Good day, ladies and gentlemen, and welcome to the Sappi Limited second quarter 2018 results conference call. All participants will be in listen-only mode. There will be an opportunity to ask questions later during the conference. If you should need assistance during the call, please signal an operator by pressing star and then zero. Please note that this call is being recorded. I would now like to turn the conference over to Steve Binnie. Please go ahead, sir.
Thank you. Good day, everybody. Thank you for joining me on the call. I am joined by a number of my colleagues, I will be going through the investor presentation deck, I will refer to page numbers as I move through. Starting on page four, highlights for the quarter. EBITDA, excluding special items, of $211 million U.S., that is up from $208 million in the prior year. Bottom line profit, $102 million compared to $88 million last year. Earnings per share, excluding special items, $0.17 U.S. Net debt was $1,632 million, up from $1,329 million. The main reasons for the jump, obviously, are the acquisition of Cham, which occurred during the year or the quarter, $132 million. The stronger euro versus the dollar as we convert that had a significant impact. Obviously the higher CapEx that has come through.
During the quarter, we completed the acquisition of Cham specialty paper business, that is integrating nicely into Sappi. Moving to slide five, the EBITDA and operating profits. You can see the impact over the last couple of years, the growth that has come through. Some of the key metrics, net debt, on the back of the number that I just explained to you, is slightly higher at 2.2 leverage. We continue to target lower than two times, that remains in place, we will maintain that discipline. EBITDA margin at 14.1%, still healthy. Return on capital employed 16.8%. Moving to the earnings bridge on page six. Pleasing to see sales volumes growing across the board in all regions, in all the segments whether it is dissolving pulp, packaging, graphic paper, all up. That was encouraging.
We were able to realize higher selling prices, again, in all our businesses. Clearly that had to be done in graphic paper to offset the impact from higher raw material costs, primarily pulp, which you see in the red block under variable costs. The exchange rates had a significant impact. The fact that we have got a stronger rand now against the U.S. dollar, the net impact of all of that was $10 million down on last year, giving us the $211 million that you saw us achieving. Across to slide seven, the product contribution split. Dissolving pulp was 45% of EBITDA. A little bit lower than previous quarters or recent quarters, but that is because of the stronger rand that I referred to. Printing at 39% and packaging at 16%, that is rising, will continue to rise as we integrate Cham and complete the conversion projects.
Moving to slide eight, the debt maturity profile. This paints a good picture. There's no short-term material debt. The next larger item would be the securitization in 2020, and we would expect to roll that over. We don't anticipate any challenges. Our euro bonds are 2022 and 2023. We have quite a bit of runway there. On slide nine, the CapEx development. A little bit later in the presentation, I'll be talking about all the projects that are underway. Obviously we've got the conversions from graphic paper to packaging that we have undertaken in the U.S. and in Europe, and the expansion and debottlenecking projects for dissolving pulp. Again, I'll go into more detail. That's why the number has risen in 2018 and in 2019 relative to where we've come from in recent years.
Turning to the divisions, on slide 11, we talk about printing and writing graphic paper. It's encouraging that operating rates have been healthy. All our machines are full in both the respective regions. We've clearly benefited from the fact that there were capacity closures and conversions in those regions. It's allowed us to or it's ensured that the supply-demand balance is more in line, which has enabled us to put through a series of price increases, which we had to do because of rising paper pulp prices. I think we began raising prices April last year, April 2017, and we've seen a series of these since then each quarter, and there's been a further one announced for the next quarter as well.
There's always a lag effect, you can see in our performance and our profitability, we have been able to implement these selling price increases to offset much of the impact from pulp. The conversions will reduce our exposure once they're completed to this market. We continue to make investments and focus on efficiencies. The investments that we make will be to lower costs, a good example of that is the Gratkorn PM9 investment that we announced, I think last quarter, for ZAR 30 million. Ongoing focus on costs and efficiencies. Moving to packaging and specialties on page 12. There's obviously a global push now towards paper-based packaging to replace plastics, that's creating further opportunities for us. We're very excited about the prospects. Most of the markets that we're in are growing between 1% and 5%, in fact we've been beyond this.
We would expect more conversions across the board in a highly fragmented market. We've recently announced price increases to offset the higher pulp costs. Cham was completed at the end of February, I have a slide on that later and I'll go into more detail. The conversions that we've announced will boost our capacity because we're limited by the capacity we have available currently. Obviously with Maastricht having recently been completed in the board space and Somerset in the process of being finalized, that will give us opportunity to grow our packaging. The Cham and the Rockwell Solutions technologies will give us further scope for growth. On dissolving pulp, I move to slide 13, the demand continues to be strong.
We've seen a lot of new viscose capacity coming on board, which has depressed viscose prices a little bit, but dissolving pulp, because there has been strong demand, continues to be stable, and we would expect that to continue for the foreseeable future. As we look across the board, there's a little bit of new capacity coming on board in 2019. Relative to the market demand growth, we think the balance in the market is very favorable. The fact that paper pulp prices have been rising has helped support the DWP pricing as well. The prices have been steady over the course of the last couple of months, and we would expect that to continue. We continue to look for opportunities to grow our capacity. Obviously, we've got the debottlenecking projects underway at the moment. Moving to slide 14, Sappi Europe.
They've done a great job at putting through price increases to offset the higher raw material costs. We've got an example of the one product on the top right, and you can see that it's been continuously rising over the last year. The markets have been relatively better, and as I said earlier, our machines are all full. At the same time, specialities and packaging is going extremely well. Volume's up 12%. That excludes the Cham. That will expand further as we move more of our Maastricht capacity into folding boxboard. The costs were up mainly as a result of pulp, but latex has also been an issue as well. On to Sappi North America. Similarly, we've put through a series of price increases.
The market dynamics in that market with some recent closures have been more favorable, again, our machines are full, which has helped us to put through these price increases. At the same time, dissolving pulp demand has grown, and we swung a little bit more capacity to dissolving pulp at Cloquet during the quarter relative to last year. In addition to pulp costs, energy and chemicals have also risen. You'll see from the performance that we were able to offset those. On to South Africa. Obviously, we're up against the stronger rand, compared to a year ago approximately ZAR 12 to the dollar. A year ago, it was ZAR 13. That has a significant impact, so obviously profits would be lower than last year. However, in spite of that, the performance has been good. DWP volumes have been strong.
At the same time, packaging has had an excellent start to this financial year. We've seen volume growth there, which has more than offset demand growth, which has more than offset any impact from the drought conditions in the Western Cape. We turn to the four pillars of our strategy, and the first one is the cost Advantages and focus on costs. On page 18, we continue to do a lot of good work on our procurement side. We've talked about this last quarter, the ZAR 60 million, we are still on track to achieve that in this financial year. The focus on the continuous improvement across all the mills has offset some of the impact from raw material costs.
In Europe, we continue to look for opportunities to debottleneck pulp capacity, because Europe is about 55% pulp integrated and clearly in a cycle like this where raw material or pulp prices have been rising, that has put pressure on us. The cycle expansion, which we'll go into a little bit more detail later, will help lower variable costs. Rationalizing declining businesses. The two big conversion projects underway in Europe, firstly at Lanaken, we'll progressively move out of lightweight coated as we complete at Lanaken. Reduced exposure at Maastricht and Somerset as we finish that conversion. Page 20, the maintaining of a healthy balance sheet.
As I said earlier, we are still committed to the 2x net debt to EBITDA ratio, and we'll use that as we move through this period of conversions and growth projects. The finance costs are approximately ZAR 60 million-ZAR 70 million per annum. We renewed our RCF during the quarter. That's been unutilized, but it's always nice to see that we can achieve that, and we did that at a lower spread, 165 basis points versus a previous rate of 190 basis points. That's encouraging. On slide 21, in terms of our growth into the higher margin areas, we have debottlenecking at our various DWP mills.
The investments that we've made in terms of the Rockwell technology and the Cham acquisition, we think we can grow further at our South African packaging mills in Ngodwana and Tsikale, and we continue to look for opportunities for additional hardwood timber supply in South Africa. Last quarter we talked about it, but we applied for the environmental approvals for the expansion of Saiccor by a further 110. We're hopeful that we'll get that soon, that environmental approval, and then we can commence the whole construction, which would be complete early in 2020. On slide 22, the Cham acquisition. It's gone very well. Integration is proceeding according to plan. There's been no surprises for us or no material supply surprises. We're very happy with the assets that we've acquired.
The people are fitting in very well into Sappi, and we continue to believe that there will be synergies of ZAR 10 million to be realized within the next two years, which would give that business a ZAR 30 million EBITDA, which is what we said at the time of the acquisition. Just to remind you, it's the two mills which you see pictures of in Northern Italy. Further opportunities as we accelerate growth. We were finally able to sign the Ngodwana Energy Biomass project with the Department of Energy. Construction begins in March 2018. Sappi has an equity share of 30%, so we equity account it. We don't consolidate this onto our balance sheet. It will deliver good returns and good Black Economic Empowerment benefits as well. Moving to slide 24, the specialty packaging expansion.
This is just a reminder of all the component parts of the conversions that are underway. The primary ones being the Maastricht conversion to Folding Boxboard. They'll continue to make some coated woodfree on the machine, but that will ramp up as we move ahead towards more and more Folding Boxboard. The other big one is at Lanaken, and I talked about that already, but enabling us to make the coated woodfree on PM8 there. The Somerset construction is in the process or it's just been completed literally in the last couple of days. We're now in the process of testing all the products, and there will be a ramp-up over the next couple of years. We've targeted an additional 350,000 tons of packaging and specialties on that machine.
In terms of DWP, just to remind you once again, we have the smaller project with Saiccor, which gives us 10,000 in the short term. Ngodwana, the additional 50,000 will be completed in September of this year, and then Cloquet, an additional 30,000 tons by next financial year. On top of all of that is the Saiccor expansion that I referred to, the 110,000. We continue to scan the external market for opportunities to boost our dissolving pulp capabilities further. That brings us to the outlook. On page 27, just to summarize and recap, dissolving pulp demand remains good, prices are stable, and we have a favorable outlook over the next couple of years. Q3 will be impacted. We have shuts at all three dissolving pulp mills during this quarter.
In Europe, operating rates are strong, paper prices have been rising and as you saw, we had a further price increase announced. Somerset conversion as we talk, is in the process of being completed and again, we've been able to put through selling price increases. Packaging continues to grow as customers switch to paper-based solutions. Taking all of that into account, obviously, we're still up against the stronger ZAR, but markets across all our segments are in a pretty good state. Taking that all into account with the shuts, we say that the Q3 performance will be broadly in line with last year in terms of profitability. Operator, that's me gone through the deck. I'll hand it back to you for questions.
Thank you, sir. Ladies and gentlemen, if anyone would like to ask a question, please press star and then one on your touchtone phone. If you decide to withdraw the question, please press star and then two to remove yourself from the question queue. If anyone would like to ask a question, please press star and then one. Our first question is from James Twyman of Prescient Securities.
Yes. Thank you. I've got two questions. The first one is: In the last call, you mentioned that there was capacity switching from dissolving pulp to paper pulp, and I'm just wondering whether you've seen any more of that happening, given that we're seeing paper pulp prices continuing to outpace dissolving wood pulp. Secondly, in the U.S., I know that you're looking at a price increase for June or July for fine paper. Just wanted to know whether that feels like a realistic option for you.
Okay. In terms of the switching of capacity between dissolving and paper pulp, I don't think there's been anything materially changed since our last earnings call. A lot of it has already shifted across to paper pulp. Mohamed, is there any other major changes you've seen in the last few weeks?
Steve, no. Only just to add that the switch from dissolving pulp to paper pulp is not only going from dissolving to bleached paper pulp, but also from dissolving to unbleached kraft pulp in China.
Yeah. Okay, thanks. Mark, how confident are you on your price increase for July?
Well, we just announced the price increase on the web grades on Friday. We expect that to go through. We generally see about 25%-30% of the price coming through as we announce. Then by the end of 90 days, about 80% of that will be through.
Did you get that, James?
Not really. It's promising, it sounds like. Is it?
Yeah. We're confident that we can get it through. In the short term, 25%-30%. By the time we get a couple of months out, we're confident that we'll get 80% of what was announced.
This is the July increase we're talking about, is it? Or was this the recent one?
Yes.
Okay. Good. Thank you very much.
Our next question is from Brian Morgan of RMB Morgan Stanley.
Hi, guys. Thanks very much. Great to see the numbers. If I can just ask, you make a note in the presentation pack about increase in specialty packaging. Could you just expand on that a little bit?
Are you talking?
It's on slide 12. On slide 12, you say more conversion is expected into various grades of a highly fragmented market.
Look, there has been announcements by other competitors out there, not specifically in the same grades as us. Clearly with the global push towards paper to replace plastics, everybody's looking for opportunities. With potential new legislation in the U.K. and in Europe, it's really a bit of a race. We're getting a lot of contacts from FMCG companies wanting to focus on paper-based solutions for their packaging. It's really a very exciting time. Obviously, the fact that we've been making investments in this area, we've acquired Cham, the conversions that are underway. We think the opportunities are vast. [Barry], I don't know if you want to expand any further?
No, I think that answers it, Steve.
Steve, just the concern obviously is, this is obviously a cyclical industry, and we obviously just worry that with attractive looking markets tend to attract a lot of supply. Just interested to hear your thoughts in that regard. I'm just worried that we're chasing a fad here that could end in tears.
Yeah. Look, in the sectors that we are in, the competition that we're up against there tend to be smaller niche players. We're not talking the mass packaging categories. Many of them are highly technical, and the machines that compete in that space are not the larger machines. They tend to be smaller machines. Based on that, we're reasonably confident that there won't be a mass shift from the large producers into those categories.
Okay, cool. Then if you could just remind us, the payback periods on these conversions, three to four years, if memory serves me. Is that-
Correct
still intact?
Yep, still intact.
Nothing changes there. Okay.
Nothing changes.
If we can, just in terms of that CapEx outlook for 2019 that you've provided, a small increase for 2018. Roughly, what portion of that would be maintenance CapEx? If you could tell us.
It's between 150 and 200.
150 and 200. Then in terms of the return criteria for the expansion component of that CapEx, could you give us a rough number? Anything above 20%, 15%? What sort of number should we be thinking about?
All the big projects that we've looked at are between 15 and 20 IRRs.
Between 15 and 20.
Correct.
Okay, that's excellent. Thank you very much. I appreciate it.
Our next question is from Ross Krige of J.P. Morgan.
Afternoon, everyone. Thanks for the call. Just with regards to the Somerset conversion and perhaps the SBS market in North America. If you could maybe just give an idea of what sort of sales volumes you would expect from that Somerset SBS. In terms of pricing, if you could give us some insight into that market. Would you expect to have to take a discount on those volumes? Perhaps what do you expect the margins to be versus current specialty margins?
All right. Mark, I'm gonna hand over to you just to talk about the ramp-up. Obviously, we've got certain commitments at the moment. There will be a time period for ramping up. Do you want to elaborate further? Mark?
Yeah. Yes. Can you hear me okay?
Yeah, can hear you now.
Okay. All right. We're in the process of starting the machine up now. We'll be ramping that up over the course of this month into next. We do see the SBS market as being a fairly large part of the output of the machine, but just remind all on the call that the machine also will be making C1S technical papers and also graphic papers. We're not planning on the machine to be 100% dedicated at this point in time to any one market segment. The total volumes, as you mentioned earlier, Steve, out as we ramp up over the next year or so, could go as high as 350,000 tons of packaging grades. A large part of that would be in the board grades.
Yeah. Mark, there was a second question just on the pricing.
Well, we're looking at the market pricing. We feel comfortable with that market pricing. Our product, we are quite confident will be a very good product in the market. We wouldn't be surprised. We in fact expect that the product will drive a lot of demand just because of the design of the product and the quality we expect off this rebuilt machine. I think the question was, do we see discounting in the market? That's not part of our strategy.
Okay. Thanks very much, guys.
Our next question is from David Roux of BAML.
Good day, guys. Thanks for the time. A few questions from my side. Within our coverage, I think some of the factors that we have struggled with is certainly the less transparent costs in the feed, such as wood as well as wages. Perhaps you can just comment on the direction of wood and wage costs across your businesses in the U.S. and Europe. That's my first question. My second question is, what will the delta be in the scheduled annual maintenance impact versus last year? Because I'm still struggling to reconcile to get your guidance. My feeling is that we could see a high impact from annual maintenance shuts. My last question is quite a high-level one, but can you perhaps comment on the risks from potential land expropriation in South Africa? Thanks.
Okay. We'll take each of the questions in turn. Firstly, on wages in Europe and the U.S., we would expect those to be in line with inflation, around 2% or 3%. The second part of the question was on wood. The near-term outlook is lower prices on the wood front, particularly in the U.S. The annual maintenance shut. Obviously, the first one we've got is the fact that we've got Somerset, which has an extended shut for the conversion. Then also we have the Saiccor shut as well, which is about, I'm looking at it relative to last year, it's probably an incremental ZAR 5 million relative to last year's impact. Ngodwana was in Q3 last year. It's Q3 this year, so there's not a material difference. The two bigger ones relative to last year are the combination of Somerset and Saiccor.
Combined, if I add the increase at Saiccor of about, as I say, ZAR 5 million, then the remaining time period for Somerset, you're looking at ZAR 5 million or ZAR 6 million. That's about ZAR 10 million relative to last year, additional costs of shuts. Does that answer your question, David, on that one specifically?
Yes, Steve, that does. Thanks very much. Just the last one on land expropriation.
Clearly, it's a very sensitive issue, and we've been engaging, and we've made submissions. We are using business leadership as our communication vehicle. We've had comprehensive discussions with them, and we've had assurances indirectly through business leadership that the threat of land expropriation will not impact on productivity. It won't impact on jobs, economic growth for the country. It's not something
Higher year-over-year. It's mainly due to this one you had in South Africa about transfer pricing. I'm asking if that difference of ZAR 18 million, it was 100% coming from this issue, or was there something else in it?
No, the ZAR 18 million is just 100% from that issue.
Okay, great.
On transfer.
Okay. In terms of Cham paper, you talk about synergies. Did you quantify how much you expect and over what kind of a timeframe?
ZAR 10 million. By the end of two years, we'll be running at that level.
Okay, great. During your previous call, you had mentioned when it came to your capital structure that your priority at the moment was your CapEx expansion plans. You were monitoring the markets as your 2020 bonds are currently callable, it wasn't high on your list of things to do. Is that how you're still looking at it?
Yeah, for the time being. It's not something we're planning on doing. Clearly, the market continues to look favorable, as that window opens, we'll monitor it. It's not an immediate priority for us, no.
Okay. The fact that your other bonds 2023 has become callable April next year, is that a factor in terms of timing, like to do something together in April next year when both of the bonds are callable or not really, you could do something before?
No. As I said, it's not really an immediate factor for us. As they move into the callable window, we'll monitor it. Our focus at the moment, obviously, is on these conversion and debottlenecking parts.
Okay. Fair enough. Then, in terms of in your presentation slides, you mentioned dissolving wood pulp capacity coming on stream in 2019. Given where things are currently, when projects are expected to finish, what sort of capacity we're talking about in terms of % of the market?
Look, as we look forward, let's talk the demand side first. We continue to believe that the market will grow somewhere around 5% or 6%. If you convert that into actual tons, you're talking 400,000 or 500,000 tons per annum. As we look at the new capacity that's coming on board, it's not in excess of that. We think.
Okay
balance will continue to look favorable over the next few years.
You expect the additional capacity to be absorbed by the increase in demand?
I'm talking about 5%, approximately.
Okay. Lastly, on the coated woodfree. A competitor of yours mentioned during their call that the deliveries in Europe for the whole market was up 1% last year in 2017 fiscal year, which is 2%-3% structural decline that we normally see in this market in Europe specifically. Having finished such a good year, do you think in terms of volumes this year in Europe in coated woodfree, we would see some sort of accelerated decline when it comes to volumes, having done a good year already? I don't know what the inventory levels are like. I think they mentioned they were already seeing some softness. Is that something you also see or not really?
Yeah, I don't think really. Clearly, over a longer period, we have seen a gradual slowing on the pace of decline. You're right, 2017 was a better year. The European economy was stronger and the demand for graphic paper benefited on the back of that. The early months of 2018 have not been as positive as 2017, but that doesn't change our longer-term outlook. We've said it many times that we continue to think in the near-term future, we'll be down about 2% or 3%. Despite what happened last year, and we'll take it when it comes, we continue to believe it will be down 2% or 3%. That's what we build into our models, and that's why we wanted to take capacity out of coated woodfree and allocate it to other segments, and primarily focusing on the packaging side.
Great. Very helpful. Thank you so much.
Thank you.
Ladies and gentlemen, just a final reminder, if anyone would like to ask a question, please press star and then one. We will pause a moment to see if we have any further questions.
Okay, operator, if there's no further questions, I'd like to thank everybody for joining us on the call today, and we look forward to discussing our results at the end of next quarter. Thank you very much.
Ladies and gentlemen, that concludes today's conference. Thank you for joining us. You may now disconnect your line.