Fisher Webinar – How Does China’s Containerboard Market Compare to the U.S.?

welcome to Fisher webinars the following is a recording of how this China’s containerboard market compared to the u.s. originally recorded on Thursday June second 2016 so today’s topic is valuating the Chinese and US containerboard markets and of course you know given the 30 minute time slot today we couldn’t possibly completely do a detail looking at every aspect of the markets and so what we’ll do today is is what you might think of as a quick look or a mini diagnostic on some key factors within each market and hopefully what we’ll try to do is is demonstrate how through good good use of facts and data we can develop some insights and answer the question so what so what does it mean for each marketplace given the structure that we find during our analysis and that’s important because oftentimes executives who are running businesses and those who are observing industries you can only see the performance the performance of producing Mills performance of suppliers in the industry but we often we know that performance as a result of behavior that is the choices that individuals make in a given industry and often times that behavior sometimes might seem unusual or different than we’d expect but upon further examination if we understand the structure of the industry that that we’re analyzing we can often find the actions that participants take and therefore the performance is entirely predictable because of the structure of the industry and today what we’ll try to do is analyze the structure of Chinese containerboard and compare it with the US and think about what that means in terms of how the containerboard market might evolve in China in the first chart we’d like to start with just a set the talk is graph that shows total production of continued board for each producing country this is from the Fisher salt database and we can see clearly that China in the US one and two respectively these are big markets in we’ve we’ve done this analysis as what’s what’s called a Pareto graph some of you might be familiar with the 8020 rule where the orange line shows the cumulative total production by each country and so the way you read that is china and the u.s. containerboard markets account for fifty percent of the world’s total production of containerboard so another way to say that is these two countries the US and China make as much production of continued Lord as the rest of the world combined and so I you know obviously the implication is that what happens in both of these markets is extremely meaningful in important to the overall containerboard industry and worth and worth understanding in terms of the growth rates of the of the two marketplaces China and the US when I’m showing you here is a screenshot from Fisher solve and I did this for one reason I throughout the rest of the the presentation you’ll see analysis mostly in charts that we’ve derived by exporting data and analysis from Fisher solve this particular screenshot shows you that you can in fact you most all of this analysis within the tool itself if if you chose to this is from our capacity trend module in Fisher solve it shows changes in capacity both historical and announced over multiple time periods and over multiple combinations of the data in Fisher solve when I’m showing you today is the trend of containerboard capacity in China which is the green bar in the US which is the red bark there’s a pretty clear story here what you can see immediately from the chart is China has experienced quite impressive and rapid growth whereas the US as one might expect as a more developed marketplace has been relatively flat Chinese compound annual growth rates over this time period have averaged about ten percent whereas the u.s. is just under one percent so if we take the data in and smooth out some of the lumpiness in that that total

capacity number we can start finding I think some it some interesting takeaways within the data so what I’ve done here is smooth Chinese total containerboard capacity that’s the purple lining you can see it is it is a bit bumpy some of that’s caused by timing of projects obviously I’ve smooth that out that’s the orange line and then what we’re going to do is evaluate the derivative of that that line that total capacity number so what we’re thinking about now is how is the growth in capacity in China changing but we’re going to even go one step deeper into this analysis to find something interesting so what we’ve done is now charted that change in total Chinese capacity so this is the first derivative for those who are familiar with math if we draw another line in this trend what we can see clearly and this is what you might refer to as the second derivative or the rate of change of capacity change so another way to think about this is this telling this is telling us something about the momentum of change in the marketplace is the growth rate growing faster or is the growth rate slowing and this could be again a good indicator of momentum and where the marketplace is headed and we can clearly see in the early 2000s through 2011 of course there was a great recession in the middle there but overall very we see two different periods of increasing growth rates in capacity change so market that had a lot of momentum for growth in what I think most importantly what we see since 2012 is a decline in the growth rate of capacity at China a very clear trend that the growth rate is slowing and what this old certainly means is this is driven just created a situation of surplus capacity in China so the dramatic growth rates in Chinese containerboard that we saw four or five years ago almost certainly created capacity surplus in the country and so therefore we would expect to see low operating rates in China and in fact that’s exactly what we find so this chart shows operating rate that is the apparent demand / The Container board capacity and what we can see from the chart is that Chinese operating rates were okay they were in the ATI 80 per centage range in 2008-2009 and starting in about 2011-2012 when all of this tremendous capacity growth occurred we see a fall in the operating rate now of course this is totally you know the global economy hasn’t recovered as quickly as folks thought it would coming out of the Great Recession it certainly hasn’t certainly the Great Recession didn’t extend through 2013 and so what we can draw from this is this is mostly a function this low operating room is mostly a function of over capacity or capacity surplus rather than demand though certainly slowing overall global demand over the last year or two hasn’t helped things the takeaway here is that Chinese containerboard market essentially over built to demand that we’ve seen and that’s resulted in very low operating rates particularly compared with the US which has averaged in the mid 90 percentage since 2010 in terms of how quickly the two largest containerboard markets evolved on this chart we have a total of containerboard machine capacity by year built the dark green bars the United States the the light yellow bars China and as we can immediately see the u.s whereas the u.s. took oh call it 50 to 60 years to evolve the Chinese containerboard market was essentially built in the last 20 25 years or so so a very very young market very new market very rapid growth so just how rapid of growth are we talking about I thought this was a an interesting interesting analysis something you might be able to use in conversations with your colleagues going forward so one way you might think of how quickly and how rapid Chinese growth has been is to compare

one mill in China very large Mills is nine Dragons dongguan mill with the entire US containerboard market so there were more containerboard machines built in dongguan twice as much in fact after the year 2000 then was built in the entire United States in the over that same time period so again one mill in China dongguan more containerboard machines since 2000 twice as much in fact as as in the entire United States so very rapid growth very rapid investment and what this is generated as you would expect this rapid growth is a very different result in terms of the fragmentation of the marketplace and market share so this is a chart that shows company shares of production for China in the United States you can immediately see that the u.s. is much more consolidated where essentially you have four large players that account for those 20 lion’s share of the capacity in the marketplace whereas in China outside of night dragons and lien man the two largest producers you have very fragmented market place lots of companies in fact about 191 container work companies in China whereas 29 in the US and and so from a certainly from a perspective of the volatility we’d expect in the marketplace the behavior of participants that we’d expect in the marketplace going to be quite different because of this fragmentation it also of course impacts you know how suppliers to the industry might might approach both segments so whereas you know for example you could have a few strategic corporate accounts individuals call on most of the capacity in the United States it’s three or four companies obviously in China you’re going to have to have you’re going to require it’s going to require much different resourcing to cover a you know 191 different companies throughout the country so this is a pie chart that shows that bar of Chinese company share a little bit more detail and so we can see nine dragons and lien man have thirty percent of total marketplace capacity and hui xiang ning has five percent and then after that it really drops on off into what you might call the twos threes and one’s very fragmented we can actually see that from this chart that almost half of the marketplace is made up with companies with with less than one percent share of the market place and as we mentioned before we’d expect this amount of fragmentation would contribute to more volatility in the market then you would see say in the US we’ll take a quick quick look at how the two markets production differs in finished products and also their channel dynamics so let’s start with the u.s. alright so this pie chart shows share of total production in the US by finished product we can see from the chart it’s fifty percent craft liner so this is Virgin craft liner followed by recycled corrugated corrugating medium and then some of the men white top liner and recycled liner this production is going into a marketplace that’s predominantly integrated forward integrated box plant so this purple box is represents the percent of total us continue board shipments that goes into that goes to box plants owned by containerboard companies so for example IP westrock georgia-pacific PCA etc own their own box plants in front of the mill and they transfer or sell paper to to their own box plants and as you can see that’s a very large portion of the marketplace around seventy percent or so that the next two boxes the orange boxes non-integrated box plants in the u.s sometimes this is referred to as independent box plants so these are open market sales of container boards to box plants not owned by us producing mills and then the blue box is export there’s a fairly significant amount of volume exported out of the United States primarily craft linerboard in fact it’s nearly all virgin crafts linerboard and as we can see that’s a large share of total production of the u.s. so let’s take a look at how this is different in

China so we’ve got the same pie chart and as we can see immediately the u.s Chinese sheriff production is much more ask you to recycled linerboard in medians than it is in the US and in fact nearly all of the container board produced in China is is based on recycled really old corrugated containers and that’s going into a different different looking channels as well in fact to start be different from the United States so remember whereas the for the u.s. the non-integrated channel is much smaller portion of the total volume in China it’s nearly reversed where we find that most companies most container where companies in China are not forward integrated in fact it’s probably below twenty percent forward integration so they’re selling to a almost completely selling to an open independent market of box plants very low integration levels in China the second thing I want to point out is is the blue bar which is nearly impossible to see for the Chinese channel map there is there is essentially zero exports of containerboard out of China and so the implication of this importance of this is where as you can think of the u.s. if you’re a US producer you have you have several levers you can pull if you’re in the in the in the goal of optimizing your production and managing market dynamics and volatility in China on the other hand you’re really just you’re really relying on the domestic non-integrated marketplace for your volume so we’d also expect this to contribute to volatility because to the extent demand would change we’d have capacity surplus in China there isn’t those different channels to move volume around like there is in the US and as we saw in the pie charts that the large almost entire proportion of Chinese containerboard capacity is recycled and and let’s think about whether or not you might expect to see that export channel grow out of China this chart shows occ gathered in various regions Europe North America and China and then production or consumption of OCC and a quick take away is that China imports nearly all of it all of it some CC from North America and Europe and so again if we recall back to the previous slide that showed all of the production in in China is occ or recycled base it does it’s it’s not logical that chinese producers would be able to import occ say from the US or Europe run that OCC through a container board machine spend the energy to dry it and the labor to make the stuff and then only to ship it back from where it came so we can do a simple thought experiment to to conclude that you know grow at a growing export channel within China it’s probably not going to happen at least at least in the short run and extending this thinking about the different channels that Chinese containerboard companies have and and and the lack of options we can see this again in the operating rate so as Chinese market build capacity in relying on that domestic having to rely on that domestic demand without other outlets to push production we see the result again is in this very low operating rate now an implication of low operating rates particularly that the types of numbers we see out of China just currently around eighty percent operating right we’d expect the price to be on the floor and we’ll we’ll describe what the floor price is in a few charts and if we look at a trend of prices out of China particularly for fluting and test lining this is a this is a chart presented by a chinese paper it distribution company we can see a couple things interesting one is as prices of chinese containerboard that’s the dark gray and light gray lines were or bumpy or volatile up until 2013 or so and then have been flat and we’ll show you why it’s been it’s been flat in a moment but let’s look at the price it sits around 3,000 you on per metric ton if we look at a cost

curve we can understand it a little bit a little bit more clearly exactly why that price is where where it is the 3000 number and why it’s been so flat so this is a cost curve showing total capacity in China remember we estimate the operating rates around eighty percent so if we find a spot on the curve about the eighty percent level this with the orange first orange arrow is demonstrating we can find an equivalent cost of production when we do that we shouldn’t be surprised to find that again we’re at the 3000 you want number which is exactly the price in China and so as we would expect from the structure the industry is over capacity has caused prices to fall to what we use in Fisher terminology the floor and the the floor price is a point at which is really set by the higher cost producers at the level of operating rate within a given market place and you usually see this phenomenon when you have a situation of a very low or low operating rates we if we see the price fall to the floor that’s the point at which producers can’t sell any you know sell any more tons of product and make a profit and so the price tends to be sticky at that point and in fact we can see that I unwind this we can see that exact same stickiness in the pricing chart where prices have fallen to a floor it even looks like a floor in this chart in really there for two years okay so because because because China relies so much on imported occ primarily we can see that their costs on average are higher than the US which is the green bars China in the red bars us if we just take a look at the averages for each country we can clearly see the drivers of those differences in costs Green is fiber here so we can we can see that Chinese fiber costs are on average thirty dollars or so higher the US and logically this is of course because you’re collecting this material so as you see material in US or Europe and then having to ship all the way to China in because of you know the usage of recycled hive usage of recycled in China we also see a equivalent increase in chemical cost this is things like starch and strength aids and additives when you’re running a high recycled machine if we split that cost curve that we saw earlier in two groups that Chinese containerboard Mills on the left us containerboard mills in the right we can see that these slopes are different so each of these numbers shows the average change in cost per mil so what you think about this is the next highest mill in the u.s. is on average of dollar 70 per metric ton higher cost than the one before it China is about sixty cents so what’s interestingly what’s interesting to note is the takeaway is that in the being low cost for one in China doesn’t create as much differentiation as it as it does in the US but two because there’s more more of a cost difference or more of a margin difference to be made with lower cost in the u.s particularly on over volume you’d expect we’d expect to see you know incentive for more rebuilds or projects to D bottleneck machines in the u.s. that we do in China and I think that’s also reinforced with this chart this chart shows for each miss containerboard machine in both the US and China the US as the light green china is the dark green we can see a couple of trends immediately one is that the u.s machines technical age which is the y-axis much older than China and so if we think about the two marketplaces you’ve got a situation in the US where you’ve much or technology a steeper cost curve meaning there’s a there’s a larger benefit for incremental volume production week we should expect to see more rebuilds in the u.s. going forward than we would in China another aspect of the two marketplaces which is quite different is labor dynamics so this chart shows the average price of Labor on the x axis versus the what we call the usage on the y axis this is a total number total average total employees on given containerboard site so in China we

can see that 425 average employees on a given mill site whereas in the u.s. you have 250 you can also see the productivity is much higher in the u.s nearly three times three times as much as it is in China in terms of metric tons per year per person and clearly you know obviously what we can we can see from this graph is that higher higher wage rates in the US nearly four times as high forty dollars per hour creates a larger incentive to run leaner in the US than it does in China what’s interesting is if we still if we if we took a dive again and the Chinese containerboard cost even though we have a situation with low labor rates low wages i should say there’s still a large difference between what I’m going to call here the indirect cost or you might think of it as the fixed cost per ton for Chinese mills so this chart just shows Chinese containerboard capacity this is a build up from Fisher Saul’s cost curve benchmarking tool where we’ve we’ve we’ve removed all of the direct costs so these are fiber and chemicals things that you need to buy every time you make another ton so we’re now looking at at cost components you might think of more of as fixed we look at this we can see there’s quite a gap from the highest cost producers in terms of fixed us but those are loke with those that are low costs and so we can think of this is ironically even though we’ve seen there’s lots of capacity in China lots of new machines being built and you might say well is there going to be more green fields interestingly enough it appears that at that building large-scale machines could still pay in China and actually what’s interesting is as that compares to the u.s. chinese producers get a better return on new greenfield investments than they do in the u.s. so this chart is too simple math you taking the average cost of a green field mill in dollars per annual ton of capacity and we’ve divided it by that spread by that difference between the highest cost and lowest cost producers both for the u.s in China and so what this tells you is if can expect you build a brand new very large very efficient high capacity greenfield mill in China it gives you a better pay back than it doesn’t in the u.s. because there’s such a difference in fixed costs among participants in China and so what’s interesting Lee is even though we receive operating rates about eighty percent today you might in fact see new capacity coming online in China and in fact when we look at data from Fisher solve showing announced capacity in China we can see just that’s true so this is China and the US green bars and red red bars respectively and despite low ish operating rates in China we still see through the next two years 11 million tons of capacity announced now of course some of these projects will come to fruition they’ll be postponed or something will happen but but clearly we can see still still a drive to add capacity in China and you know despite the analysis we showed earlier which is this dramatic slowdown in the rate of capacity I think we should remember this is still a cyclical industry right so this this chart shows a capacity change for both China and the US again China still the green bars in it as you can see they’re all others changes in the rate of capacity growth you can also clearly see cycles in the industry and the data from Fisher solid showing announced announced projects clearly I think continues that trend that this that this is an industry that moves in cycles so what’s astonishing is despite what you might think of having a mindset from you know a different kind of mindset that you know why in the world would you add more capacity to a marketplace that as eighty percent operating rate and it appears that just that is happening and if we look at those machines that are under construction versus though our operating we we start to prove the point which we made earlier which is that it still pays if you will or chinese producers still

incentivize to put in scale machines and so this chart shows the average trim width of operating containerboard machines in China versus those under construction as we can see those under construction are twenty to forty percent wider than they are in than they are for operating machines and this is probably a smart strategy this chart shows Chinese wage growth as you can see it’s it’s it’s been phenomenal the growth has been quite rapid essentially tripling annual wages over the last sure so and so what is this going to do to Chinese containerboard producers how it might change the market dynamics so what we’ve done on the next chart is done a scenario with in Fishers all that what-if analysis changing the labor rate the green bar is the base case that’s today’s curve and then we’ve pushed those costs up by changing labor rates and and what you can see is that obviously as you think those machines that have lower Prada Louis kale a change in the price of Labor is a much larger lover than it is for the largest machines and so we’d expect a bit of an asymmetry here as wages increase in China more pressure on higher cost smaller lower productive machines and large machines and of course if you’re a producer you have an expectation of higher wage rates going forward this is also something that might incentivize you to add even more capacity into the marketplace because you have to uh today if we look at the three largest producers leadman nine dragons and we shine ii we can see that they’re there they’re already fairly low cost this is a total average cost by company and so let’s let’s let’s segue from this chart showing total average cost per company to thinking about MA so the first point I would make is that you know we talked about how we’ve spoken about how fragmented the Chinese market place is and if you’re the three largest producers it’s it’s not it’s not likely you’re going to buy a lot of your higher higher cost competitors just for the sake of consolidation so let’s think about what happens as new capacity and there’s the marketplace and if that might consolidate the market in itself as we as we showed earlier there there should be an incentive still for new capacity to enter the Chinese market place as that does it’s almost certainly going to be lower cost you never purposefully add a higher cost machine to a marketplace so you’ll expect those machines to come in the first second quartile as that does as that happens it will pressure higher cost producers and eventually push them out and to the extent that those machines come in through players that are already big today we can imagine how this consolidates the marketplace and in fact we can see from this chart the wider bars show us that to a certain extent that that’s exactly what’s happening that the more of the fragmentation or the smaller machines exists in the in the upper third and the third and fourth quartile the cost curve so as we see this industry continue to evolve I’d expect to see some consolidation just through what you might think of a shakeout that is higher cost machines coming out of the market place and the survivors that are left are bigger and they get bigger and bigger and they leverage additional fixed costs and they get bigger still and so we should expect that as more of a mechanism for consolidation moving forward then ma at least for the largest producers as that happens we talked about the price before you would expect to see the floor price actually fall right so as higher cost producers are pushed out of a marketplace so long as the price remains on the floor you’d expect to see a new floor price which is Laura yet of course this this would serve to provide even more pressure on the higher cost producers pressuring pressuring them to remove capacity but also perhaps and potentially resulting in lower margins for the remaining players so to summarize you know should we expect to see M&A at least from the biggest players in China probably probably not you know from nine Dragons and Leah man they’re already quite large but but again white in the main why would you go around and buy smaller mostly higher cost capacity and you in fact you know because there’s so many of those small players one two percent you’d have to acquire many of them to

consolidate the marketplace that’s not to say where I can see any M&A in China there has been ma and so you’d expect whereas we’re making the case you might not see it with the largest players you probably could see it with the small smaller in mid tier sized companies merge in the marketplace in fact we’ve seen a little bit of that I thought this was interesting this is from a few months ago this is an announcement of seven board mills merging in China which a 77 player merger is something you don’t often see in the US so again you might you might expect this kind of activity amongst smaller participants as we as we tie this talk up and wrap it up let’s just summarize where come back to the chart showed at the beginning which is you know again in in the 30 minutes or so we’ve had here a impossible and be an exaggeration say you’re going to walk away with everything you know about continuing board in China in the US but we can start to scratch the surface and and think about you know what what’s different about the two marketplaces in what does that mean in terms of implications so you know for example if you look at the company shares we found that china is much more fragmented at us we would certainly expect something to do you know that some impact on the on the cycles that you should expect to see China’s a little bit at operating rates you know if your supplier to the industry I think it also should inform how you think about going to the market so in the US for example you can you know if you find the right right individual or group of individuals and Gifford corporation you can call on five appointment and essentially have you know face time with with the majority of the market well in China is 191 different companies so much different timing territory management strategy sales cycles etc but lastly let’s look at technology as an example as soon as you’re reading as I what is that let you read the other points much newer in China much older in the US but we showed how when you shouldn’t be surprised to see additional rebills in the US and I think many would actually argue that the u.s. containerboard actually paper industry as a whole has been somewhat underfunded in last five to ten years so you should expect to see more investments to bottlenecking investments to get more productivity out of us jeans and what’s interesting is despite the fact that china is fleet as so new and history so new you want whereas you might not see as many remonte rebuilds in in China machine rebuilds you should expect us to continue to see more scale machines because as we show their stola there’s still a big enough differential between the fixed costs of highest cost producers and low cost producers to probably make that a good economic choice in in some circumstances and of course like we said there’s there’s so much more we could analyze on this topic we you know we need to take days if not weeks to do it to do complete justice but that’s you know as we end the talk and for many of you on the call who are customers that’s why we’ve we’ve tried to collect really what’s an ocean of data and push it into a tool that you can analyze many different ways and answer questions that that might be important to you so that you can understand the annoying structure of a marketplace and therefore think about the strategic choices and levers you’re in a poll to make you successful you