SPECIAL ENGINEERING REPORT

Industry insiders say North American companies are learning quickly that the route to better returns isn't necessarily in building new capacity

Embattled Paper Companies Seek Wise Capital Investment Strategies

BY KIRK J. FINCHEM, Editor

"All International Paper businesses are expected to meet specific performance objectives, including progress towards achieving an average 12% return on investment over a business cycle, having market leadership within their industry, and developing technological superiority," said Dillon. "This improvement plan underscores the sense of urgency required for us to meet these commitments to shareowners and customers."

IP is continuing to restructure its printing papers businesses in the United States and overseas, reducing pulp and uncoated paper capacity by at least 400,000 tpy. The company is planning to sell about $1 billion in "non-strategic assets" during the next year. In the announcement, the company also said that it will maintain its capital spending at $1.2 billion next year, with no significant additions to capacity now being planned.

According to Ron Charbonneau, the retiring director of corporate engineering services for International Paper based in Cincinnati, Ohio, "Spending more than $1 billion next year, without adding substantial capacity, is a 'big deal' for International Paper-a significant change in the way we do our business. And I see the entire industry making similar changes-'improving capacity' rather than adding capacity."

"Producer companies are paying much more attention to industry analysts. And what the analysts are telling us is that there is too much capacity. Companies are focused on getting more out of the installed capacity and getting out of unprofitable businesses-those that can't recover their cost," Charbonneau adds.

ORIGINS OF CURRENT PERFORMANCE. "I would have to say that U.S. forest products companies are investing much more wisely today than they did 10 to 15 years ago," says Chip Dillon, managing director of Salomon Brothers' North American paper and forest products research group. "Beginning in the mid-1970s, two undeniable long-term realities have become apparent in the forest products industry. The first reality is that the capital intensity of the industry has increased-it takes more investment in property, facilities, and equipment to create a dollar of sales. The second reality is that the return on those investments has decreased over time. Ironically, this has happened during a time when the return on other investment has increased."

The current return on capital performances of many forest products companies-less than their cost of capital-have their roots in the late 1980s, a period that saw a huge surge in capital spending. Adjusting for inflation, the capital spending during 1989 through 1990 was the highest in the industry's history.

"Everybody used to read the same 'tea leaves' the same way, spending cash flow in the same segments at the same time," says Charbonneau. "Today there is much greater awareness of the need to spend capital effectively. But I still don't sense that anyone is doing anything that is particularly innovative so far as getting more bang for their buck. And if they are doing it, they as being awfully quiet about it."

According to Dillon, "During the terrific up-cycle that lasted from 1985 through 1989, a lot of executives decided that their companies' increasing cashflow would be best invested in expanded production capacity. In hindsight, that was a poor decision."

History has shown that the secular growth trends (i.e., excluding cyclical influences) in the economy in general, and the paper market in particular, were not sufficient to support the added capacity. The high growth rates of the 1980s-when capacity investment decisions were made-gave way to much slower growth rates in the 1990s as the added capacity came into the market.

Dillon explains, "It take two things to grow the economy: more people and more productivity. While productivity is generally increasing, the people part of the equation can jump all over the place. In the 1980s, 'baby boomers' were still entering the workforce, and the proportion of women choosing to enter the workforce was continuing to increase. The 1980s also had some other strong drivers, including the growth of personal computers, high-speed copiers, and the catalog business. These factors, viewed in a 1980s context, encouraged paper industry executive to overspend on capacity expansions. They seem to have believed that the high growth rates they saw would continue. In the 1990s, those growth drivers-particularly new entrants into the workforce-weren't present."

"Still," according to Dillon, "the current down-cycle was more the result of capacity expansions on the part of non-North American-primarily Indonesian-producers, than the result of overspending on capacity by North American producers, except perhaps in containerboard grades."

NEWFOUND WISDOM. According to Sherman Chao, first vice president at Merrill Lynch in New York and a long time industry observer, "It's difficult to make any quantitative judgments about any increases in the industry's collective investment 'wisdom' over the last five years. While it is fair to say that since 1988 or 1989, the industry's performance has been poor, market conditions have not allowed industry spending plans aimed at improving performance to bear fruit."

But the tone to management announcements is changing. "For the first time in many years," says Chao, "many companies are voicing a reluctance to spend just to build capacity. Most are talking about avoiding the addition of new paper machines for the balance of this decade. And while their actions are consistent with their statements, their actions have also been inhibited by business conditions since 1995. Few paper companies have had the financial flexibility to 'ramp-up' their capital spending, even if they had chosen to. The real test of collective learning will be whether companies adhere to their newfound spending discipline as the business cycles turn up."

Chip Dillon also sees a change. "Most recently-during the price spike of 1994-1995-we did not see the same kind of expansion in capital spending that we had seen before. Rather than investing shareholders' money in bigger, faster, new machines, companies began buying back their own stock, reducing their debt, disposing of the capital assets on their balance sheets that were not earning the cost of capital, and some merger and acquisition activity."

"Now the industry is entering the second year of a down-cycle-one which we think will begin to trend upward later this year in containerboard, and next year in the bleached grades-and companies seem even more serious about not using their free cash flow internally to add capacity. Instead they are using it to either reduce debt, buy back stock, or make acquisitions."

Dillon adds, "As preliminary proof of the change in strategy, during the last up-cycle (1994 and into 1995), spending did not keep pace with the increased cash flow. We are seeing very different behavior than what we saw in 1988 and 1989 when four uncoated free-sheet machines were announced.

"Of course, the only way you can tell whether a compulsive gambler has been reformed is by taking him to the race track and seeing if he can walk away. On the last up-cycle the industry showed-collectively-that it had changed its investment practices-they 'walked away from the track.' This next cycle, I think that they'll do even better."

In particular, there seems to be a trend among paper producers to spend less total capital than their annual depreciation expense-in effect, trying to generate more revenue with a smaller fixed asset base. "Georgia-Pacific and International Paper have both been very public about this," says Dillon. "And not for just 1997, but carrying into 1998. More recently, Union Camp has also indicated a lower level of capital spending than previously announced."

Dillon goes on to explain, "One of the important differences we see is that these producer companies do not seem to be cutting back their spending to simply 'survive the times.' We are seeing commitments to keep the level of spending down next year, even though next year could be a very good year. The reasons being given are not that times are bad, but that companies are striving for higher returns."

According to Chao, "Most of the announced capital spending is aimed at modernization rather than new capacity. There is also significant spending planned in anticipation of the Cluster Rule." However, the latter area-implementing the much-awaited Cluster Rule-is one area that may be at odds with the drive for higher returns.

Charbonneau agrees about the generally lower rates of spending. "Producer companies are investing less, of course, because the earnings have been so lousy. And the Cluster Rule is inhibiting a lot of spending as well. Companies are reserving a lot of capital to comply with the new regulations."

He adds, "Cluster Rule compliance is an area of great concern because of the lack of financial payback. In the case of IP, we are well down the path to ECF bleaching, well ahead of the rule. But there are a lot of things in the pulp mills and power plants that will be required under the Cluster Rule that we have not completed. In the final analysis, I do not expect a 'rush to compliance' beyond that which is required by the rule, unless the changes also improve the financial performance of a mill operation. And some of the requirements will actually improve operations."

Irrespective of any improvements in financial planning or analysis, Charbonneau remains concerned about a lack of engineering and project management innovation. "Many people are 'thinking and talking' about improving their capital effectiveness, but no one-not producer companies, not technical associations, and not consultants-are demonstrating much innovation. It is true that companies are showing much more selectivity in the projects they undertake. But once the decision has been made to spend the money, no one is doing much to really save money on capital jobs."

OUTSTANDING PRODUCER COMPANIES. Historically, many companies have viewed free cash flow as "their money"-the product of insightful business plans that were well executed. "When times were good, they spent the cash," says Dillon. "That is not the right thing to do."

Brad Rosencrans, managing partner of Andersen Consulting's North American forest products practice, says, "Our research suggests that there are three factors that separate the companies that have done a good job creating value for their shareholders and those that have not. First, the top performers tend to be more focused in fewer market segments-building capability in and dominating their segments. Second, they demonstrate superior operating excellence-they do a better job integrating their supply chain, servicing their customers, pricing their products-all of the traditional 'nuts and bolts' of running a business. Third, and perhaps most important, they are more effective with their capital dollars."

According to Rosencrans, there are some common themes among the most "effective" companies.

• They seem to exercise more fiscal discipline is their capital spending. They are less driven by year-to-year cash flow than those companies that have under-performed the stock market.
  
• They are employing practices that more effectively maximize the value of their capital.
  
• They can bring major capital projects online faster than their competitors. Startup time for the top tier companies is about 18 months for major projects, vs 24 months for lower tier companies. The impact that can have on the net present value of a project can be immense. A 12-month difference in schedule on a $500 million project can amount to as much as $50 million depending on the business cycle timing.
  

One of the consensus favorites of analysts-one company that has not spent free cash flow on expansion-is Bowater Inc., based in Greenville, S.C. "During the last few years, they have been very disciplined in their spending," explains Dillon.

He adds, "Bowater kept their capital spending low, and as a result, their stock has nearly tripled in price compared with its value at the same point during the last down cycle-from $16 or $17 in 1990 to the low $50s/share today. The company's assets haven't changed that much, but the company carries much less debt. They have reduced their net debt by more than $15/share, while repurchasing 10% of their own stock. Today they are in an excellent position and looking at several major projects-including a new TMP plant at the Calhoun, Tenn., mill," says Dillon.

Chao explains, "Before going to Bowater, Arnold Nemirow, the company's chairman, president, and CEO, was a senior executive at both Great Northern Nekoosa and Wausau Paper. At Great Northern, I think that he saw what a 'traditional paper company' can do running commodity grades on larger-scale facilities and how difficult a job earning superior returns that can be. At Wausau, I think that he saw what can be done on the 'flip-side'-pursuing niche businesses and acquisitions. Nemirow seems to have done an effective job of 'marrying' the two approaches at Bowater, making sure that the company's capital spending has yielded a return."

And Bowater is one of the companies that, during the past two years, has spent less than their depreciation expense. Part of that is because of the product mix," according to Chao. "Newsprint producers are learning that 'tweaking' existing capacity is more cost-effective than adding new capacity."

Chao also credits a portion of Bowater's performance to the company's patience. "They have deferred some cost reduction-related capital projects and some potential expansions, choosing instead to keep an eye open for acquisitions-historically, a better use for investment dollars than 'pure expansions.'"

Another company that stands out in terms of their investment performance is Willamette Industries, a company Rosencrans considers a "best in class" as a spender of capital. "They believe that they can reduce the cost of expansion projects by up to 30% by using in-house engineering capability. And when you are spending $500 million or $1 billion annually, that advantage is $150 million to $300 million dollars."

Chao agrees, "They do two thing that distinguish their capital investment programs from most other forest products companies. First, they contribute a lot of 'sweat equity'-engineering their projects internally and building capacity at lower cost than other forest products companies. Second, they create internal demand for their products prior to adding the capacity.

"As an example, the company will expand its box plant operations to the point where they are buying linerboard from outside suppliers. Once they have built the internal demand for linerboard, selling the products of those box plants well beyond their production capacity, Willamette proceeds with building a new linerboard machine.

"Currently, they are building demand for their form and cut-size free-sheet papers to a level that is substantially larger than their free-sheet manufacturing capacity. When the gap is large enough, they will probably build the additional free-sheet capacity. While most companies try to build demand in this way, Willamette starts several years prior to the startup of a new machine," says Chao.

One of Dillon's favorites has found success following a different strategy. "Mead is spending well above its depreciation levels in 1997 and 1998. But they are doing it on a project that makes a lot of sense and that had to be done-that is, the doubling of the Stevenson, Ala., corrugating medium mill, a project that started in 1995. In every phase of the project, they have come in ahead of expectations, under budget, and sooner than expected.

"In fact, in their most recent earning statement, Mead announced that the pulping portion of the project, which includes a recovery boiler replacement, will be completed in the second quarter of 1998 rather than early 1999 as expected. Here is one of the world's lowest-cost medium mills and it needed a new recovery boiler. Mead could have simply replaced the boiler-getting little or no return on the project. Instead, they decided to double the mill's size by adding lighter-weight medium, which is used in some of the micro fluted-grades."

Debottlenecking projects are also a critical element in the improvement plans of many companies. "These investments have always made sense to me," says Chao. Such projects, according to Chao, have several characteristics that make them attractive.

• They tend to be smaller in scope.
  
• The timing can be more precisely tied to when you want the new capacity to come online.
  
• The capacity increases come into the market in "more bite-sized chunks."
  
• Because they are generally incremental in both their spending and execution, debottlenecking projects typically are projects that can be started, accelerated, slowed, or stopped as market dynamics and company financial situations dictate.
  

According to Dillon, "When you look across the planet, most industries have gone through quite a bit of consolidation. The paper and forest products industry is still highly fragmented. Given the dynamics of the industry-including little brand loyalty and massive capital requirements, which make it a fundamentally tough business-certainly a greater concentration and fewer decision-makers is preferable to improve the industry as a business."

Citing the Abitibi-Price/Stone-Consolidated 'merger of equals' and Consolidated Papers' purchase of some of Repap's capacity, Dillon believes, "These moves will ultimately benefit the industry."

Major producer companies are also consolidating their operations, moving products to newer, higher efficiency facilities. IP's Charbonneau says, "We recently announced the shutdown of several non-competitive machines. On some of those-particularly the ones at Erie, Pa.-we are looking for products to convert them too and haven't found the right ones yet."

"We displaced the paper from those Erie machines to a true low-cost machine-the No. 16 machine at the Riverdale mill in Selma, Ala. We did not add a lot of capacity to the marketplace. Instead, we shut down inefficient machines in favor of a machine that is very efficient. I think that that's what you'll continue to see from IP and the rest of the industry," says Charbonneau.

He goes on to explain, "Some machines just won't 'make the cut.' The are small, slow, and operating in high-cost areas. Or they lack the infrastructure for long-term operation. The days of 'carrying' weak operations are over."

And the future for those inactive assets is more uncertain than they might have been in the past. "I think that the industry is going to be very selective about what they do with those machines," Charbonneau says. "Selling machines that are operating unprofitably in high-cost regions like the Pacific Northwest for relocation to low-cost regions like Indonesia or Brazil make little sense for a North American producing company.

"The capitalization on that relocated machine will be far less than it was for the original owner, and the operating cost would be less. North American producers are going to be very careful about putting more low-cost capacity into the market place."

GLOBAL CAPACITY ADDITIONS. Always a concern for industry executives and analysts alike is the pace of capacity expansion. According to Dillon, "It appears that capacity has been growing faster than demand, particularly in Asia. Fortunately, it also appears that the rate of capacity growth will slow in 1998 and beyond. Most of the projects that were announced at the height of the last up-cycle in 1995 in Japan and Korea will be running by early 1998. In Indonesia, the pace of capacity growth will begin slowing in mid-1998-not dramatically, but slowing nonetheless. The Indonesian forestry ministry has begun discussing concerns about the potential strain on the wood supply. That suggests that the pulping capacity growth rate will begin slowing."

Dillon also points to the burst of activity in Europe, particularly in the coated paper market, that began in mid-1995. "Fortunately, nearly all of that capacity will be in the marketplace by the first quarter of 1998."

In the U.S., domestic capacity growth is expected to grow at a compounded rate of 1.5%/year for the next several years. "This is the lowest growth rate for any three-year period but one since AF&PA began the survey 35 years ago. The one exception was the period from 1974 through 1976-a period of deep economic recession-when growth averaged 1.4%/year," says Dillon.

U.S. FIRMS REMAINING COMPETITIVE. There is little doubt that some North American producers will continue to generate adequate returns on their capital over the long haul. A few are doing it now. Others are making serious moves to improve their performance.

The key element to success is business focus according to Dillon. "Forest products companies must be very careful about identifying what business they are in. They must be much more focused than they have been in the past. Besides being frugal with their capital and focusing on a few, rather than many, grade segments, North American producers in particular need to focus on businesses where they have some distinct competitive advantages."

But "racing up the value-added chain"-moving high-cost operations to higher margin products-can be problematic as markets shift. Charbonneau explains, "International Paper sunk a bunch of money into the coated free-sheet business because, at the time, the investment decision made a lot of sense. It looked like a growing product segment, and it was a segment where we were not competing. We felt that the margins on coated paper would be far superior to what we were getting from the machine at Jay, Maine. Whether that decision was right remains to be seen."

"In general, North America is softwood-rich," Dillon points out. "There is an advantage to focusing on softwood-rich grades such as containerboard and newsprint. Producers in emerging areas like Southeast Asia and Latin America cannot compete effectively in these grades because they lack the fiber. On the other hand, in grades where low cost-production regions of the world are competitive, North American producers need to focus on quality and marketing."

Dillon cites the uncoated free-sheet business as an example. "That is going to be an increasingly tough business for North American producers. Tropical producers have a fiber cost advantage in these hardwood-based grades. Rather than trying to 'spend their way around the problem,' North American producers need to 'come to terms with their mills.' Boise Cascade has done a great job of reducing their exposure to high-cost uncoated free-sheet capacity. "

Another key element, according to Chao, will be the current shift on the part of producers to making decisions based on a total-cost model. "There are a number of demands that are being placed on companies in North America-shareholders' expectation of a return, customers' desire for high-quality products at reasonable prices, and rising competitive threats. To be fully competitive, companies need to be mindful of total costs.

"In the past there has been a near-myopic view of production costs. This gave rise to the belief that if a company's machines were efficient and their production costs were low, profitability and ultimately high returns would follow. Companies are starting to understand that it is total costs that matter, not just cash production costs. Reducing corporate administrative, fixed, and interest costs is a critical element to being fully cost competitive on a global scale, regardless of currency exchange rates and shifts in wood baskets."

Rosencrans adds, "As far as competing with overseas firms that are installing world-class technology and have access to short-rotation timber, effective capital investment might include taking a position in that short-rotation timber. Long term that is probably a good idea. In any case, if your view of 'the world' is confirmed to the North American market because it is the largest in the world-that is very shortsighted. The emerging producers view their markets as global."

New relationships between producers and their customers are also affecting financial performance. Dillon cites the newsprint business as an example. "Newsprint producers and their customers are working together to meet their common challenges-shift to electronic media and the declining trends in readership levels. Companies need to make sure that they know who their customers are and be focused on helping those customers."

Dillon adds, "Staying with the newsprint example, during the past 10 to 15 years there has been a 'love-hate' relationship between newsprint manufacturers and their customers-the publishers. When times were good for producers, prices would rise as high as they possibly could. When times were bad for producers, prices would swing as far as possible in the other direction. What's interesting is that during this cycle both sides seem to have realized that they are in business together-if one fails the other fails, too. In this cycle, as prices declined, newsprint publishers did not force newsprint prices down as far as they could have (i.e., cash cost). On the other hand, the producers seem to have realized that it doesn't pay to raise prices so high that customers start to conserve."

Chao agrees about the moderated pricing behavior. "Now that prices are rising again, I have detected-on the part of newsprint manufacturers-the impetus to raise prices to restore their profitability. But they are not going after the price increases with the same kind of gusto they have shown before-the kind that can threaten their customers. Time will tell if such a change shows in other segments."