FINANCIAL AND VALUE METRICS BASED PERFORMANCE EVALUATION OF NORTH AMERICAN PULP AND PAPER COMPANIES AND IDENTIFICATION

AND ADJUSTMENT OF DEFICIENCIES TO COMPETE IN THE GLOBAL MARKET PLACE

V.R. (PERRY) PARTHASARATHY, PhD WEYERHAEUSER COMPANY PORT WENTWORTH, GA 31407

YOU CANT MANAGE WHAT YOU CANT MEASURE.

Knowledge @ Wharton, September 6, 2006

In any industry cyclical or otherwise, the winners are the Atomizers focusing on segments where they can achieve dominant position even though they may hold only a small fraction of the assets or revenue. The companies that create value become Leaders irrespective of their size, and the Under Achievers of the industry have to follow the model of the Leaders even though they may be the largest; this is the only way the companies can deliver the promised value proposition to their stakeholders.

Campbell and Hulme, The McKinsey & Co

There is not a single perfect measure to describe different aspects of performance of a Company. It is recommended that a framework of economic and accounting measures is used to describe performance. In using these metrics, it is important to understand the impact of factors outside managements control and exclude them in accessing how a company is doing.
Copeland, Koller and Murrin in Valuation Measuring and Managing the Value of Companies.

FINANCIAL METRICS
OPM NOPLAT= ROI ROE = Operating Profit Margin, % Net Operating Profit Less Adjusted Taxes, % = Return on Investment, % = Return on Equity, %

VALUE METRICS

EVA MVA TSR SVC FCF

= = = = =

Economic Value Added Market Value Added Total Shareholder Return Shareholder Value Creation (Risk Adjusted Basis) Free Cash Flow (Current and Future (Forecasted))

To take the CAP effect, Value Metrics are calculated as ratios.

EVA/TIC MVA/MV of E TSR SVC/CR FCF/EBITDA = = = = = Economic Value Added/Total Invested Capital Market Value Added/Market Value of Equity Total Shareholder Return Shareholder Value Creation/Return on Capital Free Cash Flow/Earnings Before Interest, Taxes, Depreciation and Amortization

EQUITY FLIGHT IS REAL

Common equity is the cheapest yet the largest value distribution in the Enterprise Valuation (EV) of a company with multiple business segments. With continued poor performance, a company will eventually lose significant shareholder equity (common EV) which would force it to raise capital from other sources (like junk bond, etc.). Such a capital is expensive and would make it difficult for the company to post positive EVA.

TOTAL = 2000
Convertible Securities

200 250

Corporate 250 Overhead

*all values in million US$

400 1750

Debt

EXHIBIT 1. Valuation of an Enterprise with Multi-Business Segments

450

Operation D

350
Operation C

200 Preferred
Stock Common Equity Stock

1150

Operation B

750*
Operation A

Value of the Operating Units

Enterprise Value

Value Distribution

Source: Copeland, Koller and Murrin in Valuation Measuring and Managing the Value of Companies. John Wiley Press, NY 2003.

THE STATE OF NA P&FP INDUSTRY

By any stretch of measurement, value and/or financial, the performance of North American P&FP Industry, to put it mildly, is anemic. The industry destroyed EVA over the years and even with the current price support for its products, it will take a long time for the industry to gain positive EVA.

Comparative EVA Analysis

20,000 15,000

EXHIBIT 2.
US$ Millions

10,000

5,000

PROCESSING

BEVERAGE*

STEEL

CHEMICALS**

HOUSEHOLD

PRODUCTS

CHEMICALS

SPECIALTY

FOOD

-5,000 -10,000 -15,000

&MINING

METALS

HOMEBUILDING

PUBLISHING

NA P&FP Destroyed EVA of More than US$ 20 Billion

NEWSPAPER

PUBLISHING

OTHER

-20,000
-25,000 -30,000

* Non-Alcoholic Beverage ** Basic and Diversified *** Specialty Textiles and Non-Wovens

TEXTILES***

P&FP

THE STATE OF NA P&FP INDUSTRY

For a 10-year period (1994 to 2004), the ROTC was 5.8% in comparison to a WACC of 8.6%. In all, the industry earned only twice over a 30 year period higher ROTC than WACC and only once between 1994 and 2004. The industry has returned 37% less than the WACC during this period.

Value is Being Destroyed The Industrys Returns are 37% Below the Weighted Average Cost of Capital (WACC)

EXHIBIT 3.
ROTC is Lower Than the Cost of Capital: Value is Being Destroyed

15.0 12.0
% Return

Industry WACC = 10.8%

9.0 6.0 3.0 0 1988 1990 1992

Industry ROTC Average = 7.1%

1994

1996

1998

2000

2002

2004

Source: BDCI Date Base. Value Performance Based on 47 NA/ Canadian/ European Companies

THE STATE OF NA P&FP INDUSTRY

o o The industrys record on MVA (Market Value Added) is no better than its record on EVA. The MVA in 2003 was US$ 9.71 billion in 2003. The up tick in MVA/EC (the so called Rate of Market Capitalization = an efficiency measure as to how the Economic Capital (EC) is converted to market value) between 2002 and 2005 is an indication to shareholders guarded belief that future performance would be better than in previous nine (9) years The ratio of MVA/EC, if greater than (>) 1 indicates value being created but less than (<) 1 is an indication of value destruction.

EXHIBIT 4.
ROTC is Lower Than the Cost of Capital: Value is Being Destroyed

THE STATE OF NA P&FP INDUSTRY

o In 1988 to 2004, P&FP industrys Return to Risk were worse than that of the other benchmarked industries except textiles. Even the steel and homebuilding sectors that were lagging the P&FP industry, have reversed course in the past 10 years, improving their value position and out performed the P&FP industry significantly

Comparative Risk versus Return Analysis

170
* Non-Alcoholic Beverage

EXHIBIT 5.
P&FP Industry Has Returned Poorly Relative to the Risk of Investment
(Source: VLI Data Base and BDCI Data Base)

Return/Risk (ER/WACC), %

150 130
110 90

** Basic & Diversified

70 50
30
HOUSEHOLD PRODUCTS
BEVERAGE* PROCESSING CHEMICALS SPECIALTY NEWSPAPER HOMEBUILDING CHEMICALS** OTHER PUBLISHING TEXTILES

STEEL

P&FP

METALS AND

PUBLISHING

MINING

FOOD

THE STATE OF NA P&FP INDUSTRY

o o Given the drubbing that the investors had taken in investing in new technology start-ups and other dot com investments, one troubling aspect of the P&FP Industry is that it suffers poor valuation relative to investment in other industries but for textiles. The driving factor behind this poor valuation is the Capital Turnover (CT = Sales/EC) which is one of the lowest among the benchmarked manufacturing industries

Capital Turnover (CT) for the Industry Considered (1994-2003)

3.5 Capital Turnover, CT 3 2.5
CT is indexed with respect P& FP Industry (P&FP Index =1.0)

EXHIBIT 6.
Capital Turnover (Indexed) for the Other Manufacturing Industries as Compared to P&FP Industry

(Sales/EC)(Ratio)

2 1.5
1

0.5
0

THE STATE OF NA P&FP INDUSTRY

o The P&FP industry could never be able to exploit shifts in supply and demand situation because the producers have always invested their excess cash flow back into capacity increases rather than investing in product development, R&D, developing new markets for the products or priming the supply chain. The new capacities in the P&FP industries have often come on line all at once in big chunks and that too at the start of the recovery from the trough in business cycle, thereby chocking off any sustainable recovery. This has perpetuated price and earnings volatility ( see the next exhibit).
NA Capital Spending as a % of Sales has Fallen to its Lowest Point and R&D Spending as a % of Sales is Flat but Miniscule

EXHIBIT 7.
Capital Spending as % of Sales = 4.45% (Average)

% of Net Sales

Capital Spending is Decreased and R&D Spending is Flat but Insignificant

10.0 8.0 6.0 4.0 2.0 0 1990 1992 1994

R&D Spending as % of Sales = <0.85% (Average)

1996

1998

2000

2002

2004

Source: BDCI Date Base. Value Performance Based on 14 NA/Canadian Companies

THE STATE OF NA P&FP INDUSTRY

o These boom and bust cycles have consequential effect on valuation and the viability of the industry in many ways. (1) Cash is Automatically and unjustifiably reinvested when available, thus tipping the supply-demand balance. (2) The Return on Invested Capital (ROIC) is very sensitive to early year cash flows and the volatility of the cycle makes project timing and therefore adequate returns difficult. (3) The industry continues to grow value destroying businesses instead of re-deploying the assets or fixing them. (4) Operating profit volatility increases the risk of equity investment in the business and therefore, increases the cost of equity capital

EXHIBIT 8.
Percent

Net Operating Profit Margin (NOPM)

9 8 7
6 5 4 3 2 1
Average = 4.7%

Volatility of Net OPM for the P&FP Industry

(Source: VLI Data Base, BDCI Data Base and 2005 Pulp&Paper Global Fact & Price Book)

INDIVIDUAL COMPANY PERFORMANCE

o The industry performance is the cumulative performance of individual companies. Despite the fact that the industry performance is poor, there are individual companies within the industry that performed better or superior to its peers. In this study, 27 individual P&FP companies were compared and their performance ranked. To keep the anonymity of the companies, they are represented by letters A to AA with their 2005 revenue (audited) detailed . Most of the data used in preparing this research came from public domain documents including annual reports,10K filings, etc., The companies were ranked based on certain Value and financial metrics with each metric weighted to their relative importance to the Valuation process (see next exhibit)

EXHIBIT 9.
List of 27 Companies with their FY 2005 Revenue

FINANCIAL METRICS
OPM NOPLAT= ROI ROE = Operating Profit Margin, % Net Operating Profit Less Adjusted Taxes, % = Return on Investment, % = Return on Equity, %

VALUE METRICS

EVA MVA TSR SVC FCF

= = = = =

Economic Value Added Market Value Added Total Shareholder Return Shareholder Value Creation (Risk Adjusted Basis) Free Cash Flow (Current and Future (Forecasted))

To take the CAP effect, Value Metrics are calculated as ratios.

EVA/TIC MVA/MV of E TSR SVC/CR FCF/EBITDA = = = = = Economic Value Added/Total Invested Capital Market Value Added/Market Value of Equity Total Shareholder Return Shareholder Value Creation/Return on Capital Free Cash Flow/Earnings Before Interest, Taxes, Depreciation and Amortization

RANKING BASED ON FINANCIAL METRICS

o Weighted ranking of the companies based on four key financial metrics (see previous exhibit for the list of value and financial metrics) is summarized below. Companies S, T are ranked lower than the Company M (index = 1.00) and Companies G, B, C and K while ranked above M, only slightly. These companies are weak performers in all the four key financial metrics and were responsible for pulling down the average performance of the P&P industry as a whole.

EXHIBIT 10.
Weighted Ranking (Indexed) For NA P&FP Companies Based on Four Key Financial Performance Metrics
Financial Metrics = % OPM, % NOPLAT, % ROI and %ROE

ROE VERSUS ROI

o Return on Investment (ROI) is a long-term financial performance metric and used to calculate the value metric EVA. Return on Equity (ROE) is a short-term performance metric and decides the market capitalization (MVA/MV of E) and forward Price to Earning ratio (P/E) of the company. The matrix between ROE and ROI can be used to compare the short- and long-term performance of the companies. The companies that registered strong short- and long-term performances (1st quadrant, I), companies that recorded strong short- but weak long-term performance (2nd quadrant, II), companies that are lackluster in short- but strong in long-term performance (3rd quadrant, III) and companies that are mediocre in both short- and long-term performance (4th quadrant, IV)

HIGH
%ROI

25

III
20 15
10
I, Q J C
F Z L

KMB

EXHIBIT 11.
ROE versus ROI Matrix for the P&P Companies (PG and KMB is included for comparison)

PG

5
S

Y
M W B

%ROE
5
O 10 U H

-10

-5
-5
T

15

20

25

30

35

LOW LOW

IV
-10

II

HIGH

VALUE METRICS

VALUE METRICS

EVA MVA TSR SVC FCF

= = = = =

Economic Value Added Market Value Added Total Shareholder Return Shareholder Value Creation (Risk Adjusted Basis) Free Cash Flow (Current and Future (Forecasted))

EVA VERSUS MVA

o o EVA decides the ROI realized by the company and dictates the cost of borrowing. MVA is an indirect measure of ROE, because any added market value would ultimately result in top line (revenue) growth and significant bottom line profit (NOPLAT) under constant DDA resulting in substantial increase in cash flow from operations. Increased revenue and NOPLAT growth will attract equity flow into the company. Also, an increase in equity flow under constant debt will change the Debt to Equity ratio of the company thus helping the companies to consistently post positive MVA. The relationship between EVA and MVA is depicted below and resembles the ROE versus ROI matrix closely as depicted in Exhibit 11.

EXHIBIT 12.
EVA versus MVA Matrix for the P&FP Companies (PG and KMB is included for comparison)

VALUE METRICS: SVC OVER TSR

VALUE METRICS

TSR SVC

= =

Total Shareholder Return Shareholder Value Creation (Risk Adjusted Basis)

SVC is an indexed metric and in a sense is the true TSR delivered by the companies. To eliminate the influence of the size of the company (the socalled CAP Effect), each companys equity volatility (beta) is weighted and indexed relative to the industry and sector volatility.

SVC OVER TSR

There are at least three advantages in using SVC over TSR.

(1) SVC is an intrinsic metric like TSR but unlike TSR measures the economic impact in absolute dollar terms. This allows the easy comparison of companies of different sizes within the industry group. While the TSR reflects only the return to common shareholders, SVC reflects the value created for all shareholders including the preferred shareholders. SVC challenges the very notion that only large corporations have the resources to realize their objective of focus or specialization. MC Required ROIMEC1 Shares Issued2 + Other Equity

(2)

(3)

SVC = Events3

1. The Required ROIMEC is calculated by compounding companys initial equity market value by the beta () adjusted market index return; the same value adjustment is made for share issuances, dividends and spin-offs starting on the issue date. 2. Includes both common and preferred issues 3. Other equity events include dividends, share (stock) buy-backs, spin-offs, etc.,

SHAREHOLDER VALUE CREATION (SVC)

o o o
o

The total SVC lost by the 27 P&FP companies over a 8-year period is about US$ 41.23 billion. Out of the 27 Companies, only five had a positive SVC The two of the largest P&FP companies (Companies K and M) had a negative SVC of about US$ 14.4 Billion. It is not easy to compare the disposition of P&FP companies share prices to their FCF because traditional value proposition models cannot be applied to valuation of cyclical industry. One such process is comparison of market-to-capital to TSR ratio and as an extension, MC to SVC

in U S $ , B illio n s
4 .4 5 %

R evenue
U S $ 5 .7 B illio n U S $ 5 5 .8 B illio n NEXT 7 M ID D L E 1 7

EXHIBIT 13.
The Big Three Companies Destroyed More than US$ 27 Billion in SVC.
(Source: ZACKS Investment Research 2003, Forrester Research 2003, BDCI Data Base, Annual Reports 1998 -2005)

100 90 80 70 60 50 40 30 20 10 0 -1 0 -2 0 -3 0

5 1 .9 4 % 4 3 .5 9 %

U S $ 6 6 .5 0 B illio n

TO P 3

SVC U S $ 1 .4 B illio n U S $ -1 4 .7 B illio n U S $ -1 4 .4 B illio n

MARKET TO CAPITAL VERSUS TSR

o

It is not easy to compare the disposition of P&FP companies share prices to their FCF because traditional value proposition models cannot be applied to valuation of cyclical industry. One such process is comparison of market-to-capital to TSR ratio and as an extension, MC to SVC

Average Annual TSR (Jan.1989-Dec.2005) (Indexed) 5.0 4.0

Kimberly-Clark Procter & Gamble

EXHIBIT 14.
3.0

Market-to-Capital and TRS for 15 leading NA P&FP Companies.

2.0

Z H E D W

2
1.0 0.0 -1.0 -2.0 0.0 T B 0.2 S M

N AC K

1.0 0.4 0.6 0.8 Market-to-Capital (Dec.2005) (Indexed)

4
Source: 1990 to 2005 Annual Reports

RANKING BASED ON VALUE METRICS

o Weighted ranking of the companies based on four key financial metrics (see previous exhibit for the list of value and financial metrics) is summarized below. Companies S, T are ranked lower than the Company M (index = 1.00) and Companies G, B, C and K while ranked above M, only slightly. These companies are weak performers in all the four key financial metrics and were responsible for pulling down the average performance of the P&P industry as a whole.
Company
Weighted Scale 34.65 39.38 43.03 16.53 11.14 9.43 9.30 9.30 9.07 5.86 4.96 4.75 2.49 Indexed Scale 20.61 23.42 25.60 9.83 6.63 5.61 5.53 5.53 5.39 3.48 2.95 2.82 1.48 Rank ** ** 1 2 3 4 5 5 7 8 9 10 11

EXHIBIT 15.
Weighted Ranking (Indexed) For NA P&FP Companies Based on Four Key Value Performance Metrics
Performance Metrics = EVA/TIC, MVA/MV of Equity, SVC/CR and TSR

Kimberly-Clark Procter and Gamble D Z L E I Q H F U C N

O
B S T Y G K A M W

1.68
0.34 0.14 (3.37) (3.56) (4.24) (4.94) (6.73) (10.46) (24.89)

1.00
0.20 0.08 (2.00) (2.12) (2.52) (2.94) (4.00) (6.22) (14.81)

12
13 14 15 16 17 18 19 20 21

QUARTILE RANKING OF NA P&FP COMPANIES

o Weighted ranking of the companies based on four key financial metrics (see previous exhibit for the list of value and financial metrics) is summarized below. Companies S, T are ranked lower than the Company M (index = 1.00) and Companies G, B, C and K while ranked above M, only slightly. These companies are weak performers in all the four key financial metrics and were responsible for pulling down the average performance of the P&P industry as a whole.
Assigned Proportional Weight 0.45 0.52 0.03 1.00

Financial Metrics Value Metrics FCF/EBITDA COMPANY Kimberly-Clark Procter & Gamble 1 Company A 2 Company B 3 Company C 4 Company D 5 Company E 6 Company F 7 Company G 8 Company H 9 Company I 10 Company K 11 Company L 12 Company M 13 Company N 14 Company O 15 Company Q 16 Company S 17 Company T 18 Company U 19 Company W 20 Company Y 21 Company Z Mean Std.Error of Population Mean Strength Index Ranking Strength Index Quartile Position >1.8 1 < 1.7 but > 1.2 2 < 1.2 but > 0.3 3 <0.3 4

Weighted Scale 21.82 22.15 (0.43) 1.21 2.66 19.62 6.47 3.67 (0.31) 5.91 5.89 (0.27) 7.06 (2.78) 2.66 2.71 5.78 (0.57) (2.08) 5.89 (6.23) 0.99 9.13 3.19 0.71

Strength Index1 4.50 4.60 (0.14) 0.25 0.55 4.07 1.34 0.76 (0.06) 1.23 1.22 (0.06) 1.46 (0.58) 0.55 0.56 1.20 (0.12) (0.43) 1.22 (1.29) 0.21 1.90 0.66

Quartile Rank COMPANY Quartile Rank Kimberly-Clark 1 Procter & Gamble 1 Company D 1 Company Z 1 Company E 2 Company H 2 Company I 2 Company L 2 Company Q 2 Company U 2 Company C 3 Company F 3 Company N 3 Company O 3 Company A 4 Company B 4 Company G 4 Company K 4 Company M 4 Company S 4 Company T 4 Company W 4 Company Y 4

EXHIBIT 16.
Quartile Ranking of North American P&FP Companies Based on the Weighted Strength Index of Eight Financial and Value Performance Metrics

24.60 22.12 3.55 2.46 2.62 13.98 7.84 3.94 1.98 6.70 6.70 2.79 7.97 1.00 4.17 4.73 6.45 (1.36) (2.35) 9.64 3.14 4.59 8.94 4.74 0.85

20.61 23.42 (4.00) 0.20 2.82 25.60 5.61 3.48 (2.52) 5.39 5.53 (2.94) 6.63 (6.22) 1.48 1.00 5.53 0.08 (2.00) 2.95 (14.81) (2.12) 9.83 1.98 1.71

0.94 0.59 1.65 0.00 0.50 0.59 0.83 2.85 3.64 3.06 0.00 0.00 1.02 0.00 0.57 2.12 0.00 0.11 0.58 0.76 1.81 0.90 0.00 1.00 0.25

4 4 3 1 2 3 4 2 2 4 2 4 3 3 2 4 4 2 4 4 1

CONCLUSIONS
o On a micro level the health of the industry is dictated by the performance of individual companies within its sector. The recent events in the equity market suggest that it is the winner-takes-all economy and the P&FP industry is no exception. Across NA P&FP sector, a select few companies are creating almost all of the new shareholder value; two of its largest players o are not presently among them. Two indicators were used. o One is the ranking using five key financial measures, %OPM, %NOPLAT, %ROE, %ROI and %FCF. o The other is a measure using value metrics, EVA and MVA, supplemented with TSR and SVC.

CONCLUSIONS
o The profit drivers distinguish the Leaders from the Followers and the Trailers. Profit drivers include, Capital Turnover (CT), %OPM, %NOPLAT, ROI and ROE. o Financial indicators like revenue growth and ROIC though useful should be supplemented with strategic value drivers like MVA to gauge where a company is heading and to decide the course of action to maximize performance and to enhance TSR. o Almost 50% of the companies in the P&FP sector are value destroyers including two of its largest. The P&FP industry over an 8 year period destroyed EVA of more than US$ 20 billion, which makes barrowing capital for project financing expensive; compounding with low ROI, the equity inflow to the industry is one of the lowest among all manufacturing industry as reflected in the poor MVA to MV of Equity.

CONCLUSIONS

To become a global leader again, the NA P&FP industry should focus on delivering decent numbers on the five key financial measures and the four value measures.

Thanks.

V.R. (PERRY) PARTHASARATHY, PhD WEYERHAEUSER COMPANY PORT WENTWORTH, GA 31407