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Forest Products Industry
Chris Cook
Insoo Park
Elizabeth Juwono
Rachel Zhu
Evan Vahlas
Agenda Industry Analysis Risks Faced Weyerhaeuser Company Domtar Inc.
Industry Analysis Forest Products Industry
Produces primary products valued at US$850 billion/year (PriceWaterhouseCoopers, 2003)
Global reach Mature, capital intensive and cyclical industry Highly competitive
Comprised of thousands of small and large enterprises
Industry Trends Oversupply of forest products in every industry
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:
China Russia
Top Industry Performers
Source: PWC, 2003
Lumber & Wood Products
Roundwood Products Industrial Roundwood Fuelwood
Mechanical Wood Products Sawnwood Wood based panels
Global consumption of wood products: 767 million m3 (ICFPA, 2002)
Products
Fuelwood
33%
28%
Industrial Roundwood
Sawnwood
36%
3% Wood-Based Panels
World Wood Production (by volume)
Products Pulp & Paper Products
Wood pulp Paper Paperboard
Global consumption of paper products: 323 million tons (ICFPA, 2000)
Global consumption of wood pulp: 150 million tons (ICFPA,2000)
Substitutes: steel, aluminum, plastics
Paper & Paperboard
64%
Wood Pulp
36%
World Pulp & Paper Production (by weight)
Raw Material Evolution Natural Forest or Forest Plantations
RoundwoodSale of whole unprocessed logs
Wood Chips Mechanical Wood
Products
Paper Pulp
World Consumption of Forest Products
Source: XI World Forestry Congress, 1997
Sales Growth Demand and sales growth of lumber & wood
products are closely correlated with construction, primarily residential construction (ICFPA, 2000)
Demand and 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 Approximately 35% of
forest and paper products are traded internationally (ICFPA, 2000)
Canada is the world’s leading exporter US$43 billion in wood,
pulp & paper per year (FPAC, 2003)
Revenue Structure Major sources of revenue:
Raw materials (logs, chips, timber) Manufactured forest products Interest income Proceeds from sale of property & equipment Proceeds from sale of timberlands
Cost StructureMajor Expenses % of Total ExpensesCost of Products Sold 85%Depreciation, Amortization & Fee Stumpage 6%Selling Expenses 7%Other: 2% Plant Closure and Integration Costs Research & Development
Interest Expense: 4-5% of total sales revenue Major expenses compose 90-95% of total sales
revenue
Firm Strategy for Future Growth Problem: Overcapacity
Lumber-mill capacity has increased at a rate of 2.25 times that of demand (Weyerhaeuser, 2002)
Future firm objectives Close inefficient facilities and higher-cost producers Streamline operations
Decrease operating costs Optimize manpower utilization Increase operating efficiencies More consistent production
Regulatory Environment Sustainable Forest Policy
Conservation of biological diversity Maintenance of the productive capacity of
ecosystems Maintenance of forest ecosystem health and vitality
International trade tariffs Paper tariffs: Range from 0-2% Wood tariffs: Range from 0-22%
Regulatory Environment Country-specific environmental regulations
Supported by national forest products associations
International Council of Forest and Paper Associations 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
Types of risks faced How they are measured How they are managed Conditions promoting active risk
management Potential hazards in active risk management
Commodity Risk (Price Risk)
Changes in prices of the products of the company
Demands for forest products are cyclical
Pulp and paper industries are notorious for price volatility
Major Risks: General Business
Major Risks: General Business Commodity Risk (Supply Risk)
Adequate and timely supplies of raw material are critical
Especially wood, energy and chemicals
Dependence on a few key suppliers is risky, but often necessary Constrained by availability, locality, price, quality, etc.
Measuring Commodity Risk Measured by sensitivity analysis
Techniques & Products to Manage Commodity Risk
Forward Contracts Commodity Futures Commodity Swaps
Natural Hedging Product Diversification Efficient Cost Management Vertical Integration
Major Risks: General Business Project Risk
Risk of investing in specific projects, ventures or companies
Can depend on many factors Demand conditions Poor management Local political/economic environment
Measured by expected cash flow analysis and managed with efficient resource allocation
Major Risks: Financial
Interest Risk
The risk that market borrowing rates may rise
Forest industry typically finances incremental capital
investment with operating cash flow 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
Interest rate futures and forward rate agreements
Interest rate swaps
Option products
Major Risks Foreign Exchange Risk
Assets and liabilities in foreign currency Also known as balance sheet risk
Sales and purchases in foreign currency Also known as transaction risk
Especially relevant to international firms Global production facilities and customers Large mismatch between revenue and cost
Foreign Exchange Risk
Sensitivity analysis can show the extent of exposure 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 Futures Hedge
Currency Options
Others Cross-Currency Hedging Invoice Currency Hedging Currency Diversification Natural Hedging (Exposure Netting)
Plant locations Borrowing from foreign sources
Credit Risk Possibility of customers defaulting on accounts payable A company typically set internal credit ratings of its customers to
measure exposure
Funding Risk/Liquidity Risk 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
Major Risks: Financial
Techniques & Products to Manage Credit & Funding Risks
Thorough Analysis of Customers Letters of credit Bank guarantees Credit Insurance
Coordinating Debt Maturity Requirements for minimum cash reserves
Major Risks: Others
Operational Risk Damages and Liabilities Transportation Physical Delivery of Goods
Political & Legal Risk National political stability Relationship with local government Tariffs and trade feuds Environmental regulations
Available Techniques & Products
Insurance General Liability Shipping Environmental
Strong internal controls over operation Scenario-building Lobbying
Factors Promoting Active Risk Management
Many of the major risks faced can be hedged Interest, Foreign Exchange and Commodity
Many leading companies are large and/or multinational 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
Most forestry companies are not diversified
Wood, pulp and paper products are mostly homogenous and thus price sensitive
Industry is heavily influenced by business cycles
Input & output prices are volatile
Potential Hazards from Risk Management Activities
High costs of purchasing derivative products Takes away from the bottom line Can cause liquidity problems
Potential Losses from Hedging Inability to capitalize on favourable risks Competitive disadvantage
Random Walk Nature of Risk? 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 Incorporated in Washington in 1900
Engaged in the growing timber; the manufacture, distribution and sale of forest products; and real estate
Corporate strategy: vertical integration
Worldwide company serving domestic and international market
Has access to 42.7M acres of forestland
Financial Situation Increased net sales and revenues by 27%
Increased total asset by $1B
Increased operating income by 40%
Decreased net earning by 32% and earning per share from $1.61 to $1.09
Increased 3 times as much as interest expenses compared with 2001
Revenue Source
Cost structure
Interest Expenses
Major Risks faced Economic and Market risk Political risk Financial risk
Increasing debt (interest) risk Interest-bearing debt by $7.6M , debt to
capital ratio from 37.7% to 55.6% Commodity price risk Foreign exchange risk
Foreign exchange transaction (gains) losses
Derivatives used to: 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 Forward contracts Commodity swaps (notional value of
$54M) Commodity futures Interest swap (notional value of $50M) Investment swap (notional value of
$160M, exposure size $7M)
Designated and non-designated hedges for managing financial risks
Designated
FX contracts Commodity contracts
Non-Designated
Variable rate swap agreement
Variable-to-fixed interest rate swap agreement
Lumber and other commodity futures
Implementation of FAS 133
Increased liabilities by approx. $24 M
Increased assets by approx. $37 M
Net offsetting amount of $13 M in cumulative other comprehensive loss
Long-Term Incentive/ Compensation Plan
For certain key officers, other employees, and its subsidiaries
The common share will increase by 22M resulting from exercising all options
Executive officers’ Long-term incentive plan (2-yr time limit)
Extra Information on Company’s Risk Management
Gary A. Baxter, the director of insurance and assistant treasurer for the company
Insurance department developed Long-term relations with insurers, brokers and other vendors
4 brokers in different areas and fee-based rather than commission-based payment to brokers
Insurance purchased: Excess casualty, joint venture liability, director and officers liability, wrap-up program coverage, aircraft and hull liability, excess crime, etc.
Has purchased risk management software to manage some of their trading risks.
Domtar Inc.
Company Profile
Canadian company, with majority of sales in US Business:
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)
Medium sized player; market capitalization of just over CDN$3.5 billion*
*[ 227,680,352 common shares x (CDN$17.8 + $13.5) / 2 ]
-Highest net sales in 3 yrs, but similar profit as in 2001 (due to low selling prices)
-High debt-to-capital ratio due to mill acquisitions in 2001
-High FCF (CF from op activities – net addition of property, plant, equipment) due to increased sales from newly acquired mills
1. Financial Statement
Net Sales 23.6% in Canada, 72.4% in US
Properties 51.6% in Canada; 47.9% in US
So, around 24.5% sales is subject to FX risk (CDN$/US$)
Net Sales/Production
Net Sales/Production
Paper (59%) Prod: 50% in US Sales: 85% in US
Paper Merchants (22%)– Canada: 8 branches– US: 20 branches– Newly added in 2002– Paper used to be 82%
Packaging (11%) Joint venture;
own 50% of Norampac Canada, US, Mexico, France
Wood (8%) Prod: All in Canada Sales: 57% in US
Financing Expenses
2. Balance Sheet
Balance Sheet
3. Cash Flow Statement
Cash Flow Statement
Sensitivity Analysis
Sensitivity Analysis
Only hedge 20%
Risk and Uncertainties
1. Product Prices
2. Operational
3. Foreign Exchange
4. Interest Rate5. Liquidity (not mentioned explicitly as risk)
6. Credit
1. Product Price Risk Management Product Prices Risk
Factor of market demand and supply
Associated with certain products only—Northern Bleached Softwood Kraft (NBSK) pulp, semi-chemical medium paper, purchases of old corrugated containers and electricity
Management: Enter cash settled commodity swap
Product Price Risk ManagementAmount Time
PeriodNet Unrealized Gain
NBSK Pulp 1,500 tonnes/ month
Nov 2002 - Oct 2005
CDN$ 1 Million
Linerboard 98,600 tons
2003-2007 Loss
CDN$1 Million
Semi-Chemical Medium Paper
14,500 tonnes
Corrugated Container
439,850 tonnes
Electricity 161,630 megawatts
2. Operational Risk Management
Operational Risk Changes in energy (natural gas and crude oil) and other
raw material prices, competition, performance of key suppliers and distributors, renewal of collective agreements, regulatory risks, successful integration of new acquisition, retention of key personnel and reliability of information system.
Compliance to environmental law Changes in trading regulations.
E.g.. lumber export duties to the US.
Operational Risk Mgmt
Natural Hedging Product Diversification
Paper (59%), wood (8%), paper merchants (11%), and packaging (22%)
Efficient Cost Management 2001, add 4 pulp & paper mills in US 2002, shut down 3 high-cost paper machines in US 2002, permanent closure of 2 lumber mill in Canada
Vertical Integration Manage owned (26,500 ha) and leased forests Own paper merchants as distribution channels
3. Foreign Exchange Risk Mgmt
Foreign Exchange Risk Approximately 24.5% of sales are in US$ denominated from
Canadian operations weak US$, low sales value
Management: Use natural hedging
US$ 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.
Only around 4% of the total sales are hedged this way.
Foreign Exchange Risk Mgmt
Natural hedging: long-term debt denominated in foreign currency = hedge
of net investment in foreign subsidiaries
Foreign Exchange Risk Mgmt Options and Forwards
Put option
Call option
Interest Rate Risk Risk related to changes in interest rate on debt
payment
4. Interest Rate Risk Management
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 Interest rate swap on CDN$956 Million
Financial Institution
Domtar
Creditor
Receive average 4.45% fixed on CDN$956M until Oct ‘06
Pay fixed 2.48% on C$478M to Oct ‘02 then 3-m LIBOR to Oct ‘06
Pay fixed 3.16% on C$478M to Oct ‘03 then 3-m LIBOR to Oct ‘06
Pay 7.875% fixed on CDN$956M to Oct ‘11
Interest Rate Risk Management Swap terminated (prior to maturity) Nov 2002
Financial Institution
Domtar
Creditor
+ CDN $51 M
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$956M to Oct ‘11
- CDN $11 M
Receive average 4.45% fixed
Pay 2.48/3.16/LIBOR
NET GAIN + CDN $40 M
5. Liquidity Risk Management Liquidity Risk
principal liquidity requirements are for WC, Capex, and principal and interest payments on debt.
fund primarily with internally generated funds from operations, through borrowings under revolving credit facility, and through the issuance of debt and/or equity.
no explicitly-stated minimums
Liquidity Risk Management
Operating leases for plants and equipments Off-balance sheet arrangements:
Securitization Sell a portion of Cdn and US A/R through
securitization programs As of Dec 31, 2002, the value of securitized
receivables CDN $264 M. (2001: $238 M)
6. Credit Risk Management Non-performance of customers’ accounts receivable
Reviews new customers’ credit histories before granting credit Conducts regular reviews of existing customers’ credit
performance
Non-performance by counterparties to its financial instruments: 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. Executive Stock Options
2. Executive Share Purchase Rights
3. Deferred share unit plans Outside directors Executives
4. Employee Share Purchase Plan
1. Executive Stock Options
Options may be granted to selected executives.
price = market value on the day immediately preceding the date the options were granted
generally expire 10 years after the date of the grant
1. Executive Stock Options
Most recent grant Q2 2001 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
Rights may be granted to selected executives.
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
Authorized issuance under the plan
11,300,000
Actual issued under the plan
4,301,071
Total common shares outstanding
227,680,352
3. Deferred Share Units (DSU) Plan
Available to eligible outside directors and executives 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 All employees are eligible to
purchase common shares at a price of 90% of the quoted market value.
Shares purchased under the Canadian plan are subject to a mandatory twelve-month holding period.
If held for 18 months, receive shares worth 10% of original purchase
Authorized
5,050,000
Issued
3,591,862
Total common shares outstanding
227,680,352
Risk Management Structure Risk management is a part of Treasury
Department. 2 employees are directly involved in risk
management 5 additional employees are indirectly
involved.
Remarks Expected to see more financial risk
management, esp. from Weyerhaeuser Foreign exchange risk management
vast majority of Weyerhaeuser’s sales & assets in US
Domtar has a much larger percentage of its sales & assets in US
Remarks
Interest rate risk management appears both companies view fixed interest
rates on LT debt as significant component in risk management
minimal interest-bearing revenues
Remarks
Credit & counterparty risk management important to both companies
Liquidity risk “judicious management of maturing short-
term debt and the structure of long-term debt”
Remarks Natural hedging important to both
companies 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 Poor reporting
at first glance, seems to indicate lack of sophistication, awareness
Appears both companies are concentrating on operations “bigger fish to fry”
Recommendations for Weyerhaeuser
Current focus on debt reduction should not ignore exposures to other risks such as FX
Recommendations for both
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 International Council of Forest and Paper Associations (2000). The forest and paper
industry on its way to sustainability. Retrieved February 10th, 2004 from www.icfpa.org.
PriceWaterhouseCoopers (2003). Global forest and paper industry survey. Retrieved February 20th, 2004 from www.fpac.ca/english/news/public.htm
XI World Forestry Congress. (1997). Demand for 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 10th, 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)