from the chairman and Chief Executive Officer
The company continued the strategy of recent years to diversify its product portfolio into higher margin segments and position it for future growth.
Sir Nigel Rudd
Chief Executive Officer
Market conditions across Sappi's major product categories were challenging throughout the year. Dissolving wood pulp (DWP) market prices in China fell US$273/ton and reached historical lows by year-end, despite global demand growth of more than 6%. We experienced prolonged weakness in global graphic paper markets, while demand for some of our packaging and speciality grades was also under pressure. Uncertainty as a result of the ongoing trade wars and slower economic growth in various geographies were the major drivers of the volatility encountered during the year.
The company continued the strategy of recent years to diversify its product portfolio into higher margin segments and position it for future growth. The recent projects to increase capacity at each of the DWP mills and convert capacity at Somerset and Maastricht Mills towards packaging boosted sales volumes in each of these segments during the year, thereby lessening the impact of weak graphic paper markets. Early in the fourth quarter we announced the acquisition of the Matane pulp mill, which will increase the pulp integration of our packaging businesses, and lower costs. The acquisition was subsequently completed on 03 November 2019.
As market conditions weakened, working capital was tightly managed and discretionary capital expenditure was postponed or reduced to decrease debt levels.
The group's earnings before interest, tax, depreciation and amortisation (EBITDA) excluding special items was US$687 million, declining 10% year-on-year as a result of weak graphic paper demand and declining DWP prices. Operating profit excluding special items for the year was US$402 million compared to US$480 million in the prior year.
We continued our efforts to improve safety across all our operations in the past year. All three regions have safety programmes aimed at creating an environment where there are no injuries. We do not accept that injuries and accidents are inevitable and remain committed to Project Zero with improved personal behaviour and making safe choices, enforcing compliance and leadership engagement. We are pleased to report that our North American operations achieved their best own-employee lost-time injury frequency rate (LTIFR), while being disappointed with an increase in that metric in both Europe and South Africa. Regrettably we must report four contractor fatalities in South Africa during the year. Our target is zero injuries, and we believe we can achieve this with enhanced procedures, training and most importantly, behaviour.
We built on our commitment to be an ethical corporate citizen with an ongoing communication and training campaign following our roll out of the revised Code of Ethics in 2016. This code recognises that we are a global company, operating in many different countries and jurisdictions. Presenting a coherent and consistent culture of the highest integrity is a core value of the group. We must ensure we interact ethically and honestly with our staff, customers and other stakeholders. How we do business is never a short-term consideration but should rather contribute to our long-term sustainability. For our code to be effective, we must live our core values of doing business with integrity and courage; making smart decisions which we execute with speed.
The year started strongly for DWP markets, with pricing above long-term averages for the first six months. Thereafter, the combination of the impact from global trade wars on Chinese textile markets, excess viscose staple fibre (VSF) capacity and a weaker Renminbi exchange rate drove DWP prices to historical lows, impacting profitability in this segment. The weak paper pulp prices and demand dynamics kept many swing producers in the DWP market, further exacerbating the situation.
The packaging and speciality papers segment had a mixed year. The trend towards paper based packaging in consumer segments was positive. Stable South African containerboard demand was offset by higher paper pulp prices at the start of the year which negatively impacted margins, as well as the slower-than-expected ramp-up of newly converted machines at Somerset and Maastricht Mills. The slower European economy also adversely impacted the market for certain consumer speciality grades.
Global graphic paper demand declined by nearly 7% in the past nine months. In European and United States markets, demand declines exceeded 10%, impacted by a general weakening in economic activity, high inventory levels, secular demand trends and the rapid series of price increases in 2018. This necessitated 268,000 tons of production downtime during the year. However, in the second half of the year, the segment started to benefit from a reduction in input costs, particularly paper pulp, helping to mitigate the impact of lower volumes.
Calendar 2019 was the fourth year of our strategic 2020Vision and was one in which we expected to make further progress in improving profitability and cash generation via the shift into faster growing and more profitable segments. This was supported by our investments to convert Somerset PM1 and the Maastricht Mill to paperboard, and the DWP debottlenecking projects at Cloquet, Saiccor and Ngodwana Mills. As described above, however, market conditions for each of our major segments deteriorated in 2019 and attaining our 2020 financial goals became more challenging.
Our strategy encompasses the following four main objectives:
Achieve cost advantages – We will work to improve operational and machine efficiencies, maximise procurement benefits and optimise business processes to lower costs
Rationalise declining businesses – Recognising the decreasing demand for graphic papers, we continuously balance paper supply and demand in all regions to strengthen our leadership position in these markets, realising their strategic importance to the group and maximising their significant cash flow generation. Where possible we will convert paper machines to higher margin businesses
Maintain a healthy balance sheet – This will reduce risk and improve our strategic flexibility
Accelerate growth in higher margin growth segments – We will invest in expanding our paper packaging grades, enhancing our DWP portfolio and extracting value from our biorefinery stream.
The strategic objectives are supported by our value statement: At Sappi we do business with integrity and courage; making smart decisions which we execute with speed. Our values are underpinned by an unrelenting focus on and commitment to safety.
Initiatives and actions undertaken to support our strategic objectives are outlined below.
Achieve cost advantages
Reducing both variable and fixed costs throughout the business is integral to maintaining or improving margins and the sustainability of our operations. This is especially true in commodity businesses where we face declining demand, such as graphic papers. In the past year, we set ourselves the target of a US$60 million reduction in third-party expenditure compared to 2018 through efficiency and raw material use improvements as well as delivering savings through various procurement initiatives. We are pleased to report that savings of US$87 million were realised, which helped offset declining paper volumes and DWP prices. In 2020 we are targeting a further US$54 million in savings. In 2019 we began the Saiccor Mill 110,000 ton expansion. This project, due to be completed towards the end of 2020, will improve our energy and chemical recovery, lowering variable costs for the full mill by an estimated ZAR300/ton. We also invested US$30 million for upgrades to the Gratkorn Mill, resulting in improved efficiency and lower costs. As mentioned above, we acquired the Matane high-yield pulp mill post-year-end and this acquisition, along with some small pulp mill debottlenecking projects in Europe during 2020, will help improve the paper pulp integration of our packaging and speciality papers business, lowering our cost base and reducing the volatility of earnings through the pulp cycle.
Rationalise declining businesses
Graphic paper demand in Europe and North America remains in long-term structural decline. This was exacerbated in 2019 by general economic conditions and as a consequence of a rapid series of price rises in 2018 as a result of then record high paper pulp prices and the impact that had on input costs. Maintaining operating rates and lowering costs are key to our strategy to maximise cash generation in these markets. As noted we had to take 268,000 tons of production downtime in the last nine months of the year which negatively impacted the profitability of the graphic paper business.
In 2018, we converted PM1 at the Somerset Mill. The capacity of the machine was expanded, and it now has the flexibility to produce both coated graphics paper and paperboard products used in the folding carton and food service markets. During 2019, we ramped up production of paperboard grades on this machine as we qualified the various products with a range of customers. In 2020 we expect to continue increasing paperboard volumes, gradually filling the machine as graphic paper sales volumes decline.
In Europe we focused on cost reduction and our go-to-market strategy – Sappi&You – which has enabled us to be a preferred supplier in coated woodfree grades in particular and has seen us increase both direct sales and market share in a declining market. In 2018, we converted the Maastricht Mill to focus predominantly on paperboard packaging grades in support of our existing packaging and speciality papers business in Europe. In 2019, we began the conversion of PM8 at Lanaken to enable the machine to make either coated woodfree (CWF) or coated mechanical (CM) paper. This will allow the transition from CM to CWF production on that machine over the next three years and align our CM capacity with demand. We also made investments at Ehingen Mill to enhance its packaging and speciality papers offering and will be doing the same at Alfeld Mill in 2020. In combination, these projects will replace 200,000 tons per annum of graphic paper with a similar volume of packaging and speciality grades.
In South Africa, our exposure to declining markets is limited to newsprint, where we are the last local producer, and office paper.
Maintain a healthy balance sheet
The decline in profitability of the business in 2019 due to factors noted above, along with a large and committed capital expenditure pipeline during the year has resulted in the net debt to EBITDA leverage ratio increasing from 2.1 to 2.2 times over the course of the year, below our target leverage ratio of 2.0 times. With the completion of the Saiccor expansion project in 2020, capital expenditure levels will remain elevated, but we have reduced discretionary capital expenditure in 2020 to limit the rise in debt levels as far as possible.
In 2019, we refinanced the 2022 Euro bonds with a new seven-year Euro bond at a rate of 3.125%, our lowest ever rate. We now have no significant maturities due before 2023 and we are comfortable with the maturity profile of our debt. Net finance costs may rise slightly to between US$70 million and US$80 million as the net debt increases in the coming year. We proactively amended the leverage covenant on our European revolving credit facility in the fourth quarter at no additional cost to give us more headroom in the coming two years, and allow us to complete current capital projects without putting the business at unnecessary risk.
Accelerate growth in higher margin growth segments
After debottlenecking the Saiccor and Ngodwana DWP Mills in 2018, in the second half of 2019 we completed the upgrades to the Cloquet Mill, adding a further 30,000 tons of DWP production capacity. As mentioned above, we initiated the 110,000 ton expansion project at Saiccor during the year. Apart from additional sales volumes, this will decrease unit production costs for the mill's entire output, introduce new technology, reduce the environmental footprint and future-proof manufacturing systems. Current market conditions, with record low prices, viscose customers under significant pressure and an excess of DWP capacity make a further significant expansion difficult to justify in the near term. We continue to evaluate various options, however, as robust demand growth from our major customers and pressure on the textile industry for more sustainable solutions increases.
Following the acquisition of the paper mill assets of the Cham Paper Group and the completion of the Somerset PM1 and Maastricht Mill conversions in 2018, the packaging and speciality segment volumes grew by 12% in 2019. With increasing sales volumes on the converted machines and the related improvement in sales mix and production efficiencies, profitability of the segment will improve, aided by lower purchased paper pulp prices and the increased pulp integration as a result of initiatives noted above. The pressure on fast-moving consumer goods companies to embrace alternative packaging solutions that are more renewable, recyclable and reusable is encouraging joint R&D efforts to provide these solutions. Many of our packaging products are ideally placed to take advantage of this accelerating demand and we have made good progress in the last year in launching new products and solutions for our customers. The technology acquired through Rockwell Solutions in 2017 is now ready to be rolled out to additional machines in the group in future years, allowing us to capture more of this market.
Sappi Biotech continues to make progress in developing new and innovative products, ideally suited to a world looking for more sustainable chemical and material solutions. We continue to grow our lignin business and have made significant progress to enter higher-value lignin markets in the near term. The demonstration plant adjacent to our Ngodwana Mill has allowed us to test and optimise xylose sugars extraction technology on an industrial scale for markets such as xylitol and furfural. We are pursuing various options to develop projects in these markets. Pending successful commercial arrangements, this may result in final product technology scale-up and ultimate construction of commercial xylose or furfural plants at our mills in the United States or South Africa. Our cellulose nanofibrils and cellulose microfibrils development is ongoing, with exciting co-development and product acceptance progress made in our paper business as well as with firms in the coatings and cosmetics industries. We are furthermore running development trials with our fibre composite product alongside automotive producers.
Since developing our 2020Vision, sustainability has become increasingly more prominent in our strategic thinking as climate change, governmental, societal and brand owner pressure mount and technological change brings new opportunities and risks. Sappi has always focused on the sustainable management of our operations, focused on increasing efficiency and maximising value from our sustainable natural resources. We have also recognised that we need to be more proactive in our dealings with various stakeholder groups and become a trusted partner to these groups to pursue growth opportunities, while managing the risks inherent in this more complex operating environment. Sustainability will become a key component of our 2025 strategy, more deeply integrated into the overall business strategy.
The markets we operate in are expected to remain challenging in the coming year, and profitability is likely to be negatively impacted as a result. DWP pricing in particular will have a significant impact on earnings as this segment is a major contributor to our profit and cash flow generation. We have responded by reducing our capital expenditure in the past year and for the next; and other than the 110,000 ton expansion of Saiccor Mill which is currently under way, we have not committed capital to any material project. We have reduced working capital, amended debt covenants, targeted further cost reductions and are evaluating various options for our paper machines in Europe to lower fixed costs and match capacity to demand.
DWP pricing remains under significant pressure, having declined to historical lows of US$638/ton at the time of writing this report, US$306/ton lower than a year ago. We believe that current pricing is below the cash cost of production for a significant proportion of global supply and is therefore unsustainable over any prolonged period. Underlying demand for DWP is still growing at rates consistent with our long-term forecasts. A recovery in DWP prices is likely to be prompted by a recovery in VSF prices, which have been depressed by excess VSF capacity and a weak Chinese textile market.
In the packaging and speciality papers segment, we are making good progress with customer acceptance in the United States and European markets and the ramp-up of volumes continues, aided by the shift from plastic to paper in many packaging categories. However, the slowing South African economy will probably impact domestic demand for containerboard in the coming year.
Global graphic paper markets continue to show weakness from a combination of economic factors and ongoing shift to digital media. Pricing has declined only marginally over the past quarter, and as paper pulp prices in Europe and North America approach those prevalent in China, margins should be maintained.
Capital expenditure in 2020 is expected to decrease to US$460 million as we complete the Saiccor 110,000 ton expansion project and some smaller European pulp mill debottlenecking projects. Payment of the adjusted Matane net acquisition price of approximately US$158 million will be made in the first quarter of the coming financial year, funded via a new term loan.
Due to current very weak pricing in the DWP market and with paper markets yet to show signs of a sustained recovery in demand, we expect EBITDA in the first quarter of fiscal 2020 to be below that of 2019.
Our wide groupings of stakeholders contributed in many ways to our business in the past year. We appreciate their ideas, constructive criticism and support, which guided our thinking and actions. This support and guidance are invaluable in these difficult market conditions.
To our customers who have supported us in all our different markets, and with whom we increasingly collaborate to provide relevant products and services that generate sustainable value for all parties, we thank you.
Our employees have continued to demonstrate belief in our strategy and a commitment to the business in these challenging markets. Their initiative, resourcefulness and drive towards our One Sappi vision make it clear that our values and ethics are embedded in the organisation. We also thank them for their hard work.
Our gratitude goes to our board for their continued commitment to the group, sharing their valuable insights and encouragement while holding us to the highest ethical standards to enable us to execute our strategy.
We welcomed Mr Brian Beamish, Mr James Lopez and Ms Janice Stipp to the board as independent non-executive directors during the year.
Earlier this month we announced the retirement of Mr John McKenzie (Jock), lead independent non-executive director, and Ms Karen Osar, independent non-executive director effective from the end of December 2019. Jock McKenzie was appointed to the board in September 2007. He was a member of the HR and Compensation Committee from 2007, and chaired the Social, Ethics, Transformation and Sustainability Committee until his appointment as lead independent director in 2016 and then member of the Nomination and Governance Committee. Karen Osar was appointed to the board in May 2007 and has been a member of the Audit and Risk Committee. She also served as Chairman of the North American Audit Committee from 2007 to 2016. We thank them both for their significant contributions over many years.
In conclusion, we value the support of our shareholders as we work to enhance our sustainable long-term shareholder returns. We look forward to their participation at the annual general meeting (AGM) on 05 February 2020.