NEW YORK (MarketWatch) -- Vast and largely desolate Siberia is home to one of the world's largest stands of untouched timber, full of red pine and larch coveted by the pulp and paper industry.
These remote northern Russian woods are also right next door to China, where demand for paper and consumer packaging for the country's booming middle class has far outstripped supply.
Closing the gap between the two is exactly where International Paper Corp. (IP) wants to be, positioning itself in Asia, where paper and board production is expected to surpass output in the languishing North American market by 2015.
In August, International Paper, the world's biggest paper and packaging company by sales, formed a 50-50 joint venture with Russian mill operator Ilim Group Holdings. If all goes well, one analyst predicts the deal could add almost 10% to the company's 2008 per-share earnings.
It's not a move without risks, PricewaterhouseCoopers analyst Craig Campbell said, citing potential political instability, poor infrastructure and a fractured market with numerous competitors. "But it does have potential," Campbell said. "Ilim is the biggest player, a smart player, with older mills that could benefit from new investment."
Indeed, International Paper agreed to invest $650 million in Ilim. The venture is expected to tap cash flow from operations and additional debt to sink another $1.5 billion into Ilim's four mills -- two of which are in western Russian -- over the next five years. International Paper has predicted the investment will eventually lift profits through equipment upgrades, allowing for greater capacity and high-product development.
Meanwhile, in pulp-starved China, International Paper has a 50% stake in Shandong Paper & Sun Coated Paperboard Co., which it purchased in December for $28 million. In addition to coated paperboard, Sun makes bleach board, used to package food and consumer staples like those used by International Paper's biggest customers, McDonald's (MCD) , Wal-Mart (WMT) , Cadbury-Schweppes (CSG) , Revlon (REV) and Johnson & Johnson (JNJ) .
The strategy hasn't been good for the stock, which currently trades at about $36, or 12.2 times analysts' average 2009 earnings estimate of $2.93 a share, as calculated by Thomson Financial. Rivals MeadWestvaco (MWV) and Weyerhaeuser Co. (WY) trade at 17 times and 20 times analysts' estimates, respectively.
Furthermore, International Paper sold almost all its North American timberland to raise $11.3 billion to help pay for the venture, along with its investments in Brazil and Eastern Europe. After paying off about $6.2 billion in debt and buying back about $1.4 billion in stock, that's still a lot of cash investors might not see again if the Russia-China gamble fails.
"The unknown is worrisome, sometimes for the right reasons," Chief Executive John Faraci told MarketWatch. But, he added, IP has been in western Russia since 1999. "We know how to do business there, and we've been successful."
J.P. Morgan analyst Claudia Shank said Faraci and International Paper already have had great success with similar operations in Europe, growing earnings before interest and taxes at its Kwidzyn, Poland, mill by 67% between 2001 and 2006.
The deal with Ilim is expected to close before the end of October, and International Paper has already appointed a new CEO there and placed several members on Ilim's board of directors and in key executive positions. Furthermore, Faraci said he anticipates additional cost efficiencies, not built into the value of the deal, between International Paper's Russian and Chinese operations.
China wants goods; Russia wants business
Double-digit economic growth has made China one of the world's hottest markets for paper and packaging products. And as long as its middle class continues to grow in hand with the country's rapid urbanization, demand for fast food, over-the-counter medication and other packaged consumer staples should keep growing.
China's paper mills and packaging plants are severely underdeveloped, with small "mom and pop" shops often using antiquated equipment, said Bruce Manchester, senior managing director at RSM EquiCo, a financial-services firm. That's a plus for International Paper, which has the capital and business structure needed to boost capacity, cut costs and grab market share.
The big challenge is securing a steady supply of pulp.
For the first half of 2007, China's pulp demand was up 15% from a year ago, according to data from the credit-rating agency Fitch. In the same period, U.S. pulp demand rose 7%, with much of the increase tied to shipments of recycled linerboard to China.
The Russian forest holds about 20% of the world's timber resources, by both area and volume, and nearly 32% of the world's commercially productive forest, according to Midway United Ltd., a Boston-based firm that has been logging timber in the country for about three years. More than half of that is in Siberia, which includes the Russian Far East.
The region is similar to Canada in size and population, with most residents clustered in the south near the China and Mongolia borders and along the Trans-Siberian railway linking Moscow to the Pacific port of Valdivostok.
About 65% of Siberia's timber grows in the desolate north, where permafrost and severe cold hamper road construction and settlement.
Russia's timber industry has been experiencing a re-emergence of sorts. Production fell off soon after the Soviet Union dissolved in 1991. Moscow has more recently been encouraging investment in the sector to upgrade Soviet-era equipment and to help diversify an economy heavily dependent on oil and gas production.
"It's an interesting time over there, and it's one of the last true frontiers for the timber industry," Midway United's director of operations, Murphy Vanderbilt, said. "The industry is pretty well developed, but it's in great need of capital improvements and infrastructure," Vanderbilt said, adding that most of the tree-cutting operations resemble old-fashioned logging camps.
The Forest Stewardship Council, which certifies what it calls sustainable forestry management, has said Ilim is ahead of other Russian companies in terms of operations upgrades, worker safety and environmental impact. Of about 25 million hectares of commercial forest in Siberia being managed, only about 6 million is FSC-certified, of which 4 million is leased by Ilim.
International Paper performed almost two years of due diligence before diving into the venture with Ilim, but in analysts' view the greatest risks are tied more to the political climate in Moscow than the physical challenges of Siberia -- most evident in Moscow's reassertion of national control over its oil and gas industry.
Several Western oil companies, among them Royal Dutch Shell (RDS.A) and BP PLC (BP) , have been forced to relinquish some operations to Russian counterparts after state officials accused them of failing to live up to the terms of their original production licenses.
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