Arctic Paper — Resilience from a transitioning strategy

Headquartered in Poland, Arctic Paper is one of the leading European manufacturers of innovative, renewable and premium-quality graphic and packaging paper, in addition to pulp. It specialises in numerous types of uncoated and coated wood-free paper and wood-containing uncoated paper. The company has a long and rich history dating back to 1740 when the first mill, Grycksbo, was founded. It listed on the Warsaw Stock Exchange in 2009 and on Nasdaq Stockholm in 2012. It also acquired 51% of the pulp producer Rottneros Group in December 2012, which is also listed in Stockholm.

Arctic Paper is currently primarily exposed to the paper and pulp markets, which are highly commoditised and undoubtedly face large price fluctuations. According to Statista the European pulp and paper industry generated revenue of €95bn in 2021, which implies Arctic Paper has a c 1% market share, based on its FY21 revenue. This is likely due to the oligopolistic nature of the European paper and pulp market, dominated by the larger players such as UPM. Wood pulp is a critical global commodity within the paper industry, with a constant presence in global trade flows, as a result of its primary role in manufacturing numerous paper grades; Arctic Paper produced an average of 394kt of pulp annually, over the last three years. This is modestly lower than its 613kt average for paper owing to the extra paper mill versus pulp.

In recent years, the company has been through a comprehensive transformation process, proactively repositioning its business from largely a niche and agile pulp and paper company to a more diversified business by adding Packaging and Power divisions as part of the 4P strategy. The evolution should enable Arctic to successfully manage market fluctuations, build on modernisation and innovation, meet growing market demand for packaging products and address challenges in light of the structural decline in the paper market. In 2022, the paper business contributed 73% to revenues and 72% to EBITDA, with a standalone pulp business accounting for 27% and 30% respectively. As a result of the 4P strategy, the company envisages that by 2030 the higher value-add packaging business will generate 7% of group revenues and 25% of EBITDA, with another 25% coming from renewables.

Arctic Paper’s size means that it is small enough to be flexible in terms of evolving its business model, and large enough to be efficient while others might struggle to mitigate the foreseeable graphic paper decline as effectively. Paper margins are driven by paper pricing trends and raw material costs, mainly pulp (56% of COGS in Q123). While a favourable pulp and paper mix provides an inherent hedge between the two, generating positive EBITDA results (2020–23 range of €65–217m), a relatively high exposure to these more commoditised market segments results in higher volatility in earnings and profitability. The company’s expansion into the higher value-add packaging business should boost consolidated margins (c 15% target vs c 10% historical average) and improve earnings visibility through the economic and commodity cycles, allowing it to capture the higher end of the value chain and to achieve better diversification and vertical integration.

The 4P strategy for 2022–30 stands for Paper, Pulp, Packaging and Power, the four current and developing divisions of the business:

The four-pillar strategy includes targets for EBITDA to be c 68% higher than FY21 levels (PLN328m) by 2030 and for Arctic Paper to be carbon neutral by 2035 (2030 in the paper segment). Arctic’s current business comprises mainly paper and pulp, albeit by 2030 the company plans to generate c 18% of revenues from packaging and c 7% from power production, with each pillar contributing c 25% to EBITDA. Management believes the anticipated strategic investments in the higher-margin Packaging and Power segments could enable EBITDA margins to be maintained at the c 15% level, a substantial improvement from the historical long-running average of c 10%. The company expects c 40% of its planned PLN1.5bn capex spend to 2030 to support expansion of the new business areas, including 120kt of packaging paper capacity (19.4% of FY22 paper production: 616kt) and 100MW of renewable power capacity by 2030.

The decline in long-term demand for fine-grade paper is expected to persist and management continues to leverage its capabilities to mitigate the trend and transition to higher value-add, niche areas offering greater earnings and cash flow stability. It has a leading position in book paper markets that remains relatively stable, although subject to the same macroeconomic trends that have moderated customer demand recently. In addition, it is seeking to develop products and segments, such as in non-graphic (packaging, technical) paper markets, where it is investing to grow to c 18% of group consolidated revenues over the next few years.

Artic Paper’s 4P strategy to diversify the revenue streams away from dependency on the declining European graphical paper markets should enable greater focus on sustained profitability and cash flows. The company’s solid financial position and cash-generative characteristics, boasting a strong balance sheet with net cash of PLN290m at Q123, should enable the company to pursue the extensive capex plan. In addition, the company has indicated that it will assume debt to help optimise the balance sheet, which will be used to part fund the programme.

Arctic Paper’s capex programme in the period 2022–30 is expected, by management, to surpass PLN1.5bn, c 37% of which will be strategically invested into the Packaging and Power divisions. Management anticipates paper production of c 580,000 tonnes in 2030, 80% of production capacity, with the remaining 20% (120,000 tonnes) utilised for packaging products.

For the past three fiscal years the company has invested in capex broadly in line with depreciation levels, in a range of PLN110–140m. Management guides FY23 capex to be higher due to a wide range of ongoing projects related to increasing pulp capacity to meet external customer demand, new photovoltaic (PV) energy projects in Sweden and Poland, energy storage projects in Sweden, as well as the PLN100m Rottneros joint venture (JV) investment in the production of moulded fibre trays.

Arctic Paper boasts a leading position in the subsegments of books and design paper, with a focus on stable niches where premium products based on renewable material are valued. It specialises in the production of three main categories of paper with a diverse range of end-markets. Its client structure is shown below:

Within the paper market, there are two primary segments: uncoated and coated paper, available in both wood-free and wood-containing varieties. Coated papers undergo a process where a thin layer of calcium carbonate or china clay (kaolin) is applied to the surface. This treatment enhances durability and reduces absorbency. Consequently, coated paper is particularly well-suited for applications such as printing leaflets, brochures and magazines. On the other hand, uncoated paper is composed of fibres without any clay or calcium carbonate sealing. As a result, it possesses a porous and highly absorbent nature, making it ideal for use in books and office paper.

Woodfree paper is exclusively manufactured using chemical pulp, rather than mechanical pulp. Chemical pulp is typically derived from pulpwood, which undergoes a process in which the majority of lignin, an organic polymer that binds cellulose fibres together, is removed and separated from the cellulose fibres. This approach generally yields paper with excellent strength and archival properties. In contrast, wood-containing papers contain a higher proportion of lignified fibres, known as groundwood pulp. While this type of paper may exhibit lower strength, it offers increased cost efficiency and sustainability.

Arctic Paper focuses its efforts on uncoated and coated woodfree paper, in addition to uncoated wood-containing paper (Exhibit 8). Notably, the company is now ranked number four in Europe for uncoated and coated graphical papers (excluding office papers) based on the annual tonnage of paper produced. In addition, it is ranked number one in terms of both European high-quality bookpaper sales and European design paper sales, and envisages maintaining its leadership position in these fields. Arctic Paper currently owns and operates three paper mills, shown in Exhibit 9.

The company’s top three brands in terms of revenue share are Amber (advanced offset production in heart of Europe), G (the most complete matt coated paper assortment) and Munken (the largest uncoated design brand).

The core materials used to produce paper in the mills are pulp, chemical fillers (primarily calcium carbonate), starch (extracted from maize, potatoes and tapioca) and optical bleaching agents. Unlike some other companies that use their own pulp produced in in-house mills, Arctic Paper is non-technically integrated, acquiring all of its pulp externally on a revolving annual contractual basis, concluded under framework agreements or one-off transactions. This is mainly due to the fact that the pulp produced in its pulp mills is of a differing quality to that required to produce its specific grades of paper. Although not integrated, Arctic is nevertheless naturally hedged against pulp price fluctuations; as pulp input costs increase, so does its pulp revenue. The company utilises approximately 10 different pulp suppliers a year (both long-fibre and short-fibre), the majority of which are based in Europe. The process of buying pulp is not done at spot price; rather, each yearly contract signed grants the company a fixed tonnage of pulp, but the exact price depends on the PIX price indices. These function as independent market reference prices of pulp with the price partly linked to changes in energy prices. Buying on a contractual basis enables the company to have certainty in volumes, unlike buying on a spot price basis.

There is a continuing structural decline in graphic paper consumption in Europe, primarily attributable to digitisation, which accelerated during the COVID-19 pandemic with the introduction of virtual work from home policies. As conditions normalised, the more recent geopolitical tensions have inflated input costs, leading to volatile pricing and subsequent customer destocking, and Arctic Paper has suffered from a substantial decline in total sales volumes of paper and production capacity; total sales volumes declined by 30% and 3% in Q422 and Q123 respectively, with production levels at 71% of capacity, the lowest level since Q220.

A total capex of c PLN540m from 2022–30 (35% invested from 2022–24) will be utilised to shift the product mix generated from the paper mills to increase the proportion of packaging paper. In 2030 the company envisages a production volume of 580,000 tonnes (c 80%) of paper and 120,000 tonnes (c 20%) of packaging from the paper mills. Through this process of transformation, Arctic Paper will somewhat mitigate the long-term decline expected in the paper market and expand into the higher-margin paper packaging market, which is currently experiencing a boost in demand from booming e-commerce. In addition, a shift from plastic to smart fibre-based packaging solutions should lead to a more balanced business development, with the potential for improved margins and profitability versus the previous business structure with exposure to volatile paper markets and limited growth potential. In particular, decreasing demand is being seen in newsprint paper and to a lesser extent graphic papers. Consequently, the company has redirected its activities so that within several years, the segment of non-graphic papers (technical/packaging) accounts for 20% of its consolidated revenues.

As a material based purely on a renewable resource (wood), wood pulp plays a key role in the renewable economy. Through the ownership of 51% of Rottneros, a Swedish producer of long-fibre and high yield pulp, Arctic Paper is well positioned to grow in sustainable pulp production for paper, packaging, tissue and technical applications. The company owns two pulp mills, each specialising in the production of two different types of pulp:

The company’s pulp mill products are bought by a diverse range of customers that produce paper primarily for printing, paper hygienic products and cardboards, as well as electrical devices and filters; in FY22 the share of the largest buyers did not exceed 10% of total sales revenue. Pulp is supplied to entities that lack in-house production capabilities, as well as to buyers seeking alternative pulp suppliers to complement their existing product offerings.

Arctic Paper recently announced its decision to invest SEK180m (PLN72m) to increase CTMP pulp production capacity in the Rottneros mill from 125,000 to 165,000 tonnes. This puts the company on track to meet its 2030 aim of pulp production of at least 500,000 tonnes, a substantial improvement compared to the 397,000 tonnes produced in FY22, and will enable the company to meet external demand.

Arctic Paper successfully launched its initial range of packaging papers in 2019, which thus far have emerged as a particularly fast-growing product line. The group is capitalising on the market trends that accelerate packaging paper demand, such as a shift from plastic to smart fibre-based packaging solutions and the booming e-commerce market. The group’s paper mills produce two different types of packaging paper, both of which are suitable for a wide range of applications, such as shopping bags, food bags or laminates. One of these is kraft paper, manufactured under the brand name Munken Kraft, and the other is one-side coated packaging papers, G-Flexmatt, launched on the market in Q221.

During Q123, Arctic Paper entered into a JV agreement with Rottneros, under the name Kostrzyn Packaging, with an initial share capital of PLN460k. The objective of this JV it to construct a moulded cellulose fibre packaging plant in Kostrzyn, planned to be operational by year end 2023; the finalised manufacturing moulded cellulose fibre packaging will be sold on to primary and secondary customers. The estimated value of this strategic investment is c PLN100m, and Arctic and Rottneros will each hold 50% of its share capital. Once finalised, production capacity is expected to reach c 80m moulded fibre trays annually, with revenue of c PLN60m at full capacity (2% of FY22 paper revenue). We believe that the expansion of Arctic Paper’s product portfolio will help strengthen its position in the rapidly growing green packaging markets, a vital aspect of the 4P strategy.

Sustainability remains at the heart of Arctic Paper’s 4P strategy. The company sources its raw materials from sustainably managed forests and processes them into climate-positive products that help its customers achieve sustainability goals. Behind Arctic Paper’s Power pillar stands a clear vision to make the shift from fossil to non-fossil energy sources possible and gradually approach self-sufficiency. Hydropower, solar panels and other green energy in combination with intelligent waste/bio energy plants are currently being utilised, reducing the company’s overall exposure to the volatile electricity market and opening up opportunities for external users (third parties and national grid).

One of Arctic Paper’s primary objectives is to maximise on site energy production and eventually sell surplus supply to third parties. With anticipated capex of PLN450m focused on expansion of the Power pillar from 2022–30, there are multiple upcoming projects in the pipeline. New projects in Sweden include a solar park and battery storage with initial start-up planned for 2024. Arctic is also advancing the plan to build a solar park in Kostrzyn (Poland), as well as several other new energy and energy efficiency projects.

In Q322, a new boiler designed to generate steam from waste fuels was commissioned at the Munkedals mill. Energy for the Grycksbo paper mill is obtained from biomass with electricity, in part, acquired from external suppliers. The Rottneros pulp mill purchases all required electricity from external suppliers and the Vallvik pulp mill meets the majority of its electricity demand from its own resources, with the remainder purchased from external suppliers.

In FY22, the total energy produced on site and taken from outside sources was 3.2TWh, with 3.1TWh used in the company’s production units. By 2030 the company envisages generating a total of 4TWh of energy annually (enabled by the PLN450m capex for power), which has the potential to contribute over 7% of group revenue. This significant increase in energy production is expected to be largely attributable to the scalable new energy plant (boiler) at the Kostrzyn mill, planned for 2028–2030. The large drivers of this market include the ongoing decarbonisation of the Polish and European power generation sectors, the increasing costs of fossil energy due to growing carbon emission allowance prices, in addition to rapid increases in electricity prices.

Wood pulp is a critical global commodity within the paper industry, with a constant presence in global trade flows, as a result of its primary role in manufacturing numerous paper grades. Market pulp prices are consistently volatile and relatively cyclical, being subject to a wide range of influencing factors such as geopolitical tensions, supply chain issues and fluctuations in paper demand and wood prices. According to Statista, the global wood pulp market size was valued at just over $160bn in 2022 and is expected to experience a modest CAGR of 2.7% from 2022 to 2027, approaching a value of $190bn. During 2022, European pulp production declined by c 4% yoy, with an estimated total output of 36mt. The fall is partially attributed to the temporary closure of pulp mills in addition to large-scale strikes (UPM); output of mechanical pulp decreased by c 5%, the segment in which Arctic Paper produces its groundwood pulp and CTMP. Volumes in the chemical pulp category, specifically NBSK, which makes up a large percentage of Arctic’s pulp revenue, was estimated to have fallen to a lesser extent of c 3%.

FY21 saw a significant 43% increase in European NBSK pulp prices compared to end-FY20, with the second quarter showing the sharpest rise of 26% compared to Q121. This annual increase can be attributed to a range of factors, including the global supply chain crisis, with significant congestion in ports and ships having to wait to unload. This resulted in European pulp producers experiencing more demand from local customers. The shipping situation continued into 2022, with the first three quarters experiencing consistent increases in pulp prices, and an annual increase of 13% compared to end FY21. Pulp price increases were further attributable to the UPM paper and pulp mill strikes in Finland, which lasted 112 days from 1 January 2022, causing a temporary decrease in the supply of pulp, particularly in Europe. Q422 and Q123 have seen NBSK pulp price declines of 5% and 4%, respectively, as a consequence of the drop in global paper demand. The short-term outlook for the upcoming quarters shows slim signs of improvement, with ongoing downward pressure on European pulp prices, and continuing capacity curtailments in the paper segment and subsequent flagging demand for pulp.

As mentioned previously, Arctic Paper procures distinct grades of pulp for its proprietary paper mills, which differ in quality from the pulp produced within its own facilities. Consequently, the company is susceptible to the fluctuations of the dynamic pulp market in terms of both buying and its selling prices. Arctic’s average quarterly selling price of pulp (US$/tonne) correlates strongly with the average price of European NBSK pulp, although seemingly at a lower price (also compared to bleached hardwood kraft pulp (BHKP) pulp average prices). This is likely related to the fact that in addition to the more expensive long-fibre NBSK pulp (c 59% FY22 revenue) that the company sells, it also produces and sells cheaper groundwood pulp (c 11%), used to produce inexpensive, non-durable newsprint paper stock. Its paper mills also produce CTMP pulp (c 22%), a cheaper alternative to NBSK.

According to Statista, Confederation of European Paper Industries (Cepi) member countries generated almost €100bn in revenue in 2021, with Europe’s share of global paper production estimated to be c 25%. Various sources estimate that the European paper market will grow at a CAGR of c 5% from 2022 to 2027. This market, unsurprisingly, is experiencing a period of substantial change; the printing and writing segments continue to show a downward trajectory, facing a steady decline in demand, mainly attributable to digitisation, which is expected to continue in the foreseeable future. However, the paper industry continues to grow, albeit at a slower pace than historically, as alternative paper products close the gap left by the eroding graphic paper market. Numerous companies, including Arctic Paper, are investing heavily in transformative projects, diverting to paper grades that are expected to experience relatively consistent demand, such as packaging paper.

In general, graphic fine paper prices tend to follow pulp prices with a slight time lag. Consequently, paper prices are currently experiencing the downturn that pulp prices have shown in the last two quarters. Uncoated and coated woodfree graphic fine paper prices are highly correlated. We expect graphic paper prices to continue to decline in the short term, reflecting the continuing lack of demand and well-stocked inventories. Arctic Paper’s Q422 and Q123 total paper sales volumes declined by 31% and 4% respectively, to a value of 113,000 tonnes, which represents a decrease of over 30% compared to Q122.

Industry experts assume low-capacity utilisation for all European paper mills during Q223 and Q323. In the long term, the company aims to evolve from 100% graphic paper production to 80% by 2030, with the remaining 20% of paper mill capacity (120kt/year) dedicated to produce paper for packaging applications.

Looking at Arctic Paper’s paper and pulp EBITDA margins relative to one another, it appears as though no or little pass through exists, and they are independent of one another. This is likely due to the company being non-technically integrated, buying separate pulp for its paper mills rather than using the pulp it produces in its pulp mills. Technical integration may be beneficial to the company from a cost perspective, given the volatility of pulp prices, albeit its current model allows for more flexibility in terms of the specific quantity of various types of pulp it can buy, affected by fluctuating demand for certain paper grades.

A supervisory board of five members, appointed at a general meeting and nominated by the main shareholders, provides oversight and review of the performance of the management board. The management board currently consists of two members, including a president (effectively the CEO). Michał Jarczyński is president of the supervisory board and CEO, reappointed in February 2019. He was previously CEO of Arctic Paper from 2008 to 2013, with a wealth of experience in the paper industry (nearly 15 years), in addition to his role as CEO of Radpol, a refined polyethylene manufacturer that delisted from the Warsaw Stock Exchange in Q122.

The other management board member is Katarzyna Wojtkowiak, who replaced Göran Eklund at the end of May 2023 following the news of his retirement. She is another well qualified business expert and has been chief accountant and group treasurer at Arctic Paper for over 11 years. She is well positioned to continue Göran’s strong efforts in maintaining the positive trajectory of the company.

Arctic Paper has a total share capital of 69,287,783 shares. Nemus Holding, a company under the Swedish law (owned directly by Mr Thomas Onstad), is the majority shareholder of Arctic Paper, holding (as at 9 May 2023) 40,381,449 shares of the company, which constitutes 58.3% of its share capital and a corresponding total number of votes at general meetings. Thus, Nemus Holding is the parent entity of the issuer.

Additionally, Mr Thomas Onstad directly holds 6,223,658 shares, representing 9.0% of the total number of shares in the company, and, via another entity, 600,000 shares, accounting for 0.87% of the total number of shares. Altogether, Mr Thomas Onstad’s total direct and indirect holding as at 9 May 2023 was 68.1%. The remaining 22,082,676 shares represent the free float of 31.9%.

For Arctic Paper, FY22 was a pivotal year, with annual sales and earnings at an all-time high, and a group EBITDA margin approaching 20%, which in previous years stood consistently at the c 10% level. The company responded proactively to the market headwinds that emerged as the year progressed. However, the outlook for FY23 appears less favourable, as the company grapples with the ongoing market challenges that affected Q422, with lower demand, higher input costs and price volatility across most of its segments in Q123. With customers naturally hesitant to lock in a higher pricing environment given the macroeconomic shocks and geopolitical uncertainty, demand now appears unlikely to bounce back sharply.

In FY22 Arctic Paper delivered a very strong performance, with revenues increasing 43% to a record PLN4.89bn (FY21: PLN3.41bn). All three segments (coated, uncoated and pulp) saw significant increases in sales reflecting buoyant demand and higher selling prices across the year, although customer destocking moderated the performance in Q422. For FY22 overall, coated increased sales by 56%, uncoated by 46% and pulp by 31%.

Gross profit almost doubled to PLN1,411m (FY21: PLN708m) reflecting the favourable market dynamics for most of the year with selling costs only increasing by 28.8%. As a result, the gross margin expanded to 28.8% (FY21: 20.7%). Again we note the impact in Q422 of customer destocking and inflationary pressures driven by higher energy costs.

Arctic Paper saw operating costs increase by 22.5% to PLN567.8m (FY21: PLN463.4m). The major cost components were selling and distribution costs (primarily transportation), which rose 16.8% to PLN445.2m (FY21: PLN381.3m), and administrative expenses, which rose 34.6% to PLN138.8m (FY21: PLN103.1m). In addition, depreciation and amortisation was 14.2% higher at PLN131.0m (FY21: PLN114.7m).

As a result, EBITDA almost trebled to PLN974.0m and EBIT increased by almost 3.5x to PLN843.0m, both record highs for the group and representing margins of 19.9% and 17.2% respectively. The improvement in profitability was apparent across all three main segments, with EBITDA margins of c 20%.

The impact of the customer destocking and inflation meant Q422 generated EBITDA and EBIT margins of 12.9% and 10.1%. While these and the absolute levels of revenue and profitability were substantially up on the Q421 performance, sequentially these compared to 21.5% and 18.3% in Q322. With Q422 revenues down 23% on Q322, profitability more than halved at both the EBITDA and EBIT levels.

After a positive net interest contribution PBT was PLN927.6m in FY22. After tax and minorities, net income attributable to shareholders was up almost fourfold to PLN631.0m, with a similar increase in EPS to PLN9.1.

Operating cash flow for the group was extremely strong at PLN607.4m (FY21: PLN238.2m), reflecting the improved levels of profitability. Even after significant investment in facilities and pension obligations, the resulting net cash at FY22 was PLN276.2m, which compared to net debt of PLN119.1m at end FY21.

The strong trading performance and balance sheet provided confidence for management to increase the dividend for FY22 to PLN2.7 per share compared to PLN0.4 in the prior year, although management also made a subsequent payment relating to FY21 and previous years of PLN0.4 in June 2022.

Despite the continuation of the challenges experienced towards the end of 2022, Arctic Paper delivered a resilient performance, which, while down against the very strong Q122 performance, was sequentially well ahead of Q422. The cash flow and balance sheet remained strong with net cash of PLN289.9m, an increase from the FY22 level (PLN276m).

Outlook

As a result of the conditions experienced over the previous two trading quarters, management stated in its Q123 report that expectations for FY23 are less favourable than anticipated at the start of the year.

However, the group’s main strategic financial objectives for the years 2022–30 remain unchanged:

As mentioned, the total investment over the period to achieve these ambitions is planned at over PLN1.5bn, of which 37% will be allocated to new business areas. Management expects the investment programme to provide a more optimised balance sheet structure, and assumes that it will achieve carbon neutrality by 2035 at the latest.

The oligopolistic nature of the European paper and pulp market means that no new paper or pulp mills, to our knowledge, have been put into production in the past five years; this is also likely partially attributable to the declining nature of the industry as a whole. According to Statista, from 2010 to 2021, the number of CEPI paper and pulp mills in Europe decreased by 11% to 886 (735 paper/board mills and 151 pulp mills). Arctic Paper’s direct peer group consists mainly of the three large, publicly listed players UPM, Mondi and Navigator Company, which have an international customer base, alongside smaller public/private (c 150kt paper production annually) or family-owned companies (c 30–70kt paper production annually), which act as local/regional suppliers. Arctic Paper has the potential to set itself apart as it continues to leverage its capabilities to mitigate the trending decline in long-term demand for fine-grade paper, through transitioning to niche areas and offering cash flow stability.

Exhibit 18 shows a selected list of Arctic Paper’s peers. We recognise that the companies included are of a different scale; however it is a guide to how the market rates the European paper and pulp industry.

Arctic Paper increased its net asset value by 40.9% to PLN2.03bn (€452m), or PLN29.3 per share (€6.5/share), in Q123 compared to Q122, which was over triple the level at the end of FY19 (PLN568m) despite the global pandemic. The company trades at a 2023e EV/EBITDA multiple of 2.2x and a P/E multiple of 4.1x, representing discounts of 71% and 64% respectively to the peer group average. This may reflect the current business structure of mainly lower value-add and more volatile pulp and paper, whereas peers are operating higher-margin packaging businesses; Arctic Paper’s average EBITDA margin over the past three fiscal years is 4.6pp lower than the peer group average. That may indicate the potential valuation increase if the 4P strategy is successfully executed. The company also has an attractive FY22 dividend yield of 11.2% (over 3x covered by earnings), almost double the peer group average, albeit we note that this was subsequent to its record FY22 and the current outlook appears less favourable.

As a European paper and pulp producer, with its current primary source of revenue derived from high-grade paper sales, Arctic Paper is exposed to the long-term structural decline in demand for fine paper (in the level of executed orders); the intensification of remote working has accentuated the effect of reducing demand for high-quality graphic papers. However, diversifying the business into packaging paper and power, in line with its 4P strategy, should provide a more stable and long-term cash-generative underpinning of the group activities, although volumes can fluctuate, reflecting the cyclical nature of the industry. The other sensitivities include:

Paper prices: most obviously, higher (or lower) revenue per tonne sold – through pricing strategy or mix evolution – can have a significant positive (or adverse) operational gearing impact on profit. Underlying input pulp costs are a key driver: selling prices that recover input cost increases maintain the profit per tonne spread through dilute margins. Paper prices are strongly correlated with pulp price fluctuations, typically with a modest time lag before prices fully adjust, which can provide a short-term boost or dampening effect on profit. According to Q123 results, pulp accounted for 56% of COGS. Paper prices are additionally subject to various factors concerning supply, predominantly driven by fluctuations in production capacities at the global and European levels.

Input price volatility: raw material price fluctuations, such as pulp for paper mills, transportation costs and electricity for all operational entities, significantly influence the financial performance of Arctic Paper. Specifically, the financial performance of the paper mills may be negatively affected by consistently high cellulose prices (notably BHKP). Conversely, declining prices of NBSK pulp may have an adverse impact on the financial performance of pulp mills. Moreover, fluctuations in electricity prices in Sweden may have a material impact on the financial results achieved by the group.

Foreign exchange risk: fluctuations in currency exchange rates, particularly the appreciation of the Polish zloty and Swedish krona against the euro and the pound, as well as the appreciation of the Polish zloty against the Swedish krona, and the depreciation of Polish zloty and Swedish krona against the US dollar, could potentially have a detrimental impact on the group’s financial results. It is also worth noting that the pulp mills within the group may benefit from the appreciation of the US dollar against the Swedish krona.

Financial considerations: Arctic Paper boasts a strong balance sheet with net cash as at the end of Q123 of PLN290m, implying a rolling 12-month leverage ratio of -0.27x. With its growth strategy and extensive capex programme, with expected investment of c PLN1.5bn in the 2022–30 period, we note that the company may need to use more financing through debt, which could pose a risk with the current high interest rate environment, although it would improve balance sheet efficiency.

Liquidity: Mr Thomas Onstad’s total direct and indirect holding as at 9 May 2023 was 68.1% (58.3% held by Nemus Holding, the majority shareholder, which is indirectly owned by Mr Onstad). We understand that this has been a relatively stable position for a number of years and have no reason to believe this is likely to change significantly. However, investors should recognise there is a relatively small free float of 31.9%, which could partially be responsible for the valuation discount.