* Stora Enso and UPM seen taking steps towards tie-up
* Joint venture could fix oversupply problem in Europe, say analysts
* Mill closures would add to Finland's woes after Nokia phone exit
By Jussi Rosendahl
HELSINKI, Sept 24 UPM-Kymmene and Stora Enso, the world's leading makers of printing and writing paper, are being driven towards a merger of their European units by a relentless fall in demand and prices in the digital era.
A shift by consumers and offices away from newspapers, magazines and the printed word in favour of smartphones, tablet computers and online working has trimmed European demand by around a quarter since 2007.
A decade-long programme by manufacturers to cut excess mill capacity has failed to stem the decline in prices and profit.
Now after years of speculation about a possible tie-up, investors have in recent weeks raised bets UPM and Stora will fold most of their paper businesses into a joint venture over the next year.
The two companies have declined to comment on potential deals and there are no signs they are in official talks.
But many commentators say consolidation is inevitable.
"The industry has reached a point where it has no choice but to take drastic action, and this joint-venture scenario is basically the only possible way to salvage cash flow in the business," said Handelsbanken analyst Karri Rinta.
Such a move, followed by more mill closures, would help trim output and costs and allow the owners to focus more on their growth areas such as pulp and packaging board.
The cuts could also help stabilise market prices and make life easier for the whole European industry including Sweden's Holmen, Norway's Norske Skog and South-Africa based Sappi.
More shutdowns would be a blow for Finland, which has already lost tens of thousands of jobs in the paper industry in recent years and is smarting from the decline of Nokia and the planned sale of its phone unit to Microsoft
But analysts say it's the best way to put a floor under plummeting paper prices and for the two companies to bolster their finances for future growth investments.
Paper remains the biggest business for the two groups, corresponding to 69 percent of UPM's total sales of 10.5 billion euros ($14.2 billion) and 44 percent of Stora's revenue of 10.8 billion euros.
But both units reported adjusted operating losses in the first half of the year amid an accelerated decline in margins.
Handelsbanken's Rinta says a likely scenario for the two companies would be to form a European paper joint venture, 65-percent owned by UPM.
He said such a venture, with a combined 40 percent share of the European market and low debt, would have the muscle to close down several mills totalling up to 2.0 million tonnes of annual capacity, or 12 percent of its overall production.
Previously, merger speculation was shrugged off on the grounds that EU anti-monopoly regulators would block the way.
But recent smaller deals, like UPM's 835 million euro acquisition of Myllykoski in 2011, showed authorities understand the weak state of the industry and the digital pressures piling up on it.
The companies themselves have fuelled merger talk, helping to push up UPM shares by 22 percent and Stora's by some 19 percent since the beginning of August.
In the past year, both Stora and UPM separated their troubled businesses from the rest, installing new leaders - a move Taaleritehdas fund manager Mika Heikkila, who counts both stocks among his fund's biggest investments, sees as a step toward a spin-off.
"A move like that is not a sign they would seek to develop new paper grades - the units are up for restructuring," he said.
Both groups' strategic focus has been steadily shifting away from paper for some years, in favour of pulp and packaging board mills and plantations in countries such as China and Uruguay.
Analysts also said recent comments from executives at both companies showed dealmaking is on their minds.
Stora CEO Jouko Karvinen said in April the company needed to be clearer about which businesses to keep investing in and those which "will have a better home with somebody else."
UPM's chief executive Jussi Pesonen said in August there were no "sacred cows" in its portfolio.
"We are determined to change UPM. We will also seek to simplify our business portfolio and uncover the value of our assets," he said. ($1 = 0.7412 euros) (Editing by David Cowell)
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