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Analysis: A mega-merger could be answer to Europe's paper woes

By Jussi Rosendahl

HELSINKI (Reuters) - Finland's paper giants UPM-Kymmene and Stora Enso have been looking at piecemeal solutions to the crisis in Europe's paper industry, but it may be that nothing less than a mega-merger will do.

Battered by the global debt crisis and the shift to online media, the region's industry is currently estimated to have 10-15 percent of overcapacity in paper grades such as newsprint, and magazine and office paper.

The world's two biggest producers of those graphic paper grades, whose headquarters are separated by a few hundred meters on Helsinki's seafront market square, have closed down several paper mills since 2006, but more consolidation in the European paper industry is seen as inevitable.

Analysts say the ideal solution may be a merger of UPM and Stora Enso that would create the world's number one paper company by any measure, which would give the combined entity substantial control over capacity and therefore, prices, helping rivals as well as themselves.

The move would be certain to draw scrutiny from European competition authorities, but had a good chance of going ahead with some modifications, sector analysts said.

"It would make good sense for the firms themselves. There would be a lot of synergies to look for," said analyst Markku Jarvinen from Helsinki brokerage Evli.

Paper making is still by far the biggest operation for the two companies, accounting for 69 percent of UPM's sales of 10.1 billion euros ($13.09 billion) and 51 percent of Stora's 10.9 billion euros last year.

Paper provides both with cash to help finance projects they consider to be key to future growth, such as their low-cost pulp plants in Uruguay and Stora's packaging board mill in China, but profits in the paper divisions have been disappointing.

Stora's underlying paper business margin was 3.5 percent and UPM's 0.1 percent in the second quarter.

A merger would improve profitability by combining production facilities while at the same time allowing them to take advantage of growth areas and business that are not overlapping such as in packaging and label products.

"It is crucial to shut down capacity, and as we have seen, that is easiest to achieve through consolidation," said analyst Karri Rinta from Handelsbanken.

MYLLYKOSKI NOT ENOUGH

UPM's investors had hoped its acquisition last year of debt-laden rival Myllykoski, followed by the consolidation of magazine paper production and mill shutdowns, would narrow the widening supply-demand gap. But there has been little improvement.

Katja Keitaanniemi, the head of Swedbank's investment banking business in Finland, said UPM's efforts to keep prices high after the Myllykoski acquisition were undermined by rivals including Stora Enso.

"For me it was a very big disappointment. They lost market share trying to protect prices, while rivals sold volumes," she said.

UPM Chief Executive Jussi Pesonen told Reuters last month that he was open to more deals but was noncommittal on the idea of a merger with Stora Enso.

"I don't know," he said when asked about the possibility of a deal. "We could do all kind of things."

Stora Enso spokesman Lauri Peltola said the company did not believe consolidation was necessarily an industry cure, but declined to comment further.

One reason the two companies are holding off may be a calculation that the longer they wait, the more likely it is that smaller rivals will be forced to close or sell their operations at fire sale prices.

Companies seen as particularly vulnerable include Norske Skog and southern Europe-based Burgo and Lecta.

"The strong companies are happy to run their paper business... at zero operating profit, because the goal is to kill the weak players," said Cheuvreux analyst Mikael Jafs.

He said the big players were waiting for smaller ones with little or no cash flow to fall into the hands of lenders.

"Then the strong players will come and say, 'OK, I will take this off your hands if you write down part of the loan'," Jafs added. "Below the surface, there is an economic war going on."

Many companies have difficulty planning cost cuts by themselves. Shutting down a paper mill that makes 500,000 metric tonnes (551,156 tons) per year and employs hundreds of workers costs around 100 million euros on average, paper sector thinktank Risi has estimated.

GOOD FOR FINLAND

The government of Finland, which owns 25.1 percent of Stora Enso's voting shares, would welcome a mega-merger as it could help keep paper mills and expertise in the country, which is heavily forested with pine, spruce and birch.

Solidium, the Finnish state's investment arm, declined to comment for this story, but an executive in September said more consolidation was possible.

"The paper industry is having a challenging structural situation, and that might lead to more consolidation. We are following the situation with interest," managing director Kari Jarvinen said in early September.

Tens of thousands of jobs have disappeared from Finland's forest industry, which makes up some 18 percent of Finland's exports, in the last few decades.

With troubled phone maker Nokia also slashing operations at home, there are few strong sources of growth in the small Nordic economy.

ANTI-COMPETITIVE?

One issue is that a mega-merger would be looked at very carefully by the European Union's anti-monopoly regulators, who would likely demand the closure or spin-off of some paper mills.

UPM has around 22 percent of the region's total graphic paper capacity while Stora has some 16 percent. South America-based Sappi , Norske Skog and Burgo follow with 7, 6 and 5 percent, respectively.

Evli analyst Jarvinen said any asset sales to please regulators would limit merger benefits.

Some said anti-trust regulators have become more relaxed in recent years. But in a deal that could be an indicator of how a mega-merger in paper could go through, they have demanded significant asset divestment in a planned stainless steel merger of Outokumpu and ThyssenKrupp's Inoxum.

Another obstacle is that while both companies are Finnish-based, they have different ownership structures. The majority of votes in Stora Enso are held by Sweden's Wallenberg family and the Finnish state, while UPM shareholders are more diverse.

Analysts said the main deterrent is that for now they can afford to wait for smaller players to fold first.

"I'm sure they're all hoping other players will take chances and consolidate the market," said Danske Markets analyst Oskar Lindstrom. "Everyone is trying to starve out everyone else."

($1 = 0.7715 euros)

(Additional reporting by Ritsuko Ando and Terhi Kinnunen; Editing by Sonya Hepinstall)

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