SPECIAL ENGINEERING REPORT

Failure to earn cost of capital threatens the future of many North American companies, but strategic options are available to reverse that trend

Paper Company Strategies Should Focus on Building Economic Value

By David Null and Daniel Cenatempo



The North American pulp and paper industry is not creating value. Preliminary analysis of more than 40 North American forest products companies indicates that the industry has generated more than $29 billion in economic losses during the past 10 years.

The industry's poor performance probably does not come as a surprise to many industry participants. The financial community, academics, management consultants, and the producers themselves continually extol the importance of "creating shareholder value."

Meanwhile, the pulp and paper industry continues to operate, expand capacity, and increase production despite claims of poor performance by industry outsiders. This may lead some to question the importance of creating value.

HOW IS VALUE MEASURED? What is meant by creating "value?" Value is created when companies generate financial returns in excess of their cost of capital over the long term. When this occurs, debt and shareholders are repaid their expected return, and excess cash is accumulated within a company. ¹

Value can be calculated by discounting expected company free cash flow available to repay debt and shareholders by the cost of capital. Over the long term, this measure of value is highly correlated to actual stock prices and the market value of a company.

Value is the best measurement of performance because of this correlation to actual stock market performance. It is the only one that incorporates complete information about long-term cash flow, risk, and timing.

Recently, a measure of value derived from this "discounted cash flow" approach-called Economic Value Added (EVA)-has gained popularity. EVA is a performance measurement and employee incentive system popularized by Stern Stewart and Co. Simply stated, the method subtracts the full cost of capital from corporate earnings (after various adjustments to put earnings on an economic vs accounting basis). If there is profit remaining after subtracting the cost of capital, economic value has been created. If there is a deficit, value has been destroyed.

In other words, EVA equals (Return on Total Capital-Cost of Capital) x Capital Invested. If long-term returns are greater than the cost of capital (borrowing cost) then value is created. If returns are less than the cost of capital, then value is destroyed. Again, return on total capital (ROTC) is adjusted from an accounting to an economic basis.

The appeal of EVA lies in its simplicity. One measurement captures both the rate of return relative to the cost of capital and the magnitude of the performance. In addition, progress can be measured both short and long term by analyzing EVA on both an annual basis and over long periods of time.

WHY IS VALUE IMPORTANT? Creation of shareholder value is vital to pulp and paper companies because shareholders are the only stakeholders of these companies who simultaneously maximize everyone's wealth in seeking to maximize their own. More plainly stated, take care of shareholders and you take care of yourself.

Shareholders take the greatest risk of all claimants on a company's cash flows-they are the last in line to be paid. Therefore, they are the only stakeholders that consider all claims on the cash flow of the company when making decisions. They also have the greatest incentive to manage corporate resources to outperform competitors in the long run.

If these shareholders do not receive a fair return to compensate them for the risk they are taking, they will move their capital to other companies, industries, and countries. This capital flight will stagnate North American pulp and paper industry competitiveness, growth, profitability, and, ultimately, stock prices. Short of capital flight, poor financial performance opens companies to the perils of hostile takeovers and activist investors.

HOW HAS THE INDUSTRY PERFORMED? Jacobs-Sirrine Consultants analyzed the 10-year financial performance of 43 leading North American forest products companies. Based on this analysis, the industry has earned an average ROTC of only 7.6% vs a cost of capital of 10.7% (Figure 1). This has resulted in the destruction of more than $29 billion in economic value (7.6% ROTC - 10.7% Cost of Capital x $96 billion average total invested capital x 10 years). Risk-free U.S. government bonds yielded 7.5%, approximately equal to the pulp and paper industry, during the same period.

Economic value addition is not the only benchmark indicating that the forest products industry has performed poorly. In Forbes' annual analysis of 21 industries, "Forest Products-Packaging" ranked 15th and "Forest Products-Paper and Lumber" ranked 18th in average five-year return on total capital (Figure 2).² The industry would fall even further in the rankings if returns were presented on a risk-adjusted basis.

Equally troubling, industry returns have become much more volatile. While the industry has long suffered from cyclicality, recent performance has added the dimension of unpredictability. For example, 1992-to-date ROTC has been the weakest period in 25 years despite steady, if unspectacular, economic growth of 2% to 4%/year. In addition, the strong portion of the last industry ROTC cycle (1995), although extremely profitable, lasted only one year vs a two- to three-year historic average. Obviously, this poor capital effectiveness is cause for concern by industry stakeholders.

Financial performance of the industry's producers is beset with a number of problems, many of them structural in nature. The following section focuses on the three main contributors to these financial problems-capital intensity, market maturity, and new competition.

CAPITAL INTENSITY. One of the most frequently acknowledged problems is the high degree of capital intensity for the pulp and paper industry. Capital expenditures, as a percentage of sales, averages almost 10%, or nearly double the level of all manufacturing and other capital intensive industries, such as chemicals and primary metals.³ While this capital intensity in itself makes generating satisfactory return on investment difficult, it leads to industry behaviors that are even more detrimental.

The most obvious example is production continuity. Because such a high proportion of the costs for most producers is fixed in nature, mills avoid shutting down when market demand is weak relative to available capacity. This is reflected in the industry's high operating rates of 92% to 95%. Inventories are built up and cash flow dwindles during these weak periods. Eventually, producers discount prices to move product, dooming all to poor profitability. The prices, cash flow, and returns increase when demand strengthens relative to available supply.

The industry has historically reinvested almost 100% of its after-tax cash flow generated during strong periods within one to two years, mostly for new capacity and facility improvements (Figure 3). The result is that periods of good profitability are quickly followed by excessive capital spending, leading to too much new capacity. This, of course, results in overcapacity, lower prices, and poor cash flow. As commodity producers, most companies pursue growth of market share resulting in increased competition, and potentially less attractive markets after the expansion period. Eventually, the new capacity is absorbed, prices recover, and the cycle begins again.

A more subtle effect of the capital intensity involves the avoidance of risk. With the huge investment required for most new capacity projects, the cost of failure is enormous. This fear of failure breeds risk aversion and discourages technology and market innovation. As a result, the industry's producers use the same technologies, developed by a limited number of suppliers, to produce essentially the same products. Additionally, the capital intensity in itself encourages large initial and maintenance expenditures to ensure quick startups and nearly uninterrupted operation.

MATURING MARKETS. To add to the industry's problems, domestic pulp and paper markets are becoming mature. Since 1970, overall demand growth has been slower than GDP growth (Figure 4). Grades such as newsprint, grocery bag, and forms bond have seen increased competition from substitutes and are now in the decline phase of their product life cycles.

Increasingly, North American producers have looked to the offshore markets to maintain growth. Exports have grown from 5% of shipments in 1970 to 15% in 1996. Per capita consumption of paper and paperboard is still very low in most developing countries, and prospects for strong demand growth are excellent. Most North American producers are positioned to participate in this growth, although due to political, economic, and resource risks and barriers to entry, few have local production facilities.

NEW COMPETITION. However, others are overcoming these barriers and taking on the associated risks, resulting in large capacity expansions in some of these regions, most notably Indonesia. These investors are utilizing state-of-the-art technologies to build world-scale mills that will be low-cost producers. Capital costs for many are reportedly less than comparable new capacity in North America.

While these mills are being built to serve regional markets, their impact will be global. Many will export from their regional market to generate marginal sales and maintain high operating rates, just as North American producers have done. Price pressures and volatility will continue.

Domestic producers have also seen new local competition. For example, of the 12 new newsprint machines built from 1989 to 1991, seven involved new entrants. More recently, the industry has seen a number of new entrants build market deinked pulp mills and recycled containerboard mills (mini-mills). These companies have employed new concepts and taken on risks that traditional producers avoided. Interestingly, several of the large established producers have followed the lead of these entrepreneurs, albeit with their own interpretations.

Many of these projects have been unsuccessful, and the success of others is still uncertain. In any event, new capacity has been added, and it will affect capacity utilization rates, prices, and returns. Furthermore, these projects have further fragmented what was already a fragmented industry.

SOLUTIONS? How can sub-par industry performers increase their returns? Let there be no false illusions. This is an extremely difficult question. The problem has existed for many years. Some of the same issues were being discussed at least 20 and 30 years ago. Furthermore, the pulp and paper industry has many very bright people who have dedicated considerable time to finding solutions.

However, the industry certainly cannot accept its return situation as fait accompli.One could argue that to some extent, the situation would correct itself. An underperforming industry will not attract its share of capital. Expansion will lag demand, and prices will strengthen. The problem with this scenario is that expansion could very well continue in other regions of the world. In this case, industry returns could continue to suffer, despite low growth in North America.

STRATEGY DEVELOPMENT. Improving performance must start with strategy. There are many definitions of strategy. Strategy comes from the Greek word "strategia" that means, "a maneuver designed to surprise the enemy." In the pulp and paper industry, capital spending becomes the articulation of strategy. Rarely is the enemy surprised. More frequently, the producers make the same capacity addition decisions following boom cycles, and the status quo is maintained.

Selection of an appropriate strategy is quite specific for a particular firm, at a point in time, for a particular industry. There is no one right strategy. What works for one will fail for another.

Theories regarding the type of strategy to employ abound. Michael Porter of Harvard Business School argues that firms must choose an arena in which to compete.⁴ He contends there are three types of strategies-cost leadership, product differentiation, and market focus. He argues that a business must only employ one of these strategies. To attempt to do more will result in a business "stuck in the middle," trying to be all things to all people.

Michael Treacy and Fred Wiersma make similar arguments in their book, "The Discipline of Market Leaders."⁵ They also believe a company must choose an operating model. They believe the choices are operational excellence, product leadership, and customer intimacy. They assert that successful companies must excel in one dimension of value while maintaining threshold levels in the other dimensions. Again, they believe companies are doomed to failure by trying to be all things to all people.

One can certainly see application of these theories in some of the strong industry performers. Conversely, there are many examples of companies trying to do too many things among those pulp and paper companies that have generated poorer returns.

Of course, there are many more theories on developing strategies and improving performance. And, all this "help" can create its own confusion and complexity, hindering performance improvement.

STRONG PERFORMERS. Despite the industry's poor performance, a number of companies have generated positive, or near positive economic value during the 10-year period from 1986 to 1995. These include the following:

• Consolidated Papers
  
• Greif Brothers
  
• P.H. Glatfelter
  
• Kimberly-Clark
  
• Sonoco Products
  
• Wausau Paper Mills
  
• Willamette Industries.
  

Despite the differences, there are some notable similarities. Each company has a defined strategy. The companies are focused on particular sectors and have developed appropriate core competencies. For one company this means building close relationships with its clients. For another company it means emphasizing cost control. While for another it means delivering differentiated, high valued products. Generally, these companies are forward integrated and end-use oriented. Each of the companies is generally known across the industry for a unique and singular strength. The companies have some unique cultures that support application of their competitive advantages.

Ultimately, a company's assets, resources, target markets, culture, and incentive systems must be aligned. If they are not, strategy will never be successfully implemented. For example, a company that pursues an operationally excellent strategy with facilities that produce sub-standard quality and are not cost competitive has a disconnect between strategy and resources.

Notable by their absence among this group of strong performers are the large, traditional producers. Only Willamette is among the top ten largest producers in terms of paper and paperboard production tonnage (at number 10). In terms of consolidated sales and total assets, only Kimberly-Clark makes the top ten list (at numbers 3 and 4, respectively).

IMPROVING PERFORMANCE. With all the challenges facing the industry, there are hundreds of opportunities to improve performance. One major opportunity is a transformation from historical industry management practices to "value management."

Value management requires commitment to several key steps. First, value managers must understand the drivers of value within their businesses. Issues and problems must be analyzed, communicated within, and understood throughout the industry.

There has been good progress toward this need. Awareness has increased considerably during the past couple of years. TAPPI dedicated a session at its last Engineering Conference (1996) to the topic of capital effectiveness. Industry management, analysts, and consultants have raised the topic during numerous presentations and publications. This issue of Pulp & Paper is an excellent example.

But just as importantly, the industry's awareness of this challenge must not stop the first time industry returns improve. This has occurred too frequently in the past.

In addition, this understanding must be extended to individual companies. Management must understand which of their markets, customers, business units, product lines, facilities, and technologies create and destroy value.

Secondly, value managers must focus planning and investment decisions directly upon their impact on value creation. The industry has done an ineffective job of evaluating projects (as evidenced by the industry's 7.6% return on total capital). This is the result of an operational vs value orientation. A great deal of time, money, and effort is placed on estimating the capital costs, project schedule, production volume, quality potential, and operating costs of a given capital project. Relatively little time is spent on modeling the impact of the project on shareholder value or the largest project risk factors-pricing, sales volume, and sustenance capital requirements.

Furthermore, the industry relies too much on capital solutions-particularly expansions-to improve financial performance. The traditional paradigm has been to expand capacity to improve returns by increasing market share, enhancing economies of scale, and develop synergies. It is a reasonable strategy, but it hasn't worked. Consolidation, a better alternative, offers the same benefits without adding new capacity. Even more importantly, a new value-creation paradigm should be considered-optimization of existing businesses via non- or low-capital solutions. The industry should use more of its intellectual capital and less of its monetary capital.

Thirdly, value managers must develop targets, performance measurement systems, and compensation programs directly tied to value creation. EVA can be a powerful tool in this pursuit. An interesting and regrettable aspect of the pulp and paper industry is that the determinants of financial performance are functionally segregated in most organizations. Operations are responsible for costs and volume. Marketing is responsible for price and revenue. Engineering is responsible for the cost of the investment. Who is responsible for return on investment- only senior management?

Many mills operate as cost centers. They have no ownership for the revenue portion of the equation. Probably even worse, few mills are charged their cost of capital. Sure, they are charged depreciation. But, how many are charged for the interest associated with the investment at their mill? What about the cost of equity?

Finally, value managers must communicate with stakeholders, including investors and the financial community, in terms of value. Investors are ultimately concerned with the returns, not the tons a facility produced. Therefore, value managers must communicate market, operational, and investment strategy in the shareholder's language-Economic Value Added. This will facilitate understanding, build shareholder confidence that management has the proper focus, and help keep capital "patient."

REFERENCES

2. T. Copeland, T. Koller, and J. Murrin, Valuation, Measuring, and Managing the Values of Companies, 2nd Ed., 1994, John Wiley & Sons, Inc., New York.  [Back to article]
   
3. Forbes, Annual Report on American Industry, Jan. 13, 1997. [Back to article]
   
4. American Forest and Paper Association, 1996 Paper, Paperboard and Wood Pulp Statistics, Washington, D.C.  [Back to article]
   
5. M. E. Porter, Competitive Strategy, 1980, The Free Press, New York. [Back to article]
   
6. M. Treacy and F. Wiersema, The Discipline of Market Leaders, 1995, Addison-Wesley Publishing Co., Reading, Mass.  [Back to article]