Stora Enso Oyj (SEOJF) Q2 2023 Earnings Call Transcript

Start Time: 04:00 January 1, 0000 4:58 AM ET

Stora Enso Oyj (OTCPK:SEOJF)

Q2 2023 Earnings Conference Call

July 21, 2023, 04:00 AM ET

Company Participants

Annica Bresky - President and CEO

Seppo Parvi - CFO, Deputy CEO, Country Manager Finland

Conference Call Participants

Lars Kjellberg - Credit Suisse

Charlie Muir-Sands - BNP Paribas Exane

Henri Parkkinen - OP

Linus Larsson - SEB

Cole Hathorn - Jefferies

Harri Taittonen - Nordea

Brian Morgan - Morgan Stanley

Ephrem Ravi - Citi Research

Annica Bresky

Welcome everyone, and thank you for joining us today for our Second Quarter Results Presentation. I am here today with our CFO, Seppo Parvi. I will take you through the highlights and financial performance and then go through our key priorities and how we're accelerating restructuring in the current challenging market conditions. Seppo will then take you through the financial performance in more detail. At the end, I'll give you an outlook of the coming quarter before we get into the Q&A session.

But before that, let's briefly take a look at our purpose. As you're aware, sustainability is deeply embedded in our strategy and corporate culture. Our purpose to do good for people and the planet is more important and relevant now than ever. Replacing fossil-based materials with our renewable products is what drives our underlying performance and are opportunities for growth and innovation. At the same time, we positively contribute to mitigate climate change future proofing our own company and our societies.

And I would like now to show you a very exciting example of that. The image on the right shows a project called Wisdome Stockholm part of Sweden's National Museum of Science and Technology. It's built with our material and will be a landmark for sustainable and climate-smart construction in wood. The ongoing reduction of carbon dioxide in the actual construction phase, the building alone will be storing almost 700 tons of carbon dioxide. The project is now completed with doors opening in December. And if you have a chance, go and see for yourself how the boundaries have been pushed of what is possible to build with wood. I believe it's truly amazing.

Now, let's take a look at the market dynamics and the recent development. The long-term structural tailwind, such as sustainability megatrends, also the climate change the world faces, are still robust and direct our strategic choices. And there are several regulatory initiatives and directive supporting our strategic roadmap. Some of these are, for instance, the nature restoration regulation, which intends to set targets to restore nature, important to create biodiverse and resilient ecosystems, and already an integral part of our forest management.

The packaging and packaging waste regulation supports our renewable and circular packaging. And another strong driver for our products comes directly from the brand owners who are responding to the increasing consumer demand for eco-friendly products. Lastly, the EU's Batteries regulation supports our development of Lignode with the introduction of the battery passport requiring battery producers to specify the amount of renewable content in a battery.

Now, if we then take a look at the current situation, the market has so far this year been hit with strong headwinds. The macroeconomic uncertainty still persists and continued high inflation is challenging for consumers. It's causing a cost of living crisis. They reduce their consumption of different packaged goods and driving our customers to reduce orders to manage increasing inventories.

More specifically, in the second quarter, we experienced low demand and the fastest ever decline in global pulp prices. At the same time, global pulp inventories are at very high levels and a large amount of new pulp capacities entering the market. The China market is also weak. We also saw reduced demand and continued customer destocking in our packaging business. The high interest rate environment has also severely reduced the activity in the construction market. And unfortunately, we can see no improvement in sight in terms of building starts or housing permits.

In the forest, the tight wood market continued. This was due to increasing energy wood consumption and also the lack of wood imports from Russia. In general, our costs in many of our input materials and services are elevated compared to historical levels. And as a result, the second quarter was disappointingly weak. But we are committed to deliver on our strategic roadmap.

So now let's take a look at some of our key events for this quarter. Naturally, in this turbulent market, we must adapt and continue to focus on what we can impact and control. Therefore, we have accelerated our restructuring plans, actions that will improve our long-term competitiveness and profitability by €110 million annually. And I will give you some more details on this later.

On a positive note, I'm excited to see that the acquisition of the De Jong Packaging at the end of last year positively contributed to our results. And as we speak, we are building market share in Western Europe by ramping up Europe's largest and most modern corrugated packaging unit.

Another part of our roadmap is to sustainably secure our funding and liquidity. We have just launched a combined green and sustainability linked financing framework for issuing these types of financing instruments. And during the quarter, we issued €1 billion of green bonds and raised €550 million in bilateral loans.

Now let's take a look at our financial performance. As mentioned, our profitability for this quarter was significantly impacted by higher input costs and lower volumes and prices leading to squeezed margins. Our group sales decreased by 22% to €2.4 billion, and this was mainly due to lower demand and customer destocking, decreasing deliveries in all our divisions. We have also prioritized profitability over volumes taking production curtailments when needed.

Lower sales prices, especially in wood products, biomaterials and packaging materials together with increased variable costs, mainly due to higher wood costs had a negative effect on our profit. Structural changes also had an adverse impact on sales, mainly related to the paper site divestments at Nymölla and Hylte in Sweden, Maxau in Germany, as well as the exit from our Russian operations. Our first division, however, delivered record Q2 results. And as said before, our Packaging Solutions business performed well.

In summary, our group operational EBIT decreased by 93% to €37 million and the operational EBIT margin decreased to 1.6% from 16.5. The operational return on capital employed for the last 12 months, excluding forest, was 10.7%, which is below the long-term target of more than 13. Despite all, I'm pleased to say that we are continuing to grow in our selected strategic areas of packaging, building solutions and biomaterials innovations. These have in Q2 increased their share of group sales to 57% from 53% in the previous quarter. The last few years, we have accelerated our actions to fulfill our strategic roadmap. And we have successfully accomplished the significant transformation of our product portfolio towards growth areas.

You can see on the left that in 2006, 70% of our sales were generated by the previous paper business. Today, we have no longer a paper division. We project that in 2025, 60% of our sales will be derived from our growth areas rising to 80% in 2030. With this objective, we can profitably grow share with our existing and new customers both in current and new markets with new products and solutions. The allocation of our capital I believe is key to achieve this objective.

The choices we make on how we use and develop our assets enables our long-term growth and our profitability, and I will now try to cover some of these recent initiatives. I mentioned the acquisition of De Jong earlier. It is a major strategic investment now moving ahead with integration. The expansion of the new high tech packaging unit has been designed with a strong focus on cost efficient and sustainable operations.

The divestment of our consumer board production site in Beihai in China is progressing and this will enable us to focus capital allocation on our most competitive assets. We have now also started the construction of our new high volume and cost efficient consumer board line at our Oulu site in Finland, and this will significantly advance our growth in renewable packaging and we will be stronger when the cycle turns.

As you're also aware, biomaterials innovation is a key area for us that we continue developing. The largest potential is in Lignode. This is our anode material for hard carbon based on lignin. The pilot plant for Lignode continues its operation at a similar site in Finland. And we are currently investigating for more competitive locations for commercial scale up and production. Recognizing the potential for lignin-based products, we're also exploring external sourcing for lignin.

I promised earlier to give you some further details on our restructuring plan, so let's go through that now. We have a short to long-term action plan for value creation. And of course with the current challenging market environment, we are accelerating restructuring to improve future competitiveness and profitability, and also to build market share where we already have leading positions. These are my key priorities.

As announced here in the quarter, we are planning to permanently close down and divest non-competitive assets, the pulp production site in Sunila, Finland, the De Hoop containerboard site in Netherlands, one containerboard line at the Ostrołęka site in Poland, and the Näpi sawmill in Estonia. We also intend to divest the wood products Do It Yourself unit in Netherlands, and the divestment process is ongoing for Beihai mill and forest operations in China.

We're also continuing to decentralize creating leaner and more efficient group functions to simplify our organization and reduce overhead costs. This will further empower the divisions to independently drive customer intimacy, increased business focus and implement cost reductions. The restructuring actions across the group would result in a total headcount reduction of approximately 1,150 employees and it will improve profitability by an estimated increase in operational EBIT of around €110 million per year. Such actions are however never easy, especially since it impacts our people, but unfortunately necessary to strengthen Stora Enso now and for the future.

If we look long term, as mentioned earlier, we are building on strong market positions, driving innovation and focusing capital allocation into strategic growth markets. They are strengthening their whole business into a more resilient and cost efficient platform with cost competitive assets and cutting edge products to support the long-term growing demand for Stora Enso's renewable products.

With that, let's now take a look at the development of our long-term group financial targets. The weak second quarter is of course also reflected in how we deliver against our group targets, remembering of course that we are comparing ourselves with a very strong quarter last year. Our sales decreased by 22% impacted by, as I said, the lower demand and structural changes, mainly related to the previous mentioned paper site divestments as well as the exit from the Russian operations. And although the net debt related targets were achieved in the second quarter, the operational return on capital employed targets were not met. For the divisions, biomaterials and forest division are ahead of their rock targets while the other divisions clearly underperformed.

And now, I hand over to you Seppo to give us some more light and insights on the financial.

Seppo Parvi

Thank you, Annica. Losses, prices and volumes together with high input costs significantly reduced our profitability. As mentioned earlier, the market demand was clearly the gap compared to the previous year trying to import sales prices and volumes down [indiscernible] they can't be higher due to the increase in both costs, especially in Finland or Sweden, market is tight due to the increase in demand of energy board and lack of volumes from Russia.

Energy, logistics and fixed costs were lower year-on-year, but chemical costs were still increased slightly, the negative impact from other variable costs and change of inventories mainly coming from Packaging Materials division. In Packaging Materials, destocking in the supply chain continues. Sales decreased by 19% or 269 million to below €1.2 billion due to lower containerboard prices and lower volumes for consumer board. They were partly offset by higher consumer board prices.

The container board market softened further with lower demand. The containerboard market stabilized at a low level, but in [indiscernible] continued and we have taken production curtailments to access the lower demand. Operational EBIT decreased by 222 million to negative €22 million. Higher consumer board prices were offset by mainly lower containerboard prices and also lower volumes and higher wood costs. Total variable costs increased due to wood prices, but other variable costs decreased from peak levels. Operational return on capital was 7.3% below the long-term target of over 20%.

Here you can see market prices for the Packaging Materials division. In the second quarter, containerboard prices continued to decrease due to weak demand and continued high inventories in the supply chain. The demand was weak due to slow economic growth and low private consumption, but is expected to stabilize at lower levels. Destocking continues as mentioned. Folding boxboard prices have decreased from the peak levels of summer '22 as a result of softening demand and destocking. Price pressure has been mounting due to low demand.

In Packaging Solutions, there was solid result development despite the weak market. The market has now stabilized at the low level. Sales increased by 55% or €102 million to €288 million. The acquired De Jong Packaging Group more than offset the impact of the divestment of the Russian operations in Q2 a year ago. Sales from Northern or Central-Eastern European businesses decreased slightly due to the soft market.

Sales prices in corrugated packaging were lower as a consequence of lower containerboard prices, and we continue to focus on defending our selling prices. Operational EBIT increased by €13 million to €15 million. We acquired De Jong Packaging group as well as actions to reduce costs and improve business performance mitigated the impact of the soft market and the divestment of the Russian operations a year ago. Operational return on capital was 5.9% below the long-term target of over 15%.

In biomaterials, very challenging market conditions continued, decline of the market started late first quarter this year. Sales decreased by 27% or €143 million to €379 million. Market has softened further with lower demand and increased global pulp inventory levels. This has led to a record decline in market pulp prices and lower deliveries impacting sales negative. Also curtailments of production losses due to maintenance impacted sales volumes negative.

Operational EBIT decreased to a negative €30 million due to lower sales prices and volumes as well as higher maintenance and wood costs. Market-related curtailments, annual maintenance shutdowns and high wood costs significantly impacted the result for the quarter. The Montes del Plata site in Uruguay and the Skutskär site in Sweden had planned major annual maintenance shutdowns followed by challenging start increasing the maintenance impact in the quarter. Operational return on capital was 19.1%, above the long-term target of over 15%.

The record speed of decline in market pulp prices and lower deliveries pressured sales and margins. For our biomaterials division especially, we faced the fastest ever decline in global market pulp prices as is visible in the graph on the right-hand side. A significant amount of new capacity is entering the market at a time when demand continues to be low and the global market pulp inventories are on very high levels. We also expect inventories to remain on a higher level going forward. Global pulp inventories continued at the level above the five-year average, as you can see on the other graph on the left-hand side here.

In wood products, demand has significantly weakened as construction activity goes on hold. Sales decreased by 31% or €195 million to €436 million, mainly impacted by lower sales prices and volumes, especially for sawn wood. After last year's record strong market, demand for sawn wood has significantly become weaker.

Construction activity in the division's main markets remains low and is negatively impacted by fewer building permits and projects. This is due to the high interest rate environment and cost of living crisis. Operational EBIT decreased by €140 million to negative €6 million, affected by lower prices and volumes. The results were impacted by lower sawn wood prices, lower volumes and continued high raw material costs. Operational return on capital was below the long-term target of over 20% at 5.6%.

In the forest, stable and strong performance continues. Sales decreased by 4% or €29 million to €620 million, caused by lower demand. Wood prices remained high due to tight wood markets. The wood market in the Baltics and Nordics remained especially tight due to the industrial and energy wood demand and lack of Russian wood imports. We have managed to secure wood availability through flexible use of our own forests and efficient wood sourcing both from Nordics and Baltics.

A record-high second quarter operational EBIT of 62 million was driven by a stable and a strong operational performance in our own forests and in the wood supply operations. Operational return on capital at 4.1% was above the 3.5% long-term target. Forest valuation continues to show strong resilience in the high interest rate environment. On this graph, you can see the stable development of our forest assets fair value by quarter.

The total value of our forest assets, including leased land and our share of Tornator's forest assets in Finland remains stable at 8.1 billion. This declined to €10.23 per share. There was a €266 million decrease versus previous growth in value, mainly due to the Swedish krona. Market transaction-based forest property prices are updated in Finland and Sweden in connection with Q2 and Q4 reporting, so this is based on the latest market data rate.

Now I'll hand it back to you, Annica.

Annica Bresky

Thanks, Seppo. And I will now go through the market demand outlook per division for quarter three compared to Q2 this year. And it's fair to say that Q3 will be another challenging quarter due to sequentially deteriorating market conditions. In Packaging Materials, the demand for consumer board is expected to be weaker and destocking at customers continue, but the demand for containerboard is expected to stabilize at low levels.

In Packaging Solutions, demand for corrugated packaging is expected to be stronger, but it is lower than the normal seasonal peak. In biomaterials, the pulp demand is expected to be weaker as high inventory levels are expected to continue, as Seppo showed, together with a larger amount of new capacity entering the market.

For wood products, the market demand for both sawn wood and building solutions is weaker as the building activity and construction industry continues to be slow. For the forest division, sawlog demand is expected to remain stable due to tight wood market and the pulpwood demand is expected to decline due to weak pulp market. The demand for pulpwood for energy however will remain strong.

And I will now summarize our key takeaways before we move into the Q&A session. So all-in-all, we continue to adapt and navigate the challenging market environment. Our financial performance for the second quarter was disappointingly weak and was caused by market-related lower demand in combination with high input costs for most of our businesses. Therefore, we are accelerating our restructuring plans to improve our long-term competitiveness and profitability.

These initiatives are expected to improve our operational EBIT by €110 million annually. We reiterate that we expect the full year of 2023 operational EBIT to be significantly lower than the €1.9 billion achieved in the full year of 2022. On our strategic initiatives, we're focusing capital allocation on long-term value creation in key growth areas.

And to further accelerate our sustainability commitments and strategy, we launched a new framework for greener sustainability linked financing, raising 1 billion from the bond markets. And in addition, we've raised €550 million in bilateral loans to secure our liquidity and financing in the current business environment. We are positioning ourselves for profitable growth in our key segments and to be stronger when the cycle turns.

And with that, we are ready to take all your questions and moving into the Q&A session.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. Our first question comes from Lars Kjellberg at Credit Suisse. If you could unmute your line and then ask your question.

Lars Kjellberg

Yes. Good morning. A couple of questions relating to the structure of your business now. Clearly wood costs have been moving up quite materially. And you obviously are highlighting energy use as an issue when it comes to demand but even so we have weak demand in your industrial products. So the question is really how should we think about this structural tightness of the Nordic/Baltic wood market? And in that context, your ability to drive profitable growth through the organic investment, for example, in Oulu? That's one of my questions. Thank you.

Annica Bresky

Thank you for your question. And of course, right now, the Finish sites are challenged by high wood costs as we have said in the Nordics and the Baltics. However, the investments that we are doing in consumer board, they are driven by long-term growth. We have seen our consume board business to be resilient even though right now the market is weaker. And the site in Oulu is going to be Europe's most cost efficient folding boxboard and see UK or brown qualities production site, which is of course long term how we are repositioning our assets. So I have no doubt that we will be able to deliver a very strong results going forward from that business when the cycle turns. And also if we look at kind of the wood market, yes, it is true that we miss the Russian wood import. We are now taking decisions to close down, for instance, our pulp mill in Sunila that releases wood volumes for our other sites taking off some pressure on the Finish wood market. So thinking about it a little long term, we will see of course as the demand goes down for sawn logs and also for pulpwood that there will be an adjustment also on the wood prices. But there is a lag effect of approximately six to nine months before that happens. Structurally though there is a lower volume of wood available in that region.

Seppo Parvi

And we also believe that over time, consumption would go down. Then electrification of the boilers moves forward. Obviously, it doesn't happen overnight. It takes time as an investment cycle and that would also ease the situation on the market.

Lars Kjellberg

Got you. Thank you.

Operator

Thank you, Lars. Our next question comes from Charlie Muir-Sands at BNP. Please unmute your line by pressing star six and ask your question.

Charlie Muir-Sands

Hi, there. I'll limit myself to two questions, if that's okay. The first one is on the forest valuations. I think you attribute them to being mainly related to the movement in the krona. But I'm just wondering, can you clarify are you seeing any signs of negative revisions to forest valuations on a local currency basis? And then the second question relates to your working capital and CapEx. I just wondered if you can update us on what you think you can achieve in working capital this year and what you're thinking about CapEx for this year, where I see the guidance unchanged and perhaps even for next year? Thank you.

Annica Bresky

So if I start with the forest valuation, the answer is no. We cannot see any other effects impacting beyond the currency effect.

Seppo Parvi

Yes. And on your question of working capital and capital expenditure, so we believe and what we are working on is to reduce working capital by €250 million to €300 million. And when it comes to capital expenditure, we have actually lowered the range by 100 million reflecting the reprioritization of the projects and the focus on cash flow in short term.

Charlie Muir-Sands

Thank you. Any view on next year?

Seppo Parvi

No, we don't comment next year topics yet, but obviously under the current business environment and assuming that it's not changing, we will keep focus on cash flow and cash flow generation and look at the priorities and capital expenditure size and investment and potential postponements.

Annica Bresky

And as we have communicated before, we will deliver on the strategic projects that we have in pipeline, and we have kind of the Oulu investment there raising kind of the general CapEx levels, but we will not take any more decisions on new investments until we'll see the market cycle turning.

Charlie Muir-Sands

Great. Thanks.

Operator

Our next question comes from Henri Parkkinen at OP. If you could unmute your line and ask your question.

Henri Parkkinen

Yes. Good day for everyone. I have two questions, first regarding the consumer board business. In your comments, you say that you expect the demand to decline when going to the third quarter of this year. Could you please remind about the contract structure when talking about liquid packaging board and folding boxboard for how much of your, let's say, contracts will be renewed during next 12 months, or something like that? And the second question is related to packaging solutions. In your report, you mentioned that the IFRS and net profit that impacts from De Jong was something like €7.3 million negative during the first half of this year. But if we go to the comparable operating profit level, what was the impact, for example, during the second quarter of this year? Thank you.

Annica Bresky

So if I start with the consumer board, we constantly renegotiate contracts. And folding boxboard, as you know, are mainly one year contracts and we have them of course spread around the year. So not everything takes place at the same quarter. But generally most contracts are renegotiated during quarter three, quarter four. If we look at liquid contracts, they are longer kind of contracts between three to five-year contracts. We have seen if we analyze kind of consumer board businesses such that the liquid business is resilient and stays more stable, folding boxboard has been going down demand wise and that is what we expect for coming quarter. The inventories on folding boxboard however have remained stable. So this is -- kind of they are not increasing. And as I said we are taking curtailment and production curtailments in order to make sure that when we enter price negotiations, we keep the inventories on as low levels as possible. So that's why we're working with that. And if we look at kind of the liquid business there, we expect it to be more or less kind of stable. And even though it's kind of weakening a little bit, it's resilient under these circumstances. For containerboard, however, you didn't ask that question but in relation that is where we see that it will stabilize at low levels. And of course that improves the situation for pricing. And there we have more kind of contracts being renegotiated all the time and have also bigger opportunities to adjust for changes in input costs and so on.

Seppo Parvi

Then on your question on this IFRS result and comment relating to De Jong, that is relating to write of the whole [ph] potential closer that we announced a month ago. And it is a [indiscernible] account affecting comparability IAC and that's why it is not visible enterprise or -- it's operationally no issues. It's the restructuring-related charge.

Henri Parkkinen

But you do not want to comment that the profit impact on the comparable operating profit level from De Jong during the second quarter of this year. So how much additional comparable operating profit you will – okay, I understand. Thank you very much.

Seppo Parvi

We don't comment separate individual units for any of the divisions.

Annica Bresky

And we have to remember also that last year, we had the Russian operations in our results, but De Jong is delivering -- is strong and delivering good results for us.

Seppo Parvi

And integration is moving forward as planned with the expected benefits.

Henri Parkkinen

Okay, that's good to hear. Thank you.

Operator

Our next question comes from Linus Larsson at SEB. Please unmute your line by pressing star six and ask your question.

Linus Larsson

Thank you very much. My two questions are relating to your near-term outlook. And you were saying that in the third quarter, you're expecting sequentially deteriorating market conditions. What do you see regarding variable costs? How do you expect variable costs to change in the third compared to the second quarter please?

Seppo Parvi

The constant variable costs in Q3 versus Q2, obviously year-on-year we continue to see pressure on an increase in inflation, but “variable costs are starting to flatten up.” So we don't expect such a big pressure, but temporary are coming down either. And on the market conditions between Q3 and Q2, do you want to comment that, Annica?

Annica Bresky

On the market conditions, well, the biggest kind of -- we are long in pulp as you know 2.1 million tons and with a closure of course of Sunila if that is progressing after the negotiations, we will reduce that long position. It is the market pulp pricing levels that is the uncertainty and the weakening that we see on that market that drives mainly that comment that we are making. And as you saw, we are on high inventory levels there. So that is kind of what's driving our outlook.

Linus Larsson

Thank you very much. And relating to that not only in biomaterials, but on a group total, do you expect -- what's your production planning currently? Do you expect to take more or less market related downtime in the third compared to the second quarter?

Seppo Parvi

We don't, Linus, comment in detail our plans when it comes to downtime, market related or otherwise. But it's clear that assume that market conditions don't improve as we expect, it doesn't. So we continue to take downtime when needed to adjust our production volumes to the demand to avoid inventory buildup.

Linus Larsson

Great. That's fair enough. Thank you very much.

Operator

Our next question comes from Cole Hathorn at Jefferies. Please unmute your line by pressing star six and ask your question.

Cole Hathorn

Good morning. Thanks for taking my questions. Two quick ones. On the disposal of the China business, can I just confirm you're looking to try and sell your forest holdings as well as that mill activity all into one package, so the 340 million forest value on the balance sheet plus whatever you can get for that Beihai mill is the first one? The second question, Seppo, you mentioned that there was an inventory write down effect in the second quarter, mostly in packaging materials. Could you quantify that and will there be sequential improvement effectively next quarter because I imagine they wouldn't be further write downs in that inventory [indiscernible] and then I've got one follow up.

Annica Bresky

So on Beihai, yes, we are selling both the mill and the forest operations. And as I said, that divestment process is proceeding well and we have interest in our assets. We will decide if we sell them in a bundle or separate to maximize the value of our assets.

Seppo Parvi

[Indiscernible] packaging materials, it's not really directly packaging materials, inventory valuation or revaluation, it is relating to volumes in inventory into Q2 a year ago, inventory volumes had been up, they have been going down this year, that is where the effect is coming from. And then obviously, going further depends on how the inventory levels move sequentially. But obviously, like I said, normally these kind of big changes between the sequential quarters don't happen. This was year-on-year and different business environment.

Cole Hathorn

And then maybe looking into '24 and '25, packaging materials now at negative EBIT. It's not a sustainable level for this business, nor a medium term level for the business. What are the big buckets or big roadmap items that need to change to get to profitability to improve in this business? Is it a case of if wood cost stay higher for longer, you need to step up a liquid packaging for contract prices? What are the key buckets that you need to turn around the profitability? And I realize it'll be '24, '25. I'm just trying to understand how we should expect the sequential improvements in profitability in those outer years? Thank you.

Annica Bresky

So first of all, just a reminder, in packaging materials, we have the asset of De Hoop there, which we are restructuring and closing, which is contributing, of course, to the negative results that we have on that division. And then if we look at going forward, of course, now we have the perfect storm situation where input costs are still high. They haven't come down due to inflation and then the prices come down faster. Moving forward, of course, we expect in a slowdown of the economy, inflation will gradually kind of reduce. We will be able to renegotiate sourcing contracts on logistics, on other input costs such as chemicals and so on. And also through restructuring, find ways of redirecting our wood opportunities to where we have most profitable kind of products. And in our contracting with customers, of course, we cannot have a kind of non-profitable product. So what I see in packaging materials, if we look at underlying demand, even if it has come down, it is still resilient and it is on good levels. Once destocking is done for the customers and the brand owners which is what we're trying to achieve by taking curtailments now, we also have a better negotiating position to kind of deliver on the underlying demand. And long term, we need to remember that renewable packaging is growing and expected to grow for the years when the cycle turns. Pulp price is also declining for packaging materials will eventually also be visible in reduced kind of pressure from input costs.

Operator

Thank you. Our next question comes from Harri Taittonen at Nordea. Please unmute your line and ask your question.

Harri Taittonen

Sure. Thank you for taking the question. Good morning. Maybe on the power market, just if you can give color, you have quite a diverse portfolio and it seems that the short fiber prices have declined much more steeply and the long fiber prices have been holding up a little bit better than the price differential is quite wide. So what are you seeing there going into the second half of the year in terms of your product mix by grade, if you can elaborate a little bit on that?

Annica Bresky

So for Europe on softwood and also hardwood, we expect continued kind of demand decline by 7% approximately for both these type of grades. Fluff is holding on better. So there we expect the demand increase to 2.9% or almost 3%. Then in China, we also -- we had kind of demand and the bottom kind of -- for softwood and hardwood around 3% decline for the coming quarter -- year-on-year. If we look at it sequentially, if you're interested in that, we would see in Europe softwood and hardwood at approximately and also fluff at the same levels of demand. That's also true for China. But the challenging situation is that there is new capacity coming on stream, it's quite sizable when demand is not really strong. We see weakening of the packaging and uses of the graphical paper and uses on the demand side. So there is going to be continued price pressure on the pulp side. And as said, the inventories are high. If you look back historically to come down from the levels that we are now on inventory levels, it takes one year before they get imbalanced. So that's why I'm not very optimistic that we would see a quick turnaround on the pulp market.

Harri Taittonen

Yes, I understand. Yes, surely we are interested in sequential development. So thank you for that. And maybe the second question on the packaging materials, what is the best sort of estimate on the underlying demand growth and sort of [indiscernible] destocking? And then obviously, during the pandemic years, there was not that much supply coming from Asia, but how much is that kind of affecting their supply/demand balance at the moment? Is it sort of a new feature, which also needs to be taken into account when thinking about the sort of timing of the potential kind of end of the destocking period?

Annica Bresky

Did I hear your last question -- you asked about Asian imports or did I --

Harri Taittonen

Yes. I was just thinking that the market is -- and are completely right sort of that there's two elements. One is destocking and the other one is underlying demand, which are both kind of affecting supply/demand. But then the third issue is if there is sort of an increase in supply affecting the market in a different way compared to the pandemic years?

Annica Bresky

No, I don't see -- your last question about the Asian supply, I don't see that impacting our European market at all actually. The board production that's set up in China is used for domestic production and consumption in the Asia kind of region. So that is not impacting our business where we have a majority of our sales in Europe. So it's more kind of a European demand driven. I would say that destocking is going to continue to take place Q3, Q4 for consumer board, but I expect that to be kind of them reaching more balanced levels where the true underlying demand will kind of -- is resilient even though it's weaker than the record year last year, it's not weak. So it's a matter of now making sure that inventory levels do not increase and that they are kind of balanced by the end of this year. And we are taking the actions necessary to make sure that from our side, we do our best to get there.

Seppo Parvi

And looking over the cycle, economy in general and this destocking, we foresee that the growth is still there. Look at the replacement of plastic by fiber packaging and these trends, they are not disappeared anywhere. But we need to look over the cycle. And this destocking has been unusual this cycle.

Annica Bresky

I think it is a residue from the pandemic years where a lot of supply chain challenges and kind of our customers wanted to be sure that they had materials so the stocks were higher. And now we are normalizing that and that takes a couple of quarters to get there.

Harri Taittonen

Right. Thank you so much. Thank you.

Operator

Our next question comes from Brian Morgan at Morgan Stanley. Please unmute your line and ask your question.

Brian Morgan

Hi, there. Thanks very much for the time. Two questions from my side. Could you break down the operational and operational EBIT improvement that you see the €110 million annual number in a bit more detail, how much of it is related to mill closures? How much is variable cost savings or fixed cost savings, et cetera? And then the other question is just on pulp and just perhaps from a high level perspective, do you think the industry is doing enough to rebalance the pulp markets? And do we need some tough decisions made by the industry in general to rebalance this market?

Annica Bresky

If I say about restructuring, of course, majority of the fixed costs and also the FTE impact is on the assets that we are planning to close. And that also, of course, takes down maintenance costs, it takes down headcount and other services that are needed to service these units. Also, as I said for Finland where the wood market is tight, it releases wood volumes that can be used for other sites, taking off some of the pressure. We do not comment more in detail kind of specific items on that. On the headcount for the lean group functions, that is 20% reduction on headcount, which is included in this numbers and brings efficiencies also as we right size our kind of group function operations. If we look then at the pulp, if you could remind me again the question on that?

Brian Morgan

So the question is --

Annica Bresky

You asked a question about the pulp market. I forgot to --

Seppo Parvi

It was if enough is done by industry.

Annica Bresky

Thank you. I believe that it's going to take a while until this new capacity is absorbed by the market. It's quite sizable. It's 4.5 million tons coming out. They're coming this year and the next year. So there is long-term growth in the pulp business of about 2% per year. But naturally, when this big capacity comes out, when market demand generally is slow, and macroeconomics are slow, it's going to take a while before that is absorbed. If inflationary pressures stay on high levels, I expect that kind of uncompetitive smaller units will suffer. And of course, then if the situation does not improve since the cash cost is now on such levels, that it is not profitable to run some of these pulp units, and we have seen that in China, there are smaller pulp mills there temporarily closing down and so on, there will need to be restructuring to stabilize this market. And we have taken the step with our unit in Sunila. I expect more to come if this situation becomes a longer issue.

Brian Morgan

That's perfect. Thank you.

Operator

[Operator Instructions]. Our next question comes from Ephrem Ravi at Citi Research. Please unmute your line to ask your question.

Ephrem Ravi

Hi. Just a hypothetical question just to think about how you're looking at the business. So in the scenario, well, your net debt to EBITDA reaches 2x by the end of the year. Can you give us a priority of how you stagger out your strategic growth projects in terms of which will take priority between Oulu conversion, Langerbrugge and Lignode just to know that which is more critical, which is probably less critical for you from the way of your thinking about your long-term strategy? And secondly, again at least in the last 10 years, you haven't had a negative free cash flow year. How should we think about your capital returns in terms of your dividend payout which is 50% across a cycle? So theoretically it can go down to zero but in a year because you haven't had this before, if your free cash goes negative, would you still think about paying a dividend?

Seppo Parvi

Well, first of all on your question on net debt to EBITDA ratios and movement there, as we have said we have already started actions to improve our cash flow, working or working capital reductions, we are working to look at the priorities when it comes to topics how to improve cash flow by postponing some of the projects or cancelling some and postponing those to future and we also doing restructuring when it comes to bleeding units and an unprofitable businesses to improve profitability. So with those actions, we are obviously managing our balance sheet. When it comes to dividend and dividend policy, obviously, that is something that is tied to the recent development being to pay half of the earnings per share over the cycle. And as in the past, even if policy has followed the dividend, so the dividend policy has followed the profitability development of the company. But of course it is our cycle. So we take a bit longer term view on the dividend payments. But that is obvious on the [indiscernible] then towards the end of the year, early next year before AGM.

Annica Bresky

And if I say a few words about prioritization of CapEx initiatives, we have already decided on the Oulu conversion and that is ongoing. Actually, it's a good time to do investments during a down cycle and then ramp up the unit, which is expected to ramp up in 2025 once the cycle turns. And if we look at Langerbrugge, we have done the feasibility study that shows that that unit can be converted profitably into a containerboard unit. But we will of course not do that until we see that the market kind of improves. In terms of Lignode, we are continuing to focus on the development there looking for the most cost competitive asset to do such a scale up. But of course also there we need to be sensitive of how the market is generally kind of directing and our opportunities to free up capital for such investments.

Ephrem Ravi

Thank you.

Operator

Thank you very much. That concludes today's session. So I'll hand back to our speakers for any closing remarks.

Annica Bresky

Thank you very much. A lot of interesting and good questions for you and thanks for participating actively today. Looking forward to talk to you again in quarter three and wish everyone a great summer. Thank you very much.

Seppo Parvi

Thank you.