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Edited Transcript of SAP.J earnings conference call or presentation 14-Nov-19 2:00pm GMT

Q4 2019 Sappi Ltd Earnings Call

Johannesburg Dec 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Sappi Ltd earnings conference call or presentation Thursday, November 14, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alexander van Coller Thiel

Sappi Limited - CEO of Sappi Southern Africa

* Berend John Wiersum

Sappi Limited - CEO of Sappi Europe

* Glen Thomas Pearce

Sappi Limited - CFO & Executive Director

* Michael G. Haws

Sappi Limited - President & CEO of Sappi North America

* Mohamed Mansoor

Sappi Limited - EVP of Sappi Dissolving Wood Pulp

* Stephen Robert Binnie

Sappi Limited - CEO & Executive Director

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Conference Call Participants

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* Brian Morgan

Morgan Stanley, Research Division - Equity Analyst

* Hubert Tissier de Mallerais

Chenavari Investment Managers LLP - Partner and Senior Portfolio Manager

* James Twyman

Prescient Securities (Pty) Ltd., Research Division - Head of Fundamental Equity Research

* Julien Raffelsbauer

Millenium Management, LLC - Investment Analyst

* Lizelle du Plessi

APG Asset Management NV - Senior Credit Analyst

* Maggie O'Neal

Barclays Bank PLC, Research Division - Research Analyst

* Roger Neil Spitz

BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst

* Ross D. Krige

JP Morgan Chase & Co, Research Division - Analyst

* Sean Ungerer

Arqaam Capital Research Offshore S.A.L. - Analyst

* Wade Napier

Avior Capital Markets (Pty) Ltd. - Research Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to Sappi Limited Fourth Quarter and Full Year of 2019 Results Conference Call. (Operator Instructions) Please note that this conference is being recorded.

I'd now like to hand the conference over to Mr. Steve Binnie. Please go ahead, sir.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [2]

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Thank you. Good day, everybody, and welcome to our results call for the year ended 2019 -- financial year ended 2019. As always, I'll go through the investor presentation, and as I go through each slide, I'll call out the page numbers.

Starting on Page 3, the highlights for the year. It was a difficult year for us. However, EBITDA was down 10% to $687 million. That was as a consequence of lower dissolving pulp prices, which we saw drop considerably during the year, almost $300 a ton. And then we saw weak graphic paper markets between -- down between 8% and 12% in the regions that we operate, which forced us to take 268,000 tons of downtime. We did have higher dissolving pulp sales following the successful completion of the debottlenecking project last year, and we made nice progress on the packaging and specialities. And we saw -- in the quarter, we saw 12% higher volumes -- sorry, that's for the year, 12%. We completed the Matane acquisition, which we announced earlier in the year. That transaction was completed earlier this month.

Moving to Slide 4, which is the highlights for the quarter itself. EBITDA -- for the same reasons, EBITDA down from $224 million to $185 million. As I said, we saw both dissolving pulp and graphic paper under pressure. However, we did have a nice increase in profitability from packaging and specialities. The downtime that we took in the quarter in graphic paper was 94,000 tons, which had about a $25 million impact on EBITDA. The EBITDA margin overall for the group was down from 14.6% to 12.7%, and our net debt leverage to EBITDA up to 2.2x, obviously as a consequence of the lower profitability.

Moving to Slide 5, the earnings bridge last year versus this year. Firstly, we did have lower sales volumes overall, but our growth segments showed positive volumes, and that's both in dissolving pulp and packaging and specialties, which were up -- both up 6%. However, graphics, obviously, from the weaker markets was down also by 6%.

On the pricing front, the lower dissolving pulp price is, obviously, having an impact on the average prices, and there was a bit of a mix issue in there. Positive impact from lower variable costs, predominantly coming from pulp -- paper pulp costs, which did decline during the year, so we did get some relief from there. And overall, that explains the main variances between the $224 million and the 11 -- $185 million.

Moving to Slide 6, the product contribution split. This is on an LTM basis. So obviously, you're not seeing the full impact yet of the lower dissolving pulp prices. But nevertheless, for the year, it was 45% of the contribution to EBITDA. Clearly, as dissolving pulp prices have declined, that proportion will or has in the fourth quarter and as we move into the new financial year, that proportion will decline naturally. I'm pleased with the progress that we're making on packaging and speciality, it's up to 19%. And as we ramp up in the new financial year, that will clearly take an ever-increasing share.

Moving to Slide 7, and this is -- for graphics segment, it's the volumes and EBITDA margin. And clearly, you can see the impact of our strategy to reduce capacity in this segment over the last few years and also more recently, obviously, the production downtime that we've taken. Despite that, because of, obviously, the lower pulp costs, our margins actually for the quarter did improve compared to the previous quarter.

Moving to Slide 8, Packaging and Specialties, and we're very pleased with this progress. And you can see that over the last couple of years, we continued to increase volumes, and we had a nice margin for the quarter being just under the 14% level. It's higher than it was a year ago and up substantially from the Q3. And as we ramp up further, and this is something that we've talked about on previous results calls, as this business continues to grow, the margins will obviously benefit from that.

Moving to Slide 9, on dissolving pulp. We -- obviously, the lower selling prices will have an impact on margins this year. We did have the extra volumes following the successful debottlenecking project that were completed.

Moving to Slide 10, the maturity profile of our debt. A lot of good work done this year, and we refinanced our 2022 bonds to 2026. And obviously, at the same time, we extended our securitization structure and that's now through to 2022. So over the next couple of years, we don't have any material maturities, and we feel that, that gives us -- puts us in a good place.

Moving to Slide 11, and just our CapEx. You can see that earlier this year, we were talking about substantially higher CapEx levels. We pulled that, but we've deferred and postponed some of the CapEx and stopped some of the discretionary CapEx. No impact on maintenance CapEx, which is clearly very important, but across the 2 years, we've pulled back $150 million of CapEx. The '21, we haven't finalized numbers yet, but I would expect that to come down further, and we haven't committed any major projects beyond 2020.

Turning to our segments. And firstly, on graphic paper, which is reflected on Slide 13. We have seen very weak markets during the course of the year, and I quoted the number earlier, declines of approximately 10%. Some of that is related to the weak economies that we've seen, particularly in Europe and other areas of the world. At the same time, last year, when selling prices rose substantially, there was a big inventory build and that's had to work its way through the system as well. And obviously, global trade flows has also had an impact. As we move forward, the capacity reductions that are being announced by some of our competitors and also as we ramp up on packaging, that will help improve operating rates over the next 12 months.

Selling prices have held up reasonably okay. We've seen small decline, but in terms of protecting our margins against the production curtailment that we've had to take, we have had the benefit of lower paper pulp prices. Going forward, we will continue to focus on costs to protect our margins, managing our capacity as the markets do develop. We continue to evaluate our portfolio of assets. And the recent acquisition of Matane improves our pulp integration and will lower our costs.

Turning to packaging and specialties on Slide 14. The -- we all know that there's significant trends happening across the globe with a push for paper-based packaging solutions, the big brand owners pushing for solutions and that's creating opportunities. On the other side, we do know that there's been a number of conversions also in the containerboard market. We've seen conversion there as well. Selling prices have been stable. However, these selling prices do tend to get negotiated annually or semiannually, and we're going through a process of negotiating prices for 2020. We're hopeful that we can keep them at stable levels. The paper pulp prices -- the lower paper pulp prices, obviously, helped us as well to preserve margins in this segment. The ramp-up of volumes, I've talked about it already. It's picking up momentum and will continue to grow as we move forward. And clearly, the whole innovation and looking for sustainable solutions in the packaging segment is creating opportunities for us here as well.

Next, we turn to the regions, and Slide 15 is Europe. The profitability of the region was impacted by the production downtime that we had to take in the quarter of 37,000 tons and due to the lower graphic sales. Interesting, coated wood free, we've gained substantial market share, and a lot of good work's been done there. And then, however, on coated mechanical, that is a segment which we've talked about in the past, that has been under pressure. For us, obviously, we've made the recent Lanaken conversion, so that means that we've taken capacity out of that segment and would have impacted our market share there. The packaging and specialities, I've talked about, and clearly, we are benefiting there. And we obviously had lower variable cost led by pulp.

Turning to Slide 16, the North American region. Nice progress on packaging and specialities. Volumes are now up 36%. Margins are increasing and the PM1 machine at Somerset that we completed is now about 1/4 on packaging grades, and that will ramp up further in the year ahead. However, obviously, profitability down because of the: one, lower dissolving pulp prices; and secondly, the very weak graphic paper markets, and we did take downtime, 57,000 tons in the region. Clearly, as we build up -- our strategy here is to build up this packaging volumes to offset the declines that we are seeing in the graphic. Region also benefiting from lower variable costs and fixed costs.

Then Slide 17, we talk about the dissolving pulp market. It has been a very tough year. It's fair to say there's been supply side issues and demand side issues. On the supply side, we have seen extra capacity come on board and the weak paper pulp markets has made that -- swing producers have probably -- we're not getting any relief from swing producers. On the demand side, a lot of new viscose capacity coming on board, which means that viscose prices are under pressure, and then we're also seeing weak global textile markets related to the economy, the trade wars that we've seen underway. So being hit from both sides. At these price levels, we estimate about 40% of mills are cash negative. Obviously, Sappi is on those at a low end of the cost curve, so we think that -- we believe that was, in a good cause -- cost competitive situation, albeit that we are facing the pressure of short-term lower selling prices. The prices dropped by close to $300 during the year. They're currently, today at $638 a ton. A year ago, they were $930 a ton. So it's had a substantial impact, and that's the main reason why our profits are down, and we have put a negative outlook statement out for next year.

Going forward, the Saiccor project is going well, with 40% complete. That will add 110,000 tons of capacity. And our big differentiator here is our wood certification. That puts us in a very strong competitive position. We have a strong green story to tell, and that ensures that we have close alignment with our key customers.

Moving to South Africa. The business -- the volumes were higher, firstly, because of the extra dissolving pulp capacity we have had coming through, and we did benefit from a weaker rand. But clearly, the lower selling prices for dissolving pulp will have an impact. The packaging side of -- in South Africa, the packaging market has been weaker of late. It's a sector that's done well for a significant period of time, but we have seen recent weakness and that's related to lower citrus exports out of South Africa. Fixed costs were higher, but that was because as we staffed up because of the additional volumes coming through ahead of the additional volumes coming through at Saiccor. The -- and wood prices are higher as well. So that puts some pressure on costs.

Moving to strategy. And -- the 4 areas that we always focus on. And firstly, on Slide 20, on costs. Periods -- in this period of uncertainty, the focus on cost needs to be ongoing. And I'm pleased to say that we took further cost out of the business in 2019, $87 million, which helped offset some of the pressures that we faced. And there are ongoing improvement initiatives, and we'll be targeting further cost reductions in the year ahead. The pulp acquisition at Matane will improve pulp integration and will benefit us and reduce volatility as we move forward. The other benefit that the Saiccor project itself will also lead to lower variable costs.

Slide 21. We talked about this at the end of the last quarter, but we're pleased to say that we successfully completed the acquisition of Matane. Very pleased with how things have progressed. The integration is going well. We're very excited about high-quality people, the assets that we've acquired and the quality of the pulp at Matane is excellent. So very pleased and things are going well.

The -- move to Slide 22. The -- just to remind you, the reasons for the acquisition. It was very important that we secured a critical source of supply for our raw material that, that mill supplies both our European operations and our Somerset Mill as well. So that has to be a key focus for us. At the same time, it will -- as I said, it will reduce input pricing and volatility as we move forward. And it was a significantly lower cost alternative than adding capacity at the Somerset Mill. So it made a lot of sense for us.

Moving to Slide 23, the declining businesses. We've obviously made these conversions away from graphics in recent times. In the quarter itself, we can -- oh, sorry, in the year itself, we completed the conversion at Lanaken, and that will allow us to get out of lightweight coated at the mill. It's -- and obviously, we talked earlier about the real segment, the coated mechanical segment in Europe is the one that's been under the most pressure. So this helps us as well. We -- at the end of the last quarter, the results call, we talked about the fact that we were evaluating our machines in Europe. That work is near completion, and we will hopefully be in a position to make an announcement very soon.

Slide 24, maintaining a healthy balance sheet. Very good -- pleased with the good work that's been done on working capital. And as you saw earlier, we pulled back on the CapEx commitment. We generated cash of $173 million in the quarter. And as we move forward over the next year or so with the low dissolving pulp prices and the uncertainty that, that creates a strong focus on the balance sheet, strong focus on cash generation. We renegotiated our leverage covenants at no additional cost, so that gives us more flexibility. And yes, good work done here. The one thing I should call out to you is that the new accounting statement, IFRS 15, where you have to capitalize operating lease costs. When we report our next numbers, it's going to add $90 million to debt on the balance sheet, and obviously, like a lot of businesses, it's important to call that, that has no impact on any covenants. That's an accounting adjustment, but it doesn't impact there.

Moving to Slide 25. The investments in terms of growth areas. Very pleased with how the conversions went at Saiccor, Ngodwana and Cloquet. Obviously, we've got the additional 110,000 tons coming through. That project will be completed third quarter of calendar 2020. We continue to believe that we have packaging opportunities in South Africa at Ngodwana and Tugela. And similarly, on the bioproduct side, the lignins and sugars, we -- as you know, we've put in those pilot plants, and we continue to make progress. The key here is ramping up as fastly as possible at Maastricht and Somerset following the completion.

We're also excited about the barrier coating opportunities that we are making. And we announced some nice work that we've been doing Nestlé. There was a press release earlier in October and making exciting progress with the big brand owners there. And we think, in time, there will be substantial opportunity.

Turning to the outlook. Markets are still tough. Dissolving pulp prices are still low. We are making good progress with customer acceptance on the packaging side, and that will ramp up further. Global graphic paper markets are weak. However, paper pulp prices being low, that do provide some relief and the capacity that's likely to come out will help operating rates. But with prices where they're at, at the moment for dissolving pulp, we have to put out a negative outlook statement for the first quarter. The profits will be lower than a year ago.

As a consequence of that, we made the decision to temporarily hold dividends until the market prices improve and those conditions improve. We feel it's a prudent thing to do. And along with all the other good work that we're doing on the cash management side will help us get back down to the leverage levels that we've targeted long term.

So operator, that's me read through the deck. So I'm going to put it back to you now for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from James Twyman of Prescient.

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James Twyman, Prescient Securities (Pty) Ltd., Research Division - Head of Fundamental Equity Research [2]

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A few questions from me. Firstly, on the downtime that you've taken, could you just give us some idea of where you see that going in Q1? I mean Europe's probably tough, but hopefully you should be seeing some improvement in the U.S. from the Verso closure. And secondly, on the machine closure that you're planning, could -- I mean, you must be pretty close to it now. It's been a little while. Could you give us some idea of what the cost of it would be? And what you would expect to say from that? And then finally, I'm sure there aren't any, but are there any noncore assets you have which you could sell just to help the debt along a little bit?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [3]

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Yes. Okay. Firstly, on the downtime, things are a little bit better. We do estimate downtime for the quarter at about 17,000 tons for the quarter, and that's predominantly in Europe. We -- October, November, we've been relatively full. December, we were still looking to fill the machines, but our latest estimate is about 17,000 tons, mainly in Europe. The impact of machine closures, yes, you're right. We did announce it -- or we did talk about it at the end of the last quarter. And you have to appreciate there are -- there's a lot of work that needs to be done and discussions that need to be had, and we are very close. The impact, depending on -- we estimate depending on the machine, hopefully it will be able to take about $20 million of costs out of the business, if we close a machine.

The -- Berry, in terms of cost without -- because clearly, we haven't decided, made a final decision, you just want to talk broadly about cost of machine closures?

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Berend John Wiersum, Sappi Limited - CEO of Sappi Europe [4]

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Well, in terms of cash costs, Steve, the cash costs pay (inaudible) about 1.2 to 1.5 years, you do have a balance sheet effect as well, of course, that doesn't have a cash effect.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [5]

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Sorry, Berry, I think you broke up a little bit there, just repeat that.

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Berend John Wiersum, Sappi Limited - CEO of Sappi Europe [6]

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Yes. It's in terms of cash cost and the payback time will be between 1.2 and 1.5 years. There is also a balance sheet effect of write-offs, but that, of course, does not have a cash impact.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [7]

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Yes. And James, just remind me what was your -- oh, asset sales. Yes, look, I don't think there's any at the moment. Clearly, we continue to monitor the situation, James.

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James Twyman, Prescient Securities (Pty) Ltd., Research Division - Head of Fundamental Equity Research [8]

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Okay. So just on that, on the one before you're saying there is no cash impact from the closures so that...

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [9]

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No, no. No, what we said is, we estimate approximately $20 million of fixed costs would come out. The cash cost of the closure would be about 1.5x that.

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Operator [10]

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The next question comes from Brian Morgan of RMB Morgan Stanley.

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Brian Morgan, Morgan Stanley, Research Division - Equity Analyst [11]

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Are you still selling DWP in the spot market?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [12]

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Brian, good question. Yes, we are. We think strategically that makes sense. As you know, that's the Chinese market, and we believe we've got some very important customers there. And we think it makes sense to stay in that market, yes.

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Brian Morgan, Morgan Stanley, Research Division - Equity Analyst [13]

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And then obviously, the next question is, how do you work at the trade-off between sort of participating in the spot markets and -- or maybe pulling out of the spot markets and let the price recover a bit?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [14]

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We believe that maintaining relationships with our key customers in China is strategically important, Brian. Clearly, if there are opportunities to reduce our production and swing a little bit at Cloquet, we would look for those opportunities, but I would be very hesitant to lose our customers in China because it may be difficult to get them back.

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Brian Morgan, Morgan Stanley, Research Division - Equity Analyst [15]

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Is there a price point where you would say, sorry, this is as far as we can go?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [16]

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Look, I don't -- look, we don't think prices are going to drop further. But I guess, we didn't expect them to get to these levels. At these levels, we would still want to stay in the Chinese market. That's all I can say, Brian.

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Operator [17]

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Your next question comes from Sean Ungerer of Arqaam Capital.

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Sean Ungerer, Arqaam Capital Research Offshore S.A.L. - Analyst [18]

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Just a follow-up from Brian's question. I mean just the commentary on hesitant to lose customers in China. Maybe you can just elaborate a bit more on that in terms of your sort of quality offering. And then just 2 or 3 more questions. Just specifically, I think if you look at your outlook statement, I think everything hinges pretty much on the DWP price understandably and obviously, in turn VSF. Maybe you could just give us a very high level view on how you see VSF playing out given the amount of capacity coming online?

And then if you also look at the SA business in terms of cash fixed cost inflation this year, it was pretty high. And you obviously attributed it to couple of reasons. Maybe you could just expand on that a bit more as well as your sort of outlook for that variable?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [19]

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Yes. I'm going to -- I'll start briefly, and then I'm going to hand you to Mohamed, who heads up our dissolving pulp business, on the first 2. And then Alex, I'll come back to you for the last question as well on the fixed costs.

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Sean Ungerer, Arqaam Capital Research Offshore S.A.L. - Analyst [20]

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Sure.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [21]

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Before I hand to Mohamed, first, we believe we've got a quality product, we've got a strong sustainability story to tell. And as I've emphasized with Brian earlier, we want to preserve our customers in China. On the VSF -- so I'm going to hand you to Mohamed to in fact elaborate a little bit further, and Mohamed, you can just talk about the outlook for VSF.

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Mohamed Mansoor, Sappi Limited - EVP of Sappi Dissolving Wood Pulp [22]

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The VSF market still continues to grow. So although there's been a lot of new capacity that has come on stream, the underlying growth continues to remain positive. We're still seeing longer term trend, growth rates of around 6%. And the market is just at a point where it just needs a little bit of time where the underlying demand catches up with the installed capacity. So the positive is that there is growth. The sustainability side of the business is -- all the trends that are moving in the direction of sustainability are also helping the underlying growth for fibers that are biodegradable and cellulose fibers are -- provide that benefit.

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Sean Ungerer, Arqaam Capital Research Offshore S.A.L. - Analyst [23]

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And just on that, I mean, just in terms of the catch-up, I mean, when do you sort of envisage the inflection point?

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Mohamed Mansoor, Sappi Limited - EVP of Sappi Dissolving Wood Pulp [24]

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If I look at where the underlying demand is at the moment and the installed capacity, 6% growth is about 340,000, 350,000 tons per annum. Typically, what we've seen is when the operating rates get to around -- for VSF around the 80%, 85%, things start firming up. At the moment, it's around the 78%. So I reckon middle of next year, end of next year, the underlying demand should get closer to the installed capacity.

The other one thing that I think everyone is -- in the market is expecting to help viscose demand grow probably even faster than the underlying long-term growth is the whole cotton issue. One of the things that has prevented, or I would say, not prevented is wrong, but one of the things that has delayed the China government from buying larger quantities of cotton because the cotton stocks are very low in China, it's been this issue between the U.S. and China. And a big part of the Phase 1 agreement that people are expecting is, including a large amount of agricultural products that China will buy from the U.S.A. And as part of the agricultural products, cotton is expected to be one of those products. And if -- or when this deal happens and is made public, I suspect the one positive outcome will be increased buying of cotton and that will be very positive, I think, for the fibers market, in general.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [25]

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Thanks, Mohamed. Alex, do you just want to talk about the fixed costs down in South Africa?

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Alexander van Coller Thiel, Sappi Limited - CEO of Sappi Southern Africa [26]

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Yes. The drivers for the year were really -- as we get ready for the 110,000 tons of additional dissolving corporate cycle, we have taken an approach to employ 100-odd people -- additional people. We do think it makes sense to actually train them early. You do get them hitting the road running then. And we've seen that -- very positive results at Ngodwana.

Second issue, we had a bit of additional maintenance cost. We had some boiler tube leaks, which we had to spend money on. And then finally, with the project, the additional volume at Saiccor, during this shut, we do have to do some tie-ins and that does add little bit to costs.

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Operator [27]

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Your next question comes from Ross Krige of JPMorgan.

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Ross D. Krige, JP Morgan Chase & Co, Research Division - Analyst [28]

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Just to follow up on -- just with regard to the DWP market and to follow-up on Sean's question. So I understand how that operating rate moves up with the growth in demand, but is there not still quite a lot of capacity coming on stream from Sateri?

And then below that, within the DWP market, it sounds like -- with a lot of production under water from a cash perspective, it sounds like a lot of that needs to close. Are you hearing any stories of capacity closing? And related to that, there's also a lot of capacity expected to be added to the DWP market. Is any of that being delayed? Or how do you see that impacting the market?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [29]

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Yes. Okay. Firstly on Sateri, you'll appreciate we're not going to talk specifically about our competitor. However, obviously, there has been a lot of new capacity coming on board. The company you refer to is an integrated player. So they're adding viscose capacity as well as dissolving pulp capacity. And it's clear that the excess capacity, as I outlined upfront, is having an impact on pricing. That's just a natural force that's underway.

However, and that leads into your second question that we do estimate that 40% of production is under water. And again, Ross, we can't name them, but there are -- we are hearing stories of certain producers stopping production. Mohamed -- without naming, Mohamed, you -- maybe you want to elaborate further.

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Mohamed Mansoor, Sappi Limited - EVP of Sappi Dissolving Wood Pulp [30]

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Yes. Steve, thank you. Certainly, there's lots of public announcements about capacities shutting down or stopping in Canada. There is announcements that came out also about production coming out in Brazil. And what we are picking up in China, although production of dissolving pulp is continuing, it's continuing to a much lesser extent in terms of volumes and some of the producers in China, from what we are picking up through our own market intelligence, are switching to making other grades of pulp. So not shutting down the lines altogether or the sites, but shifting out of DB to one particular grade called unbleached crop because they need -- the containerboard guys need fiber and there's an issue with importing fiber from the U.S. So there are lots of activities suggesting that output is being reduced.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [31]

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And Ross, just to add to what was said, the other key factor, and again, that's why I called it out, with 40% of capacity being swing capacity, when the paper pulp markets recover, that is going to create opportunities for that 40% to swing production. Again, paper pulp prices are -- have been under severe pressure. But if you look at recent data in China, things do seem to be leveling off. Another factor I would add to everything that we've said is inventory levels, both on paper pulp and dissolving pulp. They were at very high levels late 2018 and into 2019. They are still at relatively high levels, but they are coming down considerably. And again, you, obviously, can't name the individual companies, but there are some large paper pulp producers in the last few days that have announced substantial reductions in inventories. And they are major players, and that will help paper pulp prices and indirectly with 40% being swing, that will, we believe, help dissolving pulp market.

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Operator [32]

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The next question comes from Wade Napier of Avior Capital Markets.

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Wade Napier, Avior Capital Markets (Pty) Ltd. - Research Analyst [33]

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Could you just give us an indication of where you see graphic paper inventory levels? You sort of mentioned that through last year, inventory levels were rising and have sort of compounded to cause the sharp decline in demand that we're seeing this year.

Second question is, given the sort of state of the balance sheet, is there a sort of possibility to sort of license your Rockwell technology with sort of paper producers and converters to really capitalize on a market that's likely to sort of grow well ahead of where you are able to supply it over the next 3 to 5 years?

And then third and final question is, considering you're mentioning energy inflation in South Africa as a sort of headwind, what are the sort of opportunities to sort of scrap the sort of lignins alternate production at Saiccor and sort of -- and move towards a more energy production for internal use at the mill?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [34]

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Okay. I will talk briefly about each, and then I'm going to hand you to Mike, our North American CEO, to elaborate a little bit further on inventory levels. When I get to the Rockwell question, Berry, I'll start, and then I'll hand it to you. And then, Alex, I'll come back to you on the lignin energy trade-offs at Saiccor.

The graphic paper inventory levels was less an issue in Europe than it was in the U.S. We saw big inventory levels rise in the U.S. Europe was -- we believe, was a combination of the economy in Europe, which had a significant impact on demand. And secondly, the price elasticity issue related to the selling price increases that we saw last year. So there's not been any major shift in inventory levels in Europe. However, in the U.S., clearly, the economy was less of a factor, but we did see substantial rises in inventory levels. And Mike, I'm going to come to you now, if you want to just expand a little bit further there.

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Michael G. Haws, Sappi Limited - President & CEO of Sappi North America [35]

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Steve, very little to add. We take the curtailment in the fourth quarter to bring inventory levels into balance and where they're at right now today is at our historical levels for our Q1. So we feel comfortable with where things are today. And I think that's what I have, Steve.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [36]

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Okay. Thanks, Mike. On Rockwell, as you know, we're very excited, and we've done some great work with Nestlé, and we're very excited about the prospects. And clearly, we would want to keep that IP in-house. There is more development work that needs to be done. And again -- maybe Berry, over to you, if you just want to expand further.

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Berend John Wiersum, Sappi Limited - CEO of Sappi Europe [37]

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Yes. Very briefly. It is a combination of 2 unique things. It's the chemistry in the recipes and it's the coating technology itself. So it is not a question that you could go to another company and say, would you make this for us because the technology to do so, they don't have. So it's very much a question of how quickly we can step up our capacity for that.

And the second thing is that there is a generation of -- there are several generations of developments coming over the next couple of years. So this is just one development. It is part of a -- sort of development program which you're going to see continuing generations coming on to the market to solve specific issues.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [38]

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Yes. And Wade, just to add to what Berry is saying, and perhaps it was your bigger question. Clearly, we have pulled back on CapEx in 2020. We do believe dissolving pulp prices will recover in time for all the reasons that we outlined. So we are going to be conservative. But clearly, when the balance sheet does improve, this would be an area that would be very exciting for us. And there are -- there is work on R&D, further work to be done to -- as Berry has alluded to, to extend it and get further developments going, but that would be something in time, which would be extremely exciting to Sappi.

The third question was on the trade-off between lignin and energy. Alex, now I'm going to hand it to you.

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Alexander van Coller Thiel, Sappi Limited - CEO of Sappi Southern Africa [39]

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Yes. Thanks, Steve. Obviously, what that will require is that we convert calcium line to magnesium. The cost saving, if you look at the energy generation, is probably similar to what we're now getting from the big -- putting in the third recovery boiler, but that does going to take some CapEx. There are shorter-term opportunities, and we're actually busy implementing them where we can reduce our steam usage in our current production process and that gives additional steam to run our turbine generators fully. And we will probably, in the course of the next 3 months or so, start utilizing that. But certainly, converting calcium to magnesium is a project we're working on as well.

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Operator [40]

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The next question comes from Robin -- Roger Spitz of Bank of America.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [41]

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I've got 2 questions. First, on the Matane term loan, 8-year term loan, what was the principal amount, the interest rate and is it secured?

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Glen Thomas Pearce, Sappi Limited - CFO & Executive Director [42]

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This is Glen here. No, it's not secured. The term loan is some 8-year term loan. And the interest rate is between -- because it's in 2 tranches, between 1.5% to 2.5%. And the overall amount is close to USD 170-odd million.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [43]

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$170 million, close to $170 million. Got it. And regarding the bank maintenance covenants, which you expanded between fiscal Q2 '20 and fiscal Q3 '21 to 4.5 from 3.75, 2 questions here. One is, when do you expect to hit your max leverage during that time period? Which quarter do you -- I know you're not going to max out at 4.5 because you want to maintain headroom. But when do you think you max when you max?

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Glen Thomas Pearce, Sappi Limited - CFO & Executive Director [44]

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It will be between quarter 3 -- fiscal -- of fiscal quarter 3 and 4 of 2020.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [45]

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Sorry, I just want to expand on what Glen said, and the reason for that is, obviously, our CapEx levels this year are still higher because we're completing the Saiccor expansion. As we get into '21, CapEx levels come down and that ratio starts to decline after the period that Glen has mentioned.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [46]

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Got it. And how is -- under your bank definitions for EBITDA and net leverage, net debt, is EBITDA, as defined under the bank agreement, similar to the EBITDA that you report? Or is there some differences? And is there any nuances in net debt? For instance, perhaps you can only take off so much cash, i.e., $50 million or $100 million, not total unrestricted cash?

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Glen Thomas Pearce, Sappi Limited - CFO & Executive Director [47]

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There are some nuances, but they're relatively immaterial. The only large one going forward is, as Steve indicated in his slide presentation, that will be the IFRS 16, which won't apply.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [48]

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Well, it's a frozen GAAP. So any changes to GAAP would not -- or IFRS would not have impact on the covenants.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [49]

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Right. The operating leases won't impact the debt.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [50]

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Yes, yes.

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Operator [51]

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The next question comes from Maggie O'Neal of Barclays.

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Maggie O'Neal, Barclays Bank PLC, Research Division - Research Analyst [52]

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Just one question for me. You talked about around 40% of the market being under water on dissolving wood pulp. What is your breakeven level in terms of prices?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [53]

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You'll appreciate, that's not a number I could give you because clearly customers are listening to the call.

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Operator [54]

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The next question comes from Julien Raffelsbauer of Millenium.

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Julien Raffelsbauer, Millenium Management, LLC - Investment Analyst [55]

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Regarding your covenant level, so you are now at 2.2 net debt to EBITDA, and you're not fully comfortable with the old covenant level at 3.75 in the next 6 months to March '20. So if I back solve it, it seemed that you could -- you're expecting a deep decrease in EBITDA by -- could be 50% for the next 6 months. Is the impact of DWP price decline so bad to your EBITDA? Why do you need so much headroom on your covenant so quickly?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [56]

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No. It's not that we think we're going to reach the covenant level. It's -- we just want to give ourselves flexibility and have some headroom. We know that the profits will be less and none of us wanted to get close to covenant levels. So we're maintaining maximum flexibility. And just to be clear, we're not saying earnings are going to be down 50%, definitely not that.

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Julien Raffelsbauer, Millenium Management, LLC - Investment Analyst [57]

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And typically, what's the headroom you like to have vis-à-vis your covenant level? Is it for [20%] or...

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [58]

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Yes. But I'll give you that, you don't want my profit numbers.

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Julien Raffelsbauer, Millenium Management, LLC - Investment Analyst [59]

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I was wanting to get...

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [60]

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3.75 the original covenant level. We just felt a little bit uncomfortable that with the lower profitability, the uncertainty on dissolving pulp, we just felt a bit uncomfortable. And we -- in order to maintain flexibility, we increased it to 4.5.

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Julien Raffelsbauer, Millenium Management, LLC - Investment Analyst [61]

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Okay. And last question, on the dissolving wood pulp, the price you're getting for this quarter is mainly the average of the previous quarter, is that it?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [62]

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Yes. Broadly speaking, we've spent some time talking about Chinese markets and there is spot pricing impacts as well. But yes, broadly, yes.

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Julien Raffelsbauer, Millenium Management, LLC - Investment Analyst [63]

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So you've got a decent visibility for the EBITDA for dissolving wood pulp for the next 6 months because we got already July to October pricing, so you got good visibility, I guess, no?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [64]

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Yes. Reasonable, certainly, for Q1. And as we get closer to Q2, yes.

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Operator [65]

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The next question comes from [Jonathan Williamson] of [Cerner Asset Management].

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Unidentified Analyst, [66]

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Just a follow-up to the last caller's question. Can you (inaudible) what EBITDA margins we should expect during Q1 for the dissolving wood pulp division?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [67]

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Jonathan, we're struggling to hear you. Is it possible to...

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Unidentified Analyst, [68]

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Can you hear me, now?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [69]

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Yes.

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Unidentified Analyst, [70]

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Yes. So just a follow-up to the last caller's question. I'm just looking for a sense of what EBITDA margins we should expect during Q1 and Q2 if possible for the dissolving wood pulp division?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [71]

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Without being too specific, I mean, clearly, the average pricing has declined further. So it will be lower margins than you've seen in Q4. I can't be too specific without giving the exact number, but current pricing for dissolving pulp is $638 a ton. To the previous caller's question, some of it is priced on the previous quarter. Yes, I can't get too more specific than that.

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Unidentified Analyst, [72]

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Okay. Understood. I mean, is it -- just to get a sense, is it possible would they be around 20% or below or that sort of area?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [73]

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Yes. It's -- again, I can't get too specific. It is lower. You should be able to work it out from the math because you know what the prices were in the last quarter, you know what current pricing is, and you can work backwards and work out our costs and work it out. You should be able to do it from the data that's available.

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Operator [74]

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The next question comes from de Mallerais of Chenavari.

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Hubert Tissier de Mallerais, Chenavari Investment Managers LLP - Partner and Senior Portfolio Manager [75]

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A lot of the questions I wanted to ask were answered, but one of the things on the working capital, you had a very nice inflow this quarter. I was wondering, should we expect an outflow in the first half of next year in line with, say, seasonality?

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Glen Thomas Pearce, Sappi Limited - CFO & Executive Director [76]

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Yes. That's correct. It's Glen here. So our working capital gain came down to a level of -- and net working capital of about $450 million. We would expect an outflow of at least about $40 million to $50 million on that in this quarter.

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [77]

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But that is seasonal. It happens every year. But on a relative basis, at the end of each quarter with all the good work that we're doing, we are hoping to improve relative to the prior year at the same time. But to Glen's point, there will be an outflow in Q1 seasonal.

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Operator [78]

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The next question comes from Lizelle du Plessi of APG Asset Management.

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Lizelle du Plessi, APG Asset Management NV - Senior Credit Analyst [79]

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Just in terms of the global paper -- graphic paper markets, what is your expectation for the rate of decline into next year and thereafter?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [80]

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Yes. Based on our outlook and where we are seeing markets, we think things will be better -- or less worse is the right term. We've come from a period of declines, as I've talked about 8% to 12%. We would expect that to be a lesser decline. Europe is probably in a better place than the North America at the moment. So we are estimating declines of 5% to 6%.

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Operator [81]

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Ladies and gentlemen, unfortunately, that is the final question. Sir, do you have any closing comments?

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Stephen Robert Binnie, Sappi Limited - CEO & Executive Director [82]

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No. I just want to thank everybody for joining us on the call, and we look forward to discussing our results at the end of Q1. Thank you.

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Operator [83]

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Thank you very much, sir. Ladies and gentlemen, on behalf of Sappi, that concludes today's conference. Thank you for joining us. You may now disconnect your lines.