JAMES K. FLICKER, is a vice president and paper and forest products analyst at Lehman Brothers.

Comment Column

Structural impediments to profitability

What's wrong with the paper industry? From a shareholder's point of view, everything is wrong. Of the 19 major U.S. paper producers, few have had acceptable returns on either equity (ROE) or on capital (ROC). Over the past 22 years, the average ROE has been 11.4% while the average ROC has been -1.7%. After removing the top quartile of companies from these ROE and ROC measures, the averages drop to 10% and -2.7%, respectively.

Predictably, these results have translated into poor stock market performance. Total returns have lagged the market. In the past 10 years, only two (out of 18) companies have outperformed the market. Aside from 1983 through 1986, the industry's relative stock market performance has lagged the overall market for the past 22 years.

The paper industry has five basic flaws which, in combination, make it very difficult to earn respectable returns. These five factors, or structural impediments to profitability, are as follows:

The U.S. industry is mature. With per capita consumption over 750 pounds, the U.S. uses more paper per person than any other country in the world. However, the growth rate of U.S. paper consumption, or incremental usage in a given year, is one of the lowest in the world. As a result, paper demand growth is very closely tied to GDP.

Too much capacity. Most U.S. producers manufacture paper on old, small, and inefficient machines. The paper manufacturing process has not changed substantially in over 50 years. Consequently, high-cost, inefficient machines built 60 or 70 years ago are still running today. Approximately 40% of the machines in the industry are over 20 years old and manufacture less than 30,000 tons per year. Incredibly, 20% of the machines are at least 30 to 35 years old.

Fragmented ownership. There are simply too many paper producers. International Paper Co. is the largest producer in the world and only controls 4.5% of global capacity. The top 38 U.S. producers will control less than 30% of world capacity in 1998.

Paper is a commodity product. Within a grade, paper exhibits surprisingly little differentiation. Paper is marketed and sold within a particular grade as long as it meets the required strength and appearance specifications. It is a typical commodity like lumber, oil, or copper and it is sold predominately based on price.

The industry is capital-intensive. The capital-intensive nature of the industry creates high barriers to entry and to exit. We have compared the paper industry to the chemical, iron and steel, metals mining, capital goods, and basic materials industries. We have also compared capital expenditures per employee, per share, per dollar of sales, and per dollar of depreciation. By virtually any measure, the paper industry is materially more capital intensive than any of these industries.

Potential solutions. First, U.S. producers must continue to increase their leverage to regions outside of the U.S. where per capita consumption is growing much faster. As a result, companies can increase the demand for their products and reduce their exposure to mature, cyclical markets; they can overcome one of the structural impediments-industry maturity. The Far East, Eastern Europe, and Latin America are the regions of the world with the fastest growth rates of per capita paper consumption. This strategy is not without its risks, as the currency crisis in Southeast Asia is currently demonstrating. However, given its historic performance, the paper industry cannot afford to overlook even the slightest opportunities for increasing its internal growth.

The second answer is consolidation. If the paper industry were to undergo a major consolidation, it could overcome its overcapacity and fragmentation problems. Consolidation can take many forms, including companies merging or simply buying certain assets of a competitor. The existing situation is still dire-there are more than 17 large producers of linerboard and there are over 19 producers of market pulp. If these grades, and indeed this industry, is to become more profitable, the number of participants in these and other paper grades will have to drop considerably.

Improving, but how much? The good news is that companies have begun to improve their profitability. All of the companies are becoming more international. In 1984, sales of paper outside of the U.S. amounted to only 3%; today, that figure is closer to 20%. Furthermore, four of the largest U.S. producers are now restructuring their asset portfolios and the pace of consolidation has increased dramatically over the past two years. The result is that a narrower production focus for many companies should translate into improved profitability.

Is this enough? If companies continue down the road of internationalization, asset rationalization, and industry consolidation, strong earnings will return. The question that remains is whether or not shareholders will return.