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Capital Expenditures: The Cost of Business

“I really believe we are going to arrive at a point where we’ll be able to stabilize for good,” Bernard Chaine, vice president of Voith Paper’s Roll Division says confidently. “I really believe that.” His opinion comes from an educated vantage point. “I spend a lot of time visiting mills across North America and everywhere I go, I see evidence of this. I cannot believe that our industry will disappear. It has been around for so long.” Chaine says his optimism for the industry is fueled by a tenacious determination on behalf of Canadian mills to pull together and uncover solutions. “I see people in our mills, and they’re prepared to fight. There is a real sense of collaboration, of better understanding, of pulling together. Mills have been taking some drastic measures, and there have been movements towards cost reduction and more productivity. There is also a better understanding between mills and unions.”

Chaine also attests to an interesting shift in mentality on behalf of Canadian mills in face of the massive transformation our industry has undergone in the past several years. Increasingly, pulp and paper operations are seeking to outsource aspects of their business in order to focus on the core segments of their operations. “Mills are much more open to outsourcing the things they aren’t easily able to do, or the things that aren’t core to their business,” he said. “While mills were at one time very reluctant to do this, many mills are now talking and listening about the possibilities of outsourcing.”

That said, Chaine offers some practical financial advice for mills undertaking investments. “I believe mills should invest in upgrades to their machines. Capital should really be directed to upgrading things such as the headbox; all the money should go to the machine itself, and not the surrounding equipment.”

The coining of buzzwords to describe the state of the industry is not a new event. For years analysts have touted a need for ‘consolidation,’ in order for the sector to ‘rationalize’ so that it may become more ‘efficient.’ Recent mergers of forestry giants Domtar and Weyerhaeuser, as well as Abitibi and Bowater have demonstrated considerable initiative along these lines. Whether or not alliances of this calibre will, in effect, help the overall industry move towards profitability remains an unknown, and many have expressed their doubts about the feasibility of this objective. One very tangible consequence of the proposed AbitibiBowater alliance according to Jukka Tiitinen, president of Metso Paper North America, is that the lion’s share of the sector’s attention has been focused on the details, circumstances and projected repercussions of the merger. “The North American pulp and paper industry is not very active, and for the moment, some of the large mergers, namely that shared by Abitibi and Bowater, seem to be the absolute highest priority of the sector.” Although Tiitinen notes there are no major expenditures on the horizon, Metso does continue to place strong emphasis on the Canadian market. “Although the business coming from Canada at the moment is largely in the form of small upgrades, it remains an extremely important market for us. Total production in Canada is huge, and companies require our services and full scope product offering, from woodyard to roll finishing.” Tiitinen notes that currently, mills are choosing to invest capital in areas of their operations that are guaranteed to provide rapid returns, and that the industry is in dire need of someone to “make a bold move.” In terms of a projected future for the Canadian sector, Tiitinen is practical, yet positive. “In the next ten years, we will likely see some more newsprint closures. However, there will be some new investments, some new lines starting up. There is hope, and there is reason to be confident.”

That said, there are sectors of the industry which, as forestry analyst with BMO Nesbitt Burns Stephen Atkinson notes, “lose money every day.” Given the financial burden imposed by continued operation, why do some companies elect not to exit the market? It’s a matter of fairly basic economics, explains Concordia University economics professor Bert Somers. When a large manufacturing facility has already paid down a substantial amount of capital, or ‘sunk’ costs, in terms of equipment, space rentals, etc, it becomes an instance of calculating whether or not the company stands to lose more by ceasing operation altogether, or operating at a loss. “There are essentially two reasons why a company would stay in business in the short run,” he said. “If you can continue to cover all of your variable costs, things such as labour, energy, materials, etc, while contributing something to your fixed costs, you would be inclined to stay in business. Also, companies might perceive this to be a temporary situation and anticipate demand for their products to pick up. If that is the case, staying in business would be justified.” Noting the cyclical nature of the pulp and paper sector, Somers confirmed, “when companies invest, they typically look at the return they expect to get from that expenditure. If they are optimistic about the future, they are more likely to invest capital. Normally, companies won’t invest if the economy is doing poorly, or if their stocks are low; these factors would all mitigate against capital expenditure.”

Interestingly, some of the loudest, affirmative voices advocating for the transformation of the forestry sector are coming from within the industry itself. As Paul Quinn, forestry analyst with Salman Partners noted, “besides general maintenance spending, I am noticing a lot of discretionary money going into energy savings projects. With the run-up in gas and oil prices, many mills took a financial hit. Biofuels or burning biomass for energy production is a big growth area.” Abitibi Consolidated’s mill in Fort Frances, ON couldn’t agree more.

The company operates on the foundation of three guiding principles. Paying down its debt, lowering costs, and in terms of capital expenditures, all investments must increase productivity but not necessarily production, while enhancing product quality. Beyond regular maintenance projects, a potential investment is required to meet these stipulations. Given that context, in 2006, Abitibi spent a total of $165 million, and in 2005 it doled out $175 million in various projects. The year 2007 is expected to remain consistent with these spending patterns. However, this year, a large chunk of that capital is being directed towards the construction and installation of a new biomass boiler at the company’s mill in Fort Frances. Construction is scheduled to begin this summer, and the generator is anticipated to be up and running by the fall of 2008. The entire project will cost $84.3 million; however, a sizeable grant from the Government of Ontario’s newly implemented Prosperity Fund went what Denis Leclerc, director of public affairs for Abitibi Consolidated, refers to as a long way in getting the project off the ground. “Their contribution was absolutely essential,” Leclerc confirmed. “We worked very closely with the Government of Ontario.” Once fully operational, the boiler will render the facility 86% energy self-sufficient.

Asked whether or not other Canadian pulp and paper companies should be encouraged to make similar investments in their operations, Leclerc was straightforward. “We just announced an investment because it is worth it,” he said. “While the commercial context of the market does need to be taken into consideration, there is still a great and bright future for Canada.” Leclerc is confident that despite its current challenges, the industry’s path to profitability will be paved by collective solutions. “We have to overcome this very difficult period of time in a different way; it’s true. I can’t predict when the industry will become cost-competitive. But it’s about acting now. Because the competition is here and more will soon be knocking at our doors. It’s a global challenge, so we need global solutions. We need involvement from all th
e parties who are benefiting from this industry. All of the stakeholders — the workers, unions, governments, suppliers and customers; everyone needs to contribute to a solution.”

Paul Quinn adopts somewhat more of a practical view when it comes to capital expenditures in the sector, saying mills should invest only if the capital they turn over is expected to produce quick results. “Yes [mills should invest], providing the payback is short and the assumptions aren’t too aggressive.” As for which kinds of mills should be investing, Quinn is equally specific. “I like lumber, OSB, some northern bleached softwood kraft mills and groundwood specialties mills that are in the bottom half of the North American cost curve.” The debate over federal or provincial support for the industry doesn’t win favour with Quinn, however. “I’m not a big fan of government support for specific industries,” he admits. “Lower taxes and a reduced regulatory burden is the best support. Provincial support is problematic in the context of the softwood lumber agreement of 2006.” Where does Quinn see the industry situated in five years? A lot depends on how the government approaches what has been coined a ‘forestry crisis.’ “Five years out, I expect the industry to be smaller but more efficient. The employment levels will be sustainable, as the downsized industry will be profitable. This prediction is predicated on my hope that local, regional or federal governments don’t attempt to save jobs with loan or grant assistance.”

That said, some of the largest projects announced for 2007, Abitibi’s biomass boiler included, are relying on significant government assistance. The $200 million deinking plant that Kruger is getting ready to build in Trois-Rivires, QC, pulled in a $20 million contribution from Investissement Qubec, as well as a $50 million loan from the institution, and additionally benefited from a $30 million contribution through Hydro-Qubec, due to its eligibility for the Plant Retrofit Program (See Government assistance: who qualifies?). The reasoning behind the decision to invest ties in with Quinn’s assessment of projects being based on energy cost reduction, and analyst Stephen Atkinson’s belief that “anything recycle-based is a reasonable place to invest.” Motivation for the investment was twofold, according to principal vice president of publication papers Daniel Archambault. “Cost reduction was one of the main motivators. We had been looking into this project for a few years, however, the demand is now here for significant recycled fibre content,” he said. The second driving factor was a quality-based issue. The new facility will permit the plant to churn out supercalendered and coated paper grades that contain a substantial 10-20% recycle content, only with the same or better quality. Archambault noted the plant will make it possible to include an even greater recycled percentage in its papers should there be a demand for it.

Similarly to the Abitibi project, Kruger is also looking to cut energy costs. The company has poured closed to $1 billion into its operations since 2000, in the province of Quebec alone. Part of this capital has been directed towards a cogeneration plant at its Bramptonville mill, and that investment has proven to be categorically advantageous for the company. For an investment of $80 million, by the summer, the mill won’t only be entirely energy self-sufficient, but will also be selling excess energy back to Hydro-Qubec.

SFK Pulp is also on the receiving end of government assistance. The company was awarded a $6 million grant in the form of an interest-free loan, also through Investissement Qubec. The capital came through a program entitled Soutien l’industrie forestire (support for the forestry industry). The company plans to use the bulk of the loan to upgrade its brown pulp washing technology at its Saint-Flicien mill, allowing the facility to implement new environmental standards and keep up with the competition. The project represents a total of $20 million worth of capital expended over a two-year period.

The past 12 months have borne witness to what can be justly labeled some fairly transformative changes to our industry. Cutthroat offshore competition, sky-high wood costs, a volatile Canadian dollar, the Mountain Pine Beetle Epidemic and softwood lumber agreement refunds have all prompted Canadian pulp and paper companies to reevaluate the way they do business. These evaluations have led to further closures and shutdowns, two large-scale mergers, and several hefty investments. There is a pervasive sense of challenging, but progressive movement towards a smaller, but resilient industry, aware of its vulnerabilities, yet capitalizing on its strengths; an industry fully aware and ready for the costs of doing business.

Polling the projects

PPC conducted a poll through its website to assess the amount of capital Canadian pulp and paper mills are investing in their operations. Here are the results.

The following question was asked: How much capital is your mill planning to direct towards improvement, procurement, upgrades or retrofit projects?

My mill is not spending any money: 36.84%

My mill is spending less than $500,000: 5.26%

My mill is spending between $500,000 and $10,000,000: 31.58%

My mill is spending between $10,000,000 and $50,000,000: 21.05%

My mill is spending between $50,000,000 and $100,000,000: 5.26%

My mill is spending more than $100,000,000: 0%

Government assistance: Who qualifies?

The majority of capital expenditure projects in the Canadian pulp and paper industry for 2007 were, at least in part, funded by government assistance programs. The push for cheaper, greener energy has created an incentive, both governmentally and industrially, to explore various energy options in order to save money, and the environment. Hydro-Quebec’s Plant Retrofit Program (PAMUGE) is one such option.

The program operates on the premise that, ‘companies regularly plan extensive retrofits to improve their competitive position, yet given the scope of the investment required in relation to anticipated benefits, few are actually carried out. The goal of the financial assistance under the program is therefore to encourage senior management to select large-scale retrofits that involve substantially greater reductions of electricity consumption than would be the case with other big projects. To qualify for financial assistance, participants must agree to demonstrate electricity savings by measuring their consumption before and after the plant retrofit project.’ The overall objective of the program for major customers is to save 500 GWh of electricity by 2010.

The program is open to any corporation, partnership or organization with a minimum of one service contract at large-power rates and operates one or more industrial sites. The project must be demonstrated to be financially and commercially viable. Also stipulated by the program is the requirement that the undertaking not result in the closing of any plants, or laying off of any employees.