As any commodity, paper products have traditionally mainly operated on the price side of the equation, providing customer value through lower priced products year after year. This price reduction was enabled by the technological development in the industry, where larger and more efficient paper machines were able to significantly decrease the unit manufacturing cost of the product, and pass those savings to the customer. This of course resulted in significant real price decreases for almost all of our products over time. The benefits to the customers and society as a whole have been significant, where we have been able share information, advertise, distribute packaged products and educate people at significantly higher efficiency.
As with any commodity, especially for one with no or low barriers of entry and very little product differentiation, the competition has been so fierce that it has resulted in a free for all situation where anybody could compete on almost any cost curve using the latest technology. This has driven the cost curves flatter. In commodities the price is determined by the last marginal producer on the cost curve, since the industry will run a machine as long as they can keep the lights on (be cash positive), hence a flat cost curve means that nobody is making money. In fact, the cost curves have been so flat that the industry has not earned the cost of capital in over 15 years, a time period often defined as the stalemate. Consequently we have been very efficient in destroying shareholder value.
Change in paradigm
However, lately the game has changed. Technical development has almost ceased to exist and the remaining improvements tend to be very incremental in nature providing only very modest if any cost savings opportunities. In addition, the high capital intensiveness of the technology requires significant improvements to justify the investment, further reducing the adaptation of new technologies. Consequently the majority of paper mills tend to be museums of technologies from the past decades, still running but not significantly improving. At the same time the input costs of the raw materials, labor, transportation and energy has been creeping up at inflation rate or sometimes even faster. This has resulted that many of our traditional paper products have seen a steady cost escalation over the past 3-5 years. However, these cost increases have not happened equally, especially when combined with exchange rate and cost alleviation differentials. Some paper mills and companies have been either better structured in terms of asset quality, geographically or just purely in capability to alleviate these input cost increases, or just happen to be located in North America as the dollar has plummeted. The differential cost escalation in combination with capacity control has meant that the cost curves for majority of the products have started to become steeper again. Since in commodities the price is determined by the last marginal producer on the cost curve the prices have started escalating, Fig. 1.
Figure 1 - Steepness of the cost curve and effect on price
Value creation in the new paradigm
Price increases above inflation have felt almost like a fresh start to the industry. This phenomenon was something that had been predicted as the industry was going through consolidation, understanding that it would drive better capacity control, but never truly believed. Today, there are many CEOs who should be happy and proud of their achievements, which were accomplished during the painful work of consolidating, shutting down assets across the cost curve and focusing again.
There is one concern - customer value. As mentioned before, we provide customer value either through improving the benefits that our products provide or lowering the price of the product that we offer. Today we are increasing the prices of our products without impacting the benefits we provide. In other words, we have moved from destroying shareholder value and began to destroy customer value. This may have consequences that we will have to pay attention to.
Think about a situation where the old standard tube TV set you purchased would cost you significantly more than it did 10 years ago, or the iPod you purchased today for $199 would cost you $399 in two years with the same exact features. Maybe you would think twice about replacing anything. However, in commodities one could argue that they are necessities, without them society would not work, and their price today is irrelevant and could double without people paying any attention. In other words they are very price inelastic. But are our products necessities, could they be replaced by other means or by non-consumption?
I wish not, but I fear yes. As an example, printing and writing papers are currently being replaced by non-consumption driven largely by the Internet. This trend is likely to continue as the generation that reads from iPhones and consumes information from the net becomes at age to be the main consumers. These all are great alternatives to paper. In fact, I (34 years old ) never print anything at home, get all my advertising though the net, and read newspapers online, and distribute information electronically only. The above example was within the printing and writing grades, however, it is likely that this behavior will also occur within packaging, where the increasing awareness on sustainability is introducing a non-consumption argument similar to that in the printing and writing grades. Because there are easy and good alternatives for our paper products they are likely to become increasingly price elastic, where slight increase in price will significantly affect the demand.
For individual companies there are few games left to play: continue delivering customer value and try to gain market share from competitors, start exiting the business either by finding other cost curves for your least competitive paper machines, find profitable growth in emerging economies or move to a totally new business and retire/sell existing assets.
Market share can be gained organically by providing customer value. There are two routes to this: either by continuing to reduce the cost of the products we make and transfer those savings to the customer and gain market share by pricing, this is often depicted as cost differentiation. Alternatively, improving the benefits our products and services provide is a way to improve the top line of the customer value equation. Both of these approaches require innovation, and internal capability to execute. The risk associated with the approach is that the innovation capability is already diminished so much that these developments will not be proprietary, but are rather supplier innovations, that readily transfer to the whole cost curve, hence providing competitive advantage to nobody. Consequently keeping the cost curves flat.
The old game of taking non-competitive assets and modifying them to compete on another cost curve is often feasible, but hasn't proven to save anybody, just to prolong the inevitable and make the new competitors on the new cost curve suffer even more. Examples of this are the uncoated freesheet alternatives produced by the old newsprint companies, with their newsprint assets. They have seen growth but often non-profitable growth, not having made positive EBIT in years. Alternatively, one could innovate and create new to the world products that are needed and can be manufactured with the existing assets. This tends to be very hard, almost all stars seem to have to align, because our assets are usually built for one purpose, and modifying them for another purpose is almost like starting from the scratch requiring significant amount of capital to move a machine into making something else.
There is an option to find growth in other geographical areas. Some of these may be opportunities that offer lower cost manufacturing opportunities, but overall they tend to be only opportunities for growth. Based on what has happened over the past 10 years many of these things end up being not much more profitable than the existing businesses, many times even worse, such as many of the recent investments in China. This is because we are in a global business and the core isn't profitable regardless where it resides.
There is another potential alternative scenario, and that is the chance that prices fall back to the historical trendlines with its cyclicality, eating away all the price increases we've seen in the past few years. There are few reasons why this could happen. First, if the industry or any of the market segments becomes profitable again idled paper machines will be restarted and companies will enter that space, consequently impacting the supply and destroying the price. Second, the customer value destruction, which may drive demand down even faster, will pressure the market segments more and more to an over supply situation, and the pressure is on the 4th quartile assets. If they are shut down the cost curve flattens. Third, probably the most important, is the exchange rate differentials that exist today, especially the low valuation of the US dollar. One of the reasons for the steep cost curves is the fact that the Canadian and European mills have dropped into the 3rd and 4th quartile as the US dollar has weakened. Today the US dollar value is significantly below that of a long-term average, and if it rebounds it will start bringing the US mills closer to the rest of the pack, lowering the cost of the 4th quartile mills and consequently flattening the cost curve, pressuring prices to decline, and pull us back into the old familiar commodity game with declining real prices. To continue to provide customer value through lower price we need to keep shaving costs. The only problem is that the technical development in the industry has ceased and nobody can significantly reduce their cost without drastic measures to what they do. The steady increase in real cost over the past years and the fact that that many of the most productive paper machines currently running are more than 10 years old, suggest that the current wet laid process is at its maximum capability. Hence, we may be at a tipping point where as an industry we need to begin developing the next generation processes that are better designed to match today's constraints. This will require us to start developing a new sustainable future with a new radical manufacturing process that overcomes the future challenges of increasing input costs, beyond that of our current process design. However, to have an effect and keep the cost curve steep, this development needs to be proprietary for only part of the cost curve.
The last option to move us away from the old zero-sum game remaining is the strategy of creating new businesses with paying little attention to the existing asset base. Initially we could start moving to a business adjacent to the core, potentially something already in the corporate portfolio. After exhausting these adjacent to the core options we could move to our newly created business opportunities borne from your new business creation innovation activities. These tend to sound rather blue sky to many paper companies. However, these corporate core renewal stories exist in the world and even within paper industry, and many times they have been successful, we just don't remember them because these companies have their core elsewhere.
What is the core we can build on?
The challenge is, off course, to look at the unreliable future and to make accurate predictions about where money can be made, and if we are lucky find internal competencies that can match these opportunities. The competencies that we have are manifold, but the ones valuable in the future are different than the ones that have brought us past success. It seems that the times are changing and running paper machines fast is not a competitive advantage anymore, nor the ability to make good quality paper products consistently, but rather an expectation, a cost of being in this business.
In anticipation of the future, there have been several industry wide discussions regarding the true core competencies of the paper industry that could be leveraged in the future. They often include the tremendous potential of the versatile wood raw material, our understanding of it, and the streamlined logistics networks that have the ability to accumulate enormous volumes of bio-based raw materials into single locations.
In addition, despite the bad historical image, we have the ability of being a sustainability leader in the global manufacturing sector. In fact, this is a potential competency that other industries can currently only dream about. Interestingly, both of these competencies are currently being leveraged in the new business development efforts around the biorefinery concept that could enable an adjacent to the core business opportunity for the industry.
There are probably several other competencies that could be better understood and may provide leverage to develop an alternative future for the industry. However, if it turns out that the core is empty and we are out of competencies that will be needed in the future, we are obligated to start rebuilding, because in a declining and increasingly declining industry this seems to be the only viable long term option. And long term is important for us to keep providing customer value because only that way can we continue to provide shareholder value.