Fundamental Changes in Demand

Declining growth rates across most industry grade segments over the past three years indicate that demand for traditional paper products is maturing. While some of the recent volume declines can be explained by external factors such as the broader economic decline and the strengthening dollar, a more complete assessment of demand drivers also identifies other dynamics that should send up yellow flags to paper producers.

Based on numerous discussions with individuals within a wide range of companies, it is clear to me that recent changes in paper usage dynamics and competitive offerings are negatively impacting consumption levels and could have far-reaching implications to the entire supply chain. Some of the major industry related and macro economic developments that are affecting paper consumption include:

• Increased access to the internet and its resulting use as a primary communication / advertising medium

• Outsourcing of general manufacturing to developing countries

• Growth in electronic commerce and related commercial applications

• Increased availability of low cost advertising mediums relative to print such as cable TV and wireless communications

• Flexible packaging innovations that offer consumers increased convenience and package functionality

• Increased organizational productivity through the elimination of processes and reduced paper usage

• Relatively higher cost of print due to rising postage costs and lower cost alternative mediums

Most of these developments are relatively recent phenomena and some of them are still in the early stages of development. And based on my observations of market and consumer behavior, I believe that their impact on paper consumption will more than likely only increase as we move forward into the future.

Reduced Competitiveness of the North American Supply Base

Going hand in hand with fundamental demand shifts is the declining competitiveness of North American producers in the global arena. It is well documented that North American companies have fallen behind other regions of the world in terms of investment, technology, and overall cost structure. This has made North American companies vulnerable to further erosion of their competitive position in domestic and international markets. Key developments driving this decline include:

• declining investment levels

• aging asset bases

• increasing energy and environmental costs

• government subsidized foreign investments

In light of these demand and supply dynamics, it would appear that unless unforeseen changes take place, there is likely to be little if any improvement in the basic fundamentals of the North American paper business in the years ahead. This will lead to further declines in demand and financial performance resulting in a continued high level of company consolidations and mill shutdowns.

New Approach is Required

To avoid this continued deterioration in business profitability, North American companies must identify new sources of growth to ensure that their business remains viable. But how exactly does a company do this when markets are becoming increasingly mature and business fundamentals are weak and likely to get worse?

The answer is that companies must view and approach their businesses in new ways. Specifically, this means:

• Looking at their businesses from an "outside-in" as opposed to an "inside–out" point of view. Rather than starting with a set of assets and capabilities and building a business around that, companies must start with a customer directed business strategy that identifies emerging customer needs and develop a corresponding set of capabilities that meet these needs.

• Redefining the company’s business and target markets more broadly. Over time, companies choose to compete in specific segments and organize themselves accordingly. However, markets change over time and some segments shrink or even disappear. By periodically redefining the company’s business to take into account these changes, it is possible to position the company in larger market segments.

• Recognizing the intangible assets inherent in the business and leveraging them to create value. Over time, companies sustain themselves by taking advantage of the knowledge base, systems, processes, brands, and customer / supplier relationships developed over time. On the other hand, physical assets lose their value over time and must be replaced, particularly those that are no longer competitive. By focusing more on these intangible assets, the relative significance of the physical asset base is reduced and is less likely to drive the business strategy.

Following are three specific actions that companies need to take immediately to begin this process of transformation.

1. Re-examine the Company’s Core Competence

Companies in our industry must revisit some of the basic beliefs they have about the organization’s core competencies. A few questions that should be asked include:

• Have you defined your competencies too narrowly and only in the context of specific historical performance?

• Could demonstrated skills and knowledge be applied to other, similar processes and circumstances?

• Does your market knowledge and customer access put you in a position to market other, related products to existing channels and customers?

• Can your technical skills be applied to related downstream processes that add value to current products?

• Can different types of expertise within the organization be made available to customers and suppliers, thereby adding value to the basic product?

The critical point is that as markets change, companies must demand that employees and their collective organizations and processes evolve and develop to meet the new market requirements. Additionally, companies need to recognize that core competencies can change over time, be acquired, or be accessed through strategic alliances or other partnership agreements. Rather than limiting the company to specific competencies that have already been demonstrated or acquired, the need is to focus on identifying how these demonstrated competencies can be further developed and enhanced so as to create new competencies and capabilities.

2. Redefine the Company’s Business

This involves taking a fresh look at what exactly the company does, what customers / groups are served, who the competitors are, and how the company is different or better than competitors. Many companies in our industry still define themselves in terms of the specific substrate type that comes off of the end of the paper machine. However, this definition is extremely limiting and may have no relation to the customer or his specific need. In addition, because we lack a broader view of the market, we may be focused on the wrong competitors, markets, or opportunities. An example of this is when folding carton suppliers elect to focus their energies on other folding carton suppliers instead of flexible and rigid packaging suppliers who are, in most cases, a greater threat to their business.

Companies must more appropriately define their business in terms of what customer problems they are trying to solve within some broad parameters. For example, the envelope paper business may be more appropriately defined as direct mail materials and C1S or label papers can be more broadly defined as "product identification" materials. The key point is that satisfying specific customer needs must be the focal point of the business strategy as opposed to providing a product that may or may not be the right customer solution.

3. Revisit the Core Business Strategy (customer centric, innovation, operational excellence) Similar but related to core competence is the concept of core strategy. In his book entitled The Discipline of Market Leaders, Michael Treacy identifies three possible / distinct orientations that define a company. These alternative orientations (operational excellence, customer centricity, and innovation) all create value in different ways and determine the way organizations build value. While competence in all three areas is necessary to be successful, one dimension should be stronger relative to the other two.

I suspect that most of the CEO’s in our industry would classify their company as focused on operational excellence. While not necessarily bad, this reflects an underlying inside-out focus, a commodity orientation, and product centric philosophy. A healthy industry offers more of a balance across the three orientations so that customers have more of a choice and can develop stronger loyalties based on distinctive value propositions. I believe that companies that adopt and become more oriented to the principles of innovation or customer centricity will create a more differentiated position in our industry and ultimately offer increased value to customers.

After redefining the company’s core competence, market focus, and orientation, it is relatively easy to identify the most appropriate growth strategies that should be put into place. In his book, Every Company is a Growth Company, Ram Charan identifies at least 10 different growth strategies that companies can choose to implement. Some of these strategies have been commonly implemented in our industry and can be classified as traditional vehicles of growth in the past. However, in mature markets, more innovative growth vehicles may be more effective. A brief review of each of the major growth strategies within these two basic growth options is outlined below.

Traditional Growth Options are Less Effective in Mature Markets

The following approaches can be classified as traditional sources of growth that have been commonly employed in the paper and other traditional industries. As markets mature, however, these approaches may become less effective since they often fail to provide unique value propositions or better customer solutions. In the interest of providing a complete list, each of the major growth strategies is summarized below.

1. Better execution. This option is the most common growth strategy employed in our industry (operational excellence) and the least likely to actually grow the business when markets are mature. Success in this area will most often allow a company to merely maintain its business in slow growth / declining markets as opposed to gain a strategic advantage. To the extent that a company can outperform its competitors (which is unlikely when most competitors are product /commodity oriented and / or focused on operational excellence), share and volume growth may be achieved to some degree.

2. Geographic expansion. This option produces growth because it establishes a company’s brand in new geographies where it does not exist today or possibly in regions where population and GDP growth potential is greater. Because most companies in our industry place more strategic value on tangible versus intangible assets, this option is often only considered in the context of asset purchases in new geographic areas. Consequently, it requires extensive capital investment which is difficult to justify when companies are not returning their cost of capital in existing markets. Also, if a company does not offer a significantly better customer solution, this option will not produce superior returns over the long-term and will ultimately fail. In other industries where intangible assets are more developed and a superior customer solution is offered, geographic expansion is more likely to create value and offer a superior return on investment.

3. New distribution channels. As supply chains evolve across every segment, opportunities in other / competing channels often emerge that provide better solutions to serve specific customer groups. The internet, club stores, catalogs, and office supply outlets are examples of alternative channels that have developed in recent years to service higher growth niche markets within the paper and other industries. While channels will continue to evolve in paper markets and provide short-term growth opportunities for individual companies, all existing paper channels are well served today and growth in one will, in most cases, be offset by declines in others to result in no new incremental growth for paper producers.

4. Mergers and acquisitions. Still one of the fastest and potentially significant roads to growth, M&A can also effectively destroy value (as many companies in our industry have demonstrated) if synergies are not realized or the value realized falls short of the acquisition cost. The lack of significant intangible assets or proprietary value in acquired companies makes it difficult to generate profitable growth in our industry using this strategy. However, to the extent that acquisitions can be implemented with the goal of creating a new idea as opposed to a bigger version of what existed before; profitable new growth opportunities can be realized.

Innovative Growth Options Are More Effective in Mature Markets

There are several growth strategies that are less commonly practiced, particularly in basic, traditional industries such as pulp and paper. However, these strategies often represent more effective growth options in mature markets because they require companies to use the techniques discussed earlier that make new growth options possible.

1. Strategic alliances. These are often difficult to execute because they require effective management techniques and strategic alignment between two or more companies. However, successful strategic alliances allow companies to effectively access new markets and introduce new products with minimal investment in hard assets. The key to success is finding the right partner with complementary goals and capabilities. Software companies and service providers have been most successful using this growth strategy because the complete commitment of each partner is critical to each other’s success. As the need for more integrated solutions for paper customers increases (e.g., commercial printer needs for total print solutions that incorporate paper, ink, print engine, and accessory equipment), the opportunities for effective strategic alliances within our industry will increase and become more critical for success.

2. Technology / intangible asset development. The paper industry has one of the lowest levels of intangible asset value among all major industries. A tremendous potential source of growth and value creation therefore involves

the development and leveraging of these assets. By developing and

leveraging proprietary brands, methods, technologies, processes, and organizational skills, companies can realize new growth opportunities without significant capital investment. In addition, developing these hidden assets usually results in the creation of significant new value in the form of more highly valued products and services and a stronger, more loyal customer base

3. Expanding target markets. This approach has been most effectively employed by companies such as GE, Allied Signal, and Coca-Cola, whose leaders challenged their organizations to look beyond historical market boundaries. An example (albeit a poor one) of this approach applied to our industry might define printing papers as portable communication devices. If this was the product definition, how many different ways could this concept be implemented besides print on paper? An expansion of target markets may also lead to the need to develop new capabilities and new customers and channels which may lead to further growth opportunities that were not available before.

4. Re-segmenting markets. This approach simply identifies new niche segments or positioning alternatives by slicing up existing / traditional markets in different ways. There are many additional ways to segment markets beyond the typical approaches such as geography, channel, industry group, or end use application. How many different product / service variations could be created by segmenting markets based on income, usage levels, demographics, organization size, competitive set, business segment, related purchase behavior, etc.? By better understanding your current customer base, new segments can be identified that could potentially create a stronger point of difference for your business in target segments. This, in turn, can pave the way for additional growth opportunities through geographic expansion and intangible asset development.

5. Expansion into related / adjacent segments. This is perhaps the boldest growth strategy of all, as it builds upon an existing business to establish a potentially much different kind of business. By utilizing existing expertise or capabilities in a different but related context, the company is able to establish a clearly differentiated business in potentially new categories. There are many different applications of this approach including horizontal and vertical integration or expansion into complementary products or related products sold into the same market or customer groups. The recent purchase by Boise Cascade of Office Max is an example of this growth strategy in our industry. Other possible executions of this concept could involve the purchase of businesses that provide equipment, materials, chemicals, information systems, measurement devices, logistics services, and other business services to the existing customer base. As you can see, the possible opportunities for growth in this area are almost limitless for companies with the right vision and commitment.

As the preceding list of alternatives would suggest, there are many opportunities for North American paper producers to grow, even in cases where the company competes in mature markets with unattractive dynamics and poor growth prospects. Importantly, the fact that domestic companies may not be cost or technologically competitive in traditionally defined paper markets does not necessarily preclude growth using some of these alternative growth strategies. In fact, the lack of traditional growth opportunities may provide just the incentive needed to take advantage of alternative growth possibilities. By having less attractive traditional growth options available, North American paper companies may be more motivated (and therefore more likely to be successful long-term) to consider bolder alternatives that will ultimately create more viable, profitable businesses in the future.

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Frank Perkowski is the founder and president of Business Development Advisory (BDA), industry-focused consulting firms based in Atlanta, GA. BDA concentrates on helping companies in mature markets identify and implement growth initiatives that add value to their business. Frank can be reached at 77 0-643-9081 or by emailing him at frank@bd-advisory.com.