declined.

CCI order, November 17, 2021, page 55:

The parallel behaviour of OP-12 by making an overall increase of Rs. 6000/- PMT between September 2012 to March 2013, coupled with an increase in prices despite fall in cost of production is strongly indicative of OP-12 being part of concerted conduct resorted to by non-wood based paper manufacturers, who increased prices after discussions in a coordinated manner.

In the CCI order, as per details on page 1, opposite party 12 (OP-12) refers to Ruchira Paper Ltd.

An investor may read our detailed analysis of Ruchira Papers Ltd along with the issue of warrants allotment by the company to its promoters where the promoters seem to have benefited at the cost of minority shareholders, in the following article: Analysis: Ruchira Papers Ltd

As per the CCI order, one of the paper manufacturers, Trident Ltd (opposite party 21) accepted its role in cartelization and price-fixing.

CCI order, November 17, 2021, page 58:

Yes, it is true that competing paper mills used to meet, discuss and arrive at a consensus on prices of paper to be increased and the quantum of discount to be offered.

Yes, on a few occasions we did implement the price increase decided in such meetings unaware of the consequences of this Act.

An investor should note that the above-discussed order by the CCI is related to non-wood-based paper manufacturers. Currently, an investigation by the CCI for price-fixing by the bigger wood-based paper manufacturers and their industry association, Indian Paper Manufacture Association (IPMA), is underway (Source: CCI orders probe into alleged cartelisation by big paper makers: Economic Times, August 29, 2014)

The companies under probe include ITC Bhadrachalam Paper Board, Andhra Paper Mills of International Paper, Singhania Group-promoted JK Paper Mills, West Coast Paper Mills and Thapar Group’s Ballarpur Industries among several others. CCI has also directed its investigation officer to include industry body Indian Paper Manufactures Association (IPMA) in the investigation.

The information disclosed by CCI in its order dated November 17, 2021, also indicates the price-fixing by the large paper manufacturers and pressurising smaller players to follow the same.

CCI order, November 17, 2021, pages 25, 27, 38 and

A number of other OPs have stated that it were the big paper manufacturing companies that actively participated in discussions and decided on implementing the prices.

The market leaders and big paper manufacturers facing cartel investigation in the existing cases are imposing/enforcing the cartel and ensuring its compliance by OPs. That bigger players of market created such compelling circumstances so that small players were left with no other option but to abide by their dictates to act as a cartel.

In the meeting it was decided Rs. 1/- per Kg increase should be done by all member mills effective from 1^st of December. It was also decided that to closely watch recently proposed IPMA meeting outcome about their price strategy.

Therefore, investors should closely watch the outcome of the currently undergoing investigation by CCI into the allegations of price-fixing and cartelization by the large wood-based paper manufacturers.

While analysing the history of paper manufacturers around the world, an investor notices that in other countries also including developed countries like Japan, paper manufacturers have engaged in price-fixing.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan, page 4:

Japan Fair Trade Commission conducted on-site inspections of some manufacturers in 2012 on suspicion of price cartel activity

In 2008, the Japan Fair Trade Commission ordered many paper manufacturing companies to stay away from price-fixing.

Cease and Desist Order against Eight Paper Manufacturing Companies: Japan Fair Trade Commission, April 25, 2008

When an investor comes across instances of cartelization and price-fixing by the players of any industry, then she should note that the prices charged by them may not represent the true market prices. As a result, the profit margins, return on investment etc. may be inflated and may not sustain going ahead when the cartel breaks.

Therefore, an investor should keep a close watch on the outcome of the CCI investigation on the large paper manufacturers in India and should accept the data of their profit margins and return ratios with a bit of caution.

Further advised reading: How Companies Inflate their Profits

3) Cyclicity in the paper manufacturing industry; the boom and bust cycle:

The paper industry is cyclical in nature where the performance of the players goes through alternating phases of improving performance followed by declining performance.

The cyclical nature of industry performance is linked to two factors.

The first factor is the dependence of paper consumption on the general economic growth of the country where during the phases of high economic growth, the paper consumption increases and during the phases of economic slowdown, the paper consumption declines.

The second factor, which is more important for the paper industry is its boom and bust cycle where during periods of high demand, many players announce capacity expansions. The new capacities become operational simultaneously after a few years leading to an oversupply situation in the industry. As a result, prices of paper products declined and many mills become economically unviable and shut down their operations. As a result, the oversupply situation changes to less supply, which leads to an improvement in product prices. After that, the paper players once again announce new capacity additions. This cycle of boom and bust keeps on repeating in the paper industry.

Rating Methodology for Paper Industry, CARE, November 2020, page 2:

The paper industry is highly cyclical and depends on general economic conditions as well as the industry demand and supply. There is a bunching up of new capacity additions which in turn results in higher supply when compared to the demand growth.

Rating Methodology for Paper Industry, CRISIL, February 2018 (click here), page 3:

The industry is also highly cyclical, mainly on account of the bunching up of capacity additions, resulting in temporary demand-supply imbalances, rather than fluctuations in absolute demand

The credit rating agency, S&P also highlighted the nature of boom and bust phases seen in the paper industry in its rating guidelines for the sector. S&P highlighted that in the paper industry, the phases of supply shortages lead to a lot of capacity addition, which results in oversupply and a decline in prices for paper products.

Rating Methodology for Paper Industry, S&P, page 4:

The industry has a history of boom-and-bust behavior, where supply shortages traditionally trigger capacity expansion and subsequently overcapacity and pricing pressure.

When an investor analyses the dynamics of the Indian paper industry over the last 15 years, then the phases of boom and bust clearly come out in the way the industry progressed over the years.

Let us see an example of the cyclicity of the paper industry by analysing the business environment faced by a paper manufacturing company over the years.

3.1) Cyclical business environment faced by Century Textiles and Industries Ltd:

During our analysis of Century Textiles & Industries Ltd, when we read its annual reports since FY2007, then we noticed that the pulp and paper business is a purely cyclical business where the industry undergoes periods of demand and supply mismatch.

At times, the demand for paper exceeds its supply in the market. As a result, the prices of paper products increase and the paper manufacturers increase their supply significantly. When the new manufacturing capacities start functioning, then the industry faces a situation of oversupply. This leads to price wars when manufacturers undercut prices to stay in the business. During this phase of decline of paper prices, many small & unorganized players find it difficult to survive and in turn, go out of business. The resulting shutdown of plants by these small & unorganized players reduces the supply in the market and the prices of paper products increase.

This seems to be a recurring phenomenon in the paper industry. While reading the developments of the paper industry over the years in the annual reports of Century Textiles & Industries Ltd, an investor can easily understand this cycle of the paper industry.

In FY2007-08, the paper industry in India was facing a shortage of supply. As a result, the country was importing a lot of paper and in addition, many Indian players were expanding their capacities.

FY2008 annual report, page 30:

The Indian paper industry is highly fragmented with numerous small players. The industry is witnessing a healthy demand and its financial performance has also improved. Most players are augmenting capacities, which are expected to come on stream over the next two to three years………With steady demand for paper in India and a surging requirement for higher quality paper, foreign players are exporting to India in a major way.

During this phase when the demand for paper exceeded the production, Century Textiles & Industries Ltd also announced capacity expansions. In FY2007, the company completed one expansion project and simultaneously, it announced another expansion project to produce tissue paper.

FY2007 annual report, page 16:

The expansion of our paper unit for manufacturing paper from waste paper has been commissioned from 03.02.2007 with a capacity of 211 tonnes per day and the plant is now running smoothly.

It has been decided to set up a 100 tonnes per day Prime Grade Tissue Paper Plant at a total capital outlay of Rs.175 crore based on imported softwood and our own hardwood pulp as raw material…..is expected to be operative by about September, 2008.

Further advised reading: How to study Annual Report of a Company

The very next year in FY2008, Century Textiles & Industries Ltd announced its plans to establish a multi-packaging board plant along with a fibreline plant.

FY2008 annual report, page 09:

We are setting-up a Multilayer Packaging Board Plant, with a capacity of 500 tonnes per day. This development, requiring a total capital outlay of about Rs. 775 crore, is expected to be operational by December 2009. Additionally, we are planning to set up a Paper Grade Pulp Plant (Fibreline) to produce superior quality wood pulp. The plant demands a capital outlay of Rs. 495 crore and is anticipated to commence operations by December 2009.

An investor would expect that during good times, individuals, as well as companies, become very enthusiastic. As a result, the manufacturers see only the positives. An investor gets a similar feeling when in the FY2009 annual report, Century Textiles & Industries Ltd mentioned to its shareholders that the demand for paper would only go up from there.

FY2009 annual report, page 24:

Due to favourable Government policies such as the thrust on education, a growing economy and young population, increasing urbanization, a clear preference for print media and widespread interest in books and publishing, consumption of paper can only increase…

However, an investor would appreciate that paper is a cyclical industry where the demand rises and falls over time. In the very next year, FY2010, the upcycle phase of the paper industry was ending and Century Textiles & Industries Ltd saw a reduction in the demand for paper.

FY2010 annual report, page 20:

The Paper Business was under severe pressure due to a substantial increase in the prices of raw materials and reduced demand.

The intense competition in the industry did not allow the company to pass on the increase in raw material costs to its customers. As a result, the company had to take a hit on its profit margins in the paper division.

FY2010 annual report, page 23:

The prices of bagasse and wood which constitute major raw materials for pulp and other input costs have considerably increased without a sizable appreciation in selling prices. This has adversely affected the performance of this Division for a major part of the year.

By FY2012, almost all of the previously announced capacity expansion plants by the paper industry, including the expansion plants of Century Textiles & Industries Ltd were operational. As a result, the industry started facing a situation of oversupply. Century Textiles & Industries Ltd also acknowledged that the paper industry is cyclical in nature.

FY2012 annual report, page 25:

The output from several new manufacturing facilities has further increased finished product supply, flooding the market and it will take some time for demand to catch up with these additional quantities.

Being in the commodity sector, the paper industry is cyclical in nature and is strongly co-related with global economic factors.

The very next year in FY2013, Century Textiles & Industries Ltd reported a net loss.

FY2013 annual report, page 23:

However, due to higher depreciation in the current year on account of commissioning of Multilayer Packaging Board and Fiberline Plant (Pulp plant) in the Pulp & Paper Division, the Company has incurred a net loss.

By 2014, the paper industry had so much oversupply that the situation of dependence on imports to meet the demand in FY2008 had now given way to exports of paper from India. Due to oversupply, the company was not able to pass on the increase in inputs costs to the customers and as a result, had to take a hit on its profit margins.

FY2014 annual report, pages 24-25:

Further, apart from rising production and consumption, erstwhile import dependent India has achieved self-sufficiency and also has witnessed an increase in exports.

While raw material costs have been increasing, the selling prices could not be increased to offset entirely the rising costs which resulted in an adverse financial performance.

By FY2015, the oversupply situation in the paper industry had worsened to such an extent that the small, B-grade, unorganized players started to go out of business and a price war was prevalent in the market.

FY2015 annual report, page 21:

With new installed capacities coming online in the second half of the year, the demand supply equilibrium in the Indian market shifted towards excess supply. This led to players dropping prices to remain competitive…..

The biggest threat for the Indian paper industry is from imports of paper products from China and duty free paper products from the ASEAN region. Products from these regions have priced out many domestic manufacturers and this has resulted in a price war in the Indian market across all grades.

This impacted the profitability of the Indian paper industry, as well as economic viability of ‘B’ grade paper mills.

Soon enough, the newly started division by Century Pulp & Paper, the multilayer packaging board business also experienced oversupply.

FY2016 annual report, page 20:

…..two newly installed capacities becoming operational by other players in the Multilayer Packaging Board business. With new capacities, the demand supply equilibrium in the domestic market shifted towards excess supply.

By FY2017, the oversupply situation in the Indian paper industry has taken its toll on paper manufacturers. A few of them had to shut down their business. Now, it was time for the demand to exceed supply and the future of the industry started to look bright.

FY2017 annual report, page 19:

Based on the recent shut down of some domestic capacities and expected growth in the country’s GDP, it is likely that the domestic paper industry will grow at a reasonable pace along with the economy, from a medium to long-term perspective.

By FY2019, the paper & pulp division of the company had started to contribute healthily to the company’s performance and became one of the key reasons for the improving operating profit margins of Century Textiles & Industries Ltd.

FY2019 annual report, page 18:

Pulp & Paper and Real Estates Divisions have primarily contributed to this growth.

The demand in the paper industry exceeds supply and in FY2020, India met about 20% of its paper demand from imports.

Investor presentation, June 2020, page 34:

Total Demand- 19.8 Million MT in FY 20-21

Total Supply:

• Domestic: ~15.8 Million
• Imports: ~4 Million

In FY2020, the paper division of the company operated with 100% capacity utilization. Press release for Q4-FY2020 results:

Pulp and Paper Business operated at 100% capacity for FY20.

In light of the same, it does not come as a surprise to the investor that the paper manufacturers have again started increasing their manufacturing capacities. Century Textiles & Industries Ltd announced its plans to expand its manufacturing capacity in FY2019.

FY2019 annual report, page 10:

The Company has undertaken a project to expand the Prime Grade Tissue Paper Plant capacity from 100 tonnes per day to 200 tonnes per day with an Anchor GSM of 19 grams at a total capital outlay of ₹100 crores at the existing Pulp and Paper Plant at Lalkua, District Nainital, Uttarakhand.

The credit rating agency, CRISIL, in January 2020, acknowledged that the paper division of Century Textiles & Industries Ltd has displayed significant improvement in performance over the last 3 years.

Paper segment’s revenue and profitability have consistently improved, backed by increased capacity utilisation and realisation over the last three fiscals. This is expected to continue over the medium term, with completion of capex in high margin tissue segment and de-bottlenecking, despite some headwinds in realisations.

From the above report, an investor would notice that CRISIL expected that the good performance of the paper division will continue over the medium term.

The management of the company is also giving a positive outlook on the performance of the paper division.

FY2019 annual report, page 20:

With increased demand for value added products and an improved order booking position, in future, we are hopeful of having further improvement in the business.

From the above discussion about the development in the paper industry, an investor would appreciate that the paper industry is cyclical in nature where demand and supply undergo phases. In FY2007-2008, in the Indian paper industry, demand exceeded supply and many manufacturers announced expansion plans. In good times, Century Textiles & Industries Ltd said to the shareholders that the paper demand would only increase. However, soon thereafter, the industry turned into an oversupply situation where price wars broke out. Paper manufacturers started reporting losses and many players went out of business and shut down capacities. As a result, the oversupply corrected itself.

An investor may read our detailed analysis of Century Textiles & Industries Ltd in the following article: Analysis: Century Textiles & Industries Ltd

As per S&P, during a cycle of the paper industry, on average, the sales of any company may decline by 6% and its profits may decline by about 20%; even though in the USA, during a cycle, the highest decline in revenue had been 16% and the highest decline in profit margins had been 42%.

Rating Methodology for Paper Industry, S&P, page 3:

Based on our analysis of global Compustat data, forest and paper products companies experienced an average peak-to-trough (PTT) decline in revenues of about 6% during recessionary periods since 1968…with the steepest decline (16% drop in revenues) occurring during the downturn in 1979-1982. In addition, forest and paper products companies experienced an average PTT decline in EBITDA margin of about 20% during recessionary periods since 1952…The largest PTT drop in profitability totaled 42% and also occurred in the 1979-1982 recession.

Based on the insights about the cyclical nature of the paper industry, an investor should be cautious before she starts projecting the good performance of any paper company into the future. She should be aware that the paper industry is cyclical where the down-phase follows the upcycle phase and vice versa.

4) Highly capital-intensive wood-based paper mills:

In the case of wood-based paper manufacturing, the players need to have an access to a large and assured supply of raw material i.e. wood or chemical pulp. As a result, most of the wood-based paper manufacturers go for integrated plants, which have a pulp manufacturing unit in addition to the main paper-making plant.

Moreover, the product of chemical pulp from wood produces an effluent called black liquor, which can be used as a fuel to produce power. Therefore, in order to make the operation more efficient and cost-effective, a wood-based paper manufacturer is also forced to install a captive power plant.

Rating Methodology for Paper Industry, CARE, November 2020, page 3:

Backward integration, including pulping and power generation capacities, is more critical in case of a wood-based mill to ensure a steady supply of raw materials at a relatively lower cost.

Creating an integrated paper manufacturing plant with an associated pulp-making unit and a captive power plant becomes a necessity for a wood-based paper manufacturer because, in the paper industry where all the players compete on pricing, it is essential to be as cost-efficient as possible.

Rating Methodology for Paper Industry, ICRA, November 2015, page 2:

Due to captive pulp capacities, the chemical-pulp based paper mills have the highest level of backward integration, as they also need captive power generation capacities to consume the black-liquor generated as a part of the pulping process.

Rating Methodology for Paper Industry, CARE, November 2020, page 4:

On account of cyclicality, lack of product differentiation associated with the paper industry as well as presence of import threats, the cost competitiveness is very critical to maintain the profits.

The credit rating agency, S&P, has highlighted in its rating guidelines that the paper industry produces commodity products where during the long-term, the product prices are determined by the cost of the most efficient producer.

S&P rating guidelines for the paper industry, page 8:

…most forest and paper products are commodities and the price of a commodity is determined in the long run by cost levels of the most efficient producers.

The credit rating agency of Indonesia, Pefindo, also highlighted the importance of managing operating costs in its rating guidelines for paper manufacturers (click here).

Rating guidelines for the paper industry by Pefindo, Indonesia, page 8:

Efficiency in managing operational costs is necessary to mitigate the fluctuation of profitability margins, as forest, pulp, and paper products are commodities

Therefore, to survive, a paper producer has to be as cost-competitive as possible. And for a wood-based paper manufacturer, it means that it has to necessarily invest in a pulp-making unit and a captive power plant as well.

An investor would note that the need to have a large integrated paper manufacturing plant with a pulp-making unit and captive power plant makes creating a wood-based paper-making plant a very capital-intensive project.

A large amount of capital needed to create a wood-based integrated paper manufacturing plant as well as access to limited raw material sources of wood create a barrier to entry for new players in wood-based paper manufacturing.

In India, as per the credit rating agency, ICRA, there has not been any new entrant in wood-based paper-making for many decades.

Rating Methodology for Paper Industry, ICRA, November 2015, page 8:

Greenfield wood/chemical-pulp based paper mills; due to its high capital cost, constraints in securing a suitable location having abundant forest reserves, water availability and environmental clearances, pose as significant entry barriers for new entrants.

Accordingly, ICRA has noticed no new entrant in this segment, and all the existing players in this segment have been present for over decades. Accordingly, there is a relatively higher level of consolidation within this segment of the industry with ~10 players accounting for almost the entire production capacities based on chemical pulp.

A highly consolidated industry position in wood-based paper manufacturers is not only limited to India. In the case of developed markets like Japan as well, the paper industry has not seen new entrants.

Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information, Inc., Japan, page 2:

Japan’s domestic pulp and paper market is mature and has no new entrants.

Therefore, an investor would appreciate that in the case of wood-based paper manufacturers, installing an integrated paper-making plant along with a pulp-making unit and a captive power plant is essential to reduce production costs. This makes the creation of a new plant highly capital-intensive and creates barriers to entry.

However, in the case of non-wood paper manufacturers using waste/recycled paper or agro-residue as raw material, there is no need for an integrated pulp and power plant. This makes installing a non-wood paper-making plant a cheaper option with low entry barriers.

Rating Methodology for Paper Industry, ICRA, November 2015, page 8:

Unlike chemical-pulp based mills, wastepaper-based mills have lower entry barriers and hence have a higher degree of fragmentation. Low entry barriers arise on account of low capital costs as the need for captive pulp manufacturing capacities as well as need to necessarily have captive power plant are negated.

Similar to wastepaper-based mills, the entry barriers in agro-residue (such as wheat straw, sugarcane bagasse, rice straw etc) based paper mills are lower than chemical pulp-based paper mills.

Rating guidelines for the paper industry by ICRA, November 2015, page 2:

This is in contrast to waste-paper/agro-residue based paper mills, which don’t require captive pulping capacities and the need to have a captive power plant is optional as the plant can be operated on grid power.

As a result, an investor would appreciate that the non-wood-based paper-making segment is highly fragmented with numerous players with small paper mills competing with each other.

As per the credit rating agency, ICRA, the average size of a wood-based paper manufacturing plant is more than 300,000 MTPA whereas the average size of non-wood-based paper-making plants is much lower at about 13,000 MTPA.

Rating Methodology for Paper Industry, ICRA, November 2015, page 8:

Wood/chemical-pulp based mills: As per ICRA’s estimates, the average size of the paper mill in this segment will be upwards of ~3.0 lakh tonne per annum, which is significantly higher than the overall average for the paper industry.

Waste Paper based mills: Accordingly, as per ICRA’s estimates, this segment witnesses mills ranging from 5000 MTPA capacities to 3 lakh MTPA capacities and average mill size of ~13000 MTPA.

Agro-residues based mills (without chemical bleaching): the average mill size in these categories typically tend to be even lower than waste paper based mills.

Therefore, an investor would notice that establishing a wood-based paper mill, which is on average a much higher size than a non-wood-based paper mill is comparatively very high capital-intensive than non-wood-based paper mills.

As a result, the wood-based paper mills have a high barrier to entry and new players enter very rarely in this segment. Whereas, the non-wood-based paper mills are much cheaper to install; therefore, there are numerous small players in this segment making it very fragmented and crowded.

From the above discussion, an investor would remember that in the wood-based paper mill segment, about 10 players own the entire production and there has not been any new player in decades. On the contrary, the non-wood-based paper mill segment has more than 800 mills.

CCI Order, Nov. 17, 2021, pages 31-32:

there are nearly 800 non-wood based paper mills in India, with approximately 40 players that sell in North India.

This leads to an intense competition where frequently, new players keep coming and old players keep going out of business.

Nevertheless, as a result of the low capital requirements of non-wood based paper mills, their share in the overall paper production has increased significantly over the years.

As per ICRA, in 2015, non-wood-based paper mills contributed about 65% of paper production; recycled paper (44%) and agro-residue-based paper mills (21%) whereas wood-based paper manufacturing contributed about 35%.

Rating Methodology for Paper Industry, ICRA, November 2015, page 8:

As per industry data, based on the raw material mix, ~35% of the capacity is based on chemically bleached pulp (either from wood or agri-residues); ~44% capacity is based on waste paper and ~21% of production capacities are based on agri-residues.

In 2020, as per CARE, the share of non-wood based paper mills had increased to about 75% of paper production; led by recycled paper (58%) and agro-residue based paper mills (17%) whereas wood-based paper manufacturing contributed about 25%.

An investor would note that the significant increase in the contribution of non-wood-based paper manufacturers is due to a low requirement of capital for establishing the mills.

Nevertheless, after a paper mill is established, it needs to continuously spend money on upgrading its machines because; old machines become inefficient. This increases its cost of production when compared to other mills and it starts losing out on getting the orders. As a result, the paper mills whether wood-based or non-wood-based, need to continuously spend money on upgrading their plants.

Rating Methodology for Paper Industry, ICRA, November 2015, page 2:

The paper machines though can be operated for decades after periodic rebuilding and regular maintenance. However such machines may also have operational inefficiencies such as high power/ steam consumption norms in relation to new mills. This apart, the product quality and machine utilization may also suffer from breakdowns resulting in operational in-efficiencies. Very old machines thus may not result in a sustainable cost advantages in longer run.

In addition, to remain cost-competitive, in a growing paper market like India, paper producers need to continuously invest money in their production capacities to maintain their market share.

Rating Methodology for Paper Industry, CRISIL, February 2021, page 19:

Developing economies usually experience high growth in demand; manufacturers, therefore, need to constantly add capacities to retain market share. In addition, the commoditised nature of the business requires regular modernisation of production facilities in order to remain competitive. With business being highly capital-intensive, the incremental funding requirement for capacity augmentation and modernisation tends to be enormous.

Therefore, paper mills, whether wood-based or non-wood based, have to continuously spend money on the modernization of their machines, increasing capital consumption. An investor needs to be cautious of this continuous capital requirement of paper mills whenever she starts analysing a paper manufacturing company as it will impact its free cash flow generation.

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

4.1) Large integrated paper manufacturing plants, a double-edged sword:

From the above discussion, an investor would remember that in the paper industry, a manufacturer must focus on being as cost-competitive as possible because in this industry with undifferentiated, commodity products, the lowest-cost producer wins.

As a result, it becomes necessary for wood-based paper-making plants to go for an in-house pulp-making unit as well as a captive power plant.

This results in a decline in per-unit cost of production for the paper mill and stable profitability for the company because it is able to produce most of the inputs like pulp and power in-house and is saved from the fluctuations of these inputs in the external market.

Rating guidelines for the paper industry by CARE, November 2020, page 3:

Backward integration, including pulping and power generation capacities, is more critical in case of a wood-based mill to ensure a steady supply of raw materials at a relatively lower cost…Although this kind of integration is capital intensive resulting in high fixed costs for a company, it results in stable profitability for a company.

The non-wood-based paper producers usually do not have pulp production and power plant integration as they can easily source these inputs from the outside market.

Rating guidelines for the paper industry by ICRA, November 2015, page 2:

This is in contrast to waste-paper/agro-residue based paper mills, which don’t require captive pulping capacities and the need to have a captive power plant is optional as the plant can be operated on grid power.

In addition, the large size of the integrated wood-based paper plants helps them achieve economies of scale and in turn, produce goods at a lower cost.

Rating guidelines for the paper industry by S&P, page 7:

A forest and paper products company’s size typically brings competitive advantages from greater breadth and scope of operations and economies of scale, contributing to better profitability.

The sheer large size of an integrated wood-based paper production plant also helps it achieve better bargaining power with the counterparties when compared to the smaller non-wood-based paper mills.

Large-integrated wood-based paper producers have a lower working capital intensity because due to their comparatively higher negotiating power, they are able to negotiate a lower credit period to their customers and a higher credit period from their suppliers.

Rating guidelines for the paper industry by ICRA, November 2015, page 5:

Overall, the working capital intensity of paper mills in the wood segment averages ~ 20% of their revenues and ~25% of revenues for the waste paper mills.

Receivable Cycle: …larger mills (mainly based on chemical wood pulp) having better bargaining power with its dealers, extending a credit period of ~30~35 days as against smaller mills (largely waste paper based) with relatively lower bargaining power offering average credit period of ~45 days.

Payable Cycle: The payable period for the larger wood based mills typically averages around ~80 days as against ~45 days for waste paper based mills due to the better bargaining power of the larger mills

The comparatively better-negotiating power of the large integrated wood-based paper mills with their customers and suppliers compensates for a higher inventory holding requirement when compared to the smaller non-wood-based paper mills.

Rating guidelines for the paper industry by ICRA, November 2015, page 5:

Inventory Holdings: The inventory holding for the larger wood based mills typically averages around ~90 days, and is higher than ~ 45~50 days of inventory held by wastepaper-based mills.

Therefore, an investor would appreciate that the integrated large wood-based paper mills are fixed-cost-intensive but enjoy stable profitability because they benefit from economies of scale and are not impacted by an increase in the pulp or power prices in the open market. They also enjoy a better working capital position due to a higher negotiating power than the smaller mills.

On the contrary, the non-wood-based paper mills are comparatively asset-light; but they are exposed to high input cost volatility in the open market and in turn, fluctuating profitability as well as having a higher working capital intensity.

However, the stability in the profit margins and better working capital efficiency of large integrated wood-based paper mills comes at a cost. Let us see such situations where the large integrated plants of wood-based paper mills put them at a disadvantage.

Further advised reading: Operating Performance Analysis: A Simple & Complete Guide

4.1.1) Inability to benefit from a decline in the raw material costs in the open market:

As the integrated wood-based paper plants use in-house pulp and power; therefore, when the pulp and power prices decline in the open market, then these mills are not able to take an advantage of the lower raw material costs. In contrast, the non-wood based paper mills are able to take advantage of the same.

Rating guidelines for the paper industry by CRISIL, February 2021, page 19:

During downturns in the industry, when pulp prices tend to be lower, integrated manufacturers are unable to take advantage of this.

For example, in FY2010, during the global recession, when pulp prices declined globally, then the large integrated paper mills could not take advantage of the same whereas the waste paper-based mills benefited.

Rating guidelines for the paper industry by ICRA, November 2015, page 9:

In contrast, when the pulp prices declined internationally in FY10 due to a global economic slowdown, the integrated paper mills were not able to take the advantage of the decline in input costs, whereas the waste paper mills benefited.

4.1.2) High vulnerability during industry slowdowns:

An investor would appreciate that due to the high fixed-cost intensity of large integrated paper mills, they need to run their plants at a high capacity to earn a return on their money. Additionally, because they have a large component of the costs as fixed, they need to earn a high operating profit margin to cover their fixed expenses.

During the industry uptrend, it is possible for the large integrated plants to run at a high capacity utilization as well as to earn high-profit margins. However, during the industry slowdown, they suffer on both fronts i.e. their capacity utilization falls and additionally, their operating profit margins also fall because the prices of all the paper products decline due to intense competition between manufacturers to keep their plants running.

In contrast, the non-wood-based paper mills, due to lower fixed costs, are able to sustain industry downturns better because, a reduction in their plant utilization levels also reduces a large part of their overall costs, which is not the case with the large integrated wood-based paper mills.

Rating guidelines for the paper industry by CRISIL, February 2021, page 19:

Units that are fully integrated, from pulping to conversion, will be more fixed-cost intensive, resulting in higher breakeven volumes. In contrast, manufacturers with a lesser degree of integration are better positioned to withstand downtrends owing to their lower fixed-cost intensity

Rating guidelines for the paper industry by ICRA, November 2015, page 2:

While backward integration provides better profitability margins, high capital costs also increase the vulnerability of mills to any declines in capacity utilization levels or profitability in comparison to waste paper based mills.

Therefore, an investor would appreciate that even though a paper mill can reduce its cost of production by becoming a large integrated player with economies of scale and in turn create strong barriers of entry for new players; still there are multiple trade-offs it needs to face.

5) Environmental and pollution risks faced by paper manufacturers:

The paper manufacturing process especially from wood has the potential to significantly impact the environment. This is because; it uses wood as a raw material, which involves cutting off forests & trees, it uses a lot of water in pulp and paper production, it uses a lot of chemicals and power during papermaking, which is environmentally damaging and it leads to a lot of effluents, which if not disposed of properly, may lead to environmental damage.

Therefore, wood-based paper manufacturers face a lot of challenges in getting the approvals for setting up new mills.

Rating Methodology for Paper Industry, CARE, November 2020, page 4:

A large amount of water as well as various chemicals are used for manufacturing paper and paper products. Therefore, any player in paper manufacturing industry irrespective of size of operations is exposed to varying degrees of regulatory oversight, including environmental standards in terms of scrutiny of disposal of raw material wastes and level of carbon emissions.

Looking at the history of events faced by paper manufacturers, an investor gets to know that despite obtaining govt. permission including environmental approvals for installing the paper mills, the manufacturers keep facing intermittent challenges on environmental and pollution control fronts.

When India signed the Montreal Protocol limiting the use of Chlorine to protect the Ozone layer, then paper companies had to make investments in their production processes to reduce the use of Chlorine in the papermaking process.

Rating guidelines for the paper industry by CRISIL, 2007 (click here), page 2:

in line with the Montreal Protocol, the paper industry is required to eliminate the use of chlorine in bleaching by 2010. To comply with this environmental regulation, manufacturers will need to incur further capital expenditure for their existing facilities.

Later on, in 2013, the paper manufacturing units in Uttar Pradesh were asked to close their operations to prevent pollution of the river Ganga in light of the upcoming Kumbh Mela.

Rating guidelines for the paper industry by ICRA, November 2015, page 4:

Recently in February 2013, various paper mills in the state of Uttar Pradesh, despite having consent from pollution control boards to operate, were issued a notice of temporary closure to prevent water pollution in river Ganga amid the Kumbh pilgrimage event.

Therefore, an investor would appreciate that the paper manufacturing process puts a lot of strain on the environment. As a result, paper mills continuously keep on facing newer challenges and guidelines in order to meet the expectations of regulators.

Therefore, paper mills need to continuously spend money on their plants to make them environmentally more efficient.

Rating Methodology for Paper Industry, CARE, November 2020, page 5:

They also expend on various cost-efficiency measures for remaining competitive as well as for adherence to environmental norms.

An investor should keep the requirement of paper mills to continuously spend money for meeting environmental norms in her mind while she assesses the future capital expenditures of paper manufacturing companies.

You may read our detailed fundamental analysis of some of the paper companies below:

• Analysis: Century Textiles & Industries Ltd
• Analysis: Ruchira Papers Limited

Summary

Overall, an investor would note that paper manufacturing is a cyclical business where the players make low-value-added, undifferentiated, and commodity products. There is very low customer stickiness because the customer can easily switch from one manufacturer to another without significant challenges. Paper mills have hardly any pricing power over their customers.

Paper manufacturing is a highly fragmented industry with intense price-based competition among the players. Increasing consumption of paper in India amid declining demand for paper in developed and many developing countries makes India an attractive export market for overseas paper mills. Therefore, the players face a lot of competition and only the ones with a low cost of production survive. As a result, cost competitiveness becomes the biggest competitive advantage for manufacturers.

Paper manufacturers tend to go for integration (forward as well as backward) i.e. pulp making and captive power plants to achieve the lowest cost of production along with large-size plants to benefit from economies of scale. However, creating a large integrated plant increases the fixed costs and, in turn, makes the break-even high. Therefore, even though, the large integrated plants mostly use wood as raw material, and achieve stable profitability due to in-house pulp and power production; however, they need to operate at a high capacity utilization with high-profit margins to cover their costs and earn a respectable return on their capital.

During an industry slowdown, both the capacity utilization as well as profit margins take a hit leading to difficulties in surviving the economic downturn for large integrated plants. As a result, in the downturn, many plants shut down leading to reduced supply and a resultant increase in product prices. This in turn leads to the announcement of new capacities by the paper mills that have survived the downturn. Usually, all these newly announced capacities commence production simultaneously leading to oversupply and a decline in product prices resulting in another industry downturn.

This cycle of boom and bust is played in the paper manufacturing industry again and again.

Large wood-based integrated paper plants create a strong entry barrier for new players due to high capital needs, access to inputs like wood and power, low-cost large efficient plants, and a strict approval process for environmental and pollution control regulations. As a result, hardly any new player has entered into wood-based paper manufacturing in decades.

In contrast, smaller plants using waste paper or agricultural residues do not need in-house pulp and power plants. Therefore, they are less capital-intensive and have lesser entry barriers making the industry crowded with hundreds of small non-wood-based paper mills.

High competition in the paper industry has taken away their pricing power. As a result, both in India and overseas, there are incidences of competing paper manufacturers acting as a cartel and coordinating their price increases as a mutually agreed strategy. Under such scenarios, an investor should be cautious because the market prices of paper products may be rigged and in turn, the profitability and the return ratios may be inflated.

Paper production is very environmentally sensitive because it uses wood as raw material, uses a lot of water and power, and releases a lot of effluent chemicals.

The companies need to keep spending a lot of money in upgrading their plants to keep them in line with newer environmental regulations, keeping the machines efficient for low-cost production and in a growing market like India, to increase capacities for maintaining their market share. An investor should keep in mind the continuous capital investment needed by the companies to sustain this business.

Key points of paper manufacturing companies:

1. Shortage of raw materials irrespective of wood, recycled paper or agro-residue
2. No pricing power and intense competition due to low value-adding, undifferentiated commodity products, and threat of imports leading to cartelization and price-fixing
3. The industry is cyclical with a repeating boom and bust cycle
4. Highly capital-intensive wood-based paper mills offer barriers to entry but suffer in the downturns
5. Environmental and pollution risks faced by paper manufacturers necessitate continuous investments

We have used the following framework to learn about new industries: How to Analyse New Companies in Unknown Industries?

We recommend that you read the following analysis to learn more about the paper industry:

• Analysis: Seshasayee Paper and Boards Ltd
• Analysis: Century Textiles & Industries Ltd
• Analysis: Ruchira Papers Limited

All the best for your investing journey!

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.