MILL MANAGERS REPORT

Executives and analysts say too many North American companies
are focused on being low-cost producers

BY KIRK J. FINCHEM, Technical Editor

Top Managers, Analysts Say Paper Industry Slow to Change

Editor's note: The following article is based on interviews with paper industry executives and senior analysts conducted as part of the International Forest Products Executive Forum, sponsored by Pulp & Paper and Andersen Consulting, held October 5-8, 1997, at Pinehurst, N.C. A report on the conference appears on p. 91 of this issue.

The 1990s have been a tumultuous period for the forest products industry. The expectations of ubiquitous 'stakeholders'-customers, investors, regulators, communities-have risen almost as fast as their patience has evaporated. Depending on the company and financial measure one chooses, paper producers have either done well, done about average, or destroyed shareholder wealth.

New global competitors, with fundamentally different cost structures and performance objectives have emerged, while established competitors have built alliances to exploit new opportunities in emerging markets. New information technologies are allowing increasingly seamless supplier-customer relationships by changing-often by disintermediation (eliminating the "middle man")-established value delivery chains.

"If you ever wanted challenges, forest products is a great industry to be in," says Jerry Tatar, chairman, president, and CEO of Mead Corp. in Dayton, Ohio. "It is a very capital-intensive business that presents a lot of economic and profitability challenges. But you find that if you do a few things right-focus on customers and performance excellence, and make the right kinds of investments-it is possible to succeed in this business."

But has the industry changed in reaction to the shifting challenges? Not nearly enough, says Marianne Parrs, senior vice president and CFO of International Paper Co. in Purchase, N.Y. "I have been with International Paper for 23 years, and before that I worked on Wall Street as a securities analyst. And we have not changed as an industry. In many ways, we still behave the same way we did in 1970.

"One of the most deep-seated notions in the forest products industry-one that I think must change-is the basic idea that when a company makes more tons, it also makes more money," Parrs adds. While that might be true on an individual mill basis, it is much less certain on a companywide basis.

And, according to Parrs, "The evidence is very clear that making more tons does not lead to making more money industrywide." Despite the long trail of evidence, the industry continues to suffer from overcapacity and the resulting price volatility.

Tatar agrees, reinforcing the need for a change in perspective. "Over the years, much of the paper industry has had a 'build it and they will buy it' mentality," he says. "It carried over into the 1990s, but I think it's going to take more than that to be successful in the future.

"Many companies have pursued a 'low-cost producer' strategy. But cost is only half of the equation of being a successful company. The other half is the denominator-return on investment. People have to focus on the size and the timing of investments in addition to costs and revenues," he adds.

OLD PARADIGMS. "There are a number of paradigms in this industry that are not quite as relevant as they were a few years ago," Tatar says. One is 'build it and they will buy it.' Another is the desire for 'world-scale' facilities, but having 'world-class' operations is more important. A third is behaving as if we were entitled to growth-directed capital. We have sought to build the biggest and the best, rather than earning the right to grow through superior performance."

Sherman Chao, first vice president and managing director at Merrill Lynch in New York, agrees. "I am struck by the notion that nearly every company in the industry has focused on being a low-cost producer," he says. "Yet striving to be a low-cost producer has not allowed many companies to earn their cost of capital. To my mind, being a low-cost producer may be an acceptable strategy but should not be the goal of a company. Earning its cost of capital should be the goal."

According to Chao, "The paper industry is very capital intensive. Spending a dollar of capital generates about twenty-five cents of revenues today. And the industry's capital intensity has been increasing over time. Paper companies around the world are looking for the different strategies to earn their cost of capital. For some, a low-cost strategy may succeed. For others, a value-added product strategy makes more sense. Others will simply have to 'cash-out'-leaving product segments or the entire industry for more promising returns elsewhere."

Chip Dillon, managing director of Salomon Brothers' North American paper and forest products research group in New York, agrees that change is underway. "I think that a lot of changes have occurred in the paper industry and that a lot of the age-old paradigms are being abandoned. But we are in a transition period. While some companies are changing their view of the world, others have been slower to change.

"Unfortunately, too many companies still believe that being 'low cost' means being low variable cost. They ignore the fixed costs they are incurring to get to low variable cost. They seemingly forget that they need to earn a return on their capital," Dillon says.

Another major change on the horizon is the rate at which the industry is consolidating (Table 1). "We're starting to see quite a bit of consolidation," says Dillon. "Two grades-tissue and bleached board-have really consolidated in the last few years. In the case of tissue, with the Fort Howard-James River merger, three producers now control 72% of the capacity.

"Other segments-containerboard, uncoated free-sheet, and coated papers-remain too fragmented," he adds. "As concentration of production increases, fewer decision-makers means a greater probability that pricing will become much more stabile in these grades," he adds.

Consolidation is also important in a global context. Dillon explains, "International Paper has about 14 million tons of paper and paperboard capacity globally. That is less than 4% of global capacity. There are few-if any-global industries where the largest producer has less than 10% of the capacity. As it moves forward, it is important that the industry becomes more consolidated if it hopes to reduce the volatility of earnings."

GETTING IT RIGHT. "There are two things you have to get right in this industry to change the pattern of profitability," says Mead's Tatar. "The first one is earning the right to invest and grow in the business. Too often companies have chosen capital investment as the solution to the problems they faced. It is more effective to focus on performance excellence-focus on customers, focus on internal cost, and focus on improving your organization-first. Then, when that is done and you know what your company does well, target your investments at those segments where you are the best."

"If the companies in this industry do those two things-focus on performance and then focus their investments on what they do best-the economics of the industry will change dramatically," says Tatar.

Dillon agrees on the importance of focusing on the needs of customers. "One critical issue is trying to get a handle on customer inventories. If you look at the newsprint industry, for example, we have a pretty good understanding of where the paper is physically. We know customer inventory levels. We know mill inventory levels. The numbers are readily available."

He continues, "On the other hand, in the uncoated free-sheet market, information is less available. During the tremendous growth in shipments in 1994 and 1995, one could infer that a great portion of the growth was merely building customer inventories. But it was hard to get a hand around that fact and customer inventory numbers to measure inventory building.

"As you see buyers of uncoated free-sheet continue to consolidate-American Pad & Paper in the writing pad business, Staples and Office Depot in the white paper distribution business-it should be easier to develop information on customer inventories and thus reduce uncertainty."

Dillon explains, "There has been an adversarial, 'feast or famine' mentality in a number of paper grades, which has contributed to the tremendous price volatility. As the availability of information increases, the payoff in the adversarial game is no longer there."

Dillon uses the newsprint industry as a case in point. "During the early 1990s, the newsprint industry and newspaper publishing underwent significant change. The relationships between buyers and sellers were highly adversarial because there was a lot of new capacity coming into the market, much of it from new competitors.

"As we look out over the newsprint landscape today, there's been virtually no new capacity added in three or four years. The number of buyers and sellers has stabilized and we are hearing increased talk about long-term contracts and some degree of fixed price contracts. As those discussions and relationships continue, both sides begin to share more information about inventories and operating rates. There is less incentive to 'play games,' and both sides win with a less volatile marketplace. Unfortunately, there are still too many incentives for people to behave in ways that create volatility in such markets as linerboard and uncoated free-sheet."

Chao echoes those comments. "There is no getting around the fact that the paper industry produces a product that behaves as a commodity as far as pricing is concerned," Chao says. Hence, that is a major reason for the continued volatility. "But several other issues are becoming critical. Beginning 10 or 15 years ago, the importance of dollar exchange rates increased significantly. Today, it's a foregone conclusion that the dollar exchange rate is something that companies have to watch very carefully."

Another issue is the emergence of new competitors, particularly those in Southeast Asia and Latin America. "Ten years ago, we really didn't hear about competitors in Southeast Asia. The whole region was seen as a major consuming area, and an area of opportunity for traditional producers such as those in the U.S. and Western Europe," explains Chao. "Now, Latin America and Southeast Asia are seen both as a potential markets for future growth and also as sources of new competition."

And those new sources of competition pose several open questions that will have a major influence on the future of the forest products industry, according to Parrs. "The first is the effect on operating cost and product quality of short-rotation timber in places like Indonesia and Brazil. The second is the massive fiber resources of Russia. Softwood is in relatively short supply worldwide-there are only a few regions where it grows well. Russia is as rich in those resources as it is lacking in infrastructure to harvest it." And the timing of that harvest is still very uncertain.

COMPETING GLOBALLY. Many forest products companies are looking to foreign markets to expand their businesses. Some, like International Paper, are establishing foreign manufacturing capacities to exploit regional comparative or marketing advantages. Others are establishing strategic marketing and manufacturing alliances for access to similar advantages without major capital investments. These 'global competitors' are hoping to leverage their version of 'globalization' into improved value propositions for their customers and shareholders.

Finally, some North American producers are focusing their attention on streamlining their domestic operations. Without losing sight of growing overseas markets and sales opportunities, these companies are decidedly regional competitors.

"North American producers can earn good returns without manufacturing product overseas," says Dillon. "It is largely a function of their grade mix and where they sell the products, and it is highly grade specific-limited by the inherent characteristics of the available fiber. On the cost front, the companies that are successful in the long term will be those that are in a low-cost position in the markets they serve, whether those markets are domestic or overseas." But, of course, it will take more than occupying the low-cost position.

"Today, there are several companies that do not have overseas manufacturing capacity but have superior earnings," Dillon explains. "For example, Willamette Industries, Consolidated Papers, and Wausau Papers have consistently earned above average returns on equity without significant manufacturing facilities outside of the U.S. To be a successful global company, first the company has to be successful-it has to earn more than its cost of capital. Then the company can seek to enhance its returns by operating outside of its home country."

For International Paper's Parrs, "There is no question but that the paper industry is becoming a 'global industry,' in terms of both supply-our production facilities-and demand-the globalization of our customers' businesses. In order to meet our customers' needs, we have to be able to supply them on a global basis.

"For International Paper, global execution means developing a worldwide supply base and serving customers from the sources that make the most sense. It means being indifferent about whether the customer and the source happen to be in the same country or geographic region."

She adds, "In that sense, I do not think that the industry is truly global yet. But clearly, it is headed in that direction. To be competitive and to serve our customers, we are moving toward the global execution model," she adds.

At Mead, Tatar explains, the strategy for success is the same whether the competitive arena is global or domestic. "Being a globally competitive company, in my mind, is similar to being a successful regional company. You have to offer a good value proposition no matter where you compete. In North America, if I do not focus on my customers-understanding what they want and providing it to them-I will not be successful. The same thing is true when you take a global perspective."

In the context of the global forest products business, time and distance are becoming less relevant. "It used to be that 'regions of competition' were bounded by limits on communications and logistics," says Tatar. "But now, with electronic communications, information technology, and improving logistics there is no time and distance. Products can enter and exit regions with relative ease. For North American producers, imports were viewed as a problem. Today, imports are a fact of life, and exports are increasingly seen as an opportunity.

"Most of the companies in the forest products industry today are still regional companies," he explains. "There are North American companies, South American companies, European companies, and Asian companies. But that is becoming less true as companies evolve, and distances shrink. Mead, for instance, has package manufacturing sites all over the world and sells products all over the world. We are also investigating investments and studying global opportunities all over the world. For us, this is a natural evolution."

Market size-and strength-should be critical elements of any global strategy, according to Merrill Lynch's Chao. "First and foremost, size matters. To be a 'global force' in any market, a company must have sufficient market presence that competitors and customers alike take their cues from your actions. Given that level of market presence, being a low-cost producer makes a company a force to be reckoned with. Finally, the company must have the financial resources to maintain a strong position in the business, adding or acquiring capacity as opportunities arise. The focus should not be on 'global competitiveness,' so much as being a strong producer in whatever region of the world one chooses."

As for emerging strategic alliances, Chao sees them as "important as an intermediate step" on the road to building global market strength. "The tendency in business is to want all of a 'good thing.' There is no long-term reason to share if you believe you have the best solution to a particular problem or an opportunity. Strategic alliances are a half-way point-a meeting point-between companies that do not quite have the 'full plate' to bring to the marketplace.

"We have not seen a truly global competitor or producer emerge in this industry yet," Chao concludes. "Strategic alliances are one model a number of companies are considering as they seek to become a global competitor. The same is occurring in many industrial sectors."

TECHNOLOGY ACCESS. Of course, one of the great facilitators of the move toward a global marketplace is universal access to manufacturing and information technologies. Producers in emerging regions of the world are installing cutting-edge technologies. In many cases, these facilities are more advanced than those of more established producers.

"In terms of the availability of manufacturing technology," says IP's Parrs, "it's not really clear to me that there's ever been any unique technology that was not 'universally available.' There have been little pieces of proprietary technology and knowledge that companies developed. But the fundamental technologies for making paper have been available, on a worldwide basis, for quite a while.

"While it is not clear to me that the situation has changed, it does raise a serious question: Can you gain competitive advantage by investing in new equipment? From a technology point of view, because the equipment technology generally comes from the suppliers and so is available to the world, I think the answer is generally 'no'-you cannot gain a sustainable advantage buying technology."

Tatar agrees. "The issue of the universal access to technology is an important one. It has changed the game. Now you have to deal with 'half of a loaf.' It used to be that some manufacturing technologies were limited to certain players. You could build a competitive advantage on technology.

"Generally speaking, that is no longer true. Instead, we have to work on the other 'half of a loaf'-learning to use technologies better than anyone else. You have to learn how to make better products, how to supply customers better and faster, and how to do these thing less expensively. We can buy equipment and we can buy information technology. But the competitive advantage comes from how you deal with your people and the skills that they carry with them."

Dillon explains that the universal access to manufacturing technologies has had a tendency to flatten cost curves beyond what one might expect in light of large differences in fiber cost. "On the other hand, it appears that some areas of the world-Indonesia and Scandinavia, for example-can install capacity at a lower fixed cost than many producers in North America can."

Chao says, "At the margin, there are some improvements that have come along perhaps once a decade that gives an edge to one company, but it is soon adopted by every one else. I do not see manufacturing technology as a source of competitive advantage.

"On the other hand, advances in forestry technology-how one approaches the management of fiber resources-is taking on a new life. Companies such as Aracruz in Brazil have made major strides in timberland management-growing trees that pulp uniformly and provide characteristics that a customer wants."

MANAGEMENT INFORMATION. The evolution of management information systems (MIS) is another major issue in most companies today, and forest product companies are no different. According to Tatar, "The vast majority of companies are in some kind of major turmoil related to changing their MIS. Most are moving from disjointed, home-grown systems to enterprisewide systems. Some companies will turn the corner-MIS will become an important competitive advantage. Others will have more difficulty-MIS will continue to be a major source of disruption for years to come. This is an area where execution skills will be critical because the technologies are available to everyone."

For those companies that excel in the MIS race, the pay-off will come in three ways, according to Tatar. "The first will be superior customer service. Firms will learn to service their customers more quickly, more responsively, and in a more consistent fashion. The second will be improvements in process and product quality consistency. Finally, these companies will simply make more money. They will literally have a better understanding of where they are making money, where they are losing money, and therefore what their strategic direction ought to be."

Parrs adds, "The information technology revolution will be at the customer interface. Forest products is a manufacturing intensive industry. We have, over time, invested a fair amount of money in systems for manufacturing and controlling our manufacturing processes. On the other hand, investments that leverage information to better service customers has been very slow in coming. And that's where I think the major change is going to be."

And Parrs does not underestimate the challenges inherent in the revolution. "In my experience with major systems investments, they take a long time, they are complex, and they are very expensive. But organizational commitment and involvement are the biggest barriers to making information technology investments effective.

"Relying on information systems people to design and implement a new business system does not work. Instead, the people that run the business must define how they want to do business, and the system should be modeled and molded on that basis. It takes time, commitment, and focus on the part of business people to do it well," she says.

"We talk a lot about senior management and management expertise," says Tatar. "But, as we enter the new millennium, the real issue is leadership-the ability to recognize the needs that are out there, the ability to create and communicate a vision, the ability to mobilize forces to realize the vision.

"Change is a difficult thing to lead and to manage. And within an organization, where you are talking more about performance ethics, performance excellence, and organizational initiatives, it really boils down to issues with people. People have to learn how to change, they have to be given the opportunity to change, and they have to be given the encouragement to change."

According to Parrs, "The evidence that the culture needs to change is very clear in the financial performance of the industry. Trying to change the culture-transform the business-is probably the most important responsibility of senior management. And it is very difficult to do to get people to change in a meaningful way. The real challenge in this business is to get up every morning and say to yourself, 'What have I got to do differently today?,' seeking each day to do a better job of serving customers and to make more money for my shareholders."

For Parrs, it is more than simply "asking the question" each morning. This past July, International Paper announced a substantial restructuring of its business. The company is redirecting capital-expected to be about $1 billion generated by the sale of assets-into its business improvement plan, which is aimed at meeting ambitious return-on-investment targets, maintaining market leadership and developing technological superiority.

BUILDING SHAREHOLDER VALUE. "The primary mission of every company is to create value for its shareholders. That's what we're here for," says Tatar. "When you look at the forest products industry over the very long term, it has earned average returns. However, in the shorter term-say, the last five or six years-the industry has tended to underperform compared with other industries.

"But, it is important to note that the performances of individual companies within any industry can vary significantly," he says. "Good companies outperform industry averages in every industry-there are always companies that excel. The forest products industry is no different."

He explains, "Certainly, during the 1990s, there is evidence that this industry has not created as much shareholder wealth as some other industries, and that has become a concern. Will we get our act straightened out? Will we have the kind of returns in this industry that investors demand? I happen to think that the answer to both of those questions is 'yes.' I believe that the shareholders have spoken. They are applying pressures on the leaders and managers."

Dillon agrees, and says he sees progress. "I think-to its credit-the industry has started along the path toward increasing shareholder value by making decisions that best benefit the owners. And I think that an important element is getting senior managers to take greater equity interests in their companies. One of the smaller companies in the industry, Buckeye Cellulose, is a case in point. Buckeye's management team owns nearly 40% of the company. As managers commit a greater proportion of their own individual wealth and the futures of their families to the enterprises they manage, I think that you will see more decisions made that benefit the shareholders of the companies."