October 2006 Pulp Nonfiction John Faraci & IP abandon their industry’s “Bigger is Better” model By Richard Daverman
Photo by John Schweikert
John Faraci
In August 2005, International Paper’s shareholders were suspended in what might best be described as an investor’s Purgatory following a six-year growth drought.
To fix the problem, the largest forest products manufacturer on Earth and among the 100 largest public companies in America, undertook a radical restructuring, shucking off $11 billion of its $27 billion worth of assets, including a couple of corporate heirlooms.
“They had to do it,” says Steven Chercover, an analyst with D.A. Davidson & Co. “They had no choice. What they were doing wasn’t working. They weren’t returning value to shareholders.” One particularly significant part of the restructuring, locally speaking, was the decision to relocate the company’s headquarters from Stamford, Conn., to Memphis. Even after the company’s rapid weight-loss program is complete, IP will still rank among Tennessee’s largest public companies. IP and its future—both immediate and long term—are now intimately tied to the Volunteer State. IP’s stock price, which first hit $40 per share in 1995, now lumbers in the low $30s. With efficiency and restructuring the watchwords for IP, the move to Memphis underscores that the company is deadly serious about serving the needs of its stockholders. But will the plan to turn it around work for Tennessee’s newest Fortune 500 company?
The Relocation
Though its official relocation to Memphis was rightly touted as an economic success story, in truth, IP was already here. The Bluff City was already home to about 3,000 IP executive/administrative staffers when the company announced it would move its official address to West Tennessee.
About 90 positions and 30 people transferred to Memphis when the company relocated its corporate headquarters, a migration that was officially complete this July.
IP promised to bring 94 jobs with a median wage of $128,103, which works out to about $19 million in annual salaries. The Industrial Development Board of Memphis and Shelby County incentivized the company to the tune of tax freezes that will save IP about $15 million over 15 years. But there was a more practical component to the decision: “It was easier to move 90 positions to Tennessee than move 3,000 to Connecticut,” explains John Faraci, company chairman and CEO.
According to Faraci, “It’s not just a cost savings, but more efficient to have the entire leadership in one place.” So, instead of getting on a plane for a meeting, people can walk down the hall to talk to each other.
The move to Tennessee is highly symbolic, as well. The Stamford office came to IP as part of the 2000 Champion acquisition, the last of the great consolidations that concentrated the paper industry into fewer and fewer hands. IP paid $9.5 billion for Champion—coming in late, snatching the prize away from other contenders and overpaying in the process. “Bigger is better,” the vertical integration model argued, given its synergies, and so on.
But that was before the advent of Faraci as CEO. Now, “management is not ego-driven,” says Chercover of the cultural shift. “They are not trying to be the biggest.” Thus, the physical relocation from Connecticut also serves as a metaphor for stepping out of the company’s old skin and into a new one—a shadow of its former self.
The Transformation
IP calls its plan for remaking the company the “transformation,” which puts forth a more optimistic, forward-looking connotation than the familiar “restructuring.” “Cost of capital returns” determined which business lines would go and which would stay, according to Edings Thibault, an analyst with Morgan Stanley. If the business did not seem capable of generating cost of capital returns—either now or in the future—out it went.
For IP, the new mantra is “Fewer, Bigger, Better,” which means that IP will be involved in fewer businesses, that it will consolidate its remaining operations into larger facilities, and that the resulting business will be more efficient. Read: profitable.
“The more businesses we’re in, the more difficult it is to compete,” Faraci says. “It’s like an athlete in a decathlon. The athlete can’t be the world’s best in every event. We have chosen the businesses in which we have a competitive advantage.”
Also on his mind are the huge capital requirements of the paper industry. “Now, we have fewer mouths to feed,” he says. (IP’s employee base is down from nearly 113,000 at the turn of the century to fewer than 69,000 today.)
Most spectacularly, IP has sold off most of its U.S. timberland. “They got good prices for the assets, better than their forecasts,” Chercover says, offering evidence that the transformation is working. (The company originally estimated raising $8 billion to $10 billion through its sell-offs, but instead could eventually raise $11 billion.)
Indeed, timberland is near the top of its price cycle, and Faraci notes that, in this day and age, timberland can sometimes mean more to non-paper companies. “IP didn’t need to own timberland in North America,” he says. “The tree business is a good business. But it is better for others than for us.”
Of course, it did not hurt that timber prices were high when the properties were on the block. And the current ascendancy of private equity firms helped out, as well. That’s not to say, Thibault points out, that the severing of the time-honored attachment between a paper company and its forests wasn’t an emotionally difficult move for the company.
But Faraci’s company stayed firm in its resolve. As a result, IP is moving towards becoming a paper company that does not own any of its own trees—an unprecedented situation. It is figuring out a new way to make money in the paper business and reevaluating some sacred cows in the process. Also out the door went the business that made coated paper—the shiny paper for magazines and catalogs. All of this—the cost of capital returns, the competitive advantage—are the rational tools of MBAs whose dispassionate analysis, in this case at least, changes the way a business has traditionally been run.
IP isn’t the only industry player making changes. IP competitor Weyerhaeuser, which has substantial Tri-Cities operations, recently announced a smaller version of the transformation, selling off its plain paper division. The move underscores Faraci’s implied point that, in the paper industry, the old vertical integration model is difficult, if not impossible, to maintain in the new millennium.
But will the new “fewer, bigger, better” IP compete better in the paper manufacturing sector? Doing so will require the right recipe. Demand for its products must hold up. The company must do a better job of weathering the intense cycles that routinely bash commodities like paper. And it must continue its focus on the now proven upsides of negative ego as it continues to be flush with capital proceeds from its sell-off.
The Remains
The sales left IP with two major businesses: uncoated free sheets (copy paper) and packaging. These are commodity businesses, where a company competes on price. But Faraci says, “We chose businesses where we could improve margins without waiting for price increases.” Nevertheless, in their conference calls with analysts, IP talks a lot about raising the price of its products as a way to improve profits.
Unfortunately, in North America at least, demand for paper is not growing. Analysts argue about whether it is flat, growing slightly or shrinking. Regardless, the lack of solid growth makes it difficult to push through price increases.
On the other hand, the widely forecasted advent of the “paperless society” hasn’t happened either. The nabobs of negativity have, on occasion, predicted the computer and its Internet connections would soon make paper an antiquated artifact, much like the stock quotes in a newspaper. But so far, people continue to use paper, as any wastebasket around an office copy machine will attest. And the home office boom may have compensated for any trimming in corporate offices. (A recent Barron’s article reported that the average American still uses 675 pounds of paper each year.)
Faraci is hearing none of the talk that paper demand is declining in a digital age. And he emphasizes that “growth in paper demand is outside the United States,” where the most often named targets are emerging markets in China and India, as well as Eastern Europe.
Besides weak demand in North America, paper companies face a perennial problem: the cyclical nature of the industry. When times are good, the paper companies make money, and stock prices seem cheap. But the next downturn in the cycle destroys the earnings part of the price/earnings fraction, sending the stock into the predictable tank.
The downturns usually coincide with a weaker economy, so analysts attribute the troughs in paper company stocks with a slack demand. Faraci disagrees. “It’s the capacity additions that cause the cycles,” he says, “not a change in demand.” While others will disagree on the singularity of the supply side of the equation, IP aims to achieve sufficient dominance in its industry to discourage competition.
Last, with its windfall of 11 billion greenbacks (laid end to end, 11 billion one dollar bills would stretch one million miles, or from Stamford to Memphis and back over 900,000 times), IP will pay down debt, bring its pension funding up to date, buy back up to $3 billion worth of outstanding stock, and keep about $2 billion for opportunistic investments.
For some, that $2 billion of investable funds will be a key piece of whether or not the transformation is successful. “Watch what they don’t do,” Chercover says. “They need to refrain from making huge acquisitions and overpaying for them,” he says, mindful of some of the missteps of the past.
The $3 billion stock buyback could reduce the share count by around 18% (and increase earnings per share accordingly). Also, as another part of the transformation, IP aims to cut $400 million in costs out of its continuing businesses over each of the next three years—$1.2 billion in all. These changes will have a big effect on the earnings of the company. Both Thibault and Chercover say they believe the investing public is underestimating the positive effect of these changes.
The Prospects
The bottom line? Give IP its due. First, the transformation does not lack for boldness. Faraci and company are doing their best to inject new life in a company that was not serving its investors. In the past, IP produced a lot of revenue, but little of it went to the titular owners of the company.
Moreover, indications are that the stock of Tennessee’s biggest new public company is on the verge of a renaissance. As this article was being written, IP stock was trading at 16.9 times expected 2007 earnings and 13.1 times 2008 estimates (compared with 17.6 and 14.4 respectively for the sector). Industry experts have reported an upswing in the paper cycle that began quietly this year and according to Barron’s “could accelerate over the next few years and could help drive the shares toward $40.”
The magazine went on to state that IP shares are “poised to improve” as the ambitious restructuring plan begins to pay off. The magazine quoted Phyllis Thomas, a portfolio manager at NWQ Investment Management, owners of 2.2% of outstanding IP stock, predicting “a strong probability of upside earnings surprises in the future.”
Recently disclosed second quarter sales—the company’s strongest in six years—provides evidence that a resurgence could be well underway. IP recently reported earnings from continuing operations rising 32% to 41 cents a share, far surpassing estimates of 33 cents, and revenue up from $5.9 billion a year ago to $6.3 billion this year.
For Tennesseans, it’s good to have the leadership here, joining the already-in-place administrative staff. It is certainly a boost to the corporate psyche of both the city of Memphis and the state of Tennessee to have one of the great business brands on Earth stake its headquarters in our soil.
Now we can all hope that the transformation does better than just look good on paper.
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