John Dillon's High Risk Paper Chase

The International Paper CEO thinks bigger is better. He's about to find out if he's right

International Paper Co.'s John T. Dillon has a plan to break the paper cycle. But with a downturn looming, will the paper cycle break him first? As CEO for the past five years and an IP employee for 35 years, he has watched the industry's fortunes ebb and flow as predictably as the tides. As demand rises, papermakers build new plants or delay closing old ones until they flood the market and prices tank. When prices eventually recover, the cycle starts again.

IP, the world's largest paper company, bought into this boom-bust mentality as much as anyone. Today, Dillon says he's gotten religion. He's abandoning the old ways, cutting back on production, and throwing money into mergers to give IP enough bulk to better control its prices.

But with demand for paper slumping for the past several months because of the slowing U.S. economy, this strategy is entering a dangerous period. Skeptics worry that the debt Dillon has taken on in a series of high-priced acquisitions might be too much to pay back at a time when low prices mean lower earnings. And it might take years for IP to grow big enough to dictate prices.

SAFER OPTION. Still, Dillon's supporters argue that doing nothing would have been much worse. Even if this does prove to be a tougher downturn for IP than for other paper companies, they say, in the long term the strategy leaves the company in a better position. "I would have done what they've done rather than stand around and hope the cycle will bail them out," says Jeffrey E. Markunas, a managing director at Trusco Capital, an IP investor. "If they don't benefit this cycle, they will next."

IP certainly needs some kind of jump start. Despite the huge acquisitions, sales have grown only 8% a year since Dillon took over as CEO five years ago. Morgan Stanley Dean Witter analyst Matthew Berler estimates 2000 sales at $28.8 billion, and he expects them to drop slightly this year. Operating income, Berler figures, will be $2.6 billion this year, just 2.5% higher than in 1995. The stock price has fallen 1% over the five years and dropped from a high of $58 a share in January, 2000, to a low of $27 last October. Today, it trades around $38.

Investors are particularly unhappy with the company's return on invested capital. That improved to 7% in the second quarter of 2000 but remains well below that of other leading papermakers and, like much of the industry, has historically run below the cost of capital.

The way out of these lackluster results, Dillon argues, is to get bigger. With size comes greater market share and, it is hoped, some control over IP's prices. It's a strategy that has worked extremely well for another big commodity producer: aluminum giant Alcoa. Faced with its own cyclical problems, Alcoa gobbled up competitors and now accounts for roughly 17% of world aluminum production and close to 50% in North America. Despite an industry-wide slump last year and crippling energy costs, it posted record earnings for the fourth quarter of 2000. But IP has nowhere near the market share in paper that Alcoa has in aluminum. Whereas there are a dozen major paper competitors, plus many more midsize outfits, aluminum is dominated by only a handful of companies worldwide. In its four major product lines, IP supplies 20% to 35% of the U.S. market.

To get to critical mass, Dillon has been on a buying spree. In June, in the industry's second-biggest deal ever, he bought rival Champion Paper Corp. for $9.6 billion. Only 14 months earlier he paid $7.1 billion for office-paper giant Union Camp. "We no longer believe cyclicality is a given," says Dillon, who grew up under the tall birch and pine of upstate New York's Adirondack mountains and started his career at Purchase (N.Y.)-based IP as a salesman. "It's been largely a factor of overcapacity. Self-inflicted," says Dillon. "Now we are moving as rapidly as we can to make the appropriate changes so that we can be one of the companies left standing."

JOB FOR SUPERMAN? The risks in Dillon's strategy are clear, however. Ray M. Curran, chief executive of containerboard maker Smurfit-Stone Container Corp., says that between absorbing acquisitions and making fundamental changes to the business, Dillon has a lot on his plate. "Superman couldn't handle all that is going on" at IP, Curran says.

In addition, all the dealmaking has left IP with a worrisome $15.5 billion in debt, or 50% of its capital and four times cash flow. For a company in a slow-growth industry facing a slowing economy and rising energy costs, that's high. "They probably couldn't have picked a worse time to be levering up," says Carol Levenson, who follows IP as director of research for Gimme Credit, an independent institutional bond-research firm in Chicago. "Now, everything has to go perfectly."

To help pay down that debt, Dillon is systematically getting out of nonpaper businesses such as petroleum and minerals. These originally had been added to the company in the hope of smoothing out paper's price swings but largely ended up as a management distraction. He's also selling the company's timberlands, which aren't big cash generators but carry a high value. All told, he plans to sell $5 billion in assets by the end of this year, possibly setting up IP for more acquisitions. Long term, "growth through acquisitions is the preferred way to go," says Chief Financial Officer John Faraci.

The push for size--which Smurfit-Stone, Bowater, and a number of other paper companies are also pursuing, albeit on a much smaller scale--may be showing results in some markets. Morgan Stanley Dean Witter's Berler says, for example, that IP this year showed that its size could prop up prices for one type of paper used largely for business forms. Demand for this paper has been dropping for years, hurt by e-mail and digital information storage. In the first 11 months of last year it fell especially fast, by 2.2%, according to Berler. At the same time, though, prices increased 11%--a testament to the power of IP, which now controls 34% of that market, says Berler.

But it could be a long time before that kind of success spreads to the rest of the paper market. Mark Connelly, who follows the company for Credit Suisse First Boston, which also is IP's investment banker, says the paper industry is so fragmented that it will take at least a decade for prices to truly come under control. "It's a very noble goal, but let's face it, it's a long way away," he says. For example, the Champion purchase greatly increased IP's share of the magazine-paper market, but it didn't insulate the company from a fourth-quarter price decline. Tom McGinn, director of corporate purchasing for the National Geographic Society, who buys 37,000 tons of paper a year from the combined companies, says IP was the first to offer him lower prices this year.

SKEPTICAL. Before IP gets a handle on prices, it will have to prove that it can integrate its acquisitions as well as pay for them. Credit Suisse's Connelly attributes Wall Street's skeptical reaction to the Champion deal to concern that the company was taking on another big purchase before it had delivered all the promised results of previous acquisitions. IP has been slow to close down facilities after its deals, an important step toward getting control over production and pricing. But in October, Dillon announced that he would be shutting down 1.2 million tons of capacity, or 5% of total production. And IP recently increased its projected total cost savings from the Champion merger, from $425 million to $500 million.

Buying up competitors isn't the only change Dillon is making. He has finally instituted an executive-compensation system that's based partly on shareholder returns--standard policy in most executive suites. And he's trying to refocus the company on customers. At Tropicana, for example, IP no longer provides just standard juice containers. It has improved the cartons, which Dillon says now retain flavor and vitamins better. And it also has begun providing a host of services for Tropicana. The company now does everything from managing inventory to purchasing and maintaining the equipment that fills the cartons.

But none of these small steps will save Dillon if his big plan to vanquish the paper cycle proves to be paper-thin.

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