What's wrong with paper's performance?

Pulp & Paper, Jan 2005 by Wilde, Mark

AS I CAME HOME THIS MORNING, I thought back just 72 hours ago when I was about 10 blocks from here with most of the other U.S. sell-side analysts who cover this industry. We had breakfast with senior management-including the CEO-of one of the world's largest paper companies.

After about 90 minutes of analysts peppering management with questions, the CEO turned the tables on us. He said, "We've done so much hard work over the last three or four years, yet we look at our stock and wonder why we are under performing?" His question wasn't only about comparisons with others in the industry but about underperforming alternative investments in other industrial companies.

In the past 12 to 18 months, we've enjoyed one of the best commodity markets since the late 1980s. Energy prices are at all-time record levels, so energy companies are making a lot of money. Most chemical companies, for whom energy is a much bigger input than paper, are managing to enjoy very high pricing and high returns. We literally have a bidding war going on for bankrupt steel companies because of the turnaround in the metals business.

All of these sectors that compete with paper for investment dollars have enjoyed great markets, yet returns remain disappointing in paper. In North America, 2004 was clearly a better year but certainly not a great year. Now, the manufacturing side of the economy seems to be slowing down.

The problem in paper?

With this backdrop, if you were a money manager, you'd legitimately ask, "Why invest in this industry now since other industrial products are generating better returns?" And why is this the case?

Some reasons are straightforward, such as a fragmented industry structure and maturing of markets. Another issue is that the industry continues to focus too much attention on mills themselves rather than end markets-i.e. think about selling packaging rather than running paper mills. We don't spend enough time thinking about customers. The attitude remains one that the job ends at the winder, and we turn products over to brokers to handle product marketing and own customer relationships.

One of the biggest issues is that the industry globally remains a magnet for enormous amounts of low-cost-and often no-cost-state-subsidized capital. In a capital-intensive industry like this, it means free capital is dragging down returns across the rest of the industry.

Mercer's Stendahl pulp mill was essentially built with an enormous free equity grant from the German government along with government-backed loan guarantees. The cost to capital at that mill looks like somewhere between 3% and 4%. Think about the fiasco at the Papiers Gaspesia mill-a bankrupt Abitibi mill that should have gone away but which government, combined with some public companies, tried to refurbish as a coated paper mill. A new newsprint mill is purported to begin construction in the first quarter of 2005 in upstate New York. Look at the financial condition of Abitibi, Bowater, or NorskeCanada and ask, "Who would build another newsprint mill in North America?"

For all of this, the silence from most industry leaders on the issue of government subsidies is deafening.

Imagining the possible

We remain tremendously constrained by our vision of what is possible. Consider the two honorees that will receive awards from Paperloop. One is Paul Stecko (CEO of the Year) and his financial partners at Packaging Corp. of America: Madison Dearborn Partners. They have thought very broadly about what is possible. Since the leveraged buyout of PCA out of Tenneco, they've sold virtually all of their timberland. They've been extraordinarily disciplined in the use of their free cash flow and have repeatedly said they will create value for shareholders, which doesn't just mean that they have to get bigger over time.

At the time of the LBO five years ago, PCA stock was at about $4.00 to $4.50/share. Today the stock trades at $23. It pays a $0.60 dividend, which means a cash yield for the original investors of about 13% to 14%. While Stecko deserves a great deal of credit, Madison Dearborn Partners is very financially savvy, investing in our industry quite successfully for the most part.

The other honoree is Louisiana-Pacific (Best Investment Return). L-P has probably enjoyed one of the greatest commodity markets in this industiy in 20 years. But what's striking about Louisiana-Pacific is not just what's occurred over the last 12 months but what CEO Mark Suwyn and his team have done during the last 27 to 30 months, which was a restructuring begun in mid-2002 that saw all the land sold out of the company. L-P remained disciplined even as free cash flow went through the roof.

Both of these companies provide examples to us of the degree to which value can be created in this industry if we're willing to take a broader view of what is possible.

MARK WILDE is managing director of Deutsche Bank securities. This column is based on a presentation at Pulp & Paper Week's Global Outlook Conference in New York, November 2004.