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Capital Expenditures Lead to Capital Rewards

What a difference a year can make. The infamous light at the end of the tunnel is still burning brightly (or so we keep hearing) but its ability to draw forth industry players to the warmth of its illumination is abating. We’re growing wary, cautious, and nervous. Mills are increasingly reluctant to part with ever-constricting investment dollars and are instead prying them from clenched fists to plunk down in sensible, practical and necessary maintenance projects. “The capital expenditures we are seeing are very restrained,” said Patricia Mohr, Scotia Bank’s vice president of economics. “They aren’t going up rapidly, there isn’t too much building going on. There are some conversions, upgrades at some mills, but apart from normal maintenance, investments are very constrained.” Mohr attributes this phenomenon to paper product prices remaining at a virtual standstill, slicing into profits and leaving mills with empty and tied hands. “We just aren’t seeing profitable levels,” she said.

It’s a difficult situation and a perpetually vicious cycle. As Bob Eamer and Paul Stuart described in the January issue of Pulp & Paper Canada, investment in the industry is pivotal to not only its success, its ultimate survival. And yet how can this be done when an immediate return on a heavy investment cannot be guaranteed, when it can’t even be banked on? What should be the first step, and who will be brave enough to take it?

“The Canadian industry is under tremendous pressure,” acknowledged Frank Dottori, CEO of Tembec. The company recently posted a prodigious Q1 loss, confirming an operating defalcation of $700,000. A year earlier, the company had a quarterly profit of $52.1 million. Despite Dottori’s categorical outlook that a hike in pulp prices is just around the corner, one of the first measures the company is taking to facilitate its return to profitability is to constrict its spending by circumscribing capital expenditures. Although the forest products company has well over a dozen projects planned for 2005, only two have been designated as modernization or improvement enterprises.

Tembec isn’t alone in its decision to scale back its capital investments. Domtar, who also recently posted large losses, is suffering under the pressure of a bolstered Canadian dollar coalesced with soaring energy, wood and transportation prices. “These are trying times,” stated company president and CEO Raymond Royer. “The combined effect of all these factors represents a reduction of $262 million in operating profit when compared to 2003.” Royer remains uncertain as to what 2005 will hold in terms of profitability potential for the Canadian industry, concurring that companies will in all likelihood experience extreme difficulty in trying to stay on top of pressures imposed by a rising loonie. “The year 2005 may be just as challenging as 2004, especially given that no cost cutting program can compensate for the rapid rise seen in the value of the Canadian dollar.” The challenges Royer spoke of are prompting the company to try and make the most of what it has, while at the same time conducting reviews of the viability of its operations and investment plans.

It isn’t only paper companies touting a cautiously optimistic outlook, financial management and advisory company Merrill Lynch dubbed 2005 “the year for paper,” in a quarterly industry review released mid January. The firm is pointing to improved and healthy demand, coupled with escalating wood prices to contend that brighter days are not far ahead. The report also maintains the crippling energy prices witnessed in 2004 are expected to decrease, stating that while oil prices are likely to dip by a substantial 8%, gas prices should drop by a staggering 19%. “This would be a welcome relief for the energy-intensive paper producers,” the report claimed. However, and as Royer pointed out upon the release of Domtar’s 2004 earnings, Canadian companies are suffering from the additional pressures imposed by a stronger dollar. ML’s currency group is forecasting a further weakening of the U.S. dollar while the loonie and the euro will remain strong. “On an absolute basis, we expect every company to be profitable except for those with large Canadian assets, Abitibi and Bowater (small losses) and Domtar (break-even).”

A powerful dollar isn’t to shoulder all the blame for restricted capital spending, however. A shifting corporate culture climate is also responsible for the tendency towards fiscal tight fists. Disasters like Enron have turned over what editor in chief of Les Papetires du Qubec Jaclin Ouellet calls, “tremendous power,” to investors, shareholders, accountants and lenders alike.

“The trend we’re experiencing now, and it started in the 1990’s, is such that mills are investing in the basics, they’re postponing the bigger projects. This trend cannot break because we’re in an organized business environment where companies are always being asked to make more profits. Making projections isn’t acceptable, if a company isn’t making enough money, it’s expected to do something about it, and fast. Numbers talk. The pressure mills are under from shareholders, banks and lenders is tremendous. Accountants now have their noses in every aspect. Mill managers and presidents of companies know they have to invest in their assets, but they are expected to work towards reducing their debt before anything else. And so they sell off assets to do so. It used to be popular and positive to stand up and say you were planning to invest x amount of dollars in a project. But mills have become more secretive and reluctant to talk about what they’re spending because if they’re still carrying a debt, shareholders want to see that paid down first. Because companies are accountable for every detail, it doesn’t leave any room to maneuver, it leaves no room for vision or creativity,” he said.

Ouellet also acknowledged the viscous cycle syndrome imposed by a lack of common interest between various sides of the industry. “The pulp and paper industry is extremely capital intensive. Because we aren’t investing, we’re now experiencing competition from elsewhere, where you can’t really see it, you don’t know exactly what they’re going to do, which makes it all the more difficult, there are pressures coming from all sides, and how do you cope with that? We’re losing market share to offshore competition, but our hands are tied. There is a real sense of urgency.”

David McDonald, vice president of research and education at Paprican also acknowledges the situation to be a compromising one. “Mills are being driven by financial markets and so they’re focusing on short-term solutions that relate to their bottom line. This, combined with the Canadian dollar, competition from other parts of the world, makes for a difficult situation. The people running these businesses are very capable people, they understand what they should be doing, but they’re being forced to do otherwise because of the situation they’re in.”

In terms of advice for the industry, McDonald contends Canadian mills should market their strong points. “Mills have to focus on specific parts of their business, and we’re seeing that happen now. Companies are closing parts of their business, while reinforcing their core. The fibres we have in Canada, being in a northern part of the world, are appropriate for certain types of products, and so this would be a good area to focus on.”

The supplier side of the industry is more positive, and president of Metso Paper North America Jukka Tiitinen is hopeful that the “light at the end of the tunnel” is in sight.

“It’s true that the first priority when it comes to capital expenditures is maintenance,” he said. “But to say that this is the only thing being done would be limiting too. There are a number of upgrade projects where mills are investing to improve the efficiency of their machines, as well as the new Metso paper machines in Canada, including those at Kruger Wayagamack and Scott Crabtree.” Tiitinen acknowledged that mills are investing less and less and do try t
o make the most of what they already have to work with, but that this isn’t a strategy that can continue forever. “You have to continue to invest in your assets.”

So where does Tiitinen contend that mills should be alotting the capital they do have for investment projects? That depends. “Investment needs to be linked to demand,” he said. “In North America, that might be in the board business, where there have been few investments made in recent years, or on the paper side, where more efficiency, capacity or quality would have a direct impact on mill profitability. If the economy continues at a decent level, which it seems to be doing, we hope these investments will be made.”

As for the almost alchemistic secrecy that surrounds mills and their investments, Tiitinen explained that keeping your competitors in the dark is the name of the game. “There just isn’t enough demand for everyone,” he said. “So to announce a project that will take anywhere from 12 to 18 months to complete, is giving your competition too much information. When you’re adding capacity, it’s one thing to tell the public what you’re doing. When you’re making strategic moves, you don’t necessarily want your competitors to know. But there are some interesting things cooking in the Canadian industry, there are some interesting things happening. It’s just a matter of waiting for businesses to make their move.” The light at the end of the tunnel just brightened up a notch.

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Where the money is going

Despite a constant barrage of media coverage that mills are making every effort to constrict capital expenditures and reduce investments, many facilities are still plugging money into their assets. Of the Canadian pulp and paper mills that elected to participate in Pulp & Paper Canada’s annual Capital Expenditures survey, here are some examples of where the money is going. As was confirmed by Scotia bank’s Patricia Mohr, the data we received indeed points to smaller maintenance projects, whereby mills work to make the most of their already existing assets. However, as Metso Paper’s Jukka Tiitinen cautioned, this is a trend that can continue only for so long.

Mill production facilities

Safety guard programs, residual energy compliance, hardwood flooring plant projects, log extractors and chippers, bleach towers, hypo storage and supply, bleacheries, MCS operating stations, emergency washing stations, forest resource projects, sawmill modernizations, specialty wood projects, capacity utilization improvements, digester outlets, chip quality monitoring systems, reel rail upgrades, motor cooling, reel waste reduction, paper machine drive upgrades, chip screening systems and improvements, computer systems, increasing capacity of cogeneration, new winder drives, TMP screening, dryer extensions, recovery boilers, etc.

Pollution Control

The replacement of main channel flowmetres, NCG system improvements, smelt tank scrubber improvements, recovery boiler opacity improvements, landfill sites.

Energy Conservation

Energy reduction, TG upgrades, power boiler air system upgrades, preheating of treated water, white water filtration, improvements to condensate return, etc.

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DID YOU KNOW?

There is no disputing the pulp and paper industry is suffering through some of its hardest times, dealing with pressures imposed by sky-high energy, wood and transportation prices, off-shore competition and a soaring Canadian dollar. However, the industry remains an invaluable contributor to the Canadian economy. Did you know…

* That total industry sales are currently over $22 billion, a substantial share of which contributes to federal and provincial government revenues?

* That most of the pulp and paper made in Canada is in fact exported, and along with other forest products, contributed more than $34 billion to Canada’s balance of trade in 2002?

* That the U.S. is Canada’s biggest export market?

* That competition from the technologically dominant Scandinavian countries, coupled with low-cost mills in Brazil and Indonesia, are now amongst Canada’s strongest competitors?

* That Canada’s share of world pulp and paper exports dropped from 40% to 32% since 1990?

* That rates of return for market pulp (2.2%) newsprint (5.9%) and other papers (5.4%) over the past decade, have been much lower than the 9-12% typically considered mandatory for a healthy industry?

* That since 1990, Canada’s pulp and paper mills have invested over $6 billion in environmental improvements?

* The pulp and paper industry has reduced greenhouse gas emissions by 28% since 1990, leading other industrial sectors?

* That despite the investment of billions of dollars in technology renewal, the industry continues to face less than satisfactory economic returns and has reduced capital expenditures?

Source: Environment Canada

http://www.ec.gc.ca/nopp/DOCS/rpt/smartReg/EN/c4.cfm