Forest Products Industry

1. Forest Products Industry Chris Cook Insoo Park Elizabeth Juwono Rachel Zhu Evan Vahlas

2. Agenda • Industry Analysis • Risks Faced • Weyerhaeuser Company • Domtar Inc.

3. Industry Analysis • Forest Products Industry • Produces primary products valued at US$850 billion/year (PriceWaterhouseCoopers, 2003) • Global reach • Mature, capital intensive and cyclical industry • Highly competitive • Comprised of thousands of small and large enterprises

4. Industry Trends • Oversupply of forest products in every industry • Due to stagnant economic growth in key countries such as the United States (largest consumer of forest products) • Decreasing sales across most companies • Emerging market influencers: • China • Russia

5. Top Industry Performers Source: PWC, 2003

6. Products World Wood Production (by volume) 3% Wood-Based Panels • Lumber & Wood Products • Roundwood Products • Industrial Roundwood • Fuelwood • Mechanical Wood Products • Sawnwood • Wood based panels • Global consumption of wood products: 767 million m3 (ICFPA, 2002) Sawnwood 36% Fuelwood 33% 28% Industrial Roundwood

7. Products World Pulp & Paper Production (by weight) • Pulp & Paper Products • Wood pulp • Paper • Paperboard • Global consumption of paper products: 323 million tons (ICFPA, 2000) • Global consumption of wood pulp: 150 million tons (ICFPA,2000) • Substitutes: steel, aluminum, plastics Wood Pulp 36% Paper & Paperboard 64%

8. Raw Material Evolution Roundwood Natural Forest or Forest Plantations Sale of whole unprocessed logs Wood Chips Mechanical Wood Products Paper Pulp

9. World Consumption of Forest Products Source: XI World Forestry Congress, 1997

10. Sales Growth • Demand and sales growth of lumber & wood products are closely correlated with construction, primarily residential construction (ICFPA, 2000) • Demand and sales growth of pulp and paper products are closely correlated with overall economic growth (ICFPA, 2000) • Sharpest growth increases across all product lines will be seen in developing countries (ICFPA, 2000)

11. International Trade • Approximately 35% of forest and paper products are traded internationally (ICFPA, 2000) • Canada is the world’s leading exporter • US$43 billion in wood, pulp & paper per year (FPAC, 2003)

12. Revenue Structure • Major sources of revenue: • Raw materials (logs, chips, timber) • Manufactured forest products • Interest income • Proceeds from sale of property & equipment • Proceeds from sale of timberlands

13. Interest Expense: 4-5% of total sales revenue Major expenses compose 90-95% of total sales revenue Cost Structure

14. Firm Strategy for Future Growth • Problem: Overcapacity • Lumber-mill capacity has increased at a rate of 2.25 times that of demand (Weyerhaeuser, 2002) • Future firm objectives • Close inefficient facilities and higher-cost producers • Streamline operations • Decrease operating costs • Optimize manpower utilization • Increase operating efficiencies • More consistent production

15. Regulatory Environment • Sustainable Forest Policy • Conservation of biological diversity • Maintenance of the productive capacity of ecosystems • Maintenance of forest ecosystem health and vitality • International trade tariffs • Paper tariffs: Range from 0-2% • Wood tariffs: Range from 0-22%

16. Regulatory Environment • Country-specific environmental regulations • Supported by national forest products associations • International Council of Forest and Paper Associations • Committed to the principles of sustainability • 39 member countries • Over 75% of the world’s paper producers • Over 50% of the world’s wood producers

17. Risk Management

18. Risk Management Environment • Types of risks faced • How they are measured • How they are managed • Conditions promoting active risk management • Potential hazards in active risk management

19. Major Risks: General Business • Commodity Risk (Price Risk) • Changes in prices of the products of the company • Demands for forest products are cyclical • Pulp and paper industries are notorious for price volatility

20. Major Risks: General Business • Commodity Risk (Supply Risk) • Adequate and timely supplies of raw material are critical • Especially wood, energy and chemicals • Dependence on a few key suppliers is risky, but often necessary • Constrained by availability, locality, price, quality, etc.

21. Measuring Commodity Risk • Measured by sensitivity analysis

22. Techniques & Products to Manage Commodity Risk • Forward Contracts • Commodity Futures • Commodity Swaps • Natural Hedging • Product Diversification • Efficient Cost Management • Vertical Integration

23. Major Risks: General Business • Project Risk • Risk of investing in specific projects, ventures or companies • Can depend on many factors • Demand conditions • Poor management • Local political/economic environment • Measured by expected cash flow analysis and managed with efficient resource allocation

24. Major Risks: Financial • Interest Risk • The risk that market borrowing rates may rise • Forest industry typically finances incremental capital investment with operating cash flow • Operating cash flow is volatile • Causes higher capital costs and uneven capital investment • Duration analysis can measure the exposure

25. Techniques & Products to Manage Interest Risk • Interest rate futures and forward rate agreements • Interest rate swaps • Option products

26. Major Risks • Foreign Exchange Risk • Assets and liabilities in foreign currency • Also known as balance sheet risk • Sales and purchases in foreign currency • Also known as transaction risk • Especially relevant to international firms • Global production facilities and customers • Large mismatch between revenue and cost

27. Foreign Exchange Risk • Sensitivity analysis can show the extent of exposure • 1 cent gain in CDN $  Loss of $528 million in Revenue for Canadian Forest Industry • Equivalent to 1% Decrease in Total Industry Sales (Source: PWC, 2002)

28. Techniques & Products to Manage Foreign Exchange Risk • Futures Hedge • Currency Options • Others • Cross-Currency Hedging • Invoice Currency Hedging • Currency Diversification • Natural Hedging (Exposure Netting) • Plant locations • Borrowing from foreign sources

29. Major Risks: Financial • Credit Risk • Possibility of customers defaulting on accounts payable • A company typically set internal credit ratings of its customers to measure exposure • Funding Risk/Liquidity Risk • Difficulty of obtaining finance for operations at a given point of time • Expected cash flow analysis and comparison with competitors can measure future financing needs • Forestry companies have large capital expenditures

30. Techniques & Products to Manage Credit & Funding Risks • Thorough Analysis of Customers • Letters of credit • Bank guarantees • Credit Insurance • Coordinating Debt Maturity • Requirements for minimum cash reserves

31. Major Risks: Others • Operational Risk • Damages and Liabilities • Transportation • Physical Delivery of Goods • Political & Legal Risk • National political stability • Relationship with local government • Tariffs and trade feuds • Environmental regulations

32. Available Techniques & Products • Insurance • General Liability • Shipping • Environmental • Strong internal controls over operation • Scenario-building • Lobbying

33. Factors Promoting Active Risk Management • Many of the major risks faced can be hedged • Interest, Foreign Exchange and Commodity • Many leading companies are large and/or multinational • Large volumes of revenue and costs at stake • Stable cash flow desired by shareholders • Cash flow and balance sheet items denominated in different currencies

34. Factors Promoting Active Risk Management • Most forestry companies are not diversified • Wood, pulp and paper products are mostly homogenous and thus price sensitive • Industry is heavily influenced by business cycles  Input & outputprices are volatile

35. Potential Hazards from Risk Management Activities • High costs of purchasing derivative products • Takes away from the bottom line • Can cause liquidity problems • Potential Losses from Hedging • Inability to capitalize on favourable risks • Competitive disadvantage • Random Walk Nature of Risk? • Risks tend to even out in long-run • No long run benefits if risks are affordable in short run

36. Weyerhaeuser Company “becoming the best forest products company in the world and a global leader among all industries…”

37. Company Profile • Incorporated in Washington in 1900 • Engaged in the growing timber; the manufacture, distribution and sale of forest products; and real estate • Corporate strategy: vertical integration • Worldwide company serving domestic and international market • Has access to 42.7M acres of forestland

42. Financial Situation • Increased net sales and revenues by 27% • Increased total asset by $1B • Increased operating income by 40% • Decreased net earning by 32% and earning per share from $1.61 to $1.09 • Increased 3 times as much as interest expenses compared with 2001

43. Revenue Source

44. Cost structure

45. Interest Expenses

46. Major Risks faced • Economic and Market risk • Political risk • Financial risk • Increasing debt (interest) risk Interest-bearing debt  by $7.6M , debt to capital ratio  from 37.7% to 55.6% • Commodity price risk • Foreign exchange risk

47. Foreign exchange transaction (gains) losses

48. Derivatives used to: • Achieve desired mix of fixed versus floating-rate debt • hedge commitments for short/long positions in commodities the company purchases/produces • manage exposure to forex rate changes

49. Derivative Instruments Used • Forward contracts • Commodity swaps (notional value of $54M) • Commodity futures • Interest swap (notional value of $50M) • Investment swap (notional value of $160M, exposure size $7M)

50. Designated FX contracts Commodity contracts Non-Designated Variable rate swap agreement Variable-to-fixed interest rate swap agreement Lumber and other commodity futures Designated and non-designated hedges for managing financial risks