John Faraci has whacked billions from International Paper's U.S. operations

Paper Cuts
Evan Hessel 06.18.07


John Faraci has whacked billions from International Paper's U.S. operations. Can he succeed abroad?

International Paper chief executive John V. Faraci kicked off the board meeting in early May by loading his nine directors into the company's corporate jet. After three flights and 11 hours in the air, the weary group set foot in Svetogorsk, Russia (pop: 16,000), a gritty industrial burg of cement apartment towers on the Karelian Isthmus, near the border with Finland, surrounded by thick pine forest.

The next day Faraci took his companions on tour of IP's 1,600-acre pulp-and- paper mill. He showed off the massive new machine that bleaches wood pulp in a slurry of caustic chemicals. He boasted about slashing energy consumption at its natural gas and biomass power plant. And he walked the group along a recently renovated football-field-length paper machine that pumps out 40 tons of white paper an hour. Thanks to cheaper labor and abundant pulp supplies, paper costs on average 13% less to produce here than in the U.S.

Why drag these folks halfway across the world, instead of subjecting them to a snappy PowerPoint presentation? Faraci has a lot to prove--to the board, to long-suffering investors, to skeptics who see a dying industry ground up in the jaws of overcapacity and shrinking demand. Svetogorsk, he believes, represents one of a handful of new investments abroad--a $2 billion bet in Russia, China and Brazil on basically two commodities: white printing paper and heavy-paper packaging. That gamble could help the 109-year-old Memphis, Tenn. company become the most cost-efficient producer--or break it. The board of directors, Faraci figured, have to like Svetogorsk in order to sign off on the $1 billion or so he wants to spend in a 50-50 joint venture with Ilim Holding, Russia's largest pulp producer.

Paper is a lousy business. Any brief spurt of profitability is inevitably followed by a mad frenzy of plant additions, and then by another round of overcapacity and depressed prices. During the current depression, which stretches back over four years, the industry's return on capital has averaged 5% a year. Companies have faced stark choices: Abitibi-Consolidated and Bowater merged; Weyerhaeuser decided to chuck paper and focus on real estate and building materials; Temple-Inland, squeezed by Carl Icahn, carved itself into three companies.

Faraci has spent the last couple of years wielding a massive ax. He has shuttered four mills in North America, canning 25,000 employees, 22% of the total. That move and some cost-cutting are supposed to add $1.2 billion to the bottom line through 2008. Last year he engineered the largest U.S. land sale since the Louisiana Purchase, selling 6 million acres of forest in the South, Midwest and Northeast, raising $6.6 billion. IP is a smaller but more profitable operation since he took over: In 2006 it netted $635 million on $22 billion in sales, versus $382 million on revenue of $25.2 billion in 2003. Long-term debt is down from $13.5 billion to $6.5 billion. But the $39 stock has barely budged, despite ip's spending $3 billion over 2006 and 2007 to repurchase shares.

An IP lifer, Faraci joined the company as a financial analyst in 1974 after earning an M.B.A. from the University of Michigan. What he loved about the company was its vast acreage, which reminded him of his boyhood summers, spent going to camp, hiking and fishing in New Hampshire's White Mountains. For 15 years he cycled through jobs managing forests in Oregon, operating sawmills and running the company's construction materials subsidiary. He moved to New Zealand in 1995 to run papermaker Carter Holt Harvey, in which IP held a 51% stake. Four years later Faraci was recalled to headquarters as chief financial officer.

IP was at a critical point. In 1999 and 2000 Faraci helped John Dillon, then chief executive, buy Union Camp, Shorewood Packaging and Champion International for a total of $19 billion. The expansion couldn't have come at a worse time. Just as paper demand was lagging, IP was adding production capacity. The acquisitions piled on $5 billion in debt. "In hindsight," Faraci concedes, "we overpaid."

That became clear soon after Dillon stepped down. Faraci began exploring what new shape IP might take. One option: unloading its prized asset--its forests. Timberland appreciates 4% a year simply from tree growth: Relying on sustainable methods, IP could cut 4% of its standing timber each year to sell to its own paper and sawmills or to those of its competitors. "The forests had been our security blanket," Faraci says, adding with a dash of emotion, "The trees were the whole reason I got into this business."

In 2005 IP's forest resources division carved up the forest into 66,000 plots and conducted title searches for each one. Faraci signed deals in April 2006 selling 4.2 million acres of forest to Resource Management Services for $5 billion in cash and notes and another 900,000 acres in Louisiana, Texas and Arkansas for $1.1 billion to TimberStar, a unit of the REIT Istar Financial. Small timber outfits, individuals and environmentalists bought the remaining 562,000 acres for $520 million. (IP still owns 500,000 acres in the U.S.)

Faraci also sold his wood products division for $562 million. While a cyclical business, lumber can be hugely profitable during housing booms. Sales of 13 lumber mills to West Frasier Timber of Canada generated another $325 million; five plywood-and-lumber processors brought in another $240 million from Georgia-Pacific.

All told, IP swept up $11 billion. Faraci used $6.2 billion to pay down debt and $1 billion to fund pension obligations. Those two moves have freed up $500 million a year.

What's left? Paper packaging, the stuff of corrugated cardboard and cereal boxes, and so-called uncoated freesheet paper, used for office and business forms, envelopes, printing and so forth. These are not especially profitable businesses, with Ebit margins of, respectively, 9.7% and 7%. (By contrast forest products, most of them sold off, had margins as high as 36%.) So Faraci has to be hyperefficient. In the U.S. he's counting on various moves--layoffs, flexible labor contracts, heat-recovery devices to lower energy bills, new software for ordering and logistics--to lower costs. But he must also be in markets where people are clamoring for paper. That's why Faraci is betting on plants overseas.

In Latin America demand is growing at 3.6% a year, capacity at only 1%. Since 1960 IP has been in Brazil, where access to eucalyptus trees--which grow in 7-year cycles, compared with 26 years for southern U.S. pine--provide a cheap source of pulp. But in February Faraci shifted gears, swapping a pulp mill in the state of Mato Grosso do Sul for an integrated white paper mill in Luis San Antonio in the state of São Paolo. IP is already increasing capacity there, 130% by 2009, to 1 million tons of white paper a year, convinced that Brazil can soak up the additional output and thereby push up prices. Operations there now generate 3% of revenue, but 10% of net profits.

Faraci's biggest wager to date: Russia. If he persuades his board and the Russian Federal Antimonopoly Service to approve a pending deal, IP would spend $400 million to buy a 50% stake in two mills in Siberia and two in the west that together produce 2.5 million tons of pulp, as well as white paper and containerboard. In addition, over three years IP and its partner would invest $1.2 billion in new capital equipment, with the idea of increasing production by 40% and introducing new products. Faraci sees Siberia as a gateway to Asia, where the mills now export 45% of their pulp and where the market is expanding 7% a year.

Still, there's risk. Despite IP's goodwill efforts in Svetogorsk, where it has created jobs for unemployed paper workers and built an orphanage, the Kremlin could insist on tough terms--as it has for Western energy giants. As Credit Suisse analyst Mark W. Connelly says, it could be years before an investment in Ilim pays off.

China poses even greater potential obstacles. In March 2006 IP put up $140 million in a joint venture with Shandong Sun Paper, that nation's fifth-largest paper-and-packaging company. The deal includes two coated-paperboard machines producing packaging for toiletries and cigarettes; a third comes onstream later this year. This comes on top of investments in nine corrugated-box plants in China.

Faraci vows to lift IP Asian sales from an expected $250 million this year to $1.6 billion in 2009. But that assumes he will consummate an as yet uncompleted deal for a white paper plant (IP declines to name where it is). And that China's paper industry, backed by $24 billion from the State Development & Planning Commission, doesn't overbuild and overproduce. New Chinese mills already make and ship paper for less than any U.S. manufacturer, and they wouldn't hesitate to dump supplies within their own borders to keep the business chugging. "The Chinese care more about jobs than profits," concedes Michael Bruner, IP's manager at the Courtland, Ala. plant, who has toured Chinese paper mills.

Faraci acknowledges the coming fight. "I know we don't have this market staked out," he says. "We have very strong competitors pulling all the levers they can. You gotta run fast just to stay even."

By the Numbers
Paper Tiger
China is a fast-growing competitor.

$54 billion Asia's paper and forestry sales last year, vs. $127 billion for U.S.

42 Number of new Chinese mills to be built by 2010; the U.S. has closed 35 since 2005.

$547China's cost per ton of white paper produced, compared with $481 in the U.S.

Sources: RISI; PricewaterhouseCoopers; Center for Paper Business & Industry Studies at Georgia Tech.