OREANDA-NEWS. S&P Global Ratings today revised its outlook on Finland-based forest and paper products company Stora Enso Oyj to positive from stable. At the same time, we affirmed the 'BB/B' long - and short-term corporate credit ratings and the 'K-4' short-term Nordic regional scale rating on the company.

We also affirmed our 'BB' issue rating on Stora Enso's senior unsecured debt. The '4' recovery rating indicates our expectation of average recovery (30%-50%; lower half) in the event of a payment default.

The outlook revision follows a period of improved profitability and structural changes to Stora Enso's business portfolio that we believe could result in a permanent strengthening of its business risk profile. S&P Global Ratings' adjusted EBITDA margin for Stora Enso over the 12 months ended June 30, 2016, was 15.7%, marking an improvement over the 11.9% annual average seen in 2010-2014. The main drivers behind the improvement have been the introduction of new profitable growth investments, such as the Montes del Plata pulp mill in Uruguay, and stronger performance in the paper segment due to cost cutting and the disposal of low-performing assets. We view positively the completion of the Beihai paperboard mill in China, which was on time and on budget and started production in May 2016. We think the mill's ramp-up mitigates concerns around execution and timing risks, although it will take two years until it is fully up and running.

We think that Stora Enso's clear strategy to steer its business portfolio away from declining paper and toward growing segments such as consumer paperboard and containerboard makes sense, because these segments enjoy healthy growth prospects at least in line with GDP growth in its countries of operation. We also consider as a strength Stora Enso's targeting of higher-end products, as evidenced by the completed conversion of the Varkaus paper mill into containerboard, the conversion of the Skutskar pulp mill into fluff pulp, and investments in the sawn timber division. We anticipate that these measures, teamed with continued stringent cost control in the paper segment, could lead to a business portfolio that is less cyclical and less exposed to structurally declining segments, while continuing to enjoy solid growth prospects.

That said, we view the operating environment in the coming 12 months as potentially challenging for Stora Enso. This is based on our expectation of a sustained period of lower pulp prices and possible price pressure for paperboard and containerboard in Europe due to new capacity coming online (including Stora Enso's kraftliner volumes from its Varkaus mill) causing temporary overcapacity. In addition, in light of an uncertain economic outlook in Europe, we see potential for an accelerated decline in paper demand and renewed pricing pressure. Despite these potential downside scenarios, we see a fair likelihood that Stora Enso's recent positive momentum could lead us to favorably reassess the company's business risk profile in 2017.

Stora Enso's financial profile has strengthened in tandem with its operational performance in the past 12 months, with a ratio of funds from operations (FFO) to debt currently around 25% versus approximately 20% in 2012-2014. We view positively the company's clearly stated financial target to maintain reported net debt to EBITDA below 3.0x (which is equivalent to about 3.8x including our adjustments) as this limits downside to the financial risk profile, in our view. We think that any further improvements in credit metrics hinge on Stora Enso's growth strategy and the extent in which it will enter any new large scale investments, for example by investing into additional containerboard capacity at the Ostroleka mill in Poland or by investing into a large-scale pulp mill next to the paperboard mill in China.

In our base case, we assume:Eurozone GDP growth of 1.7% in 2016, declining to 1.3% in 2017. Stronger growth in Eastern Europe, where Stora Enso is exposed through its paper packaging operations. Paper volumes to fall by about 10% in 2016 following disposals and structural demand decline and continuing to fall in 2017-2018. We expect a structural demand decline of 3%-5% per year in Europe. We assume a slight price increase on average in 2016, followed by stable to slightly declining prices and that the company's ability to control costs will determine profitability. Price pressure for pulp to lead to lower sales and earnings in the biomaterials business segment but EBITDA margins to remain above 24%. New volumes from the Varkaus containerboard mill to boost sales in the packaging business but some price pressure to weaken margins. Possible price pressure in consumer paperboard due to temporary overcapacity in Europe. Overall group sales to weaken slightly in 2016 and increase slightly from 2017 and onwards. EBITDA margins to remain steady in 2016 and improve slightly in 2017 following declining paper contribution and growth in higher margin businesses. Lower capital expenditures of about €750 million in 2016, dropping to €650 million per year over 2017-2020 as the company is now through its large investment phase. Dividends to rise in line with dividend policy.

Based on these assumptions, we arrive at the following credit measures: FFO to debt to remain at around 25% in 2016, followed by slight improvements from 2017.Adjusted debt to EBITDA of about 3.0x. Free operating cash flow (FOCF; cash flow after investments) to debt of above 10%.

The positive outlook indicates our view of at least a one-in three likelihood of upgrading Stora Enso to 'BB+' in the coming 12 months if we were to assess that its business risk profile has strengthened sustainably. We expect Stora Enso to maintain a ratio of FFO to debt of above 20% at all times.

We could revise the outlook to stable if Stora Enso's operational performance weakened, for example due to severe pricing pressure for pulp and paperboard and the Beihai paperboard mill not performing in line with expectations due to slowing economic growth in China. We could also revise the outlook to stable if Stora Enso's financial risk profile deteriorated, for example due to large acquisitions or a marked increase in shareholder remuneration, although we see such a scenario as unlikely in the coming two to three years.

We could raise the rating if Stora Enso establishes a track record of sustained profitability improvement with group EBITDA margins of about 15% going forward. A successful ramp-up of the Beihai paperboard mill and contained downside risk in the paper segment are also factors we consider important for an upgrade. Furthermore, we would expect Stora Enso to contain project and execution risks in future expansion projects compared with recent large-scale investments. An upgrade will also hinge on continued cautious dividend policy and maintenance of its stated leverage target.