Originally a South African forestry and paper milling company, Sappi is today a global leader in sustainable woodfibre products and solutions. Their acquisition-led global growth strategy, however, provides a sobering view of how a company can misread its market, destroying substantial shareholder value in the process. Sappi’s South African business is therefore still their biggest profit generator and a renewed source of growth. We outline their journey.

From humble beginnings to an acquisition frenzy
Founded in South Africa in 1936, Sappi started producing pulp and paper at a single mill in Springs, Gauteng. Over the following decades, Sappi invested in and acquired numerous mills and farms around South Africa. They currently own and lease plantations in KwaZulu Natal, Mpumalanga and Swaziland – spanning 379 000 hectares.

In 1988 Sappi acquired Saiccor, which then was the world’s largest producer of dissolving wood pulp (DWP). This is a purified cellulose pulp made from the cell walls of green plants (mainly from eucalyptus trees). It is suitable for further chemical processing into a range of products and is either spun into textile fibres, processed into a film or regenerated into a sponge-like material.

Between 1990 and 1997 Sappi expanded their international footprint, spending close to $3 billion on acquisitions outside of South Africa:
• 1990 – acquired five fine paper mills in the UK
• 1991 – acquired Germany’s largest coated fine paper producer (making Sappi one of the top European producers of coated fine paper used in magazines and brochures)
• 1997 – Sappi shares listed in London, Frankfurt and Paris
• 1994 to 1997 – acquisitions mainly in North America resulted in Sappi becoming the world’s largest producer of coated fine paper
• 1998 – Sappi lists on the New York Stock Exchange
• 2000 – acquired Potlach mill in the US for $480 million
• 2006 – acquired M-Real mill in Europe for 750 million euros
• 2010 to current – acquired mills in Switzerland and Canada

Sappi’s current market value of only $1.5 billion is evidence that most of these acquisitions were ill-considered, leaving the legacy of a debt-laden balance sheet and a significant consequent interest burden.

Sappi’s folly
Sappi’s glossy paper business accounts for half of its annual sales, but only around 10% of its profits due to the weak state of this business. Their acquisition spree in the glossy paper department failed to identify the looming threat of technological advancements, including the advent of smartphones and tablets, which accelerated the decline in magazine and newspaper sales. The inevitable drop in coated fine paper demand, coupled with the fixed supply of glossy paper mills (overhead costs still need to be covered even if mills are running at a loss) resulted in an oversupplied market and lower prices for glossy paper (charted below).

Paper prices have declined from just above 900 euros per tonne in 2000 to below 630 euros in 2017. Although prices for coated paper recovered briefly in 2018/2019, following significant closures of paper capacity by European competitors, the price trend resumed its decline in June 2019.

In response to the rapidly declining market, Sappi’s current CEO, Steve Binnie, embarked on a strategy to reduce unprofitable glossy paper capacity by diverting production to higher value, niche paper grades and converting certain paper mills to produce DWP (in South Africa and North America).

While Sappi has lost its leadership position in the glossy paper market, these mill conversions have restored profitability to the overall group and expanded its capacity in the faster-growing DWP market.

Clothing the world in DWP
Roughly 70% of DWP is used in the production of viscose staple fibre (VSF) for the manufacturing of textiles. The other 30% is higher quality dissolving pulp that is used in the production of acetate and ethers, which are in turn used in speciality applications. Viscose (made up of cellulosic fibres) competes for market share alongside other textiles, such as cotton and polyester. Compared to these, viscose scores well on all qualitative fronts, except for ‘wash and wear’ as it tends to be weaker. This makes for a good blending textile, ideal for the manufacture of apparel such as denims and sportswear.

The chart below highlights the superior fibre properties of DWP in viscose compared with cotton and polyester, indicating why the viscose share of the total fibre market is expected to grow at a faster rate than polyester and cotton. Currently, viscose fibres only account for 6% of the total textile market (90 million tonnes per annum) in comparison to 63% for polyester and 25% for cotton.

Sappi has not only become the single largest producer of DWP but also one of the lowest cost producers, with production facilities in North America and South Africa. While their DWP business contributes only 20% to their sales, this amounts to 60% of profits due to the higher profitability of DWP compared to paper. Expansions at Sappi’s production facilities at Saiccor, coupled with mill conversions at the Ngodwana mill in South Africa and the Cloquet mill in the US, have resulted in their DWP production capacity increasing from around 300 thousand tonnes in the early 1990s, to 1.4 million tonnes at present (charts below).

Supply, demand and sustainability cycles
Wood production has a clear cost advantage in South Africa and Brazil, which structurally benefit from fast tree maturity timelines because of temperate growing conditions. This results in a lower harvesting radius, and consequently, lower logistical costs for wood. Additionally, labour costs in South Africa and Brazil are substantially lower than in Western Europe and the US.

Dissolving pulp demand is a function of global viscose production capacity and the supply of the alternative fibres. The viscose market was stimulated in 2011 when cotton prices spiked due to cotton supply shortages. This increased the demand for viscose and dissolving pulp, resulting in a huge increase in installed dissolving pulp capacity (dissolving pulp demand was at two million tonnes in 2006 and almost five million tonnes in 2016).

China has continued to dominate global viscose demand, constituting 32% of demand in 2006 and 55% by 2016. In 2017, this was negatively impacted by environmental restrictions imposed in China due to poor environmental practices by viscose producers in the country. Furthermore, Chinese authorities added polyester to their list of ‘over-capacitated’ industries, which has resulted in the idling of a substantial percentage of global viscose capacity over the last three years.

Constraints on supply, changing consumer patterns and improvements in the qualitative characteristics of polyester has caused cotton to lose market share to polyester and viscose. Cotton supply is expected to continue to decline over the next few years as farmers increasingly favour competing crops that offer better economic returns. Supply may also come under pressure from the increased incidence of droughts or floods across the major producing regions.

The trade war has hurt
As indicated, the DWP price has risen steadily since 2011 – from $800 per tonne then, to peak at almost $950 in 2019. However, a perfect storm of rising viscose capacity coincided with a substantial decline in the Chinese textile market because of the tariffs imposed by the US on Chinese textile imports. The result has been a precipitous decline in DWP prices to levels below $650 per tonne. This has very negatively impacted on Sappi’s profits and caused a commensurate drop in the Sappi share price.

Despite current DWP prices being very low, which appears unsustainable as an estimated 40% of DWP producers are making substantial losses, Sappi should remain a profitable player in the DWP market. The outlook is dependent on how the situation is resolved, but it is our view that a normalisation in global trade relations will bring about a rebound in the demand for VSF from China and a corresponding increase in DWP prices. Sappi is well positioned to benefit from this recovery.