Enlarged Smurfit must start thinking outside the box

This week's merger with Kappa will succeed only if the firm reduces capacity, writes Una McCaffrey

A motto on the Jefferson Smurfit website declares that the firm has "grown from a small Irish box maker to a worldwide group, without ever losing the company spirit".

It seems a fair assessment of the firm's development, particularly if you translate "the company spirit" as "family leadership". Since its foundation in 1934, Smurfit has been headed by the family that gave its name to the business, and the situation isn't about to change.

This became clear this week when Smurfit and its Dutch peer, Kappa, announced they were to merge. Rather than joining together in equal parts, however, the two are forming a 60/40 alliance that will leave Smurfit in the dominant position.

And if this isn't obvious from the numbers, it is plain to see in the composition of the new company's board: four of the top five positions will be occupied by Smurfit executives.

Of these roles, two will go to members of the Smurfit family: father and son, Michael and Tony. It seems the family name will stay at the top of the company for a while yet.

It is thus no surprise to hear paper and packaging analysts this week congratulating Smurfit for "taking the initiative" in forming the largest merger in Irish corporate history.

One commentator, who did not wish to be quoted, suggested the composition of the new board reflects the relative strength of the Smurfit management. The team at Kappa, he said, has simply not covered itself in glory in managing the woes that currently hang over the industry.

Smurfit, on the hand, is not interested in "rolling over and waiting for it to end", he said.

There is of course another factor at work in deciding the composition of the new company, to be called Smurfit Kappa.

Under the terms of the deal, Kappa's two private equity shareholders, Cinven and CVC, will receive a cash payment of €300 million from Smurfit, as well as a €75 million promissory note and shares in the new company. In other words, the firms are winning a partial exit from their investment.

Smurfit's largest shareholder, Madison Dearborn (another private-equity firm), is meanwhile digging in deeper, while keeping its eye on an exit at a later date.

Experience would suggest that for Madison Dearborn, this way out will come in the form of a stock market flotation. Smurfit was taken private in a €3.9 billion deal three years ago.

Accepted wisdom dictates that private-equity companies take a five-year view on their investments. In the case of Smurfit, this would point to a return to the stock market some time in 2007.

One argument is that the combination of Smurfit and Kappa will be much more palatable as a public company than either firm would be on its own.

The rationale for this is that the enlarged company - which will be spread across most of Europe and parts of Latin America - will have more success in addressing the problems that weigh on its markets than a smaller company might. It would be a matter of the biggest and strongest surviving.

Analysts say paper and packaging operations around the world must now make up their minds between starting a price war to win back lost sales and cutting some of their own capacity in an effort to survive.

Smurfit chief executive Gary McGann declared on Tuesday that the Kappa deal would "benefit all stakeholder groups of the combined company in a challenging operating environment".

This was taken as a signal that McGann and his team have the necessary appetite for the capacity reduction that has already begun elsewhere.

At the end of last month, Smurfit and Kappa peer, Swedish firm SCA, announced an "efficiency enhancement programme" that would involve the "phasing out" of 350,000 tonnes of testliner and 100,000 tonnes of tissue. The company's chief executive, Jan Aström, said the firm was "taking further decisive measures to strengthen the conditions for favourable profitability and to contribute to an improvement of the balance in the market".

At the same time, capacity continues to come on stream from other quarters. One analyst points out that much of this new production is being introduced by private operators who do not need to answer to shareholders and who may be banking on the tax incentives that can accompany such investment.

Morgan Stanley says the European containerboard market was oversupplied by more than one million tonnes before SCA announced its capacity closures last month.

"We believe that for investor perception to lift its current bearish outlook for the sector another 750,000 tons or more would have to be closed by Smurfit Kappa Group," says the broker. As things stand, Smurfit Kappa would have capacity for producing 6.1 million tonnes of containerboard and 5.1 million tonnes of corrugated paper.

Morgan Stanley points to a precedent in the global market that bears particular relevance for the current deal - the merger (led by Dr Smurfit) of Smurfit Corp and Stone Container.

"Additionally, we believe the incentive may be even greater to create structural change this time around considering that both companies are owned by private-equity firms who ultimately look to exit their position through an equity listing."

One potentially ironic side-effect of reducing capacity is that by doing so, a firm is effectively cutting its equity levels. In a company as leveraged as Smurfit Kappa will be (Smurfit had debt of €2.6 billion at the end of March), this might not necessarily be good news for debt ratios - a concern of financial investors.

"Depending on how much you can write off, it can look negative on the balance sheet," says one analyst. "When you do the write-down, even though you might be making more money, officially your balance sheet looks worse."

Provided Smurfit Kappa can drive a course back towards equilibrium of supply and demand in the market, of course, this debt/equity ratio blip would be a short-term problem on the way to a long-term solution and another flotation.

Before getting to this stage, however, the deal must cross a number of hurdles, including approval from EU competition authorities and consultation with various employee organisations across its markets. One of the principal barriers to be addressed will come in The Netherlands, where the deal must be notified to the Social and Economic Council, a government advisory body that represents the interest of trade unions.

At least one Dutch union, CNV, has already expressed concerns about the job losses that could flow from the deal. Given that Kappa has 2,500 employees in the country, where the economy is not exactly pumping, the concern is understandable. How it will affect the deal remains to be seen, along with so many other consequences of this week's announcement.

As one analyst puts it: "the merger itself is not the solution. The solution is in taking out capacity."