Most basic materials industries share a common problem: low profitability. In steel, pulp and paper, glass, and commodity chemicals, to name a few, periods of high profits alternate with heavy losses, yielding average returns that may not even cover the cost of capital. Many accept this rollercoaster ride as inevitable; such, they say, is the nature of cyclical industries. But the truth is, poor management makes the ride rougher than it need be. For though there is indeed a business cycle, its peaks and troughs are greatly exaggerated by decisions about when and how to add new capacity.

Take the paper industry. From 1991 to 1993 it experienced its worst years ever: high losses forced more than half the companies in some sectors to put assets up for sale. The crisis was not precipitated by a dramatic drop in demand; rather, it was massive new investments and overcapacity that caused the collapse in prices. Yet just three years later, and less than one year into recovery, new capacity additions amounting to as much as 15 to 20 percent of total output have already been announced in some segments, and many players are actively looking for new investment opportunities.

Waves of mass investment will inevitably drag the industry down toward its next slump

Every company will have its own good reasons for the timing of new investments. Cash shortages and debts prevented us investing earlier; if we delayed, we would miss out on market growth; or simply, our machinery is out of date. Whatever the reason, the effect is waves of mass investment, which will inevitably drag the industry down toward its next slump.

By improving their management of capacity, companies can smooth the business cycle and moderate its impact on returns

By improving their management of capacity, companies can smooth out the business cycle and moderate its impact on returns. To do so, they will need financial muscle and the courage not to follow the pack. Such companies can earn substantial rewards. A recent study reveals that excellent capacity management can boost average annual returns on invested capital by as much as 3 to 4 percent.

Decision dynamics

If they are to make sensible decisions about new capacity, pricing, or even capacity cutbacks, companies must understand the ripple effects of both their own and their competitors’ actions. This is particularly true of industries where the construction of new capacity can take three or four years. A company investing in a major new plant today might reasonably expect a profit, given current forecasts for demand, supply, and pricing. But if competitors also invest in capacity at the same time, utilization will be lower than expected when the new machinery eventually comes on stream. And in another two years, prices are likely to start falling as overcapacity gives rise to a battle for market share.

Far better, then, to try and take account of the underlying dynamics of the business environment. That means factoring in not only how market conditions might change in the interval between the decision to build a new machine and full production, but also the role played by less tangible forces.

In good times, when capacity utilization is high, cashflows are healthy, and banks are willing to lend, a widespread sense of optimism often encourages investment. Technicians will lobby for new machines that outperform the old; salespeople will complain about revenues lost through lack of capacity. On the other hand, in bad times, investments tend to be shunned; no cash is available and no one wants to predict when the upturn will come. Whatever the scenario, the extremities of the underlying business cycle are exaggerated.

Bearing in mind influences like these, we built a simulation model to see how a company in one growing and cyclical business, the European woodfree coated paper sector, could improve its capacity management and hence its financial performance. As well as emulating the industry’s historic track record, the model showed how an individual company would perform if it took different decisions about capacity, pricing, and financial strategy. The lessons it offers are applicable to many other sectors in basic materials industries.

Where to invest?

Keeping up with high growth demands constant investment in new capacity, which cranks up the level of invested capital

Segments showing strong growth might seem the obvious areas to select for investment, but they are unlikely to generate the greatest shareholder value. That’s because keeping up with high growth demands constant investment in new capacity, which cranks up the level of invested capital per ton. High-growth areas are also more vulnerable to competitive price-cutting, as capital investments raise the proportion of depreciation, a noncash cost, to total costs.

To turn a profit over the long term, a company must sell at an average price that at least covers total cost. In a downturn, however, companies are tempted to sell below total cost (though not normally below variable cash cost), in order to generate some contribution to fixed costs. The more capital intensive an industry, the greater the difference between total costs and variable cash costs, and the greater the scope for price cuts. Unfortunately, the good times rarely compensate for the severe losses incurred in bad times. The net result is that many capital-intensive industries fail to cover their cost of capital.

Neither does the solution necessarily lie at the other end of the spectrum, in low-growth sectors. Though these will perform well if demand and supply are steady, they are particularly vulnerable to volatility. Any excess capacity will take a long time to be absorbed, again depressing prices and profits.

In fact, the sectors that produce the best returns are those that are growing at around 2 to 3 percent. Instead of having to add expensive new capacity, companies can match such a pace by improving their operations, modernizing existing capacity, and replacing obsolete equipment. Sectors that are not especially volatile also represent safe havens, being subject to fewer errors in capacity investment.

The size of the machines in which companies choose to invest will affect shareholder value, as each new machine increases total capacity. For this reason, small is best, for if capacity decisions are made incrementally, there is less likelihood of overbuilding. If existing technology does not allow small, competitive machines to be built, companies might consider sharing plants, especially if there is little or no differentiation between their respective products. Many steel companies share their galvanizing lines, for instance, but capacity sharing is still unheard of in some industries, including paper.

In industries where incremental capacity decisions are very large—those with a potential impact of more than 30 percent of total industry capacity—returns also tend to be higher. That is because companies consider long and hard before committing themselves to investment on such a scale, and get higher average utilization from their existing machinery in the interim. In addition, when new machines are very large, companies are forced to rely on improvements.

Finally, the steeper the cost curve, the more likely it is that the industry as a whole will be profitable, though low-cost producers will be the real winners. That’s because industry prices will be set by the marginal (high-cost) producers, leaving the low-cost players a comfortable profit margin.

Such a price umbrella is often made possible by new technology, but the shelter it provides won’t last indefinitely. Some 15 years ago, steel companies introducing low-cost mini-mills earned very high margins by operating under the price umbrella of the old high-cost firms. Since then, however, more and more mini-mill capacity has been built, and one high-cost producer after another has been forced to exit the industry. As a result, steel prices and industry profitability have plummeted.

When to invest?

Investing in new capacity when the industry is still in a downturn can substantially enhance a company’s profitability

Investing in new capacity counter-cyclically—when the industry is still in a downturn—can enhance a company’s profitability substantially, since the new machinery will come on stream during the upturn, when utilization and prices are high. But it can be difficult to persuade banks to lend at such a time. In an upturn, financial institutions compete to lend money; in a downturn, caution sets in, and they start to press businesses to reduce their debts. So a company will face two options: either it maintains a low level of leverage, which could leave it vulnerable to a takeover, or it finds financial backers that understand the value of a counter-cyclical strategy and take a long-term view.

Even in a downturn, building new capacity still entails high levels of invested capital per ton. A better strategy is to buy existing capacity while there are bargains to be had. In 1994, Cartiere Burgo picked up a brand-new paper machine for a fraction of its true cost from the bankrupt La Cellulose des Ardennes. It also secured a call option on the company’s pulp mill for US$1. As with counter-cyclical building, however, counter-cyclical buying requires a degree of financial independence.

Purchases in an upturn, on the other hand, will incur unjustifiably high premiums. One company paid more than twice the book value for Aussedat-Rey’s assets in 1989, but on average over the next five years failed to earn a profit.

The paper industry would be better off if all companies reduced their decision, construction, and ramp-up times

In general, the paper industry would be better off if all companies reduced their decision, construction, and ramp-up times. The shorter these processes become, the briefer will be the forecasting period, leaving less scope for the errors that lead to overbuilding. Even if companies have to pay a small premium to speed up construction, they will still come out ahead.

Old or new?

Modernizing old equipment usually pays better returns than building brand-new capacity. In our model, the rebuild investment cost per ton of additional capacity was only 60 percent of that for new equipment.

From an individual company’s point of view, modernization is a good strategy for keeping competitive yet avoiding big increments in capacity and high levels of invested capital. The downside, however, is that industrywide modernization flattens the cost curve and thus reduces prices.

When a company decides to modernize existing machinery, it should defy conventional wisdom and do the work in an upturn rather than a downturn. Though rebuilds are easier to carry out during downturns, when capacity utilization is low and downtime carries little cost, they will also add capacity when it isn’t needed and delay the next upturn. Modernizing in an upturn can mean losing sales while machinery is down, but it is the only way to bring extra capacity online while demand is still high.

How long old machinery is kept running is another factor that will influence profitability. Choosing not to modernize can be extremely profitable, as it keeps invested capital per ton to a minimum. It also allows a company to set money aside to buy a brand-new machine when the time is right, and shut down the old one without a write-off charge on the books.

Compete or cooperate?

The companies that are most aggressive in building capacity will probably fare worst of all

Our model demonstrates that expanding market share aggressively by adding new capacity does not pay, as any extra capacity destroys value for the industry as a whole. Moreover, the companies that are most aggressive in building capacity will probably fare worst of all. The only way to increase market share profitably is to purchase existing capacity, thereby increasing market share without increasing total industry capacity.

Suppose that all the companies in a given sector are happy to maintain market share bar one, which expands capacity ahead of demand and then cuts its prices to attract customers from rivals. It will gain market share, but its financial performance will ultimately suffer. Its return on sales may be only slightly below the industry average, but because it is forced to invest continuously and to suffer periods of low utilization while it looks for buyers for its new production, its return on assets will be significantly lower.

Above all, aggressive moves to boost sales should be avoided in downturns, when industry prices tend to fall. Again, this view defies conventional wisdom. The usual corporate response to low utilization is to cut prices in order to increase volume.

What would help an industry is more openness regarding capacity. Though news about plans to build machines is fairly good (corporate bluffing notwithstanding), intelligence about modernization and debottlenecking efforts tends to be thin on the ground. Wider communication of reliable information about capacity and plans to increase it could help reduce overbuilding and thus add value. Industry associations could play an important part in this process.

Preparation

As we have seen, the basic rules of good capacity management are simple: buy extra capacity rather than build it, and do so in a downturn; modernize in an upturn; avoid cutting prices aggressively to gain market share. Our model showed that a company playing by these rules could win a 3 to 4 percent lead over competitors in terms of its annual ROCE. Not surprisingly, such a strategy is commonplace to paper companies that have shown a consistently high return on capital, such as Jefferson Smurfit.

It is tempting to snap up bargain companies in a downturn when everyone else is worrying about oversupply

Companies wishing to follow suit must first do the groundwork. Tempting though it is to snap up bargain companies in a downturn when everyone else is worrying about oversupply, it can’t be done without long-range planning. An acquisition opportunity or the possibility of investing in new machinery usually needs studying for months in advance, yet such lengthy deliberations could mean missing the right moment. So how can a company ensure that it is ready to seize promising opportunities?

First, it must understand its industry inside out: the drivers of growth and cyclicality, the cost curve, the various players involved. If necessary, it should build a model to help it better understand industry dynamics. This is particularly important for new entrants such as successful companies planning to expand into unfamiliar sectors or new geographic markets.

Second, investigate the different strategic options open to all the companies in the sector. What investment opportunities does each have? Which companies might come up for sale? What would be the best timing for any move?

Third, ensure that decisions are executed swiftly. That means using an upturn not as the time feverishly to seek out new investment opportunities, but as the time to win support from financial partners and the board, so that when the cycle starts to dip again—as it inevitably will—the company is poised to strike.

Finally, in order to protect shareholder value, CFOs should avoid playing golf too often with production managers—especially in an upturn.