Improving capital productivity: the pulp and paper industry must rethink some of its capital expenditure strategies to create more value. Life cycle analysis is a good place to start.

Editor's Note: Previous articles in this series have dealt with the lack of value creation by the pulp and paper industry, the importance of and inter-relationship between manufacturing costs and strategy, and a process to improve operating performance through primarily intellectual capital. This article extends the discussion on improving performance by discussing the role of capital allocation to define a firm's asset and business portfolio.

As previously discussed, the pulp and paper industry has destroyed value over recent years. This is reflected by poor long-term equity market performance, both in relative and absolute terms. For example, $100 invested in the forest products sector in 1992 would have grown to only $106 by January 2001.

The return problem is exacerbated by the industry's extreme appetite for capital. The industry has done a good job of lowering manufacturing costs-reflected by declining real prices-but this has come at the expense of more and more investment. The result is that the pulp and paper industry is commonly accepted as the business with the highest capital intensity, as shown in Figure 1.

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The industry's capital intensity is particularly disconcerting considering that:

* Industry ,growth is slowing to less than GDP 

* Investments are made at the top of the cycle

* Project returns have generally not met expectations

* Investments are generally asset-driven, rather than business-driven

* Capital is spread evenly across businesses and assets, instead of focused allocation by portfolio role and investment type

Industry leadership is reacting to these facts and the criticism from investors and analysts. Capacity expansion in North America has slowed to the lowest level in decades. Capital spending has declined in North America, as well as the world, as illustrated in Figure 2.

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Instead of investing in new capacity or facility reinvestment programs, the leading companies have used funds for consolidation. A sample of top 30 companies globally shows that acquisition spending increased from 3% of sales for the period of 1990 through 1994, to 7% during the period of 1995 through 1998. This has provided top-line growth, at least the potential for massive synergies, and more disciplined supply management.

However, this strategy is causing the further deterioration of North America's mature assets in terms of age, scale and technical attributes relative to many other global regions. This will reduce cost competitiveness, which is already under pressure due to the strong US dollar.

The major issue facing producers is selecting the optimum portfolio of investment projects. Capital planning decisions for reinvestments have more or less implicitly assumed that the existing asset base will be sustained regardless of competitive pressure and margin erosion, and hence the remaining life of the assets. If production assets are treated as institutions with infinite life spans, the justifiability of the cost of staying in business with the existing asset base is not considered critically enough.

LIFE CYCLE AWARENESS

A first step in optimizing capital allocation within a business portfolio is to be cognizant of an asset's life cycle. Figure 3 shows a useful way to visualize this idea. This chart plots capital cost, including the cost of capital, versus manufacturing cost. By adding an appropriate price line, we can quickly determine value creation. When the sum of an asset's capital cost and manufacturing cost exceeds the price, the asset falls to the right of the price line and the asset is destroying value. Conversely, if an asset falls to the left of the price line, it is creating value.

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A new asset will typically have high capital costs, but low manufacturing costs. It may not initially create value, but as its cost of capital declines, it will begin to generate significant value, assuming it can sustain or minimize its loss of competitive cost position. However, over time, it will normally lose competitive position The key to value creation becomes determining if and when capital reinvestment should he made. Examples of typical alternatives, which incidentally are not all good projects, are shown in Figure 4.

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Generally, the industry's common asset-driven approach to capital allocation results in the acceptance of too many individual capital expense projects that ultimately have marginal or no impact on a firm's long-term value creation. With inadequate means of matching top-down and bottom-up requirements in allocating reinvestment capital, many companies have largely curtailed capital spending for easily identifiable, long-term earnings enhancing investment projects. This will perpetuate the recent return difficulties for the industry.

By establishing best practices in the use of capital funds and by communicating corporate strategy and approach to investment governance, companies can achieve significant results in capital productivity and position themselves favorably in the eyes of investors. Using a transparent capital planning process and strengthening the corporate role can achieve superior capital productivity. Together, these will enable more aggressive capital allocation. While the allocation process should be tailored to the needs of each company, a recommended framework for the process is shown in Figure 5.

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This process balances strategic and business unit considerations and creates transparency in capital planning. It uses tools such as life cycle analysis, competitive benchmarking, business and market environment analysis, and strong project financial analysis (to be discussed in the next article in this series). As a key component in company investment governance, efforts in developing and employing capital planning processes will eventually pay off in improved business performance.

About the author: David Null is associate principal, JP Management Consulting Inc., Atlanta, Georgia. He can be reached by email at [e-mail]