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
Products
World Wood Production (by volume)
3% Wood-Based Panels

Lumber & Wood Products
Sawnwood

Roundwood Products



36%
33%
Industrial Roundwood
Fuelwood
Mechanical Wood Products



Fuelwood
Sawnwood
Wood based panels
28%
Industrial Roundwood
Global consumption of wood products: 767 million
m3 (ICFPA, 2002)
Products

World Pulp & Paper Production (by weight)
Pulp & Paper Products
Wood Pulp






Wood pulp
Paper
Paperboard
Paper & Paperboard
64%
Global consumption of paper products: 323 million tons
(ICFPA, 2000)
Global consumption of wood pulp: 150 million tons
(ICFPA,2000)
Substitutes: steel, aluminum, plastics
36%
Raw Material Evolution
Natural Forest or Forest
Plantations
Roundwood
Sale of whole
unprocessed
logs
Wood
Chips
Paper
Mechanical Wood
Products
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 Structure
Major Expenses
Cost of Products Sold
Depreciation, Amortization & Fee Stumpage
Selling Expenses
Other:
Plant Closure and Integration Costs
Research & Development


% of Total Expenses
85%
6%
7%
2%
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
Major Risks: General Business

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

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


Sales and purchases in foreign currency


Also known as balance sheet risk
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
Major Risks: Financial

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
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



Potential Losses from Hedging



Takes away from the bottom line
Can cause liquidity problems
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 commissionbased 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 + $13.5) / 2 ]
-Highest net sales in 3 yrs, but similar profit as in 2001 (due to low selling prices)
-High debt-to-capital ratio due to mill acquisitions in 2001
-High FCF (CF from op activities – net addition of property, plant, equipment)
due to increased sales from newly acquired mills
1. Financial Statement
Net Sales/Production
Net Sales 23.6% in Canada, 72.4% in US
Properties 51.6% in Canada; 47.9% in US
So, around 24.5% sales is subject to FX risk (CDN$/US$)
Net Sales/Production

Paper (59%)



Packaging (11%)

Prod: 50% in US
Sales: 85% in US


Joint venture;
own 50% of Norampac
Canada, US, Mexico, France
Paper Merchants (22%)
–
–
–
–
Canada: 8 branches
US: 20 branches
Newly added in 2002
Paper used to be 82%

Wood (8%)


Prod: All in Canada
Sales: 57% in US
Financing Expenses
2. Balance Sheet
Balance Sheet
3. Cash Flow Statement
Cash Flow Statement
Sensitivity Analysis
Sensitivity Analysis
Only hedge 20%
Risk and Uncertainties
1.
2.
3.
4.
5.
6.
Product Prices
Operational
Foreign Exchange
Interest Rate
Liquidity (not mentioned explicitly as risk)
Credit
1. Product Price Risk Management

Product Prices Risk

Factor of market demand and supply

Associated with certain products only—Northern
Bleached Softwood Kraft (NBSK) pulp, semi-chemical
medium paper, purchases of old corrugated containers
and electricity
Management:
 Enter cash settled commodity swap
Product Price Risk Management
Amount
Time
Period
Net Unrealized
Gain
NBSK Pulp
1,500 tonnes/
month
Nov 2002 - CDN$ 1 Million
Oct 2005
Linerboard
98,600 tons
Semi-Chemical
Medium Paper
14,500 tonnes
Corrugated
Container
439,850 tonnes
Electricity
161,630
megawatts
2003-2007 Loss
CDN$1 Million
2. Operational Risk Management

Operational Risk



Changes in energy (natural gas and crude oil) and other
raw material prices, competition, performance of key
suppliers and distributors, renewal of collective
agreements, regulatory risks, successful integration of
new acquisition, retention of key personnel and
reliability of information system.
Compliance to environmental law
Changes in trading regulations.
E.g.. lumber export duties to the US.
Operational Risk Mgmt

Natural Hedging

Product Diversification


Efficient Cost Management




Paper (59%), wood (8%), paper merchants (11%), and packaging
(22%)
2001, add 4 pulp & paper mills in US
2002, shut down 3 high-cost paper machines in US
2002, permanent closure of 2 lumber mill in Canada
Vertical Integration


Manage owned (26,500 ha) and leased forests
Own paper merchants as distribution channels
3. Foreign Exchange Risk Mgmt

Foreign Exchange Risk

Approximately 24.5% of sales are in US$ 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
4. Interest Rate Risk Management

Interest Rate Risk

Risk related to changes in interest rate on debt payment
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
Receive average 4.45% fixed
on CDN$956M until Oct ‘06
Financial
Institution
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
Domtar
Pay 7.875%
fixed on
CDN$956M
to Oct ‘11
Creditor
Interest Rate Risk Management

Swap terminated (prior to maturity) Nov 2002
Receive average 4.45% fixed
Financial
Institution
+ CDN $51 M
NET GAIN + CDN $40 M Domtar
- CDN $11 M
Pay 2.48/3.16/LIBOR
Pay 7.875%
fixed on
CDN$956M
to Oct ‘11
Net gain CDN $40 applied to
financing expenses: (Cdn GAAP)
2003
C$ 4 M 5.3%
2004
C$ 13 M 17.3%
Creditor
2005
C$ 13 M 17.3%
2006
C$ 10 M 13.3%
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.
2.
3.
Executive Stock Options
Executive Share Purchase Rights
Deferred share unit plans


4.
Outside directors
Executives
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.
Authorized
issuance under
the plan
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
Actual issued
under the plan
Total common
shares
outstanding
11,300,000
4,301,071
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.
Authorized
5,050,000
Shares purchased under the
Canadian plan are subject to a
mandatory twelve-month
holding period.
Issued
3,591,862
If held for 18 months, receive
shares worth 10% of original
purchase
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 shortterm 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)