David and Goliath: Smaller paper firms can survive with "super niche" strategy

Pulp & Paper, Aug 2003 by Beare, Nicholas V

FEATURE: CORPORATE STRATEGY

As mega-companies begin to dominate major grade sectors, smaller competitors may be able to tap private capital and dominate specific grade segments

As the stock market continues to look for positive signs that the economy is poised to improve and the impact of the war in Iraq becomes more evident, the paper industry continues to wrestle with its greatest macro issue: there is too much capacity in most grades. This surplus can be ascribed to numerous causes such as the rise in foreign imports, reduced consumption, and excess capital expenditures on new production.What can be done to bring the markets back into equilibrium with a resultant increase in prices?

Many on Wall Street believe that the correct answer is for a new wave of consolidation to occur in the paper industry that would create, in essence, a handful of major players that would be better able to balance supply and demand. A consolidation of this nature has already occurred in some grades (Figure 1), such as uncoated free-sheet. However, the anticipated economies of scale have yet to be fully realized. According to Mark Connelly, paper and forest products analyst with CS First Boston, "Consolidation is indeed working, but far more consolidation is likely to be needed in some grades."

If it is assumed that consolidation is truly the answer, one could expect to see better days ahead for the largest producers, as they would benefit from the acquisition and rationalization of their smaller competitors. This straightforward economics lesson misses one very important point: What happens to the independent producer that wants to remain in business and isn't interested in becoming gobbled up by the industry titans?

Is the only alternative for the small public or private company to become a consolidatee or to be crushed by the giant consolidators? Not necessarily. This article will explore one possible way to survive and prosper in the land of the giants.

THE FORCES OF COMPETITION. if consolidation does occur, the major players will be better able to influence pricing and will have a distinct advantage in low-cost production due to their economies of scale. Smaller companies that are still in the fight will be forced to reduce expenses and implement operational improvements.

Despite these challenges, it will still be possible for smaller companies to compete if they are willing to think outside the box. Rather than focus on simple, tactical improvements, companies will need to consider a dramatic shift in their overall strategy.

In his seminal article, "Competitive Strategy: The Core Concepts," Michael Porter of Harvard University postulated that in the short run, the supply and demand for products dictates profitability, but that in the long run the degree of competition in an industry is the ultimate determinant of return. Further, the degree of competition is driven by five structural forces:

1. Ease of entry and exit into the industry

2. Rivalry between existing competitors

3.Availability of substitute products

4. Bargaining power of customers

5. Bargaining power of suppliers.

In highly competitive industries, returns are driven down over time until the number of firms is greatly reduced through consolidation or failure. In reality, Porter's theory mirrors the current state of the paper industry fairly closely. Porter goes on to suggest that to earn above-average returns in a competitive industry, a participant must have a strategy of either:

1. Being the low-cost producer

2. Offering a differentiated product

3. Participating in a market niche

With regard to the paper industry, the giants clearly are, and will continue to be, the low-cost producers, while the smaller participants will search for niches. The problem with niches in the paper industry is that they tend to be small, fragmented, and difficult to grow. Yet there may be a way for small and medium companies to create and control a "super niche."

GROWTH IN PRIVATE CAPITAL. Since 1998, the growth in private capital has been stratospheric (Figure 2). During the booming "dot com" era, tens of billions of dollars flowed into private equity funds to be used to purchase controlling interests in companies across a myriad of industries. For discussion purposes, an equity sponsor can be defined as an enterprise that manages and invests capital through acquisitions on behalf of large institutions and wealthy individuals.

Equity sponsors generally do not run the businesses they acquire and are motivated primarily by the leveraged return on their investments. Most of the funds that these equity sponsors manage have a finite life, specific investment parameters, and return requirements.

Currently, many sponsor groups find themselves in the uncomfortable position of having raised too much money during the boom and now have too few investment opportunities in which to deploy these funds due to the state of the economy. This surplus cash presents a unique problem.As required in most fund agreements, unless the capital is invested within the first five years of the fund's life, the money must be returned to the investors. Such an occurrence is viewed very unfavorably in the financial community and thus reduces a sponsor's ability to raise additional funds in the future.