JEFFREY SALZMAN, is a managing director and group head of the global Paper, Packaging and Forest Products Group of Credit Suisse First Boston. This is excerpted from a speech before the American Forest & Paper Assn. in March.

COMMENT COLUMN

Stock Performance And Returns In The ’90s

For many in the paper industry, the last price cycle was a long-time coming but proved to be very short-lived. No one expected that price cycles would become so compressed and unpredictable. The volatility is in part due to capacity expansions but it also results from the globalization of competition, the emergence of new low-cost producers in overseas markets, and the impact of shifts in exchange rates. Creating shareholder value in the ’90s has been very difficult. In the future, companies will need focused strategies to drive shareholder value—strategies aimed not only at the marketplace but also at investors.

Over the last four years, more than $170 billion was spent on capital expenditure projects in North America alone. Just to earn the cost of capital on these investments, the North American paper industry would have had to generate incremental earnings of $17 billion a year.

In the early 1990s, paper companies were telling the market that the addition of new world-class, low-cost machines would improve their competitive position and overall profitability. Generally, investors were supportive. The unexpected fall in product prices during the second half of 1995 shocked investors who suddenly realized that swings in product prices would overwhelm the cost advantages of the new machines and, to make matters worse, that the surge in new capacity had thrown supply out of kilter with demand. As a result, from early September to the end of December 1995, the S&P Paper index fell by approximately 20% relative to the broader market index.

Since September 1995, paper stocks around the world have significantly underperformed in the stock market as a whole. The S&P 500 Index has risen over 85% during this period, while North American paper stocks have increased only 2%. With volatile product prices and the impact of global competition constantly shifting the economics of the industry, investors have had a tough time measuring the comparative performance of companies.

One thing investors have found across the board is that returns for the paper industry during the 1990s have been disappointing. Nineteen ninety-five was the only year when returns for the industry reached the cost of capital. In 1996 and 1997, returns dropped to the meager levels of the early 1990s. While there are many different ways of measuring returns, the consistent theme compares the profits generated to the capital employed. EVA, which is currently in vogue with management and the investor community, adds the new twist of measuring the difference between the actual return on capital and the returns investors expect, which is the cost of capital.

The impact of the heightened emphasis on return on capital has led to greater scrutiny of capital investment projects by senior management. More attention is being paid to the fact that even for a greenfield capital project with positive expected net present value, it is likely to take eight years or so before the up-front cash investment is recovered; the investment is likely to be significantly EVA-negative for at least four years. For the typical investor whose portfolio performance is evaluated against the market every quarter, four years is an eternity.

This is not to say that all capital expenditure projects are bad. The point is simply that the capital cost of large projects and cycle timing risks often dwarf the efficiencies of a new machine. The EVA approach is more kind to incremental projects that are less capital intensive and that almost always have much shorter payback periods.

A critical challenge for paper companies is that long-term pricing adjusted for inflation has declined between 0.5% and 2.5% a year for most grades while pricing volatility has increased. One way to break out of the commodity product mold is to add value either through further processing or enhanced service. The trap has been that higher margins do not always translate into higher returns for shareholders.

Given these difficulties, cost reductions have received a great deal of management attention. The strategy has been to cut costs, restructure or close unprofitable operations, write down under-performing assets, and divest non-core assets. These initiatives have been well-received by the investor community.

The sharp increase in merger and acquisition volume in the paper industry has been as significant as the boom in programs focused on cutting costs and increasing profitability. Between 1994 and 1997, there has been over $90 billion in global transactions. Companies are pursuing mergers and acquisitions as a way to grow the top line in mature markets, increase market share, and realize synergies without increasing overall industry capacity. The synergies from consolidation transactions can be significant. On a capitalized basis, they typically total around 20% of the target’s unlevered enterprise value. Despite the apparent opportunities to create shareholder value through consolidations, the North American paper industry generally remains fragmented, and further consolidation is likely.