<img src="Weissenrieder-Asset-strategy-capex-management-Paper-cellulosa-pulp-1.jpg" alt="Weissenrieder Asset Strategy Capex Management Pulp and paper mill">
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.

<img src="Figure-3-1.png" alt="Weissenrieder graph 3-1">
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).
<img src="Figure-3-2.png" alt="Weissenrieder graph 3-2">
80 mills could not survive the margin squeeze so they were closed. See Figure 3-3.
<img src="Figure-3-3.png" alt="Weissenrieder graph 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?).

<img src="Figure-3-4.png" alt="Weissenrieder graph 3-4">

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.

<img src="Grafer-1-8.gif" alt="Graph 1-8 Weissenrieder">
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.

<img src="Grafer-1-9.gif" alt="Graph 1-9 Weissenrieder">

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”