Letter to stakeholders
from the Chairman and CEO

Chairman and CEO

Sir Nigel Rudd
Chairman
Steve Binnie
Chief Executive Officer

Presenting a coherent and consistent culture of the highest integrity is a pillar of our strategy.

Operating review

The overall result for the year was in line with that of the prior year on a like-for-like basis, despite the disruption caused by a number of large capital projects. Market demand for dissolving wood pulp (DWP) and specialities and packaging papers ensured our production capacity in these grades was fully utilised, further supporting our decision to invest in additional capacity in these business segments. In the printing and writing papers segment, a series of successful selling price increases throughout the year enabled margins to be maintained notwithstanding significantly higher raw material costs, mainly from paper pulp and various process chemicals. The profitability of the Southern African business was under pressure due to the stronger Rand.

Increased capital expenditure in growth projects, including the conversions of paper machines in Europe and North America as well as debottlenecking DWP plants in Southern Africa, was managed around our target of two times net debt to EBITDA. This facilitated a further shift in the product mix of the group away from the traditional printing and writing papers business towards higher margin and growth segments.

The group's EBITDA excluding special items was US$762 million, declining US$3 million on a like-for-like basis (2017 benefited by approximately US$20 million due to an additional accounting week). Profit for the period was US$323 million compared to US$338 million in the prior year.

  Dividends per share (US cents)
  Dividends per share (US cents)

In the past year we have worked to prioritise safety for our employees and those of contractors in our workplaces, bringing in external experts, reviewing risk conditions in all our operations and emphasising the importance of both the individual and the collective with regards to safety. This renewed commitment and focus resulted in each of the three regions improving their LTIFR rates, with both North America and Southern Africa achieving their lowest ever employee injury rate. Despite this, we regret having to report two fatalities, one of which was an employee in one of our European mills and the other a contractor that died in a motor vehicle accident in the Southern African operations. Our target is zero injuries, and we continue to believe we can achieve this with enhanced procedures, approach 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 (Code) in 2016. The 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 pillar of our strategy. 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.

Maintaining the highest standards of corporate governance is of prime importance to Sappi. As such, we moved to implement the external auditor rotation recommendation of King IV prior to its formal implementation. A process in this regard commenced in 2015. KPMG was selected after a thorough search for a globally capable firm reflecting Sappi's global footprint. The Sappi board is concerned about the ongoing allegations and investigations into KPMG South Africa and continues to monitor the situation and will re-evaluate our position if any new information becomes available.

Our European business maintained a good level of profitability, with increased sales volumes and prices, along with an expanded proportion of specialities and packaging papers offsetting significant cost pressure from purchased paper pulp costs. Demand for coated mechanical (CM) paper was good for the first nine months of the year, while coated woodfree (CWF) paper demand was slightly weaker than expected. Gains in market share allowed us to limit coated paper sales volumes declines. Cost pressures and tightening supply led to a number of selling price increases for CWF paper throughout the year, and prices ended 9% higher than at the end of 2017. The last few months of the year, however, were particularly weak across both coated grades and all indications are that the European economy is slowing, and that the cumulative impact of selling price increases has affected downstream demand. Variable costs increased 6% year-on-year, despite various cost savings initiatives, the primary reason being a further 24% and 16% rise in hardwood and softwood pulp prices respectively.

In North America multiple coated paper selling price rises, supported by supply tightness in the market, offset the negative sales volume and cost impact of the major project to convert PM1 at the Somerset Mill. The project to convert the machine to paperboard grades, while ultimately successful, overran both in cost and time, exacerbating the impact of lost production and increased manufacturing costs. The causes of the overrun, which led to US$10 million in lost production over that originally planned and a further US$35 – 50 million in capital expenditure, and the steps we will take to improve our project delivery in future are outlined in the Q & A with the CEO. Variable costs increased by 4% year-on-year, primarily due to higher purchased paper pulp prices.

Margins in the Southern African business were under pressure due to the stronger Rand/US Dollar exchange rate during the first three quarters of the year. This lowered the effective Rand pricing for DWP (which is priced in US Dollars) and led to decreased margins in this segment. Delayed start-ups post upgrade projects at Saiccor and Ngodwana Mills resulted in lower production and reduced DWP sales volumes for the year which exacerbated the situation. Containerboard sales did well, with both sales volumes and prices improving as strong growth in the agricultural sector led to increased exports of fruit, the primary driver of demand for this product. Variable costs increased by 7%, led by price increases in energy, chemicals and fibre.

Global demand for DWP continues to grow, and our sales volumes were 1% higher as increased production from the Cloquet Mill more than offset the lost production and sales volumes from the Southern African mills referred to above. Higher paper pulp prices supported DWP selling prices throughout the year, while a weaker downstream viscose staple fibre (VSF) market prevented DWP prices from rising further throughout the year as additional VSF capacity was brought to the market, lowering operating rates and causing VSF prices to decline. This led to spot prices in China for DWP trading in a range of US$920/ton to US$950/ton for most of the year, resulting in lower average net realised prices than that achieved in 2017. During the year we launched the Verve brand as the umbrella brand for our DWP products with the brand promise of Fibre made with the future in mind. This launch recognises the importance that customers and consumers place in sustainably sourced fibres.

The European specialities and packaging papers business grew sales volumes by 8% over the prior year, excluding the additional volumes from the mills acquired as part of the Cham Paper Group (CPG) acquisition (see the strategic review below for more detail on the acquisition and rationale therefore). The acquisition of CPG aligns closely with our focus on the growing higher margin coated specialities and packaging papers such as release liner, solid bleached board and functional papers, and allows us to leverage our coating expertise. We are working closely with customers to develop new and innovative solutions to their packaging needs. In North America, packaging sales volumes increased by 68%, with gains in both our legacy packaging products and paperboard sales post the completion of the PM1 conversion at Somerset Mill.

Strategic review

Three years into our strategic 2020Vision we have made good progress towards improving profitability, cash generation and growth. In 2018 we increased capital expenditure significantly over that of the prior four years as we initiated a number of important projects to deliver on our growth targets. While increasing the capital expenditure we have been mindful of our long-term sustainable leverage target of two times net debt to EBITDA.

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 printing and writing 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 products – We will invest in expanding our packaging papers grades, enhancing our DWP portfolio and in the extraction of 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 and commitment to safety.

Initiatives and actions undertaken to support our strategic objectives are outlined below.

Achieve cost advantagesAchieve cost advantages

Reducing both variable and fixed costs throughout the business is integral both to maintaining or improving margins and to the sustainability of our operations. This is especially true in commodity type businesses and those where we face declining demand, such as printing and writing papers. In the past year we set ourselves a US$60 million target to reduce third party expenditure compared to 2017 through efficiency and raw material usage improvements as well as delivering savings through various procurement initiatives. Pleasingly we achieved savings of US$82 million, which helped offset pressure from higher paper pulp, chemicals and energy prices. In 2019 we are targeting a further US$60 million in savings. During the year we commenced the Saiccor Mill woodyard upgrade to improve wood efficiency as well as to allow for further expansion of the Saiccor Mill. In 2019 we will proceed with the Saiccor Mill 110,000 tons expansion having recently received EIA approval for the project. This project will improve our energy and water efficiency and result in improved energy and chemical recovery, leading to lower operating costs. We will also invest in upgrades to the Gratkorn Mill, resulting in improved production efficiency and lower costs.

Rationalise declining businessesRationalise declining businesses

Printing and writing papers demand in Europe and North America continues to be in long-term structural decline, the rate of which is also impacted by general economic conditions. Maintaining operating rates and lowering costs form our strategy to maximise cash generation in these markets.

In North America our cost-competitive manufacturing facilities, excellent customer service and superior paper quality, along with closures or conversions of some of our competitors' mills and machines allowed us to increase market share in 2018. During the year we converted PM1 at the Somerset Mill. The capacity of the machine was expanded, and it now has the flexibility to produce both coated woodfree paper and packaging paper used in the folding carton and food service markets.

  Operating profit excluding special items to capital employed (ROCE) (%)   Net debt to EBITDA excluding special items
  Operating prot excluding special items to capital employed (ROCE) (%)   Net debt to EBITDA excluding special items

In Europe we have focused on cost reduction and our go-to-market strategy–Sappi&You–which has enabled us to be a preferred supplier in the coated woodfree grades in particular, and has seen us increase both direct sales and market share in a declining market. During the year we converted the Maastricht Mill to focus predominantly on paperboard in support of our existing specialities and packaging papers business in Europe. In 2019 we will undertake the conversion of PM8 at Lanaken Mill to enable the machine to make either CWF or CM, and this will allow the transition from CM to CWF production on that machine over the next three years, bringing our CM capacity in line with that of the expected decline in that market. We will also be investing at Ehingen and Alfeld Mills to enhance their specialities and packaging papers offerings. The combination of the above projects will result in the replacement of 200,000 tons of printing and writing paper with a similar volume of specialities and packaging papers.

In Southern Africa our exposure to declining markets is limited to newsprint, where we are the last remaining local producer, and office paper which has become more cost competitive post the transfer of production from Enstra Mill, which we disposed of in December 2015, to Stanger Mill.

Maintain a healthy balance sheetMaintain a healthy balance sheet

Having achieved our target leverage ratio of two times net debt to EBITDA in 2017 we will continue to focus on cash flow generation and the cost of our debt in order to maintain a healthy balance sheet, which is the prerequisite for Sappi to be able to make the investments in higher margin and growing businesses. There are no significant maturities due before 2022 and we are comfortable with the maturity profile of our debt. Net finance costs have stabilised in the range of US$60 – 70 million per annum, and we continue to assess opportunities to refinance debt at lower rates as and when the opportunities arise.

Accelerate growth in higher margin productsAccelerate growth in higher margin products

In addition to the specialities and packaging papers investments mentioned above, we purchased the paper mill assets of the Cham Paper Group (CPG) for US$132 million during the past financial year. The acquisition of CPG positions us well for growth in the specialities and packaging papers market, with a range of new and complementary products. The performance of the business since the acquisition was completed at the end of February 2018 has exceeded our expectations, and along with the technology acquired with Rockwell Solutions in 2017, allows us to accelerate the development of new solutions for a growing market focused on delivering sustainable packaging solutions. Our total specialities and packaging papers sales has grown from 854,000 to 1,009,000 tons per annum over the past year post the acquisition of CPG and the completed conversion projects. Our total production capacity is now approaching 1.5 million tons, and we expect to ramp up towards full capacity over the next three years.

During 2018 we completed debottlenecking projects at both Saiccor and Ngodwana Mills, adding 10,000 and 50,000 tons of DWP capacity respectively. In 2019 we will initiate the debottlenecking of our Cloquet Mill, adding a further 30,000 tons, and we will commence with the project to expand Saiccor Mill by a further 110,000 tons as described above. Further significant expansion opportunities remain apparent in our DWP business, with robust demand growth from our major customers and from a textile market increasingly looking for more sustainable textile solutions. Whilst our strategic direction is clear, high paper pulp prices and the narrowing of the price premium between DWP and paper pulp meant that we have not found an external project that delivers a reasonable return. We continue to look for projects that meet our various investment criteria.

Our new business development team, Sappi Biotech, has had a busy and successful year.

Sappi Biotech made further strides in developing new and innovative products for a world looking for more sustainable chemical and material solutions. In 2017, we commissioned a sugar extraction pilot plant at Ngodwana Mill and acquired technology from Plaxica related to sugar extraction from waste streams. In July 2018, we announced further progress in the development of our biorefinery capacity with the decision to construct a demonstration plant adjacent to our Ngodwana Mill that will scale up the novel Xylex technology to produce xylitol and furfural. Pending successful results, this may result in the construction of commercial xylitol and furfural plants at our mills in North America and Southern Africa. We have also made good strides in the development of our cellulose nanofibrils (CNF) and cellulose microfibrils (CMF), with some exciting co-development being undertaken with firms in the motor manufacturing, coatings and cosmetics industries. Within the next three years we believe that Sappi Biotech could contribute as much as 10% of the group's EBITDA.

Looking forward

The debottlenecking of Saiccor, Ngodwana and Cloquet Mills as well as fewer production disruptions in 2019 should lead to increased DWP sales volumes to meet growing demand. DWP spot prices are forecast to remain range-bound at current levels in the coming year as VSF prices are expected to be under pressure from excess VSF capacity, while paper pulp prices which are forecast to remain at high levels should provide support.

Demand for specialities and packaging papers continues to grow, driven by increasing consumer preference for paper based packaging and legislative changes promoting recycling and the use of recyclable materials. The completion of the conversion projects at the Somerset and Maastricht Mills in the past year will allow us to increase production of paperboard grades to serve this growing market.

Industrywide conversion and closure of printing and writing papers machines in the USA and Europe are expected to keep the markets balanced in the coming year should demand contract at similar levels to those of the past few years. Recent European data, however, indicates that a potential downturn may be realised in 2019. Cost control measures will be implemented in order to support margins as we manage the price elasticity in our paper markets.

Capital expenditure in 2019 is expected to increase to US$590 million as we proceed with the Saiccor Mill 110,000 tons expansion having recently received initial EIA approval for the project, complete the Saiccor Mill woodyard upgrade, convert Lanaken Mill PM8 from CM to CWF paper production and upgrade the Gratkorn Mill.

Having completed significant projects in 2018 to convert paper machines to higher margin and growing packaging papers, in addition to the debottlenecking of both Saiccor and Ngodwana Mills, we expect EBITDA in the first quarter of financial year 2019, given current exchange rates, to be comfortably higher than that of 2018.

Appreciation

No business operates in isolation from a wide and varied group of stakeholders that contribute in many ways to our development and performance, and who may be impacted both positively and negatively by the decisions and trade-offs that we make on a continuous basis. Our interactions with these stakeholders, their ideas, suggestions, requests and support guide us and we thank them for their contribution towards making Sappi a better corporate citizen.

To our customers in all our different markets and geographies we extend our gratitude. We will continue to work together to provide relevant products and services which provide sustainable value while impacting our natural capital as little as possible.

Our employees continue to support the strategic initiatives of the group, and in a year where we completed a number of major capital projects and where we were faced with significant cost pressures, they helped us deliver a credible result while enacting our One Sappi vision. We also thank them for embracing the values and ethics that are vital to good corporate citizenship.

Cham Paper Group acquisition
US$132 million
 
Major conversion projects
completed

 

Thanks to our board for their continued commitment to the group and sound corporate governance. Their valuable insights and encouragement, all while holding us to the highest ethical standards, enable us to execute our strategy with confidence.

We welcomed Mrs Zola Malinga as independent non-executive director and member of the Sappi Audit and Risk Committee with effect from 01 October 2018.

In January, we announced the retirement of Dr Deenadayalen (Len) Konar, independent non-executive director, effective from the end of January 2018. Dr Konar was appointed to the board and Audit Committee in March 2002 and had served as chair of the Audit Committee since 2007. Dr Konar was also a member of the Nomination and Governance Committee following his appointment to that committee in 2008. In August, we announced the retirement of Mr Bob DeKoch, independent non-executive director, with immediate effect due to health reasons. Mr DeKoch was appointed to the board in March 2013 and also served as a member of the Social, Ethics, Transformation and Sustainability Committee. We would like to thank them both for the important contributions which they have made to the board since their appointments.

In conclusion, we value the support which our shareholders have provided as we work to enhance sustainable long-term shareholder returns. We look forward to their participation at the AGM on 06 February 2019.