Technology, depreciation, and other matters.

I recently compared the capital spending histories of several pulp and paper companies with their depreciation allowances. The results were wide-ranging but not too surprising. The skimpiest spenders had annual capital expenditure budgets in the range of 65%-75% of depreciation. The most driven and competitive consumer products manufacturers were spending capital of approximately 200% of annual depreciation. Deciding from these figures who is correct is difficult. Both may be.

My favorite television channel in the United States now is CNBC--the financial channel of NBC. Since I am largely a "road warrior," I have recently installed satellite radio in my automobile. Since my radio service carries the audio feed of CNBC, my addiction has increased. CNBC and other Wall Street reporters are constantly talking about "technology stocks." By their definition, these relate to telephony, computers, and computer networking. Every time I hear this reference to "technology stocks," I want to say, "What about us in the paper industry?" After all, building a machine as long as a foot ball field and throwing a 750-mm wide wet web that is only microns thick through it at 60 mph with only a break every two or three days is not exactly chopped liver.

When I was a youth, "technology" involved machine tools, papermaking, and automobile assembly. Telephony involved live operators to complete long distance calls. Governments, universities, and insurance companies had computers. In Cincinnati, Ohio, USA, in the 1950s and 1960s, at least 50 companies made machine tools. Many other Midwestern U.S. cities, big and small, boasted similar technology companies. To my knowledge, Cincinnati now has only two or three machine tool makers remaining.

Machine tools today primarily carry Japanese names. The urban legend around Cincinnati stated the Japanese won the business by setting their sights on acceptable returns lower than the United States companies would tolerate. By selling machine tools at these prices, the Japanese simply had to wait while United States investors pulled their money from machine tool companies due to poor returns--an elimination of competition by corporate suicide. Whether this was actually true, I have no way of knowing. It is certainly a business model fitting the circumstances. It should give us pause in the modern pulp and paper industry.

What is the proper level of dividend reinvestment to keep a paper mill viable and competitive? I suspect the answer does not occur in profit and loss statements and balance sheets but requires much deeper analysis. One needs only examine the makeup of the cost of a paper mill to see this is a complex issue. For instance, the original investment costs of site preparation, pilings, foundations, etc., should require very little reinvestment to keep a mill viable. A big issue of viability--machine width matched to contemporary converting and printing equipment--is unchangeable. The only practical solution would be to level the site and start anew if you suddenly found machine width uncompetitive. The routine replacements of rotating elements (bearings, shafts, etc.) are maintenance items. Therefore, we are left with modernization of unit operations and discrete components of paper machines such as headboxes, formers, and press sections that truly are indications of proper reinvestment.

Even this analysis is not sufficiently deep to determine if you are keeping up technologically. As I have mentioned in previous writings, I was struck a number of years ago by a paper machine I visited that was about to be dismantled. If one examined the history of this machine and reviewed the timing of its original installation and various rebuilds, its life had obviously been continuously marked by having the "last or" everything. When originally installed, it had been the last machine in its grades designed for a certain technology. Through the years, various rebuilds had always been the last installed of the elements being replaced. Despite many millions of dollars spent over time, this machine was never competitive for long. Replacement technology had eclipsed it every step of the way.

As fall comes and your budget preparation season approaches, you should therefore cast a critical eye when determining what your rate of capital spending should be. It is not a formula determined by the vice president of finance. It is also not everything the vice president of technology thinks would be nice to have. In reality, it is probably a long and hard collaboration between finance, technology, and marketing. It may be the most important part of your budgeting process. Do it with care--not with formula.

ABOUT THE AUTHOR: James R. Thompson is Chairman and CEO of Talo Analytic International, Inc., an Atlanta-based consulting company. He is also a member of the TAPPI Editorial Board, Contact him at [e-mail]