Forest Products Industry

1
Forest Products Industry

• Chris Cook
• Insoo Park
• Elizabeth Juwono
• Rachel Zhu
• Evan Vahlas

2
Agenda

• Industry Analysis
• Risks Faced
• Weyerhaeuser Company
• Domtar Inc.

3
Industry Analysis

• Forest Products Industry
• Produces primary products valued at US850
  billion/year (PriceWaterhouseCoopers, 2003)
• Global reach
• Mature, capital intensive and cyclical industry
• Highly competitive
• Comprised of thousands of small and large
  enterprises

4
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

5
Top Industry Performers
Source PWC, 2003
6
Products
World Wood Production (by volume)
3 Wood-Based Panels

• Lumber Wood Products
• Roundwood Products
• Industrial Roundwood
• Fuelwood
• Mechanical Wood Products
• Sawnwood
• Wood based panels
• Global consumption of wood products 767 million
  m3 (ICFPA, 2002)

Fuelwood 33
Sawnwood 36
28 Industrial Roundwood
7
Products
World Pulp Paper Production (by weight)

• Pulp Paper Products
• Wood pulp
• Paper
• Paperboard
• Global consumption of paper products 323 million
  tons (ICFPA, 2000)
• Global consumption of wood pulp 150 million tons
  (ICFPA,2000)
• Substitutes steel, aluminum, plastics

Wood Pulp 36
Paper Paperboard 64
8
Raw Material Evolution
Natural Forest or Forest Plantations
Roundwood
Sale of whole unprocessed logs
Wood Chips
Mechanical Wood Products
Paper
Pulp
9
World Consumption of Forest Products
Source XI World Forestry Congress, 1997
10
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)

11
International Trade

• Approximately 35 of forest and paper products
  are traded internationally (ICFPA, 2000)
• Canada is the worlds leading exporter
• US43 billion in wood, pulp paper per year
  (FPAC, 2003)

12
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

13
Cost Structure

• Interest Expense 4-5 of total sales revenue
• Major expenses compose 90-95 of total sales
  revenue

14
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

15
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

16
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 worlds paper producers
• Over 50 of the worlds wood producers

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Risk Management
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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

19
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

20
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.

21
Measuring Commodity Risk

• Measured by sensitivity analysis

22
Techniques Products to Manage Commodity Risk

• Forward Contracts
• Commodity Futures
• Commodity Swaps
• Natural Hedging
• Product Diversification
• Efficient Cost Management
• Vertical Integration

23
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

24
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

25
Techniques Products to Manage Interest Risk

• Interest rate futures and forward rate agreements
• Interest rate swaps
• Option products

26
Major Risks

• Foreign Exchange Risk
• Assets and liabilities in foreign currency
• Also known as balance sheet risk
• Sales and purchases in foreign currency
• Also known as transaction risk
• Especially relevant to international firms
• Global production facilities and customers
• Large mismatch between revenue and cost

27
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)

28
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

29
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

30
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

31
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

32
Available Techniques Products

• Insurance
• General Liability
• Shipping
• Environmental
• Strong internal controls over operation
• Scenario-building
• Lobbying

33
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

34
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

35
Potential Hazards from Risk Management Activities

• High costs of purchasing derivative products
• Takes away from the bottom line
• Can cause liquidity problems
• Potential Losses from Hedging
• 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

36
Weyerhaeuser Company

• becoming the best forest products company in the
  world and a global leader among all industries

37
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

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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

43
Revenue Source
44
Cost structure
45
Interest Expenses
46
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

47
Foreign exchange transaction (gains) losses
48
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

49
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)

50
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

51
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

52
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)

53
Extra Information on Companys 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 commission-based 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.

54

• Domtar Inc.

55
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 CDN3.5 billion
• 227,680,352 common shares x (CDN17.8
  13.5) / 2

56

• 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

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1. Financial Statement
58
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)
59
Net Sales/Production

• Packaging (11)
• Joint venture
• own 50 of Norampac
• Canada, US, Mexico, France
• Wood (8)
• Prod All in Canada
• Sales 57 in US

• Paper (59)
• Prod 50 in US
• Sales 85 in US
• Paper Merchants (22)
• Canada 8 branches
• US 20 branches
• Newly added in 2002
• Paper used to be 82

60
Financing Expenses
61
2. Balance Sheet
62
Balance Sheet
63
3. Cash Flow Statement
64
Cash Flow Statement
65
Sensitivity Analysis
66
Sensitivity Analysis
Only hedge 20
67
Risk and Uncertainties

1. Product Prices
2. Operational
3. Foreign Exchange
4. Interest Rate
5. Liquidity (not mentioned explicitly as risk)
6. Credit

68
1. Product Price Risk Management

• Product Prices Risk
• Factor of market demand and supply
• Associated with certain products onlyNorthern
  Bleached Softwood Kraft (NBSK) pulp,
  semi-chemical medium paper, purchases of old
  corrugated containers and electricity
• Management
• Enter cash settled commodity swap

69
Product Price Risk Management
Amount Time Period Net Unrealized Gain
NBSK Pulp 1,500 tonnes/ month Nov 2002 - Oct 2005 CDN 1 Million
Linerboard 98,600 tons 2003-2007 Loss CDN1 Million
Semi-Chemical Medium Paper 14,500 tonnes 2003-2007 Loss CDN1 Million
Corrugated Container 439,850 tonnes 2003-2007 Loss CDN1 Million
Electricity 161,630 megawatts 2003-2007 Loss CDN1 Million
70
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.

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Operational Risk Mgmt

• Natural Hedging
• Product Diversification
• Paper (59), wood (8), paper merchants (11),
  and packaging (22)
• Efficient Cost Management
• 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

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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.

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Foreign Exchange Risk Mgmt

• Natural hedging
• long-term debt denominated in foreign currency
  hedge of net investment in foreign subsidiaries

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Foreign Exchange Risk Mgmt

• Options and Forwards

Put option
Call option
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4. Interest Rate Risk Management

• Interest Rate Risk
• Risk related to changes in interest rate on debt
  payment

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Interest Rate Risk Management
Total 2,815

• Fixed interest rates for LTD varies between
  7.875 to 10.85

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Interest Rate Risk Management
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Interest Rate Risk Management

• Interest rate swap on CDN956 Million

Receive average 4.45 fixed on CDN956M until Oct
06
Financial Institution
Domtar
Pay fixed 2.48 on C478M to Oct 02 then 3-m
LIBOR to Oct 06 Pay fixed 3.16 on C478M to Oct
03 then 3-m LIBOR to Oct 06
Pay 7.875 fixed on CDN956M to Oct 11
Creditor
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Interest Rate Risk Management

• Swap terminated (prior to maturity) Nov 2002

Receive average 4.45 fixed
CDN 51 M
Financial Institution
Domtar
NET GAIN CDN 40 M
- CDN 11 M
Pay 2.48/3.16/LIBOR
Pay 7.875 fixed on CDN956M 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 2005 C 13 M 17.3 2006 C 10 M 13.3
Creditor
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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

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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)

82
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

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Compensation

• Executive Stock Options
• Executive Share Purchase Rights
• Deferred share unit plans
• Outside directors
• Executives
• Employee Share Purchase Plan

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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

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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
• DTCTSE ? 16.70 (25), 18.51 (50) or 20.32
  (100) for 20 days
• AND
• DTC shares have outperformed SP U.S. Paper
  Forest Products index

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Executive Stock Options
Note 227,680,352 total outstanding common shares
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Executive Stock Options
Note 227,680,352 total outstanding common shares
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2. Executive Share Purchase Rights

• Rights may be granted to selected executives.
• 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

Authorized issuance under the plan 11,300,000
Actual issued under the plan 4,301,071
Total common shares outstanding 227,680,352
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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.

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4. Employee Share Purchase Plan

• All employees are eligible to purchase common
  shares at a price of 90 of the quoted market
  value.
• Shares purchased under the Canadian plan are
  subject to a mandatory twelve-month holding
  period.
• If held for 18 months, receive shares worth 10
  of original purchase

Authorized 5,050,000
Issued 3,591,862
Total common shares outstanding 227,680,352
92
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.

93
Remarks

• Expected to see more financial risk management,
  esp. from Weyerhaeuser
• Foreign exchange risk management
• vast majority of Weyerhaeusers sales assets in
  US
• Domtar has a much larger percentage of its sales
  assets in US

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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

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Remarks

• Credit counterparty risk management
• important to both companies
• Liquidity risk
• judicious management of maturing short-term debt
  and the structure of long-term debt

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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

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Remarks

• Poor reporting
• at first glance, seems to indicate lack of
  sophistication, awareness
• Appears both companies are concentrating on
  operations
• bigger fish to fry

98
Recommendations for Weyerhaeuser

• Current focus on debt reduction should not ignore
  exposures to other risks such as FX

99
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!

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• The End

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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 wont place all his business in one basket
• Roberto Cenicerrs. Business Insurance.
  Chicago Apr 30,2001. Vol.35, Iss.18 p. 90, (1
  page)