Financial Management

Pulp & Paper Canada
May 31, 2003
By Pulp & Paper Canada
This might be the defining decade for the Canadian industry. Although it has often been said, the industry is prepared to make changes to become more fiscally prudent. There is no shortage of views on how the Canadian industry can become economically stronger and healthier.

Talk about nostalgia. One would have to return to the go-go 1990s to remember the last time that the forest-products industry had a good run of solid profit-making. The millennium started with much anticipation for continued good times in 2000, but in the last two years many companies have posted less than stellar earnings. This year will see more of the same. The unanswered question is whether the Canadian industry will ever see the gravy years again.

To be sure, there is no shortage of proposed solutions to stimulate growth, and return the industry to rosy health. These include promoting industry consolidation, which would ease overcapacity problems still plaguing the industry; keeping a vigilant eye on costs; and boosting research investments as a fundamental way to get out of the ferocious fight for survival.

Although all hold some merit, let's first consider the state of the industry. In a key economic measure like return on capital employed, or ROCE, Canadian firms fared poorly in 2002. They averaged about 4.0%, far below the generally accepted minimum return of between 8% and 11%. (In 2000, Canadian producers generated, on average, an ROCE of 10.7%.). The Canadian figures are comparable to that of the American producers, which also performed poorly last year. The Scandinavian producers reported an average ROCE of 5.5%.

ROCE measures the industry's profitability against capital invested. It's an important figure for the industry, because the forest-products industry is one of the most capital-intensive in the world. The drop in net earnings, however, reflects a global phenomenon. (See sidebar, The Global Dip.)

Taking Out Capacity

"This year looks like more of the same," says Craig Campbell, partner (global forest & paper practice) for PricewaterhouseCoopers, a management-consulting firm with global reach. Campbell, who works out of the Vancouver office, says, "The global industry is facing a slow recovery in 2003. It looks as if the rate of demand and pricing will recover somewhat in 2003 to allow a slight improvement in over-all earnings."

Although pulp and paper producers have become more disciplined in the last few years, there is still excess capacity. "There is a general decline in demand for paper products," he says. "Demand for wood products, however, has been very strong."

Despite the continuing softwood lumber dispute between Canada and the US, historically high housing starts have fuelled demand for Canadian lumber. But even the high demand hasn't translated to record-high profits. The reason, Campbell says, "is record-high production." (See sidebar, The Housing Bubble.)

The solution is the same message that Campbell has been preaching for years. "The industry needs more consolidation," he points out. "Bigger is better." (See P&PC, Feb. 1999.) The reasons centre on economies of size. Simply put, as the thinking goes, large companies can more easily control production and market conditions, largely by closing high-priced mills. "If you've got 10 mills, it's easier to shut down one," Campbell points out. Abitibi-Consolidated Inc., with 27 mills worldwide, characterizes that thinking, having indefinitely idled mills in Quebec and Texas.

Even so, it's not easy to close a mill for good. Socio-political reasons prevail. "Even if a company pulls the plug," Campbell says, "the mills get reincarnated," often with the help of provincial or federal grants. And often, the unions pitch in.

Brian Payne, president of Ottawa-based Communications, Energy & Paperworkers Union of Canada (CEP) agreed with this practice. "A mill closure is more than a straightforward business argument. If you close a mill in a mill town, workers lose not only their jobs, but their homes -- it's a huge impact."

Such stands represent the ideological divide: People versus profits. The argument in a nutshell can be said as follows: Because the forest industry in Canada operates, with few exceptions, on Crown Lands, it's responsible for more than profit-making. "Companies have to honour the other side of the equation," Payne points out, "which is to maintain manufacturing facilities in communities in which they forest."

Which explains to a large degree why overcapacity problems persist. Competition might be good for the consumer, but it's not always good for the profit picture. As Campbell puts it: "We don't have any major players as other industries do." He cites industries like automotive, pharmaceuticals and energy, in which between three and five players control up to 90% of the production.

In comparison, the largest forest-products company is Stamford, CT-based International Paper Ltd., which reported revenues of $25-billion (US) for 2002. Despite that fact, Campbell notes, "It doesn't have any appreciable market share."

Cutting Costs

His chief advice boils down to this: "Firms have to be serious about cost-cutting and streamlining the supply chain. They have to ask themselves whether they have a low-cost culture." (One area that's often overlooked is selling, general and administration (SG&A), or overhead.)

One company that keeps a close eye on its overhead is Vancouver-based West Fraser Timber Co. Ltd. "West Fraser is the top-performing company in North America," Campbell says. "They have a low-cost culture in the truest sense. They don't only talk about cost reduction -- they live it and breathe it."

True enough. This low-cost culture is evident throughout West Fraser's organization. It posted an ROCE of 7.5% last year, slightly less than the 7.5% of 2001. Earnings were an impressive $138 million on revenues of $1.63 billion. "2002 was the second-most profitable year in our company's history," says Rodger Hutchinson, vice-president and corporate controller for the Vancouver-based company. "Our over-all goal is to be the lowest-cost producer in the forest-products sector."

Such thinking forms a central part of the company's five core corporate values. "We have a strong, well-developed corporate culture that reflects the cultural values of the founding family -- the Ketcham brothers." These include modesty, teamwork, competitiveness and cost-consciousness. The management values are as follows:

Maintain stringent cost controls;

Continuous re-investment in plant and equipment;

Ensure employee commitment;

Maintain product integration; and

Maintain product and geographic diversification.

Hutchinson agrees that SG&A costs ought to be controlled, notably in times when profits are harder to squeeze out. One way to lower costs is to watch unnecessary expenses, like extravagant corporate offices, which run contrary to West Fraser's values. "In many ways, it's the most visible element of cost," Hutchinson says. "If you have opulent offices, and people see it, it delivers the wrong message to employees."

Small wonder it has been able to enroll its employees in the process, of which 30% are unionized. "The key to low cost is to have employee commitment at every level," he says. "At West Fraser, employees develop the thinking of low cost."

Equally important is re-investing in people and equipment. "It is a real advantage to make investments," Hutchinson points out. "You need to constantly re-invest to remain competitive."

Investing in Innovation

Such are the chief sentiments of Joseph Wright, president of Montreal-based Paprican, one of the world's leading research institutes. Although he is admittedly biased toward research investments, independent studies prove the value of making a long-term commitment to innovation. As Wright put it: "Studies show that companies that invest more intensively in innovation -- and not only in R&D -- significantly outperform those who do not."

One can quibble on what "intensive investments" equates to, but it's safe to say, it's much more than what most Canadian companies are now spending on R&D (about 0.3% of gross revenues). A good figure would be about 1.5% of gross revenues.

Although Wright agrees that the pulp and paper industry is facing difficult times, it is not a special case because of the huge capital investments it has to undertake. He points to the semiconductor sector. "Intel operates in a sector that is every bit as capital-intensive as our paper companies. It costs Intel between $1 billion and $3 billion to build a new fabrication plant, and they make such an investment every three years."

Then there are mills operating across the pond. "You would be hard-pressed to find a machine in Europe that's older than 10 years," Wright states. "They have a fairly aggressive strategy for partial upgrades and plant modernization during the 10-year cycle, and eventually the whole paper machine is replaced in 10 years."

At the risk of sounding pessimistic, the industry, for the most part, has fallen behind in a number of areas, including equipment upgrades, consolidation and R&D. "It's hard to say precisely why," Wright says. "Thirty or forty years ago, Canada was without a doubt a world leader."

The decline generally started in the 1980s, when Canada was unsure of which direction to take, notably towards consolidation. In Finland, however, a nation of five million, the pulp and paper industry took measures to become a modern export-driven industry. The government allowed consolidation to take place. The result is that now about four companies comprise the industry in Finland.

If Wright is right, Canadian firms have to find ways to make the most of science and technology (S&T) allocations. "If most S&T dollars are focused on cost reduction, that's a losing proposition," he says. "If you are a best performer under these conditions, it means that you'll follow the cost curve down faster than your competitors -- and you won't be the first one to die."

While that might prevent bankruptcy, it's a short-term solution at best. A long-term solution has to take in cost reduction and innovative ways to increase revenues. "If you don't do that, your competitors will kill you," Wright says.

Despite provincial and federal government reluctance to allow it so, more consolidation will take place in the next few years. "I really believe that there will be continued pressure to consolidate. If we have 30, 40, 50 companies in Canada, you can't convince me that we have had enough consolidation."

Even so, mergers and acquisitions or industry consolidation do not often produce the intended results, other than make a few major shareholders and investment bankers richer. A wealth of research shows that the much-discussed "synergies" often fail to materialize. Mergers, however, often result in companies burdened with huge debts. The trick, it seems, is to do careful research before merging or consolidating -- like before marriage. Only then can companies truly benefit from expected synergies, and thus invest surplus funds in innovation.

Given the state of the economy, and the predicted slow (real) growth of the world's major economies, we might be entering a phase of fiscal prudence and watchfulness. The watchwords for the next few years will likely be debt repayment, cost-cutting, employee retention, slow and careful expansion and strategic investment in R&D. As well, we'll likely see an increase in bankruptcies, consolidations and mergers and acquisitions. Despite the awful taste, it's the right medicine for a feverish industry. There are signs that the recovery is already taking place. So, forget about the go-go 90s; this is the recuperating 00s.

The Global Dip

Net earnings of the world's top 100 forest-products companies dropped more than 20% in 2002, to $5.2 billion (US) from $6.8 billion (US) in 2001, mainly attributed to depressed prices for many grades of pulp, paper and lumber, reported PricewaterhouseCoopers in its Annual Global Forest and Paper Conference |last March. One economic measure, ROCE, dipped to 4.3% in 2002, a significant drop from 6.6% in 2000.

"The global industry is facing a slow recovery in 2003," says Craig Campbell, partner (global forest & paper practice) for PricewaterhouseCoopers, a management-consulting firm with global reach. "The economic and political turbulence of the past year added another complicating factor to the industry's woes, but there is a growing realization within the industry that the definition and measures for success have shifted from what they were 10 years ago."

The Housing Bubble

Some economists are predicting that a housing bubble -- similar to what took place with the telecommunications and dot-com sectors -- is imminent. As they put it, the ingredients are right for such a scenario: hyper-inflated housing prices, too many houses on the market, and diminishing consumer demand. Housing prices have risen, on average, 28% since 1996.

"We've had record-high prices in the last few years," Campbell points out. "They can't go any higher, and there is only one way prices can go -- down."

If they plummet, however, the consequences might be severe, notes The Economist: "An analysis in World Economic Outlook notes that 40% of house-price booms are followed by busts, and these busts cause twice as much economic damage as stock-market collapses."

Yet, Campbell dismisses the idea of a housing bubble, calling the expected downward trend in housing prices "a correction." He's in good company: Alan Greenspan, chairman of the US Federal Reserve, whose decisions on monetary policy have global effects, dismisses the notion of a national housing market in America, saying there is no excess supply.

Although the stock market continues to fluctuate unpredictably, Canadian paper companies have done surprisingly well. Eastern Canadian firms, in particular, like Abitibi-Consolidated Inc., Cascades Inc. and Domtar Inc. have seen their share prices rise slightly, out-performing the Toronto Stock Market, which declined more than 15% last year.

"Canada has not done too badly," Campbell says. "In the US, share prices of paper companies have declined 30% in the last three years, following the trend of American markets."

Canada Beats the Americans

Although Canadian forest-products companies are not posting double-digit increases in share prices, they are a safe investment. "Sure, Canadian companies are returning between 4.5% and 6%, but that better than minus 20%," Campbell says. "Some investors are willing to live with returns of 5 to 6%, because they know that it's fairly consistent from year to year."

Even so, it's important that the US economic engine fires on all cylinders. Since 1995, America has accounted for about two-thirds of global growth, helping world economies through boom and bust cycles.

Alan Greenspan, chairman of the US Federal Reserve, a prominent optimist, predicts that once geopolitical uncertainties (like Iraq and North Korea) are lessened, the American economy is poised for growth.

Perry J. Greenbaum is an engineer and an award winning business and technology writer. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .#text2#

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