International Paper’s aggressive investment in APPM has sent the Indian paper industry soaring into the stratosphere. It is likely that long-held valuation parameters will be rewritten, but small investors will do well to tread with caution rather than take to misinformed exuberance

Memphis based International Paper Inc (IP) has made a foray into the thriving Indian paper industry with a massive $319 million deal with Andhra Pradesh Paper Mills Ltd. The announcement made Tuesday last week by L N Bangur set off a wild spate of revaluation for the leading players in the paper industry. The deal includes $257 million in cash for the promoters' 53.5% stake besides an additional payment of $62 million for a non-compete arrangement.

In a move that caught the markets by surprise, IP agreed to pay Rs544 per share, a premium of about 205% on its market price at the time. In the few days since then, APPM has shot up to Rs283.35, spurting on low volumes while breaching the circuit each trading session.

It isn't entirely new for an acquiring company to pay a premium to acquire a controlling stake, especially in an overseas market. However, the extent of the premium paid in this instance is bound to excite conversations for some time to come.

The $25 billion International Paper is a market leader with operations in over 24 countries, but no presence in India before this acquisition. APPM is a leading player in India with a production capacity of 250,000mtpa (metric tonnes per annum). The Bangur group company is also known for its green manufacturing initiatives, with sales of approximately Rs720 crore per annum.

International Paper will spend another $104 million to complete the mandatory open offer for an additional 21.5% of APPM's outstanding equity. It is expected that IP will complete the formalities by the third quarter of FY2012, by which time it will own 75% of APPM.

The acquisition allows International Paper to hedge for growth with many of its current markets stagnant or in decline. India is among the fastest growing paper markets in the world-Poyry, an independent consulting firm specialising in the paper and pulp industries-estimates that India will witness CAGR (compounded annual growth rate) of 5.5% compared to 4.8% in China, marginal decline in Europe and just 0.5% growth in North America.

The fact that per-capita consumption in India is relatively low also makes the industry believe that there is huge untapped demand. A renewed thrust by the government through policy investments in the education sector also adds fuel to these aspirations. According to Poyry's data from 2009, consumption in India was rooted at just 8kg against 63kg in China and 227kg in the USA.
 
John Faraci, Chairman and CEO of IP said, "APPML is an established and highly respected company in India, and is an excellent platform for International Paper to grow in the Indian paper and packaging markets."

Meanwhile, the markets have gone into a virtual frenzy sending the prices of paper stocks soaring into the sky. Besides APPM, trading in stocks like West Coast Paper, Star Paper and ABC Paper-relatively smaller players-hit the upper circuit. Fancied players such as Ballarpur Industries and JK Paper also recorded massive gains to close at a new high.

The average valuation of Indian paper companies is about 7 times earnings, while IP has paid about 32 times APPM's 2010 earnings. It is no wonder that analysts are scrambling to discover new ways to evaluate the otherwise neglected industry. Interesting enough, BILT decided to delay its plans to raise $330 million by listing on the London Stock Exchange in order to review their valuation metrics and benefit from the developments at APPM.

At the end of Friday, there were outstanding 'buy' orders for more than 4,000,000 shares of APPM against 'sell' orders of just over 10,000 shares reflecting the mad rush to benefit from the changed circumstances. A similar trend is also evident in almost all the other players in the paper industry.

It is evident that the paper industry is all set for a rerating by the markets. But it is also likely that there might be a further consolidation of the fragmented sector as it takes a long time to build up capacities in this capital intensive business.

Given the circumstances it would be better for the small investors to avoid the risks associated with the current frenzy. It will be wise to look at the sector once the changes play out to identify and invest in fundamentally sound stocks to benefit in the long term.