Organic Growth Checklist

Organic Growth Checklist

Organic Growth Checklist

  • Do you have control over 80% of the market for additional volume?
  • Do you have control over 80% of the additional raw material need?
  • Do you have the know-how?
  • If you start up on a declining market, will you cope financially?
  • Will you maintain your focus on your current markets?
  • And finally, the eye of the needle, why are you so much better than your competition on this? Why will you succeed when others fail?

If you cannot affirmatively answer the above questions you speculate to some degree on whether growth is beneficial to your investors.

At the risk of alienating the growth evangelists that base their reasoning on the success stories of the world: by default half of all expansion capexes into a market fail to deliver on their financial expectations. This is by default since capital cost is calculated by the discount rate used for these expansion capexes’ NPV calculations.

Growth is good! For the few! The companies with the best basic conditions for growth and the ability to capture growth will show superior shareholder returns, but the companies lacking that should focus on getting their existing house in order before growing – otherwise they will most likely destroy value. Earn the right to grow!

Sometimes, only one player on a market ends up making (a lot of) money, while the others will not recover their capital cost. In other words, few will in real life recover their NPV of zero. Still, on average, the market ends up around the expected NPV of zero. Not because half of the players reach it, but because the few that succeed often win so big it compensates for the losses of the many.

Most companies talk about growth as the factor that will lead to increased shareholder value. But the above statement implies that growth will be the factor that for most companies will lead to decreased shareholder value. As obvious as it sounds, only successful growth leads to increased value for company owners. However, growth is not successful by default.

 

How can YOU make sure that unsuccessful growth does not happen to your company?

Over the last several decades we have seen many, many cases of unsuccessful growth. And only a handful of successful ones.

We have put together a checklist that we discuss with our clients. We give the “green light” if all are checked. If you cannot “check” all the bullets you are to some unknown degree speculating with the owners’ capital. You may think you’re taking calculated, well-reasoned risks, but you may just as well be speculating. Here is our checklist:

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You must already be in control of over something like 80% of the market for the additional capacity. This can, for instance, be achieved by consolidating “old” capacity into the new. If this is true for you then you’re not really growing much, you’re consolidating. It can also be achieved by having customers within your own company (integrating more), or through contracts. If you are in a growing market you might be OK still, unless your marginal output will be a substantial part of a year’s market growth for your market (others will also try to grow in a growing market).

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You must also already have access and/or control over something like 80% of the raw material supply for your capacity increase. You might succeed if you “go to war” for the remaining 20%, but probably not if you need to fight for more. In many cases this is not easy to achieve, but sometimes it is. You should be OK with <80% if your input is a commodity.

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Do you have the know-how? Is this a known market/technology for you? Or with this growth are you entering something new? Do you internally have the know-how? If you don’t, then you need to acquire the company or the people to fulfil this requirement.

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If you find yourselves in truly poor times when you enter the market with your new capacity, will you be OK from a financial point of view? Or are you risking your company?

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If you already have a business today; will you be able to maintain your focus on this? Have you already treated your current business the way you should? Or are you avoiding doing what you should be doing in your current business just to save the capital for your expansion opportunity? Because that is a classic recipe for company failure.

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Then to the one where so many companies fail: Why are you so much better than the others in this market? Because you have to be just that; truly better than the others. 9 out of 10 male drivers think they are better than the average male driver – that mentality applied to business is another given recipe for failure because the success proportions might be the opposite; maybe only 1 out of 10 will succeed. Self-confidence is good, but the belief in oneself when adding capacity must be realistic, and we often see companies thinking they are so much better than the others – while there is little to no proof of that; it is simply a mantra chanted by the leadership of the company.

We’re not saying you should say no to a growth opportunity if you do not comply with above, but understand that you are to some degree gambling with your owner’s capital and you are at great risk of becoming one of those who fail.

If you do fulfil the above, spend more money than you first expected on grasping the opportunity; do not hold back. You must secure the quality of what you do. Move faster and be more resolute. Conquer the opportunity before someone who does not fulfil the above comes in and ruins the market.

The Capital Allocation process

The Capital Allocation process

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

The Capital Allocation process – from Asset Strategy to Capex follow up – “We own it!”

Robert was out walking around the lake just outside the offices. As always, he was sipping on a decaf coffee. Mary had, for once, joined him. “Well done, Robert.” “

Thanks, but really it was my group of coworkers…

Mary raised her hand and said, “Stop it. I know what you are about to say: it was really the hard work of all our colleagues, etc., etc., etc. And you are right, of course it is. But you started it! You not only identified the need for change-you acted upon it. You were the one thinking beyond what we normally do. You are the one that initially took a risk.”

Now it was Robert’s turn to raise his hand and stop Mary, “Thanks, I appreciate it but it is a part of my job. The responsibility for the capital allocation process is in my job description and really it was not until now, or very recently, that the tools and process that enabled us to do this was made available to anyone.”

“That’s right,” said Mary, “but we are among the first to move when it comes to this-it will give us an edge for years, maybe many years. But our competitors will follow. And you know what? Maybe that is not so bad. No one benefits from anyone wasting money, not even competitors.”

Robert finished his decaf and threw the paper cup into the green trash bin. Mary did the same with the green tea in her cup and threw it into the same green bin. “Robert, have we implemented the tools and processes properly or are we still in need of help to operate it over a cycle?”

“We own it!” Robert said with a confident smile, emphasizing the word “own.” “From the company-wide Asset Strategy maximizing long term cash flow, down to the routing and follow up of an individual capex. From system administration, user rights and restrictions, to training of new personnel.” Robert continued, “We have fundamentally changed the way we think about capital allocation and capexes. We have changed our mind set. We are on top of it. It is now part of our culture-we have institutionalized it.” Mary could not only hear but also see how Robert, a normally very composed man, could not help but show his enthusiasm when speaking about the new and improved capital allocation process and the system supporting it. Robert continued, “Our ability to use and benefit from the system that supports and ingrains our capital allocation process is not dependent on any one person, group of persons, or consultants.”

Mary raised her right arm and rested her hand on Robert’s left shoulder, still walking. “Good! Because soon it will have to do without you. I’m being put forward as the new Chairman of Board and we would like to offer you the CEO position.”

Later that evening Robert was standing alone looking out over the bay. This afternoon he had felt excited about the news from Mary. And a little stressed. Yet now he felt calm. He remembered a tag line that the authors of “The tail wags the dog” had presented to him when introducing the systems and solutions that Robert eventually had implemented in the company. At the time, Robert thought it was a little silly, but now it came to him. The view of the sea with the mountains in the background was stunning and soothing; he was home early enough to kiss his kids goodnight. He felt calm and confident. He had made the “Weissr” decision.

Do you also want to make the “Weissr” decision? Contact us at contact@weissenrieder.com or phone +46 31 761 07 30.

Interested in learning how we can help you?

The New Capex Process

The New Capex Process

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert, who chaired the Capex Committee, looked at his wristwatch. “So, are we in agreement?” he asked the rest of the group. It was more of a rhetorical question than a real one. He knew they were all aligned. And it had been almost friction free. They would all get home in time for dinner. He was not sure everyone appreciated that, though. The thought made him smile wryly.

Only last year he had dreaded these meetings. Someone had jokingly called it B.C.T. – Before the Capex Tool. Even though the requests were supposed to use the same models and templates, they had often been “tweaked” or sometimes even manipulated. They had changed hands many times and the end result was something akin to a game of “Whisper.” What ended up at the capex committee was often unrecognizable to the original author and no one could understand the, at best, manually kept change log. Therefore, it was also difficult, with certainty, to say who changed what and when. And that had been the easy part to handle. The real challenge had been agreeing on the capexes to commit to and which ones to deny or potentially postpone. Robert had previously, B.C.T., always left the Capex Committee meetings with a feeling of being out of control, of being forced to accept capexes in sites and machinery on which he really, really did not want to spend any money. However, the requests always looked so good. He knew the site was using outdated equipment and that the numbers showed a very short payback and a very good NPV. On top of that, the sites’ ROCE was way above the company average and target. How could he say no? In fact, before this year he could not. So, the money went to wherever the shortest paybacks were found. It just so happened that they were seldom found in the sites and machinery that were state of the art. Too little of the money had ended up being spent on the sites that they would still operate in ten, fifteen years. On that, Robert would bet his right arm!

Now, the model, templates, strategic rational, classification, users, change logs, approval routing, the process, you name it, were all standardized and transparent. Very important in itself, but Robert suspected that many modern Capex Management Tools could help out with that. What set their chosen solution apart was how it interconnected with the long-term Asset Strategy that they had established. How ranking based on payback took the second seat compared to how that particular capex interplayed with the Asset Strategy-was it aligned? What did the Asset Strategy say about the long-term survivability of the asset? What was to be expected over the next five, ten, or even fifteen years when it came to reinvestment, investment, or compliance needs?

The Capex Committee was looking at a “dashboard” summarizing the coming year’s capital budget; a budget that Robert and Mary, the CEO, would present to the Board of Directors at the upcoming meeting. Once a year, every fall, the board reviewed the three-year investment plan and (usually) approved next year’s capital budget. Sonia, a senior controller, raised her hand as if she was still in school. “Yes, Sonia?” Robert said.

“I think that we are all aligned, but will the board be?” Sonia asked and continued, “The total limits we ask for are not that different from what we have used historically, but the allocation…it is…how should I say it…a lot more active. Some businesses get a lot, others very little. I believe, no, I am convinced that is right but will the board stomach it?” Sonia looked at the others and the others looked at Robert. Robert had expected a question like this; he was rather surprised it had not come earlier. It was very true what Sonia said, the capital allocation was much more active-between businesses and between sites and machinery-historic capital budgets were no longer any argument for getting money going forward, neither were egalitarian principles of a certain sum per capacity or sales. Egalitarian principles are very noble when it comes to people but not when it comes to machinery – not all machines and businesses are created equal. And it meant that they, as the leaders of this company, had to take responsibility not only for the fun things such as installing new machinery or updating older lines and machines, but also responsibility for active choices of machine, site, or even whole business closures. Not all liked that. Most people never said that they did not like taking responsibility, more often they pointed at someone else that they imagined would not like it such as the CEO, the board, an owner, the union, media… That is why Robert now felt so good about having started at the right end, with the asset strategy and then following it up with the capex plan and budget.

“I would not worry more than normal about the board,” Robert said, “They are already in the know.” He continued, “Both they and the senior leadership of this company is prepared to take some heat regarding a number of the upcoming decisions, but hey, that is our job. If we cannot stomach it, well then maybe we should be doing something else.” Robert felt that his tone may have been unnecessarily harsh, but he meant every word he said. He would be damned if they as a company could not take responsibility for the tough decisions when they all agreed it was the right way to go.

In the car on his way home, Robert was thinking about the meeting. Overall, it had been great both in terms of outcome and in terms of how they had gotten there. However, at the end he realized that they still had one thing to do regarding the job he and Mary started last year. The supplier of the systems and services they had used had tried to get his attention regarding this, but Robert really did not think it was necessary – yet the last few minutes of the meeting had made him change his mind. They now had the strategy, the tools, and the processes in place. A lot of people had been through some training and especially the select few that participated in the original Asset Strategy project last year had changed their mindset and learned to better understand how the Asset Strategy and how individual capex decision interlink with long-term cash flow and enterprise value. Now, Robert wanted that understanding to go beyond the select few. Alright, it was not for everyone in the organization, but definitely more than the selected few needed to get that extra training and understanding for him to honestly say that the mindset they strived for was now a part of the company culture.

 

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

Asset Strategy – Check! Tools – Check! Buy-in? 100%

Asset Strategy – Check! Tools – Check! Buy-in? 100%

IF you have missed any part, click on the buttons below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert, the CFO, was in the middle of his presentation to the board. Mary, his CEO, sat amongst the rest of the board, next to the chairman, and listened. Robert and Mary had been through the presentation in detail several times in preparation for today. Mary had also prepped the chairman of the board and she felt confident. Still, the rest of the board had not been along for the ride. They had not gone through all the discussions, all the details, all the alternatives, all the scenarios, and sensitivities. They had not seen the entire project group, including senior management, go through an emotional, yes emotional, roller coaster of facing up to the industry’s long term realities. The members of the board had not seen how the group had not only accepted, but come to embrace the responsibilities of both creation and destruction that come with running a major company. Today, however, the board would see the outcome, the asset strategy that Mary’s team supported and believed in 100%.

Mary remembered how the project group, together with a team of specialist consultants, had created a so-called Base Alternative, an alternative where they just carried on, running all businesses as going concerns. The outcome, evaluated from a long-term cash flow and enterprise value perspective was thorough. Many sites were in dire straits already and would, if nothing were done, have to be closed over the next decade. Many participants did not, at first, believe the outcome of the Base Alternative. However, it soon became obvious to everyone that the future that the Base Alternative depicted was no worse or different than the history had been, and they had all been through it. The consultants and the specially designed software had guided the group throughout the process, from detailed model building to analyses of outcomes. Every participant of the project had their personalized interface with the tool and the consultants facilitated a collaborative process that still made all assumptions, calculations, and inputs transparent and possible to challenge and easy to test from a sensitivity point of view.

Once the Base Alternative was established, the real work got started. Assume that nothing is a going concern. What happens if we expand Mill A? And close Mill B early? Can we convert Machine 10 to produce something else? Is there an opportunity to rebuild the back-end of Mill D? Can we close two mills within three years and rebuild Mill F and G, etc. All in all, the group had constructed 25 different Strategic Building Blocks, individual strategic initiatives. These had then been combined into 97 different whole business Strategic Alternatives. Out of these 97 alternatives, one had panned out. One selected Asset Strategy that maximized the long-term discounted cash flow and enterprise value of the business. One Asset Strategy, which the entire team supported, even if not all were happy about all the decisions it meant implementing. They supported it from the point of view that it was the best way forward for the company. It was not necessarily the best way forward for each individual mill. They had learned in the process that the sum of what is best for each mill is seldom or never what is best for the whole company.

From a cash flow point of view, the result was very interesting. Historically, they had spent around 400 million USD per year in capexes. Interestingly, that number would slightly decrease on an average over the next decade. Yet they would spend it very differently. It would be much more concentrated. And they would get a lot more cash flow back, definitely more “bang for the buck.” The difference in enterprise value between the Base Alternative and the selected Asset Strategy was roughly 30%, or 800 million USD! Mary believed it. Of course, numbers would be different going forward. Neither they, nor the consultants, nor the tool was a crystal ball. Still, all the tests with sensitivities and scenarios had convinced her and the team-the value was in that ballpark. Not only that, for the first time since Mary had been in a senior executive position, she had a team running the company that was in alignment regarding the major asset decisions going forward. It would certainly make her life easier! Sure, things would change, things that they had not tested for. They would come up with new ideas. Good! Robert was just talking about how the tool would be used in the ongoing strategy process. How different users are responsible for updating data, how new Strategic Building Blocks can be created and allowed to challenge the current Asset Strategy.

Mr. Anderson, the chairman of the board, asked Robert and Mary, “So do you expect us to make a decision on this entire strategy as one piece? We cannot do that!” Mary had expected this question.

No. We will ask for decisions on individual capexes and closures just as before, but we want to relate and evaluate all decisions in relation to the current long-term Asset Strategy. We no longer evaluate any strategic capexes or asset decisions in isolation. We ask for decisions on them just as we have done before, but we evaluate them and present them in the context of the long-term Asset Strategy. If you will, you can say that we are putting the horse in front of the carriage or giving the dog control of its tail.” Mary looked at Robert and smiled. She had started to appreciate his sometimes-stupid metaphors.

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

We are losing three hundred grand every single day!

We are losing three hundred grand every single day!

IF you have missed any part, click on the buttons below to read from the beginning.
The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert started his second lap around the artificial lake just outside the offices, walking and sipping on a decaf coffee. This morning he had been through a number of meetings with the “usual suspects” when it comes to management and strategy consultants. All of the tools and processes that they had discussed regarding improving the allocation of capital between sites, machines, acquisitions, and dividends did not seem to address the fundamental question – what to do differently? Not just more of, or improvements on, the same – but fundamentally different.

Robert could not stop thinking about the series of articles he had read on the plane, “The Capex Process-the tail wags the dog”. He had read them all, several times, just weeks before that conversation in the car with Mary. Those articles had inspired him when answering Mary’s question, “What should we do differently?” Since then he had also used a little tool that he had found on the internet to try to answer the last question Mary had asked in the car-how much would it be worth to fundamentally and sustainably improve the effect of investments and capexes? The group spent around 400 million USD on capexes every year. The authors of “The tail wags the dog” claimed that any company should expect a minimum improvement in capex efficiency of 10% when tying the capex process to a whole business asset strategy. Testimonials claimed much higher percentages. Robert himself sincerely believed that, if successful, a 20% efficiency improvement was possible. It would not necessarily mean a 20% reduction; it would just mean a different, sometimes very different, view on how to allocate capital and resources over time. Twenty percent would mean 80 million USD every year in lost cash flow due to less than optimal decision making on capex. Or more than 300,000 USD per working day! There was no question in Robert’s mind that there was real value in trying to take control of the capex process from a longer-term and holistic point of view…and the “usual suspects” would be of little help. Time to go to the source. Robert determined to call the authors of the series of articles he’d read and ask for help.

The senior consultant Robert contacted had made a real impression on Mary and Robert. If before their meeting they had little doubt about the need to change the whole regime regarding capex allocation, they were now absolutely convinced. And they knew where to start. Not with the capex process, but with the long-term asset strategy.

When Robert returned from his walk, Mary called him into her office and said, “Robert, I want you to look into that list of requirements on an Asset Strategy Tool that the guy talked about. Do we agree? Are they the only ones providing such a tool? Can we do it ourselves? How would we work with such a tool and how would we change our processes?

Ok – I am on it.

And don’t linger…we are losing three hundred grand every single day!”

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

What the **** is wrong with our capex process?

What the **** is wrong with our capex process?

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Glen, who had worked as a process engineer in the pulp mill for 20 years, did not understand it. A group of corporates had just finished a short speech to the employees at the mill. The mill was shutting down. Not temporarily, but for good. Only a couple of years ago, more or less the same group of people was giving a very different speech after having spent close to $100,000,000 on replacing digesters and upgrading the bleach plant. Glen remembered the enthusiasm; he himself had crunched much of the data behind the decision to invest. The payback was less than 24 months and the mill’s return on capital employed that year before the capex decision was reported at 20%-well above the group average and target. The project had, for the most part, been successful and was implemented more or less according to plan. Yet, here they now stood, only a couple of years later, facing a closure.

Mary, the CEO, was also thinking about that $100,000,000 capex. She had been the group CFO at the time and she had endorsed the decision. Mary bitterly regretted it now. Not only did the money invested go to waste, but maybe more importantly-they had not spent that money in the mills that they still operated and that they hoped to operate for many decades to come. Still, she did not know if she would act differently if faced with a similar decision now. How could she avoid making the same mistake again? The numbers-the net present value, the payback, and the mill’s return on capital employed-all pointed her in the direction of making the decision to spend the money. Additionally, the mill management had easily convinced her of the technical and market need for improving brightness and quality. Yet here she was-communicating the permanent closure of the mill. When in the car with Robert, the current CFO, she asked, “Robert-how can we avoid spending large amounts of money on sites only to see them go down a few years later? What the **** is wrong with our capex process? Why could we not see this coming?” She was now talking more to herself than to Robert. “It is not the first time, and I bet it is not the last time. Don’t even get me started on acquisitions! How many of those have we lived to regret? Robert, I know I am upset now, but tell me how on earth I, with a straight face, can tell my board when they ask critical questions on our capital expenditures or acquisitions that it is all different now, that we have learned our lesson. We are not different! We continue to do the same thing, over and over again. And it’s not only us. It’s the whole industry! Robert, tell me – what should we do differently?

Robert was quiet for a short moment. He had spent a large amount of time over the last six months, when agonizing over the closure decision, pondering that exact question. “Mary, I don’t think it is the capex process as such that is at fault. I think it is a case of putting the carriage before the horse, or the tail wagging the dog.”  Robert could see Mary opening her mouth to say, “What?” but he raised his hand and pleaded, “Bear with me.” He continued, “I think that our capex process is so strong and institutionalized that it has taken precedence over any long-term capex allocation strategy that we may have. The capex process should be there to help administer and implement a long-term asset strategy or capex allocation strategy. I am not talking about a three-or five-year plan, but something much longer in scope. After this closure, we have 12 sites with a capacity of around four million tons of packaging, pulp and paper. If we disregard acquisitions for a while, do you think that we will have all 12 existing sites operating 15 years from now?”

There was a moment of silence. “No, we won’t,” replied Mary.

I agree. I don’t think so either,” said Robert. “If I had to guess, it will probably be closer to seven or eight sites still producing more than four million tons-or even more.” Again, he paused. “We know that we will be facing closures. Continuously. We also know that we will need to expand other sites.

I think you are right Robert, so what should we do?” Mary asked again.

Robert continued, “I have the feeling that closures are something that “happens” to us, something we are “forced” to do. It should not be like that. We should take responsibility and plan for closures and exits, long before they happen. We should choose, based on the long-term cash flow for the whole system of mills, where we should be long term and where we plan to exit three, five, and ten years from now and how to coordinate that with expansions and volume moves to the remaining system.

Robert paused for a second, thinking. “Go on, I’m listening,” said Mary.

“I think in such a capex regime no decision can be made in isolation. Each and every capex decision needs to be tested against the larger and system-wide asset strategy. Does it fit or does it change or challenge the current strategy? In short, we need to put the horse in front of the carriage and give the dog control of its tail….”

I am not sure I like your lousy metaphors, but **** it, you are right,” said Mary. “Robert, I want you to look into this now. I mean it. Now. I am not making any large strategic decision before we sort something out. We need a long-term asset strategy and we need to connect that to the capex process. And Robert…this cannot be a financial exercise. We need to involve market, business owners, energy, engineering, controlling, raw material supply, etc. I don’t want this to be a one-time thing. Who can help us? Where is the external expertise? Where are the tools? How can we get this into our DNA? And also, how much would it be worth to us?

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

You are wasting capexes – but you don’t have to…

You are wasting capexes – but you don’t have to…

At Weissenrieder & Co. we have met many CEOs and CFOs from many different industries that have come to the conclusion that the way they spend and allocate capexes is far from optimal. They know that a substantial part of the capexes spent go to the wrong projects, the wrong sites, and the wrong businesses, and they want to act. They feel the need for change, but they don’t know what to do about it. Where can they find the theoretical insights and the tools that they need? How will the company need to change? And how much is it worth to solve the problem?

Follow Robert on his endeavor to improve long-term cash flow by fundamentally changing the way his company prioritizes when spending capexes. (The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

The Capex Process – The tail wags the dog 

Robert, group CFO, left the capex committee meeting with a sinking feeling of being responsible for something, but not in control of it. Every three months the committee that he chairs reviews a current list of capex requests. Except for the board of directors, the capex committee is the final yea or nay when it comes to capexes. This is the group that is responsible for, arguably, the most fundamental task of any listed company – allocating capital. Ultimately, the capex committee impacts the allocation between dividends and investments, between organic growth and acquisitions, between different businesses and different sites, but what they actually do is prioritize between different discrete capexes.

In theory, the process is rigorous. It includes approval routes, tollgates, standardized templates, company-wide macro assumptions, and a set of industry standard decision criteria that is used to evaluate and rank requests. Still, Robert left every single one of these committee meetings with a feeling of being out of control, almost manipulated by the process. Or, he felt forced by circumstances to react to needs rather than act out a grand plan, a strategy.

Most of the meeting he’d just attended had concerned one single site that was in dire straits and faced a number of capexes to comply with environmental standards. Standards that the company had to follow to avoid production limitations but also a standard that they wanted to follow, not the least because more and more customers demanded it (without wanting to pay anything extra, of course). It was a site with a healthy ROCE, but mediocre margins. The capexes’ NPV were there and the paybacks were short (compared to losing volumes or price). However, it was a mill that popped up regularly on the “need” list when it came to capexes and even though ROCE looked healthy, Robert could not remember when the site in question had contributed any significant level of cash flow. But – again – the need was there, the assumptions in the request looked realistic – positive NPV and a 12 month payback.

How could he say no? Why should he say no? Could he say no? Based on what? To the great irritation of a number of people, Robert had procrastinated on making a decision. He felt trapped by the process because he felt intuitively, and by experience, that something was wrong. He thought that the process was too myopic, too near-sighted, when what they really needed was a bird’s-eye view.

A certain text had continuously popped up in Robert’s LinkedIn feed, as contacts of his had “shared” or “liked” it: The Capex Process – The tail wags the dog.” Well, he had two hours to kill on a flight this afternoon; maybe he’d finally read the articles.

To be continued.

Interested in reading the next episode?

The “creative destruction” funnel

The “creative destruction” funnel

This is a part of a three piece article series. This is part three.
If you want to start to read the beginning of the series, click here for part one.

3.0 “The Creative Destruction” Funnel

3.1 Began the work in 1994

Fredrik Weissenrieder started working on what we do now, in 1994. He was finalizing his Master in Finance and Economics studies at Gothenburg School of Economics. Mr. Weissenrieder’s thesis dealt with how companies should calculate their capexes, etc., but also discussed inconsist-encies in his finance classes, such as why companies evaluatecapexes with (for instance) IRR, but when the capex is behind them, they evaluate the business using ROCE (two totally different mathematics).

To cut a long story short, a European Pulp and Paper companycalled him the day before he was about to get his degree. They had read his thesis and had a project for him. The person calling said “We have this mill. They show us capex plans who’s capexes average an IRR of 40%. We don’t doubt the 40% because we have been following up on capexes there for some years and they basically deliver. If they say they are going to take out 10 people they do that, cut power consumption on the PM by 3% they do that, etc. So, ‘check’ on the 40%. The mill has averaged an ROCE >25% over the last 15 years. It all looks fine, right? However, we want you to explain to us why the average cash flow from the mill has basically been zero over the last 15 years.”

So, Mr. Weissenrieder dug into cash flow data going back decades. It took him 4 months, but he eventually worked out what had been going on in that mill. Since then, wehave been working as independent consultants within this field.

This is how it all started. While investigating the mill, Mr. Weissenrieder carried out a number of interviews. He interviewed the mill’s controller and asked him the question “what is your philosophy when you invest in the mill?” His answer has haunted us for more than 20 years because he answered, “We invest according to the going concern principle.”

Mr. Weissenrieder had to ask him what he meant by that since he was into finance, not accounting. The controller said, “We invest in order to make the mill sustainable.” In other words, they invested to ensure the mill remained viable. In the summer of 1994, Mr. Weissenrieder thought his answer made sense. It took him about 4 years until he realized that this was the number one problem in the industry when it came to decision making.

3.2 Going concern – the route to capital destruction

Look at Figure 3-1 below. Each line represents three to four pulp mills in Sweden. Forty years ago, Sweden had about 110 pulp mills (including all technologies and integrated mills). Now there are about 30 pulp mills. Today, those 30 mills make twice as much pulp as the 110 did 40 years ago. They are making more with less resources thanks to technology development.

So, the Swedish industry shut 80 pulp mills. Are there 80 reasons for that? No, there are only two reasons. The first reason is that pulp prices are down (as a trend) in real terms every year, that is the red line going down in Figure 3-2. The second reason is that costs (for each existing mill, in relation to the pulp price) are up (the red line going up in Figure 3-2). There is a margin squeeze over time (as also illustrated in Figures 1-7 (p.34), 2-1 (p.15) and 2-7 (p.23).
80 mills could not survive the margin squeeze so they were closed. See Figure 3-3.
Is it a problem for Sweden that it shut 80 mills out of 110?

No, it is great from the nation’s point of view. This is growth; making more out of fewer resources. We should all welcome this as it provides a nation with more resources for healthcare, education, etc. This is nature. It is destructive to a country’s development if a government tries to stop this type of development because mechanisms of nature and development are taken out of play.

Is it destructive for a corporation? If the corporation has several (in this case pulp) mills?

No, it is fantastic. It provides the corporation with several consolidation opportunities, capital allocation opportunities, etc.

However, this is where it all goes wrong.

Think back to Figure 2-5. The mills in categories A and B are all treated as going concern mills. They are treated more or less as if they are going to live forever. Not the mill in the C category, but in the A and B categories.

What else does Figure 2-5 say?

It says that 75%, or so, of the company’s resources are put into what is not sustainable in the long term. In fact, the capital-intensive industry has a reputation for investing heavily in mills two to eight years before they close – when those mills appear to be providing a reasonable ROCE/EVA/etc. with several investment opportunities offering quick payback (in other words, a poor Category B-mill). At that point, would not many question that mill’s sustainability. Several people with some years in the industry provide us with examples of that in a discussion. It feels “safe” to invest in a mill like that. Who can say they’re doing the wrong thing? It looks great on paper – it has no sustainability, but that was never considered when making the decision.

Companies put 20-25% of their resources into assets that are sustainable long term. How competitive are those mills after 10 or 20 years when new, highly competitive Category A mills are built by others? What if the resources are spent on mills that will not survive when these new Category A mills are built in, for instance, South America or Asia?

The question for an individual who is part of the decision process is, how will your company deal with the future? The company certainly has a process that in the future will direct resources towards less competitive assets, assets that are “the next Category C mills”. How does one create a company that allocates capital to the right assets (which may well be one or more Category B mills, but which ones, how and when?).

This paper has discussed the challenges and situations companies face when assessing a capex request. It has not provided a solution. Our experience tells us that there is no point in discussing solutions if one cannot agree on the issues/problems/challenges, therefore solutions have no part in this paper. Too many people say ”these issues do not exist” or ”we don’t have these issues in our company”.

As a reader, it is tempting to think that your own company’s capex management process avoids the traps described in these articles. If this is you, then you need to rethink your position. All companies have the possibility tofix the issues that are discussed in this article. Weissenrieder & Co.  have applied the solution for years – it works. Contact us for a discussion about our solution that can help you make informed decisions on how to best allocate funds and improve your company’s long term cash flow.

Appendix 1-1

Mills/companies often assume or claim that mills will be making more money after a capex. However, it is actually about not making less money. Many times, we have heard people in companies talk about their capexes adding the NPVs they have been calculated, claiming that the mill will improve.

Think about it: name a mill/plant whose EBITDA margin has continuously improved over the last 10-20 years? If we examine it closely, currently operating mills with very few exceptions steadily, as a trend, have decreased their margins. That’s nature. Sometimes one might experience an improvement of a mill’s EBITDA margin due to and after a capex, but that will be small and short lived. It will have the character of “catching up to the level where the mill should have been,” but only for a short while.

We were at a meeting in a mill about 10 years ago, and had a discussion similar to this. The controller at the mill said something that was both amusing and interesting. He said, “If we had achieved all improvements that we have claimed in our capex requests over the last 10 years we would have an EBITDA margin of 110% and we would have only one person working here”.

So, we claim that the capexes companies make in their mills are there to prevent the mills from losing their ability to make money. Capexes are not made to make more money. Value is not added; less value is lost, even if decisions lead to costs being cut, quality being improved, etc. All efforts are directed at trying to keep up with competition – because they develop. The industry’s improvements are taken out in the price of the product to the customer.

There are two exceptions. The first is if one increases capacity. Then the mill potentially makes more money;the value of the business increases, see Figure 1-8.

The second exception is if a mill can invest in an improvement that is unique for that mill. That no other (or only a selected few) can implement. Then one will have an advantage, value is added.

We have to admit to one simplification we have made. The full green line doesn’t look as we have drawn it in Figure 1-9. They are not horizontal. They trend downwards, like the blue line in Figure 1-9, and all the capexes made are to prevent the line from falling even more quickly.

Interested in reading article two?

“The tail wags the dog – how tactical capex decisions run company strategy”

Interested in reading article one?

“The Capex Process – The Tail Wags The Dog”

How tactical capex decisions run company strategy

How tactical capex decisions run company strategy

This is a part of a three piece article series. This is part two.
If you want to start to read the beginning of the series, click here for part one.

2.0 The Tail Wags The Dog – How Tactical Decisions Run Company Strategy

2.1 Competitiveness over a lifecycle

An industry always improves, in the sense that it is always betterat what it is doing today than it was 10 years ago, because of technology development (the industry doesn’t, however, make more money due to the real price decline). We illustrate this point with the red line in Figure 2-1.

The red line is the industry average, so half of the industry’s capacity is above the red line and half is below at every point in time.

At some point, a company will build a new mill, either a Brownfield or a Greenfield. Or it will add a new production line in an existing mill. We illustrate that with the blue line starting at point A, where the mill is new and state of the art. It is clearly above the red line. Over time, the mill will be improved (the blue line goes up) but it can never follow industry average. At some point, it will cut across the red line and become less competitive than the industry average. Decades later, the company will come to the conclusion that it is better to shut down the mill because the gap between it and the industry average has become too large. This is a simple illustration of a life cycle of a mill.

A mill will slowly travel along the blue line to the right. Most mill investments will, at best, slow down the loss in relative competitiveness, not improve it. Only a few investments will take it to the left (improve mill competitiveness), and then in almost all cases it will only be a small shift. For example, a company makes a really large replacement capex in a mill. It replaces 10% of the mill with state of the art technology (like a so-called recovery boiler in a pulp mill). The time from the decision to invest in the mill to turn key (completion of investment) is often 1-3 years. Replacing 10% of the asset base shifts the mill to the left, but 90% of the mill ages another 1-3 years in the process. The net effect for the mill from the point of decision to turn key is not very large.

2.2 How capital and other resources are allocated in a system of mills

We will use Figure 2-2 (p.17) for our discussion about allocation of capital. Let’s say we run a business with 10 mills. They are all making more or less the same type of product aiming at a certain market. We assume that our port-folio of 10 mills, on average, is exactly on the industry average (i.e. we have half of our capacity in mills that perform better than the industry average, and half of our capacity in mills that perform below industry average).

Therefore, it is not unlikely that we would have three mills (making up 50% of our capacity) that are the more competitive mills, and seven that are less competitive. Let’s categorize the 10 mills. We have our Category C mill, the mill we understand we will close in 1-3 years since it isn’t performing well at all. We have our three close to state of the art Category A mills. Finally, we have our six Category B mills, good providers of our product mix, etc., but to different degrees less competitive.

How would a company within the capital-intensive industry today act in these categories with its resources? Having worked with dozens of companies within the capital-intensive industry we have an opinion on this. To understand how companies today allocate resources we ask three questions:

Question #1: “In a normal year, how would your company invest in those 10 assets?” Most companies do not have relevant information to make the categorization, but let’s give this a try. We exclude possible investments in Brownfields/Greenfields, we just look at those 10 assets.

If we begin with Category C, it contains the mill that we know we will not keep for very long. We would prefer to spend 0% of capexes on this mill, but we need to spend some capital in that mill for it to stay open another quarter, another year. Most companies spend 3-5% of their capital on this category of mills.

How about Category A?
That category is relatively close to state of the art technology. They “need” less capital. Additionally, the opportunities for this category are perceived to be not that many (since they already are relatively good). They have less environmental issues, fewer safety issues, etc. On the other hand, they represent 50% of the capacity – clearly the need to invest here exists. Most companies would invest 20%, sometimes up to 25% in this category.

Finally, we have Category B.
Six mills (twice as many as in Category A) with an increasing technology gap (aging assets). Often these are relatively complex mills – two or three of everything instead of one – and not always a “linear” layout. There are usually environmental and safety issues. Category B gets 75% of the capital.

The percent split between the categories should not surprise anyone (Figure 2-3). Category A doesn’t really need money. The desire might not be there, but some investment must be put into Category C. Category B definitely requires capital. Some companies say they don’t invest like this. A few of those companies might not, but in our experience, the vast majority of companies do invest this way. However, it is common for companies to get the categories of the mills mixed up, they think a Category B mill is a Category A mill, etc. We even came across a company who thought one of their Category A mills was a Category C mill. Question #2: “How much of the next 10 years’ cash flow do you expect to receive from each category?” While the split of capital spent between the categories is similar between companies, the split of future cash flow between the three categories isn’t, since it depends on what type of assets a company actually has.
If lucky, Category C will generate 0% of future cash flow. Category A’s mills have a higher EBITDA and margin than Category B (and C) as well as lower capexes. So, this category will clearly provide the company with the highest cash flow (if not, they have been assigned to the wrong category. This is the common mistake, mentioned above). In our experience, Category A generates about 80% of future total cash flow. We have seen anything from 60% to 300% for Category A (please do the math on Categories B and C in the latter case). Category B will provide an average of 20%, after capexes. Question #3: “Pick your 100 most important/valuable resources in the company. Exclude hours spent on budgets, reports, etc. and only look at their quality time. How much of their quality time goes into each of the three categories A, B, and C?”
Category C gets a shocking 30%.

When considering the answer to Question 3, a company must include all the discussions/analyses/etc. on, “Should we close or keep, should we make another investment?” In considering this question, include the time spent trying to fix the mill, evaluating closure costs, and eventually when the mill closes. We had a client once who hesitated over a Category C mill for a long time. Once they even had one of their senior VPs on the corporate jet going to the mill to communicate its closure. When he landed, he got the message, “We got another large order, come back home.” This can go on for years, which is why we see such a high percentage of resources allocated to Category C mills.

Category A doesn’t need resources.

Those mills are working just fine. In a project, we had a number of years ago, the project manager from the client’s side had been a mill manager for their best Category A mill for five years. He told us that the head office hadn’t contacted him even once during those years.

Category B gets 65% of the resources.

When we read the pink pages we often read about CEOs from the capital-intensive industry explaining the quarter’s poor performance with reasons such as prices not developing the way they expected, increased costs, and shaky demand. Certainly, one can explain a quarter or two with those factors, but the capital-intensive industry often fails in delivering shareholder value year in, year out. To blame the above factors for more than a couple of quarters is like saying that one lost a sailing race due to a head wind.

Prices not developing as expected, costs being up and demand being shaky is nature. It is a fact for all players in a capital-intensive industry. Technology development, even if slow, brings down prices compared to costs for existing assets – this is a fact. Companies invest in better technology in an attempt to avoid that.

Now, we cannot say that this table, for a certain company, in a certain year is “incorrect.” All we can say is that if one spends resources like this over time; one will weaken and eventually ruin the company.

We would say that all companies and all CEOs we have worked with for the last 23 years have had the ambition to do well. They want to do the right thing, to have the company make more money, but too many organizations fail.

There are several reasons for why many companies don’t deliver expected returns or fail. Why over time they don’t follow the stock market’s index, as an example. Here we show you all you need to drain a company of cash flow, and even sometimes, as shocking as it sounds, run them into the ground: All that is needed is to have the company’s future somewhere (green), but spend its resources elsewhere (red). Done year in and year out, decade after decade, results in a poor performing company. Or a company in Chapter 11.

This is all that is required to make a company fail, even if the intentions are the best. If a company has an aggressive acquisition strategy one might make things even worse (i.e. acquiring a large set of Category B mills. Acquired Category B mills usually consume more capital than the net cash flow gain from an acquisition – we have seen this countless of times. Why do companies end up in this situation, where resources are being allocated as in above table? They want to do the right thing, but the result is poor. For every little (and large) decision they make they do their homework, and they normally fulfill the benefits they claim in the capex request. Still, the company doesn’t succeed. How is this possible?
2.3 Why it goes wrong

We were engaged in answering this question in the late 90s. We came up with a long list of reasons but pared the list down to three basic reasons why companies fail.

The first two reasons are present in all companies, and they have to be there. They cause an extremely costly problem, but they are necessary.

The third reason is anything from somewhat present to very present in almost all companies. Although it doesn’t have to be present at all, companies can throw it out today – there is no point whatsoever in having it involved in the capital allocation process.

Reason #1: The capex process is a bottom-up process. It has to be. The mill knows the issues and how to fix them (supported by central technology/manufacturing resources). So, the mill manager will come to the head office and say “I have an issue, and now I know how to solve it.” This issue could be quality, cost, safety, environmental, etc. The head office will say, “We know. We have been discussing this now for two years.” On paper, the capex necessary to fix the issue makes sense.

Reason #2: Delta calculations are used to evaluate the benefit of a capex project, and the projects are evaluated one by one, in isolation. Going back to what we discussed in part one, basically all companies do what the textbook says, what we have been taught to do: they calculate the payback/NPV/IRR for each capex project individually, in “isolation” (we assume all data is accurate and correct).

So, a mill manager comes to the head office saying, “I have an issue, and now I know how to solve it. The payback is two years.” The head office is likely to reply, “We know. We have been discussing this for three years. The payback makes sense; it even looks a bit conservative.” They respond this way because an individual analysis of the issue tells the company the manager’s solution is an appropriate and reasonable way to proceed.

Reason #3: ROCE (or ROOC, Re, EVA, or any other P&L and balance sheet based measure) is used to prove the performance of the mill. It is bad enough that companies use these measures at the group level. Some claim that the errors in these measures are canceled out when applied on the company/group level. This is incorrect, and to use any of these measures on a mill level gives totally corrupt information (it doesn’t matter how many adjustments you make in, for instance, EVA). Let us give you a relevant example:

Take the blue line from Figure 2-5. It represents the life cycle of a mill, let’s say 60 years. We lay it out as the X-axis in a graph, with the categorizations A, B and C, Figure 2-6.

How does an EBITDA margin look for a mill over its lifecycle?

It would be very volatile, but for the purpose of our example, we can “normalize” it. Look at Figure 2-7 whose EBITDA margin development represents a mill from its Greenfield state to closure 60 years later.

From a poor, but normal start-up, this mill is at its peak competitiveness after about 5 years. After that, the EBITDA margin will slowly but surely decline until closure. This represents lowered relative competitiveness over time. This continues to be true even if capital is spent on the mill. In fact, the mill will decline like that because capital is spent on it. If capital is not spent, the EBITDA margin will fall even quicker and the mill will be closed a lot earlier.

In reality, the EBITDA margin will jump up and down. One can work in a mill for 20 years without noticing the EBITDA margin trending downwards.

How will the ROCE (or ROOC, Re, EVA, or any other P&L-balance sheet based measure) look for this mill? The ROCE is simply a mathematical consequence of the development of the EBITDA margin and accounting rules for depreciation. See Figure 2-8. Look at it for a while. What does it really say about “performance” according to ROCE in our three categories?

The mill carries a lot of initial capital in the first 15 years (accounting rules), but cash flow from year five is superior to any other year after that. The EBITDA margin is at its peak. Approximately at the point when it goes from being competitive to less competitive than the industry average, the mill’s accounting based performance measures will skyrocket.

**If you are ever to take the seat as a mill manager, make sure you do this a year before the initial capex has been written off in the books. Then make sure your bonus is set on ROCE or EVA; you’ll be rich. Cash flow and EBITDA margin will be down, but you’ll be just fine.

So, with “Reason #3” a mill manager comes to the head office saying: “I have an issue, and now we know how to solve it. The payback is two years. And, we still contribute well to the company’s ROCE”. Why would anyone ever say no to a capex with those attributes? No red flags anywhere in sight.

ROCE does not, in any way, indicate competitiveness. Hence it should never be involved in any capital allocation discussions.

2.4 The tail wags the dog

Any business wants to think that it sets a system-wide strategy for its assets and that its capexes follow that strategy, right? Like this:

However, our wide experience – and anecdotal evidence – is that it is not at all like that. The capex process is a well-established and truly “powerful” process in companies. An institution. Lots of people are involved with their respective responsibilities, rules not to be messed with, there are set structures for approvals, etc.

We claim that the capex process is so strong that it actually sets the strategy for the assets, in our example, the mills. The result of the selected capexes for a mill year in and year out determines the strategy of that mill and as a result, the whole company, (however, it does not determine the fate of a mill. Even stronger external forces determine that).

So, it is not that an asset strategy determines which capexes are chosen for a mill. Companies don’t even have well-established, uniform and thorough processes for setting the asset strategy for their system of mills, (the reader may think “but we do in our company”, especially if said reader is responsible for that process – we’ll challenge that statement any day).

So, the picture actually looks like this:

When the capex process determines the strategy, we call this “the tail wags the dog”, a common term for when something is backward. Our experience is that a company loses a value of at least 30% of its capexes every year. At least. As we discussed earlier in this paper, it is tempting to think that one’s own company’s capex management process avoids these traps. Individuals responsible for the capex process often react that way (CFO’s, VPs of Strategy, etc.). If this is the reader’s reaction, then he/she is acting defensive and not helping the company (or its CEO or owners). In that case, somebody in the company, other than the reader, will soon educate themselves from our descriptive articles and solutions, and bring the inevitable changes to the company.

All companies that invest capital in fixed assets (even if they are not necessarily capital intensive) need to fix this issue. All companies have to have an Asset Strategy that governs the capex allocation.

But the way to achieve it is not at all the way one might think it should be done.

Interested in reading article one?

“What really creates a short payback”

Interested in reading article three?

“The “creative destruction” funnel”

What really creates a short payback

What really creates a short payback

This is a part of a three piece article series. We hope that you will enjoy the series.
“We only do high NPV projects.

“We want to maximize the value from our capex plan.

“Only projects with short paybacks get approved.

“Our business’/mill’s ROCE is higher than our cost of capital.

Have you ever heard any of these comments in your company?

Then this is for you because your company keeps making value destroying capex decisions, and you do not invest where you actually will create additional cash flow.

In this white paper, we describe how companies apply their capex process, and how universities teach us to make capex decisions, lead to massive capital destruction. Almost all companies in all industries evaluate capex decisions in basically the same way.

It is tempting, as a reader, to think that your company’s capex management process avoids the traps we will discuss. CFOs, VPs of Strategy, and individuals responsible for the capex process often react like that. This is a defensive reaction and not helpful to any company, its CEO, or its owners. If you, or those responsible for these decisions, are not open to necessary changes to your capex process then someone else within your company will soon learn from our descriptive articles and solutions and bring the inevitable changes necessary to your company. Only change will lead to improvement.

Since June of 1994, we have studied how capexes affect mill performance in real life. Our work has

centered mainly on the pulp and paper industry, but we have also worked in other industries and the issues we have encountered are universal to capital-intensive companies. Our customers are primarily located in North America, but also in Europe. We have helped more than 500 mills/plants since 2004 when we more focused started to implement our Asset Strategy projects.

How today’s capex process leads to massive capital destruction is easily understood when visualized the way we do here. This text will change how you, as an experienced decision maker within a capital-intensive company, view your decisions. We will give you something to think about and something you have to act upon now.

Contact us: contact@weissenrieder.com or ph +46 31 761 07 30

1.0 What Really Creates A Short Payback?

1.1 The everyday capex situation

For the purposes of this paper, all examples will be of mills/plants in the pulp and paper industry. However, all principles, ideas, and concerns may be applied to any capital-intensive industry.

Imagine a mill/plant, See Figure 1-1 below.

The mill, in our example, has been making money (cash flow, net after capexes) at a certain level historically (A). Here illustrated as a normalized straight line, but it is volatile in reality. We can assume the mill will continue to make money in the future at this level. Again, normalized at this specific level.

At some point, the mill is likely to come to the Head Office and say: “Sure, we can continue to make money at this level, but to do so, we need to fix this quality issue that we have. Customers are complaining more and more often.”

Now, look at Figure 1-2. To fix the issue the mill needs to invest in a solution, and the mill – following instructions– does the math on this situation. If they make the capex, they will continue to make money as expected (the straight full green line); if they don’t, they will follow the dashed green line. The difference between these two lines is often referred to as the “delta.” The mill compares the delta to the capex amount (green down arrow) and calculates an NPV, IRR, or Payback.

We assume here that all data is correct (i.e. what the mill assumes for the future is what later comes true). Our experience is that the industry really doesn’t have much of a data issue. That is not why things go wrong.

So far so good. The NPV/IRR/Payback is correctly calculated. NPV of 15 and a payback of 18 months in this case and the company is likely to go ahead with the decision. It makes sense.

Three months later, Figure 1-3, the mill again approaches the head office saying, “Sure, we will make money at this level, but to do so we need to fix this cost issue that we have.”

Again, they do the math on this new situation and come up with the benefits of project No 2. This pattern will continue month after month, year after year, with additional projects. Figure 1-3 represents the mill’s capex plan, in this case, 10 future capex projects from “Today.”

1.2 Misunderstanding the value of a capex project

The sum of all individual capex projects’ NPV in the capex plan is 200. Now to something that is interesting: The 200 in value (USD/EUR/GBP/DKK/…) is totally unrelated to the value of this mill. There is no mathematical connection whatsoever.

Look at figure 1-4. Each capex project’s value is determined by the delta created between the green full line and the green dashed line – here the red area – adjusted for the capex outlay.

How is the value of the mill determined in Figure 1-4? Take the full green line (which also takes into account the annual capex level) and discount it to today (same discount rate as for the capexes). That is more or less how most of us would do it, for instance when calculating the fair market value or when looking at an acquisition. We get an NPV of the mill but again, that is disconnected from what-ever the value of the capex plan. There is no connection. The capex plan can say whatever it says – and still be correctly calculated.

Another way of viewing the issue is to look at each project’s delta (the area between the full and the dashed line). The deltas for the projects overlap each other. In other words, the company “mortgages” the value of the mill over and over again for each capex request.

Look at another example, Figure 1-5.

In about 80% of our projects, we have at least one mill that, going forward into the future, will have a zero-cash flow or less. Here, that mill (Mill C) is illustrated below our original Mill B that we have chosen to keep in the figure for comparison purposes.

Question: What is the Total NPV of Mill C’s capex plan if Mill C has the same projects as Mill B? After thinking about it for a while, it can only be 200. So, we have a mill with a zero or negative value, but with a capex plan that – if implemented – has a value of 200. But the capex plan will not change the value of the mill, it will still have a zero or negative value.

Why is this?

Well, the NPV of a capex is not at all determined by the level of the green full line. The value of a capex is determined by how quickly the green dashed line falls (and the capex amount, and the WACC).

Our third mill (Mill A) is now added into Figure 1-6.

Mill A is a high performing mill, with close to state of the art technology.

What is the value of Mill A’s capex plan in this case, assuming the same projects the value will still be 200?

So, we have three mills – performing very differently – but who may present identical/similar opportunities/needs.

“This is theory,” some might say. We understand objections based on the simplification of things in the above presentation.

However, this isn’t theory. This is reality, it is just that there are other situations than the three represented here, making the capex process even more difficult to control and manage. We have seen many situations in the more than 500 mills/plants we have studied that would need their own illustration, but in order to make our point, we do not need to get more complicated than this. Some readers may be thinking, “Our company is different, this does not happen here, we evaluate things differently.” In our experience that is not the case; rethink. If we were face to face with you, we would answer any comment, question or concern you would have – believe us, we have heard them all over the decades, but it is difficult to cover all in this text.

1.3 Actually, reality is worse.

Getting back to our example, the next logical question is, “How does a company distribute capital between mills that perform differently?”

We claim that in reality the three capex plans for Mills A, B, and C will not have similar values. They will differ significantly and in the “wrong” direction. See Figure 1-7.

If our first mill (Mill B) has a capex plan NPV of 200, then Mill C is likely to have a capex plan value of 400 and Mill A 100. Why? Simply put, Mill C is further away from state of the art technology. In a delta calculation Mill C has have more catching up to do for each questioned piece of equipment. The gap in the delta calculation will be larger creating a higher NPV/IRR or shorter payback, illustrated by Mill C’s dashed blue lines. The dashed lines will fall more quickly in Mill C, creating a larger value in the capex plan. Mill C will also have more projects. Not only projects 1-10, but 1 and 1b and 2 and 2b, and so on. The mill has more needs. The capex plan’s value, therefore, increases even more.

In contrast to Mill C, Mill A will have a smaller gap to state of the art technology. Mill A’s dashed line will fall more slowly, creating a lower NPV/IRR or longer payback. Also, Mill A will have less needs (hence fewer capex proposals), all resulting in a lower “NPV total” in the capex plan of Mill A.

Where is a company likely to invest if it has a capital restraint?

Will it chase the longer paybacks in sustainable mills or the shorter paybacks in mills that do not seem to be very sustainable? We will discuss this in detail later. For now, it is sufficient to keep this question in mind.

And where is a company likely to invest if it has a “hurdle rate”, “discount rate” or “required rate of return” higher than the actual capital cost? A beloved child has many names.

Companies have a fondness for setting requirements above the capital cost (the Weighted Average Cost of Capital) in the NPV calculation (or IRR reference), because they believe they add an extra buffer, and they will get their money back quicker. It adds safety, they believe. But all that leads to is that even more capital is allocated to business units (plants, mills) with capexes having short paybacks. You’ll find those in the low B’s in Figure 1.6 (p.11). So, that behavior leads to lower company cash flow: value destruction. Their intentions are good, the result is bad. Especially since really good capexes that extends company sustainability and long term competitiveness have paybacks in the range 4-8 years – and those are excluded in the capex process.

The term “payback” is, by the way, truly misleading. It is not about that. When does one see the money return in Mill C? Never. The company keeps investing in “short payback projects”, but the mill’s cash flow is still zero or less. The money is gone. The calculated payback simply never happens – even if assumptions turn out to be true in the future.

So, we seem to have a situation where companies’ capex plans indicate that a company should invest where they are not making much money. This is bad enough, but it gets worse. The thing is, that individual mills will not even present the capex plans to the head office that aim at maximizing the company’s long term cash flow. How would they even know how to do that? They don’t have the bigger picture, only the picture of their individual mill.

It gets even worse than that because the mill will not even supply the head office with the capex plan that aims at maximizing the long term cash flow from their own mill. Mills will suggest the capex plan that ensures mill sustainability, not maximized long term mill cash flow.

This can be debated, of course, but one proof is the following:

In North America and Europe at least 15% of all mills within the Pulp and Paper industry should be closed within 5 years (if maximized company cash flow is to be achieved throughout the industry). Realistically, mill managers will not come to the head office with the following message: “We have analyzed all our options, and I, as a mill manager, can only come to the conclusion that in order to maximize cash flow you should run us for cash for 3 years and then shut us down.” Again, individual mills aim at sustainability – they are probably doing the right thing when doing so. Sorting out where and when to invest from an ongoing consolidation perspective is something that is not their responsibility, nor should it be.

Interested in reading article two?

“The tail wags the dog – how tactical capex decisions run company strategy”