Despite relatively steady performance from the energy and pulp segments, UPM’s quarterly EBITDA contracted 20% year over year; EBITDA from the paper business was nearly halved over the same period. As the world’s largest producer of graphic paper, UPM remains highly dependent on its paper business, where volume continues to decline–European magazine papers fell 6%, newsprint fell 3%, and fine papers fell 6%–and present significant headwinds for the company.

Overall European paper demand fell about 5% year over year. Given the sweeping European capacity closures under way and UPM’s cost-cutting project, we expect paper margins to modestly improve in the next few quarters. In our forecast, we expect further volume declines for UPM’s paper business over the next five years, which should offset most of the benefits from capacity reduction and limit the company’s potential for significant margin expansion.

Energy and pulp posted only modest sales declines on a year-over-year basis, and operating margins improved in both segments. Electricity deliveries increased 4.5% compared with the first quarter of 2012 and operating margins increased from 44% to 50%, but sales and operating profit fell 19% and 8%, respectively, because of a less favorable generation mix (lower hydroelectric generation) and lower realized energy prices. The gains in pulp were largely driven by higher realized pulp prices (6%), as deliveries fell almost 11% compared with the prior year. Over the next few quarters, we expect pulp prices to approximate prior-year levels and segment operating margins to settle closer to 18% from 19% in the first quarter.

UPM continues to make good progress reducing net debt– EUR 473 million reduction over the past 12 months–but lower EBITDA generation has offset much of the deleveraging efforts in recent quarters. UPM ended the quarter with a net debt/EBITDA ratio of 2.6 times. Given the cyclical nature of UPM’s business and the secular headwinds it faces in paper, we’d like to see the net debt/ EBITDA ratio fall closer to 2 times. Based on our forecast, we expect this level to be reached in 2015.