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

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)

Products

Fuelwood

33%

28%

Industrial Roundwood

Sawnwood

36%

3% Wood-Based Panels

World Wood Production (by volume)

Products 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

Paper & Paperboard

64%

Wood Pulp

36%

World Pulp & Paper Production (by weight)

Raw Material Evolution Natural Forest or Forest Plantations

RoundwoodSale of whole unprocessed logs

Wood Chips Mechanical Wood

Products

Paper 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 StructureMajor Expenses % of Total ExpensesCost of Products Sold 85%Depreciation, Amortization & Fee Stumpage 6%Selling Expenses 7%Other: 2% Plant Closure and Integration Costs Research & Development

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

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

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 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

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

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

Major Risks: Financial

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 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

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 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.

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 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

Net Sales/Production

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%

Packaging (11%) Joint venture;

own 50% of Norampac Canada, US, Mexico, France

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. Product Prices

2. Operational

3. Foreign Exchange

4. Interest Rate5. Liquidity (not mentioned explicitly as risk)

6. 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 ManagementAmount Time

PeriodNet Unrealized Gain

NBSK Pulp 1,500 tonnes/ month

Nov 2002 - Oct 2005

CDN$ 1 Million

Linerboard 98,600 tons

2003-2007 Loss

CDN$1 Million

Semi-Chemical Medium Paper

14,500 tonnes

Corrugated Container

439,850 tonnes

Electricity 161,630 megawatts

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

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

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

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

payment

4. Interest Rate Risk Management

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

Financial Institution

Domtar

Creditor

Receive average 4.45% fixed on CDN$956M until Oct ‘06

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

Pay 7.875% fixed on CDN$956M to Oct ‘11

Interest Rate Risk Management Swap terminated (prior to maturity) Nov 2002

Financial Institution

Domtar

Creditor

+ CDN $51 M

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%

Pay 7.875% fixed on CDN$956M to Oct ‘11

- CDN $11 M

Receive average 4.45% fixed

Pay 2.48/3.16/LIBOR

NET GAIN + CDN $40 M

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. Executive Stock Options

2. Executive Share Purchase Rights

3. Deferred share unit plans Outside directors Executives

4. 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.

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

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.

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

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 short-

term 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)