Forest Products Industry Chris Cook Insoo Park Elizabeth Juwono Rachel Zhu Evan Vahlas
Agenda n n Industry Analysis Risks Faced Weyerhaeuser Company Domtar Inc.
Industry Analysis n Forest Products Industry n n Produces primary products valued at US$850 billion/year (Price. Waterhouse. Coopers, 2003) Global reach Mature, capital intensive and cyclical industry Highly competitive n Comprised of thousands of small and large enterprises
Industry Trends n Oversupply of forest products in every industry n n n Due to stagnant economic growth in key countries such as the United States (largest consumer of forest products) Decreasing sales across most companies Emerging market influencers: n n China Russia
Top Industry Performers Source: PWC, 2003
Products n World Wood Production (by volume) 3% Wood-Based Panels Lumber & Wood Products Sawnwood n Roundwood Products n n n 36% 33% Industrial Roundwood Fuelwood Mechanical Wood Products n Fuelwood Sawnwood Wood based panels 28% Industrial Roundwood Global consumption of wood products: 767 million m 3 (ICFPA, 2002)
Products n Pulp & Paper Products n n n World Pulp & Paper Production (by weight) Wood pulp Paperboard Wood Pulp Paper & Paperboard 64% Global consumption of paper products: 323 million tons (ICFPA, 2000) Global consumption of wood pulp: 150 million tons (ICFPA, 2000) Substitutes: steel, aluminum, plastics 36%
Raw Material Evolution Natural Forest or Forest Plantations Roundwood Wood Chips Paper Sale of whole unprocessed logs Mechanical Wood Products Pulp
World Consumption of Forest Products Source: XI World Forestry Congress, 1997
Sales Growth n n n Demand sales growth of lumber & wood products are closely correlated with construction, primarily residential construction (ICFPA, 2000) Demand sales growth of pulp and paper products are closely correlated with overall economic growth (ICFPA, 2000) Sharpest growth increases across all product lines will be seen in developing countries (ICFPA, 2000)
International Trade n n Approximately 35% of forest and paper products are traded internationally (ICFPA, 2000) Canada is the world’s leading exporter n US$43 billion in wood, pulp & paper year (FPAC, 2003)
Revenue Structure n Major sources of revenue: n n n Raw materials (logs, chips, timber) Manufactured forest products Interest income Proceeds from sale of property & equipment Proceeds from sale of timberlands
Cost Structure n n Interest Expense: 4 -5% of total sales revenue Major expenses compose 90 -95% of total sales revenue
Firm Strategy for Future Growth n Problem: Overcapacity n n Lumber-mill capacity has increased at a rate of 2. 25 times that of demand (Weyerhaeuser, 2002) Future firm objectives n n Close inefficient facilities and higher-cost producers Streamline operations n n Decrease operating costs Optimize manpower utilization Increase operating efficiencies More consistent production
Regulatory Environment n Sustainable Forest Policy n n Conservation of biological diversity Maintenance of the productive capacity of ecosystems Maintenance of forest ecosystem health and vitality International trade tariffs n n Paper tariffs: Range from 0 -2% Wood tariffs: Range from 0 -22%
Regulatory Environment n Country-specific environmental regulations n n Supported by national forest products associations International Council of Forest and Paper Associations n n Committed to the principles of sustainability 39 member countries Over 75% of the world’s paper producers Over 50% of the world’s wood producers
Risk Management
Risk Management Environment n n n Types of risks faced How they are measured How they are managed Conditions promoting active risk management Potential hazards in active risk management
Major Risks: General Business n Commodity Risk (Price Risk) n Changes in prices of the products of the company n Demands forest products are cyclical n Pulp and paper industries are notorious for price volatility
Major Risks: General Business n Commodity Risk (Supply Risk) n Adequate and timely supplies of raw material are critical n Especially wood, energy and chemicals n Dependence on a few key suppliers is risky, but often necessary n Constrained by availability, locality, price, quality, etc.
Measuring Commodity Risk n Measured by sensitivity analysis
Techniques & Products to Manage Commodity Risk n Forward Contracts Commodity Futures Commodity Swaps n Natural Hedging n n n Product Diversification Efficient Cost Management Vertical Integration
Major Risks: General Business n Project Risk n Risk of investing in specific projects, ventures or companies n Can depend on many factors n n Demand conditions Poor management Local political/economic environment Measured by expected cash flow analysis and managed with efficient resource allocation
Major Risks: Financial n Interest Risk n The risk that market borrowing rates may rise n Forest industry typically finances incremental capital investment with operating cash flow n n n Operating cash flow is volatile Causes higher capital costs and uneven capital investment Duration analysis can measure the exposure
Techniques & Products to Manage Interest Risk n Interest rate futures and forward rate agreements n Interest rate swaps n Option products
Major Risks n Foreign Exchange Risk n Assets and liabilities in foreign currency n n Sales and purchases in foreign currency n n Also known as balance sheet risk Also known as transaction risk Especially relevant to international firms n n Global production facilities and customers Large mismatch between revenue and cost
Foreign Exchange Risk n Sensitivity analysis can show the extent of exposure n n 1 cent gain in CDN $ Loss of $528 million in Revenue for Canadian Forest Industry Equivalent to 1% Decrease in Total Industry Sales (Source: PWC, 2002)
Techniques & Products to Manage Foreign Exchange Risk n Futures Hedge n Currency Options n Others n n Cross-Currency Hedging Invoice Currency Hedging Currency Diversification Natural Hedging (Exposure Netting) n n Plant locations Borrowing from foreign sources
Major Risks: Financial n Credit Risk n n n Possibility of customers defaulting on accounts payable A company typically set internal credit ratings of its customers to measure exposure Funding Risk/Liquidity Risk n n n Difficulty of obtaining finance for operations at a given point of time Expected cash flow analysis and comparison with competitors can measure future financing needs Forestry companies have large capital expenditures
Techniques & Products to Manage Credit & Funding Risks n n n Thorough Analysis of Customers Letters of credit Bank guarantees Credit Insurance Coordinating Debt Maturity Requirements for minimum cash reserves
Major Risks: Others n Operational Risk n n Damages and Liabilities Transportation Physical Delivery of Goods Political & Legal Risk n n National political stability Relationship with local government Tariffs and trade feuds Environmental regulations
Available Techniques & Products n Insurance n n n General Liability Shipping Environmental Strong internal controls over operation Scenario-building Lobbying
Factors Promoting Active Risk Management n Many of the major risks faced can be hedged n n Interest, Foreign Exchange and Commodity Many leading companies are large and/or multinational n n n Large volumes of revenue and costs at stake Stable cash flow desired by shareholders Cash flow and balance sheet items denominated in different currencies
Factors Promoting Active Risk Management n Most forestry companies are not diversified n Wood, pulp and paper products are mostly homogenous and thus price sensitive n Industry is heavily influenced by business cycles Input & output prices are volatile
Potential Hazards from Risk Management Activities n High costs of purchasing derivative products n n n Potential Losses from Hedging n n n Takes away from the bottom line Can cause liquidity problems Inability to capitalize on favourable risks Competitive disadvantage Random Walk Nature of Risk? n n Risks tend to even out in long-run No long run benefits if risks are affordable in short run
Weyerhaeuser Company “becoming the best forest products company in the world and a global leader among all industries…”
Company Profile n Incorporated in Washington in 1900 n Engaged in the growing timber; the manufacture, distribution and sale of forest products; and real estate n Corporate strategy: vertical integration n Worldwide company serving domestic and international market n Has access to 42. 7 M acres of forestland
Financial Situation n Increased net sales and revenues by 27% n Increased total asset by $1 B n Increased operating income by 40% n Decreased net earning by 32% and earning per share from $1. 61 to $1. 09 n Increased 3 times as much as interest expenses compared with 2001
Revenue Source
Cost structure
Interest Expenses
Major Risks faced n n n Economic and Market risk Political risk Financial risk Ø Ø Ø Increasing debt (interest) risk Interest-bearing debt by $7. 6 M , debt to capital ratio from 37. 7% to 55. 6% Commodity price risk Foreign exchange risk
Foreign exchange transaction (gains) losses
Derivatives used to: n n n Achieve desired mix of fixed versus floating-rate debt hedge commitments for short/long positions in commodities the company purchases/produces manage exposure to forex rate changes
Derivative Instruments Used n n n Forward contracts Commodity swaps (notional value of $54 M) Commodity futures Interest swap (notional value of $50 M) Investment swap (notional value of $160 M, exposure size $7 M)
Designated and non-designated hedges for managing financial risks Designated n n FX contracts Commodity contracts Non-Designated n n n Variable rate swap agreement Variable-to-fixed interest rate swap agreement Lumber and other commodity futures
Implementation of FAS 133 n Increased liabilities by approx. $24 M n Increased assets by approx. $37 M n Net offsetting amount of $13 M in cumulative other comprehensive loss
Long-Term Incentive/ Compensation Plan n For certain key officers, other employees, and its subsidiaries The common share will increase by 22 M resulting from exercising all options Executive officers’ Long-term incentive plan (2 -yr time limit)
Extra Information on Company’s Risk Management n Gary A. Baxter, the director of insurance and assistant treasurer for the company n Insurance department developed Long-term relations with insurers, brokers and other vendors n 4 brokers in different areas and fee-based rather than commissionbased payment to brokers n Insurance purchased: Excess casualty, joint venture liability, director and officers liability, wrap-up program coverage, aircraft and hull liability, excess crime, etc. n Has purchased risk management software to manage some of their trading risks.
Domtar Inc.
Company Profile n n Canadian company, with majority of sales in US Business: n n n Paper and wood products Packaging products Paper merchant services (newly added in 2002) Forest management of 22 million acres in Canada and US Listed on Toronto & New York Stock Exchanges (DTC. TO & DTC. NY) n Medium sized player; market capitalization of just over CDN$3. 5 billion* *[ 227, 680, 352 common shares x (CDN$17. 8 + $13. 5) / 2 ]
-Highest net sales in 3 yrs, but similar profit as in 2001 (due to low selling prices) -High debt-to-capital ratio due to mill acquisitions in 2001 -High FCF (CF from op activities – net addition of property, plant, equipment) due to increased sales from newly acquired mills
1. Financial Statement
Net Sales/Production Net Sales 23. 6% in Canada, 72. 4% in US Properties 51. 6% in Canada; 47. 9% in US So, around 24. 5% sales is subject to FX risk (CDN$/US$)
Net Sales/Production n Paper (59%) n n n Packaging (11%) n Prod: 50% in US Sales: 85% in US n n Joint venture; own 50% of Norampac Canada, US, Mexico, France Paper Merchants (22%) – – Canada: 8 branches US: 20 branches Newly added in 2002 Paper used to be 82% n Wood (8%) n n Prod: All in Canada Sales: 57% in US
Financing Expenses
2. Balance Sheet
Balance Sheet
3. Cash Flow Statement
Cash Flow Statement
Sensitivity Analysis
Sensitivity Analysis Only hedge 20%
Risk and Uncertainties 1. 2. 3. 4. 5. 6. Product Prices Operational Foreign Exchange Interest Rate Liquidity (not mentioned explicitly as risk) Credit
1. Product Price Risk Management n Product Prices Risk n Factor of market demand supply n Associated with certain products only—Northern Bleached Softwood Kraft (NBSK) pulp, semi-chemical medium paper, purchases of old corrugated containers and electricity Management: n Enter cash settled commodity swap
Product Price Risk Management Amount Time Period Net Unrealized Gain NBSK Pulp 1, 500 tonnes/ month Nov 2002 - CDN$ 1 Million Oct 2005 Linerboard 98, 600 tons Semi-Chemical Medium Paper 14, 500 tonnes Corrugated Container 439, 850 tonnes Electricity 161, 630 megawatts 2003 -2007 Loss CDN$1 Million
2. Operational Risk Management n Operational Risk n n n Changes in energy (natural gas and crude oil) and other raw material prices, competition, performance of key suppliers and distributors, renewal of collective agreements, regulatory risks, successful integration of new acquisition, retention of key personnel and reliability of information system. Compliance to environmental law Changes in trading regulations. E. g. . lumber export duties to the US.
Operational Risk Mgmt n Natural Hedging n Product Diversification n n Efficient Cost Management n n Paper (59%), wood (8%), paper merchants (11%), and packaging (22%) 2001, add 4 pulp & paper mills in US 2002, shut down 3 high-cost paper machines in US 2002, permanent closure of 2 lumber mill in Canada Vertical Integration n n Manage owned (26, 500 ha) and leased forests Own paper merchants as distribution channels
3. Foreign Exchange Risk Mgmt n Foreign Exchange Risk n Approximately 24. 5% of sales are in US$ denominated from Canadian operations weak US$, low sales value Management: n Use natural hedging n n US$ denominated debt = hedge of US$ investments and US$ income streams Use options and forwards contracts to stabilize anticipated future net cash inflows denominated in U. S. dollars. n Only around 4% of the total sales are hedged this way.
Foreign Exchange Risk Mgmt n Natural hedging: n long-term debt denominated in foreign currency = hedge of net investment in foreign subsidiaries
Foreign Exchange Risk Mgmt Put option n Call option Options and Forwards
4. Interest Rate Risk Management n Interest Rate Risk n Risk related to changes in interest rate on debt payment
Interest Rate Risk Management Total 2, 815 • Fixed interest rates for LTD varies between 7. 875% to 10. 85%
Interest Rate Risk Management
Interest Rate Risk Management n Interest rate swap on CDN$956 Million Receive average 4. 45% fixed on CDN$956 M until Oct ‘ 06 Financial Institution Pay fixed 2. 48% on C$478 M to Oct ‘ 02 then 3 -m LIBOR to Oct ‘ 06 Pay fixed 3. 16% on C$478 M to Oct ‘ 03 then 3 -m LIBOR to Oct ‘ 06 Domtar Pay 7. 875% fixed on CDN$956 M to Oct ‘ 11 Creditor
Interest Rate Risk Management n Swap terminated (prior to maturity) Nov 2002 Receive average 4. 45% fixed Financial Institution + CDN $51 M NET GAIN + CDN $40 M Domtar - CDN $11 M Pay 2. 48/3. 16/LIBOR Net gain CDN $40 applied to financing expenses: (Cdn GAAP) 2003 C$ 4 M 5. 3% 2004 C$ 13 M 17. 3% 2005 C$ 13 M 17. 3% 2006 C$ 10 M 13. 3% Pay 7. 875% fixed on CDN$956 M to Oct ‘ 11 Creditor
5. Liquidity Risk Management n Liquidity Risk principal liquidity requirements are for WC, Capex, and principal and interest payments on debt. n fund primarily with internally generated funds from operations, through borrowings under revolving credit facility, and through the issuance of debt and/or equity. n no explicitly-stated minimums n
Liquidity Risk Management Operating leases for plants and equipments n Off-balance sheet arrangements: n n Securitization n Sell a portion of Cdn and US A/R through securitization programs n As of Dec 31, 2002, the value of securitized receivables CDN $264 M. (2001: $238 M)
6. Credit Risk Management n Non-performance of customers’ accounts receivable n n n Reviews new customers’ credit histories before granting credit Conducts regular reviews of existing customers’ credit performance Non-performance by counterparties to its financial instruments: n n n Entering into contracts with counterparties that are believed to be of high credit quality. The credit standing of counterparties is regularly monitored. Collateral or other security to support financial instruments subject to credit risk is usually not obtained
Compensation 1. 2. 3. Executive Stock Options Executive Share Purchase Rights Deferred share unit plans n n 4. Outside directors Executives Employee Share Purchase Plan
1. Executive Stock Options n Options may be granted to selected executives. n price = market value on the day immediately preceding the date the options were granted n generally expire 10 years after the date of the grant
1. Executive Stock Options n Most recent grant Q 2 2001 n n 1, 050, 000 options expire in 7 years (June 2008) become fully vested January 1, 2004 Options become exercisable when: • DTC: TSE : $16. 70 (25%), $18. 51 (50%) or $20. 32 (100%) for 20 days • • AND DTC shares have outperformed S&P U. S. Paper & Forest Products index
Executive Stock Options Note: 227, 680, 352 total outstanding common shares
Executive Stock Options Note: 227, 680, 352 total outstanding common shares
2. Executive Share Purchase Rights n n Rights may be granted to selected executives. Authorized issuance under the plan The rights allow eligible employees to purchase shares at 90% of the quoted market value on the day immediately preceding the date the rights were granted Actual issued under the plan Total common shares outstanding 11, 300, 000 4, 301, 071 227, 680, 352
3. Deferred Share Units (DSU) Plan n Available to eligible outside directors and executives n n Since the inception of the plan, 137, 006 DSU have been issued for outside directors For executives: 82, 110 DSU.
4. Employee Share Purchase Plan n All employees are eligible to purchase common shares at a price of 90% of the quoted market value. Authorized 5, 050, 000 Shares purchased under the Canadian plan are subject to a mandatory twelve-month holding period. Issued 3, 591, 862 If held for 18 months, receive shares worth 10% of original purchase Total common shares outstanding 227, 680, 352
Risk Management Structure n Risk management is a part of Treasury Department. n n 2 employees are directly involved in risk management 5 additional employees are indirectly involved.
Remarks n n Expected to see more financial risk management, esp. from Weyerhaeuser Foreign exchange risk management n n vast majority of Weyerhaeuser’s sales & assets in US Domtar has a much larger percentage of its sales & assets in US
Remarks n Interest rate risk management n n appears both companies view fixed interest rates on LT debt as significant component in risk management minimal interest-bearing revenues
Remarks n Credit & counterparty risk management n n important to both companies Liquidity risk n “judicious management of maturing shortterm debt and the structure of long-term debt”
Remarks n Natural hedging important to both companies n n n vertical integration Domtar: matching assets with same-currency debt Apparent feeling that investors are aware of and assume some risk e. g. forex risk
Remarks n Poor reporting n n at first glance, seems to indicate lack of sophistication, awareness Appears both companies are concentrating on operations n “bigger fish to fry”
Recommendations for Weyerhaeuser n Current focus on debt reduction should not ignore exposures to other risks such as FX
Recommendations for both n n n Pay greater attention to hedging input prices esp. energy Pay greater attention to indirect effects of changes in risk factors e. g. exchange rate changes that result in changes in sales Improve reporting!
The End
References n n n n International Council of Forest and Paper Associations (2000). The forest and paper industry on its way to sustainability. Retrieved February 10 th, 2004 from www. icfpa. org. Price. Waterhouse. Coopers (2003). Global forest and paper industry survey. Retrieved February 20 th, 2004 from www. fpac. ca/english/news/public. htm XI World Forestry Congress. (1997). Demand forest products, consumption patterns and marketing. Proceedings of the XI World Forestry Congress, Volume 4. Forest Products Association of Canada (2003). 2003 Annual Review. Retrieved February 10 th, 2004 from www. fpac. ca/english/news/public. htm. New Weyerhaeuser RM had to fight hard for job Katz, David M. National Underwriter (Property & casualty/risk & benefits management Erlanger: Oct 23, 1995. Vol. 99, Iss. 43; p. 33 (1 page) management ed. ). Baxter manages a smooth transition during mergers Roberto Cenicerrs. Business Insurance. Chicago: Apr 30, 2001. Vol. 35, Iss. 18; p. 92, (1 page) Baxter won’t place all his business in one basket Roberto Cenicerrs. Business Insurance. Chicago: Apr 30, 2001. Vol. 35, Iss. 18; p. 90, (1 page)
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