How wide is the technology gap? Curbing capital expenditure can be good for short-term profitability, but there is a price to pay for under-investment.

In an increasingly global industry, "cultural" differences remain. Language, geography, "standard" business practices, accounting treatments, and consumer preferences have all presented their own particular challenges for pulp and paper companies. But some cultural trends have a greater impact than others.

One of the most interesting examples of a "culture gap" currently being squeezed can be found in the differing approaches to capital expenditure between European and North American pulp and paper companies. This is especially true of new paper machine investments.

History--moderately recent history, at least--shows that North American groups have been trailing their European counterparts in major capital investment. There are a large number of reasons for this: a closer focus on quarterly results in North America versus the more long-term approach generally taken in Europe, a skew toward environmental investment in the United States because of the Cluster Rule, differing consumption patterns, and simple currency movements. But whatever the exact reasons, a large asset quality gap has clearly emerged between North America and Western Europe. This gap is being driven wider by the respective business cultures of the two regions.

GAP YEARS

Illustrating the point is a quote from a senior executive at one of the industry's top equipment supply companies who preferred not to be named. "In my opinion, the difference is so big that you could say that there is something like a seven or eight year technology gap between IP [International Paper] and UPM-Kymmene."

Others suppliers have even noted that such estimates might be on the conservative side. Pointing to the older, slower machines with far more limited wire widths found across North America, one supplier said, "Is that all? I would have put it at more like 10 years."

The top representative of one European supplier based in the United States said, "If you go back in history some 15 or 20 years ago, North America was definitely the leader in its technology and installed equipment base. That has shifted totally. North American paper companies are now totally focused on the stock market and driven by quarterly results, so the long term planning you see in Europe is not the case here. But you can't really blame them. Being stock market driven, if a company announces a major investment, Wall Street reacts straight away and the stock goes down. That [lack of investment] may be okay in the bad times, but if it is kept up for too long then clearly the installed base deteriorates. Honestly, I don't see that situation changing all that much."

Clearly, this is a sensitive area for paper machine and equipment suppliers. None of them dispute that they have a vested interest in pointing out the potential efficiencies created by upgrading a company's asset base and none of them have any doubt that North America is lagging well behind in terms of asset quality. Equally, they do not want to upset their North American customers by publicly stating just how had the situation is at any given group. But in some respects, the attitude of suppliers toward their North American customers is characterized more by sympathy.

Particularly for Europeans working in the United States, they see old equipment that should be ripe for replacement, but no apparent business imperative to upgrade. At the same time, the suppliers also see people in the mills working flat out to get the best production levels possible from "outdated" equipment.

Several suppliers noted that, in some cases, mills have fallen so far behind that it might be all but impossible for them to be viable ever again. As a result, they see several of their customers engaged in running the machines down until they are so uneconomic that they are forced to close permanently.

Suppliers are well aware that these companies are under severe pressure. "There is of course a big distinction between production efficiency and financial efficiency," another supplier explained. "Generally speaking, the operational efficiency of the North American mills is not bad, and in some companies there's a real focus on maximizing machine efficiency But over time, if you don't invest in wider, faster machines, you'll simply be left behind. Of course, if financial efficiency is the focus, then companies that concentrate on quarterly results will just want to 'milk' the assets until there's nothing left, and we're seeing that too."

STATING FACTS

European paper companies are equally wary of making better or worse comparisons between the business imperatives of European and North American groups. Still, there is little doubt that they feel very comfortable in acknowledging the asset quality gap.

As the chief financial officer of UPM-Kymmene, Kari Toikka, pointed out, "we all know paper companies in Western Europe are much more modern and use the latest technology. Maybe that is because the North Americans focus on short-term quarterly profits, but our view is that the investments are long term, even if that means you have to look at the returns for a decade at least."

Perhaps the results tell the story best. "We are seeing the best efficiency and profits through long term investment, whereas Americans are seeing higher operating costs," Toikka said.

Another European executive familiar with the North American market is Jan Oksum, deputy CEO of Norske Skog and the group's senior vice president of strategy. "I am only limiting this to the publication papers area where we are most involved, but it's clear that Europe has many more wider, faster paper machines than North America. The difficult part is defining what we mean by efficiency, if you define it as output per mill, then wider, faster machines will produce a better result. But if you define efficiency as what you can get out of a machine depending on its age, etc., then that's a different issue, so here the organization's ability to get higher efficiency out of a particular machine is very important."

Oksum also pointed out that consumption patterns have played an important part in slowing investment in North America versus Europe. He notes that North American newsprint consumption has declined, "so it's not that surprising they haven't been investing. My gut feeling is that, unless we see some growth in those markets, we are unlikely to see growth in capital expenditure."

NEXT QUESTION

While few would dispute that an asset gap exists, does the gap matter? After all, IP's price-to-earnings ratio has stood far higher than UPM-Kymmene's in recent years, so if the market is to be believed, then IP's approach must be correct. It also implies that the cash flows generated by the "old" assets of IP are worth more than the cash flows generated by the "modern" assets of UPM-Kymmene. Added to the exchange rate issues, this presents a huge obstacle for European companies looking to make acquisitions in North America.

Said Oksum, "The amount of capital tied up in U.S. companies is lower, so even if we want to grow there we should not want to pay a lot for North American capacity. But paradoxically, they tend to have higher price-to-earnings ratios."

That note was echoed by Toikka. "In general, the valuations are too expensive. The value-to-asset quality is too high and the price is further increased by the exchange rate. In the long term though, we are interested in strengthening our position in the North American magazine paper market. We are already the biggest in the world in this segment. We have a relatively strong position in Europe and of course we are not so strong in North America, but our long-term strategy is definitely to improve that."

So while both companies are keen to see their market shares grow in North America, the stumbling blocks are obvious--the combination of exchange rate effects and relatively higher price-to-earnings ratios are hampering further market penetration. The question is, if the market is "logical," then why should this be the case? In fact, the question is perhaps even more complex than it first appears and unraveling the tangle of issues around the topic raises as many questions as answers.

For example, modern assets should be more efficient, but which measure of efficiency is most relevant to a benchmarking exercise examining the asset quality gap-output quality measures such as brightness, strength and smoothness, or tons produced per worker, or output cost per ton produced? One supplier suggested that workers per ton better underlines the technology gap. "Looking at how many people are employed in North American mills, it's easy to see that they're closer to sheet fed papermaking than the Europeans," he said.

Timo Suhonen at the consulting group Jaakko Poyry noted, "It's quite difficult to say exactly, but the general feeling is that the machines in North America are far behind those in Europe. If they were giving out world prizes for quality, then Europe would certainly come first and second prize would go to North America. But looking at operational efficiency, the difficult part is that the current benchmarks used in the two regions are not comparable. For example, just the way they measure capacity means that capacity utilization rates are always higher in North America because they use a different definition for machine capacity."

CAPITAL EQUATION

On the face of it, one of the most useful measures available to help look at the asset quality gap should be return on capital employed (ROCE) and here Suhonen noted an interesting trend. In the early part of the 1990s, ROCE was generally better in North America than in Western Europe, he reported; but in recent years, the situation has been reversed with higher ROCE ratios witnessed in Europe.

North American groups initially benefited by keeping machine investment levels at or below depreciation, but the strategy has been carried too far. As a result, operational inefficiencies created by running older equipment in North America are putting Europeans in the lead on this measure.

As Suhonen is quick to point out, though, "It could be that this scenario is correct, but there's not a lot of direct evidence available to confirm that based on these points. It's not a bad hypothesis, but there's just no way to be sure without carrying out a large study. There are a lot of moving parts in the equation. Whether it is down to asset quality we can't confirm, but circumstantial evidence gives some reason to believe it may be true."

In the future, will European companies become more focused on quarterly results and shy away from large investment projects, or will North American groups opt for the improvements in operational efficiency offered by a more modern asset base? In other words, is it now time for North American companies to start spending to improve the installed equipment base?

FORWARD LOOKING

Clearly, European companies still have a relatively small percentage of the total North American output, so it would be surprising if their influence were being felt strongly at this time. On the other hand, there is some evidence that European companies may be paying more attention to the capital markets than previously.

As Suhonen explained, "If you look at the history of North American firms versus European companies in terms of depreciation and fixed asset investment, you can see that, in the Nordic countries, that gap as a percentage of sales has narrowed. In the 1980s, Nordic investment as a percentage of sales was much higher, but today it is more in balance. North America has gone on that path longer than Europe, so it could be that they need to invest to improve efficiency."

According to one European executive, the convergence between European capex (capital expenditure) levels and those found in North America may have more to do with European companies reining in their exuberance. "It's fair to say there has been over-investment in Europe with not much in the way of earnings to show for it," he pointed out. "So certainly, it could be argued that there has been a lack of attention to the capital markets in Europe in the past and maybe now we're coming more to equilibrium."

Anyone who has heard speeches by Michael Smurfit in recent years will certainly recognize that sentiment, although the Jefferson Smurfit chairman usually expresses the point in stronger terms.

NOT QUITE SIMPLE

For his part, UPM-Kymmene's Toikka points to other reasons for the higher equipment expenditure in Europe and today's trend toward lower capex. "In recent years, there have been more growth opportunities in our markets. We've also been more focused on mergers and acquisitions, which has left less cash for capital expenditure. But from time to time you have to modernize the mills."

Toikka is convinced that U.S. capacity must eventually be rebuilt. The sheer scale of North American paper consumption means that paper supply cannot be based on imports to any significant degree--no matter how well low-cost mills produce in Asia or elsewhere.

Quite when that reinvestment will happen--if at all--remains anyone's guess. Recent trends may offer a clue, however. "The U.S. market for equipment sales is the lowest I have seen for many, many years, but conversely, Canada is the best I have seen it for years. Canada has probably gone even longer in not doing investments in the past and has fallen behind quite badly, so maybe they have concluded that they need to modernize their installed base if they are going to stay in the business. Another major factor is that exchange rates are favorable now, of course."

In contrast, a more cynical note from another European executive suggested that Canadian investment had more to do with unsustainable state subsidies than anything else.

At Jaakko Poyry, Suhonen is less confident that U.S. producers have any real financial flexibility As he. pointed out, "It has been popular

for U.S. companies especially to advertise the fact that they're investing less than depreciation, so we're on thin ice. It may be very difficult for North American attitudes to change."

In other words, pulp and paper companies may have painted themselves into a corner. A consensus in the United States seems to be that keeping capex at or below depreciation levels is "a good thing," and any company that defies that convention will be penalized.

Another supplier who has studied recent capex trends closely is even less optimistic about the future of the North American pulp and paper business. "Some U.S. companies are boasting about having capex at less than 50% of depreciation," he said. "You have to question whether they see any future at all for their businesses when they talk like that. It reminds me of the auto and steel industries of the 1950s and 1960s. They were well protected with import tariffs and so on and doing just fine. Along came the Japanese and the Koreans with modern factories and new processes and we all know what happened. At least the U.S. auto industry has changed and tried to compete by installing the latest technologies and manufacturing techniques."

The same supplier points oat that European companies have a greater incentive to maintain high efficiency levels since North America uses most of what it makes whereas Europe produces far more than it consumes.

CHANGING TUNES

In the short term then, it appears that Canadian companies may invest a little, but U.S. companies are not about to start spending any time soon. Across the Atlantic, European executives see only a slight shift in their attitudes, but it is discernible. At Norske Skog, Oksum said, "There is some sense of that coming here [to Europe]. We are much more occupied with the capital markets than we have been in the past, but I don't think the pendulum has swung too far."

Toikka was only slightly less certain the change was significant, though. "I don't see much change. Whether it's due to quarterly reporting or capital market pressure or whatever, it won't change our way of doing business," he stated.

It may not he all that heartening for equipment suppliers looking for an imminent boost in capital expenditure across North America, but it looks as though the status quo will hold ... for the time being. As almost everyone recognizes, though, lack of investment over the long term can mean only one thing--many companies will fail to make it, no matter how well or poorly markets fare in the future.

DOES NEWSPRINT TELL THE TALE?

Two comparisons from the newsprint sector drawn tip by Finnish industry consultant Hannu Oinonen show some interesting results. Oinonen looked at the top 10 machines in Europe and the United States and compared operational results based on 2000 data. "It seems that in newsprint, European companies have a clear lead in terms of production scale and productivity, as well as, in some cases, profitability."

It should also be noted that North American newsprint prices have been higher than Europe's over the last couple of years. The result underlines the difficulty in making meaningful comparisons in terms of "efficiency." As Oinonen pointed out, "Productivity has been counted by simply dividing the year 2000 actual net production by the number of 'effective' production days, and the width of the machine (kg/m/day). This normalizes the production figures so that they are not dependent on the width, Production efficiency is more complicated, and takes into account accidental shutdowns, tail threading, wasted production and similar events that function as minus terms. In this case, 100% time efficiency is running every day, minus public holidays (a situation that does not exist in reality) and 100% production efficiency is defined as no waste production (which equally does not exist)." As stated, machine efficiency and financial efficiency are very different things, but European companies have a clear lead in terms of production scale.

For further information, contact Hannu Oinonen at [e-mail], or refer to his quarterly report.

About the author: Jim Kenny is contributing editor/Europe, for Solutions! magazine, and is based in Brussels, Belgium. He is the former vice president of editorial for Paperloop and today heads his own company, DSI. Contact him by phone at [phone], or by email at [e-mail]

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