Koch: is it the real thing?

When I first heard the news that privately-held Koch Industries (pronounced "coke") had agreed to purchase Georgia-Pacific Corp., I thought that there must have been a misprint. Surely it was the other way around, with G-P purchasing Koch. Nope. In what amounts to a financial earthquake in the paper industry, Koch Industries is buying G-P and taking it private. The acquisition will make Koch the largest privately-held company in the United States, with annual revenues of around $80 billion. Koch, based in Wichita, Kansas, says it will continue to operate G-P from Atlanta under its current name and manage it as a separate entity.

While I knew about Koch Industries through its earlier acquisition of some of G-P's pulping assets, I had no idea how large the company was. Turns out I am not alone, since Koch Industries has consciously tried to keep a low profile. That's quite an accomplishment, considering that the company has major interests in a diverse group of industries, including oil refining, cattle ranching, asphalt production and carpet manufacturing.

Most industry observers think that this deal is a good thing, and I'm inclined to agree. Koch says it was impressed with Georgia-Pacific following its earlier acquisition of G-P's non-integrated market and fluff pulp operations at New Augusta, Mississippi, and Brunswick, Georgia in May 2004. Since the purchase, Koch has invested in these businesses, which have been operating as Koch Cellulose. These operations will be reintegrated with G-P businesses.

Koch Industries thinks that its private ownership of G-P will allow for capital investments that might well have been effectively vetoed by public shareholders. For example, G-P may now be able to put more money into its building supply businesses and packaging operations.

This makes intuitive sense, since the United States is such an unforgiving climate for industrial investment. Due to the oddities of our tax system, while the U.S. has a much lower effective overall tax rate than other Western countries, capital investment is still taxed more aggressively in the U.S. than in countries it competes with. Coupled with a climate where U.S. paper companies are punished by the stock market for making any kind of major investment, these companies are undergoing serious asset deterioration at the same time foreign competitors are building bigger and better paper mills.

For example, Europe encourages industrial investment through more favorable depreciation schedules. The U.S. paper industry's biggest emerging competitor--China--has a system where the government effectively is the banking system, and is currently offering funding for pulp and paper projects at low, low interest rates. It's no surprise that U.S. firms are behind the eight ball, and it's also no surprise that they may benefit from private ownership.

After all, the steady, relatively predictable, and large cash flows from pulp and paper operations should be attractive to private companies. Without having shareholders staring over their shoulders, Koch/G-P should be able to make the investments needed to modernize their facilities and keep them more competitive amidst the intensifying competition from modern mills in China, Latin America, and Europe. Indeed, there are already predictions that other large paper companies may follow suit and go private. The paper industry is well known for playing follow-the-leader, so if one big company like G-P is willing to take the plunge, others will undoubtedly consider making the same move.

According to Mark Wilde of Deutsche Bank Equity Research, more private deals in the paper industry appear inevitable. He expects private buyers to have major roles in the restructurings of several major companies, or buy assets directly if companies decide to exit large parts of their current businesses.

Wilde points out that overall valuations of paper companies are often less than the perceived value of their individual parts. For example, timberland valuations have skyrocketed in recent years but paper company valuations have not. Also, private companies--as in the Koch Industries/G-P deal--see the potential to improve performance and reduce costs in the acquired businesses.

Still, Wilde points out that there are risks for any investor, public or private. Consumption trends in many paper and board grades have been down since 2000 and both foreign competition and product substitution remain major threats. But if companies believe that at least certain paper grades and products have a solid future--which they most certainly do--it makes sense for savvy buyers to snap up available assets and extract their inherent value.

ALAN ROOKS 

Editorial Director

Contact Alan at [phone], or by e-mail at: [e-mail]

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