Christa Manley Jacob Freeman Eli Hernandez David Hughes

 

 

 

 

MEADWESTVACO

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Table of Contents

Executive Summary……………………………………………… 9

Business and Industry Analysis……………………………… 16

Company Overview……………………………………………….. 16

Industry Overview……………………………………………...... 17

Paper Industry ………………………………………………………………………. 18

Packaging Industry…………………………………………………………………. 19

Five Forces Model……………………………………………….... 20

Rivalry Among Existing Firms………………………………….. 22

Industry Growth……………………………………………………………………… 23

Concentration of Competitors………………………………………………….. 24

Level of Differentiation……………………………………………………………. 26

Switching Costs………………………………………………………………………. 26

Learning Economies……………………………………………………………….. 27

Economies of Scale………………………………………………………………… 28

Fixed and Variable Costs…………………………………………………………. 29

Excess Capacity……………………………………………………………………… 29

Exit Barrier……………………………………………………………………………… 30

Conclusion……………………………………………………………………………… 30

Threat of New Entrants………………………………………...... 30

Economies of Scale………………………………………………………………… 31

First Mover Advantage……………………………………………………………. 32

Distribution Access and Relationships………………………………………. 32

Legal Barriers…………………………………………………………………………. 33

Threat of Substitute Products………………………………..… 34

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Relative Price and Performance…………………………………..……. 34

Customers Willingness to Switch……………………………………... 34

Conclusion……………………………………………………………………… 35

Bargaining Power of Suppliers……………………………..….. 35

Price Sensitivity………………………………………………………… 37

Relative Bargaining Power…………………………………………. 37

Paper Products Industry…………………………………………………… 38

Switching Costs…………………………………….…………………………… 38

Differentiation……………………………………………………..…………….. 39

Importance of Pulpwood to the Cost and Quality………………… 39

Number of Pulpwood Supplier within Industry…………….……….. 40

Volume of Pulpwood Obtained from Suppliers…………………..… 40

Conclusion…………………………………………………………..…………. 41

Packaging Industry…………………………………………………………. 41

Bargaining Power of Customers……………………..…..…… 42

Price Sensitivity……………………………………………………… 43

Relative Bargaining Power…………………………………….... 44

Paper Products Industry…………………………………………………… 44

Switching Costs………………………………………….……..………………. 45

Differentiation…………………………………….………………..……………. 45

Importance of Cost and Quality to the Customer…………..…….. 45

Number of Customers in the Market…………….………………….….. 46

Volume of Paper purchased per Customer……………………..…… 46

Conclusion………………………………………………………………..……. 47

Packaging Industry…………………………………………………………. 47

Switching Costs……………………………………………………….……….. 48

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Product Differentiation……………………………………………………… 48

Importance of Packaging to Cost and Quality………………………….. 49

Number of Customers in the Market……………………………………….. 49

Volume per Customer……………………………………………………………. 49

Conclusion……………………………………………………………….…..……. 50

Key Success Factors…………………………………….……… 51

Cost Leadership – Paper Industry…………………………………….…… 51

Tight Cost Control System………………………………………………….….. 52

Economies of Scale……………………………………………….………………. 52

Efficient Production Processes and Lower Input Costs……………….. 53

Low Cost Distribution……………………………………………………………. 53

Cost Leadership – Packaging Industry……………………………...….. 54

Economies of Scope………………………………………………………………. 54

Differentiation – Packaging Industry…………………………………….. 55

Creativity and Innovation……………………...…………………………….... 55

Research and Development……………………………………………………. 56

Product Quality……………………………………………………………………… 56

Differentiation – Paper Industry……………………………………………. 57

Customer Service and Product Assurance………………………………… 57

Conclusion…………………………………………………………………………. 57

Competitive Advantage Analysis…………….…………………………..… 58

Early Innovations……………………………………………………………..…… 58

Modern Innovations……………………………………………………………….. 59

Firm Implementation of Value Creation Strategies…….…………….. 59

Cost Leadership……………………………………………………………….. 59

Economies of Scale and Scope……………………………………….….. 59

Efficient Production Process and Low Cost Inputs…………….….. 60

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Low Cost Distribution………………………………………………………….. 60

Differentiation…………………………………………………………………….. 61

Research and Development ………………………………………………… 61

Product Quality………………………………………..…………………………. 62

Variety………………………………………………………………………….….. 62

Customer Service………………………………………………………….…… 62

Conclusion………………………………………………………………………… 63

Formal Accounting Analysis…...……………………………….. 64

Key Accounting Policies……………..……..………………………………. 65

As applies to Key Success Factors………………………….……............. 65

Pension Plans…………………………………………………….….……………… 66

Derivative Risk Management………………………………….................. 67

Operating and Capital Leases……………………………….……………….. 70

Goodwill………………………………………………..…………….….............. 73

Accounting Flexibility…………………………………..…….……………. 77

Pension Plans………………………………………………………………………. 77

Derivative Risk Management……………………………….………………… 80

Operating and Capital Leases…………………………………..……........ 80

Goodwill………………………………………………………………..……........ 81

Evaluate Accounting Strategy……………..…………………............. 82

Pension Plans……………………………………………………………..….….. 83

Derivative Risk Management………………………………………..……… 86

Operating and Capital Leases…………………………………….…….….. 88

Goodwill……………………………………………………………………..…..... 91

Quality of Disclosure………………………………………………….. 93

Pension Plans………………………………………………………….……….… 93

Derivative Risk Management……………………………………………….. 94

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Operating and Capital Leases………………………………….………… 95

Goodwill………………………………………………………………………….. 96

Quantitative Analysis……………………………………….………. 96

Sales Manipulation Ratios………………………………………………….. 98

Net Sales/Cash from Sales…………………………………………….. 99

Net Sales/ Net Accounts Receivables……………………………… 100

Net Sales/Inventory……………………………………………........... 103

Conclusion…………………………………………………………………… 106

Expense Manipulation Ratios……………….……………………………... 107

Asset Turnover…………………………………………………………….. 107

CFFO/OI………………………………………..……………………………. 109

CFFO/NOA…………………………………….…………………………….. 112

Total Accruals/Sales…………….……………………………………….. 114

Conclusion……………………………………………………………………. 115

Red Flags…………………………………………………………….…. 116

Pension Plans…………………………………………………………….……… 116

Undoing Accounting Distortions………………………………..… 116

Goodwill…………………………………………………..…………………….…. 117

Financial Analysis, Forecasting Financials and Cost of Capital Estimation………………………………….… 121      Financial Analysis……………………………………………………… 121

            Liquidity Ratio Analysis…………………………………………………….…… 122 

Current Ratio…………………………………………………..……………..…….….. 122

Quick Asset Ratio……………………………………………………………………… 123

Working Capital Turnover……………………………………………………….…. 124

Accounts Receivables Turnover………………………………………………..… 125

Days Sales Outstanding…………………………………………………….…….… 128

Inventory Turnover………………………………………………………………..…. 129

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Days Supply Inventory……………………………………………………………….. 130

Cash to Cash Cycle………………..……….…………………………………………. 132

Conclusion…………………………….………………………………………………….. 133

Profitability Analysis …………………………………………………………………………………………                        133 

Gross Profit Margin..…………………………………………………………………… 134

Operating Expense Ratio……………………………………………………..……… 135

Operating Profit Margin………………………………………………………………. 136

Net Profit Margin………………………………………………………..……………… 136

Asset Turnover……………………………………………………………..………….. 138

Return on Assets………………………………………………….……………………. 139

Return on Equity……………………………………………………….................. 140

Conclusion………………………………………………………………………………… 141

Capital Structure Analysis………..………………………………………….…… 141

Debt to Equity……………….…………………………………………………………… 142

Times Interest Earned………………………………………………………………… 143

Debt Service Margin………………………………………………………….……….. 145

Z-score…………………………………………………………………………………….. 147

Growth Rate Analysis……………………………………………………………… 148

Internal Growth Rate…………………………………………………………..….… 148

Sustainable Growth Rate………………………………………………………… 149

Estimating Cost of Capital………………………………………….. 150

Cost of Equity………………………………………………………………….… 150

Alternative Cost of Equity…………………………………………….……… 152

Cost of Debt…………………………………………………….……………..... 153

Weighted Average Cost of Capital………………………………………… 156

Conclusion…………………………………………………………………………. 157

Financial Statement Forecasting…………………………………. 158

Income Statement………………………………………………………….….. 158

Income Statement (Revised) …………………………………………..…. 163

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Balance Sheet…………………………………………………………………...... 166

Balance Sheet (Revised)……………………………………………………..... 170

Statement of Cash Flows………………………………………………………. 173

Valuation Analysis…………………………………………………. 179

Method of Comparables……………………………………………… 179 Price/Earnings Trailing……………………………………………………..… 179

Price/Earnings Forecasted…………………………………………………… 180

Price/Book…………………………………………………………………………. 181

Price Earnings Growth (P.E.G)……………………………………………… 182

Price/EBITDA……………………………………………………………………… 183

Enterprise Value/EBITDA……………………………………………………… 184

Price/Free Cash Flows………………………………………………………….. 185

Dividends/Price……………………………………………………………………. 186

Conclusion…………………………………………………………………………… 186

Intrinsic Valuation Models…………………………………………….. 187

Discounted Dividends Model………………………………………………….. 187

Discounted Free Cash Flows Model………………………………………… 189

Residual Income Model…………………………………………………………. 191

Abnormal Earnings Growth Model (A.E.G.)………………………………. 194

Long Run Residual Income Model…………………………………………… 196

Analyst Recommendations…………………………………………. 199

Appendices……………………………………………………………… 201

References………………………………………………………………. 224

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Executive Summary Investment Recommendation: Undervalued Buy

As of November 03, 2008

NYSE (11/03/08) $14.71 Altman Z-scores

52 Week Range: $9.44 - $34.61

Revenue: $6.906 Billion

Market Capitalization: $1.80 Billion

Shares Outstanding: 170,812,000

Initial Revised

Book Value Per Share: $ 47.39 $ 21.33

Return on Equity: 6.26 % 6.36 %

Return on Assets: 3.00 % 3.20 %

2003 2004 2005 2006 2007

Initial Scores: 1.29 1.33 1.58 1.45 1.49

Revised Scores: 1.26 1.29 1.56 1.42 1.50

Current Market Share Price (11-03-08)

Financial Based Valuations

Initial Restated

Trailing P/E: $ 13.62 $ 10.04

Forward P/E: $ 6.83 $ 6.83

Dividends to Price: $ 3.35 $ 3.35

Price to Book: $ 51.11 $ 23.02

P.E.G Ratio: $ 11.38 $ 7.93

Price to EBITDA: $ 16.79 $ 16.79

Enterprise Value/EBITDA: $ 36.87 $ 32.21

Price to Free Cash Flows: $ 17.04 $ 17.04

Cost of Capital

Estimated R-Squared Beta Ke

2-Year .056 -.018 3.871 %

3-Year .032 -.013 3.909 %

4-Year .017 -.012 3.922 %

5-Year -.014 -.002 3.998 %

6-Year -.012 .001 4.035 %

Back Door Ke: 7.52 %

Published Beta: 1.59

Cost of Debt: 5.89 %

WACC (BT): 6.78 %

WACC (AT): 5.30 %

Intrinsic Valuations

Initial Restated

Discounted Dividends: $ 16.22 -

Free Cash Flows: $ 19.61 $ 17.17

Residual Income: $ 18.90 $ 18.66

Long Run Residual Income: $ 18.21 $ 21.67

Abnormal Earnings Growth: $ 25.23 $ 23.80

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Industry Summary

Mead Paper Corporation was founded in 1846 and focused mainly on the

production and distribution of pulp paper. More than a century later, in 1966, Mead

Paper Corp. acquired West Virginia Pulp and Paper Co. and abbreviated the name to

Westvaco. Finally, in 2002 Westvaco completed the merger with the Mead Co. to form

MeadWestvaco. In the past, Mead Corporation was primarily focused on pulp paper

production. Over a century of mainly paper production, the company acquired a variety

of different firms in order to adapt to the changing marketplace. In 2005

MeadWestvaco reallocated their operations to “boxing rather than shuffling paper.” The

packaging operations ultimately accounted for about ¾’s of the company’s sales.

MeadWestvaco holds a 7% profit growth rate and currently rakes in sales of

$6.906 billion. There are over 150 products created among their assembly lines with

over ninety five international operations. MeadWestvaco operates in five different

industries, including: paper production, packaging solutions, school supplies, consumer

010203040

MWV 1 Year Stock Price

M…

0

20

40

Industry 1 Year Prices

MWV

IP

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office products, and specialty chemicals. The two most productive segments are the

paper and packaging industries. The three main competitors in these industries include

Smurfit-Stone (SSCC), International Paper (IP), and Packaging Corporation of America

(PKG). These firms have also diversified into other market segments and industries, as

MeadWestvaco has done. All of these firms produce similar products, resulting in a

higher level of competition. These firms focus mainly on utilizing cost leadership

strategies, which entails tight cost control and efficient production processes. The

packaging industry dips into product differentiation, but must still be cautious about

costs because of the high level of competition within the industry. The packaging

segment relies more on research and development in order to employ their

differentiation strategies.

The paper/packaging industries both have a high rivalry among existing firms

because all the competitors produce a commodity. In other words, the firms operating

in these industries produce vast amounts of similar products. This industry is

characterized by a low threat of new entrants due to the domination of large companies

within these industries. A huge majority of the market share in the paper/packaging

industries are comprised of large firms, making it difficult for small companies to break

into the industry. Threat of substitute products and bargaining power of suppliers is

also low. The low supplier bargaining power in the paper industry is due to the fact of

price sensitive pulpwood contractors. The following Five Forces analysis table defines

the competitive landscape within the paper and packaging industries.

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Packaging/Paper Industry

FIVE FORCES COMPETITION

LEVEL

Rivalry Among Firms High

Threat of New Entrants Mixed

Threat of Substitute

Products

Low

Bargaining Power of

Customers

Mixed

Bargaining Power of

Suppliers

High

Overall High

The paper and packaging industries key success factors include cost leadership

and differentiation. Since variations between competing firms within the two industries

are small, they must compete heavily on these two factors. By keeping costs to a

minimum and creating new innovative packaging products, firms within these industries

are able to gain a competitive advantage relative to their rival firms.

Accounting Analysis

The accounting analysis section’s primary purpose is to identify MeadWestvaco’s

key accounting policies and determine how precise the policies are in depicting the firm.

In order to evaluate how precise the firm is portrayed by its key accounting policies,

one must asses the level of accounting disclosure the firm make available in its financial

statements. A high level of disclosure enables shareholders and analysts to have an

accurate outlook of the firm. Many firms, however, provide a low level of disclosure, in

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which they disclose only the necessary minimum that is required by the SEC. In

disclosing the bare minimum, the firm has the potential to alter or distort its financial

statements in order to hide or “puff” up their stated financials.

The key accounting policies for the firms in the paper and packaging industry

include the following: pension plans, derivative risk management, operating leases,

capital leases and goodwill. In regards to such policies, MeadWestvaco has levels of

disclosures that vary throughout each accounting policy but remain relatively high in

comparison to the industry trends and averages. MeadWestvaco has high quality levels

of disclosure in providing information on derivative risk management, operating and

capital leases, and good will. The firm provides a moderate level of disclosure on

pension plans that is relative constant with the industry trends.

Quality of

Disclosure

Pension

Plans

Derivative risk

management

Operating

Leases

Capital

Leases

Goodwill

MeadWestvaco Moderate High High High High

Paper and

Packaging

Industry

Moderate Moderate Low Low Moderate

Competitors in Paper and Packaging Industry: IP, SSCC, PKG

 

Quality of

Disclosure

Pension

Plans

Derivative risk

management

Operating

Leases

Capital

Leases

Goodwill

MeadWestvaco Moderate High High High High

Paper and

Packaging

Industry

Moderate Moderate Low Low Moderate

Competitors in Paper and Packaging Industry: IP, SSCC, PKG

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Financial Analysis, Cost of Capital Estimation, and

Forecasting

The financial ratio analysis is calculated and compared to competitors within the industry in order to benchmark the company’s performance with the industry average. The financial analysis also allows analysts to identify developing industry trends in order to grasp a better understanding of a company’s future financial position within an industry. Liquidity ratios were calculated for MeadWestvaco and main competitors to illustrate how well a company generates cash flows to cover their liabilities. After comparing MeadWestvaco’s liquidity ratios to those of competitors it was concluded that MWV was on par with their competitors and remained close to the industry averages. The profitability ratios reflect a firm’s ability to generate revenues and also give insight about how well a company is able to manage costs associated with operations. The profitability analysis showed that MeadWestvaco is not as profitable as the other companies within the industry performing under the industry average in most of the profitability ratios. The capital structure ratios measured the financial leverage of a firm and provide information on a firm’s ability to meet their financial obligations. MeadWestvaco again tended to have lower than industry average capital structure ratios. They were able to slightly cover their financial obligations, but did not much have much leeway after these liabilities were paid. MeadWestvaco’s internal and sustainable growth rates both underperformed relative to their competition within the paper/packaging industry. These low growth rates could indicate low future growth for the company. In conclusion, MeadWestvaco is currently financially sound but lag behind their main competitors within the industry. With tighter cost controls, in order to increase profitability and maintaining capital structure stability MeadWestvaco can indeed pull alongside their competition

Our first step in calculating MWV’s cost of capital according to the capital asset pricing model was to perform a regression analysis over 2 year, 3 year, 5 year, 7 year, and 10 year time horizons in order to observe an initial cost of equity. Our two year regression displayed the highest adjusted r-squared value and an initial Ke of 3.87%, which we increased by 1.5% for size adjustment. Weighted average cost of debt was calculated for MeadWestvaco to be 5.89%. Clearly, for MWV, size adjusted Ke of 5.37% was not a reasonable figure since, by definition, Ke must be greater than Kd. Consequently, a back door or alternative cost of equity was calculated using the formula M/B = 1 + (ROE – ke)/(ke – g) to arrive at a 7.52% cost of equity. In every subsequent calculation involving Ke, including WACC calculations, 7.52% was assumed as our most accurate Ke. Weighted average cost of capital for MeadWestvaco was calculated using the formula WACC = (VL/VA)*Kd + (Ve/VA)*ke as follows assuming a 35% tax rate:

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WACCbt = 6.78%

WACCat = 5.30%

Forecasting is a key factor in determining logical estimations of future

performance based on expected future market conditions. This could not hold truer

than in the current recessionary period being experienced. The capstone forecasting

figure is that of expected future sales growth, as all other forecasting is linked to this

number in one way or another. MeadWestVaco will experience some slowdown in

demand in the United States due to current market conditions thus limiting expected

sales. However, MWV has been aggressively expanding into China and has had great

success that should counter the decrease of revenue in the U.S. market. Based on these

evaluations we have assumed a sales growth rate of 2% for 2008 and 2009, followed

by 4% growth thereafter. Another key factor forecasted pertaining to gross income is a

decrease in COGS. In 2003, MWV spun off a business section that has made the

company much more efficient and has caused a continual decrease in COGS. Based on

this decrease and the benefits of economies of scale as the business in China is further

expanded, we foresee this trend to continue. MWV’s dividend increases have been

consistent and timely with a 5% increase every 5 years. Therefore, MWV’s dividend

payout is expected to remain at 170 million until 2013, when it will increase to 178.5

million. Overall, MWV is expected to suffer little overall effect in the current recession

and continue to benefit from a business spinoff and expansions into China. As stated

earlier all of the forecasting done on the financial sheets can be derived from these

assumptions

Valuations

The culmination of all previously overviewed topics is the formation of an educated

estimate of the value of MWV. There are many models that can be used to formulate

the final values used for price evaluation with differing levels of accuracy. The outputs

of these models are then compared to MWV’s $14.71 share price at 11/3/08 and

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interpreted to be undervalued or overvalued based on a degree of acceptability. This

acceptability is a reflection of an analyst’s personal aggressive or conservative views. As

analysts, we are conservative with a 15% margin in share price that was observed on

11/3/08. With this margin we allow a share price of $12.5 to $16.92 for MWV to be

fairly priced.

The models can be separated into methods of comparables and intrinsic models. The

method of comparables uses ratios to compare a company to their industry and

calculate a share price based on the industry average. Averages are computed by

calculating competitor’s ratios and excluding any firm who is an outlier to produce the

most consistent average for the industry. This average is then plugged in and a share

price is computed. These valuations are inaccurate and not based on solid finance

theory and should be used with perspective. Intrinsic models are far more effective

than methods of comparables due to a solid foundation in financial theory with the use

forecasting to discount back expected values of the company. Naturally, the assumed

discount rates need to have space for flexibility due to forecasting error and unforeseen

future market conditions. This is accomplished through in depth sensitivity analysis to

observe the effect of manipulation of variables in the models.

Business and Industry Analysis

Company Overview

MeadWestvaco was founded in 1846 as the Mead Paper Company. Through the

acquisition of Brazil’s Rigesa, Westab Incorporated, Westvaco, DZN, and Calmar, the company

has adapted to the changing marketplace. MeadWestvaco’s evolution has transformed from

paper production, to the cardboard six-pack bottle carrier, to the spiral notebook, and finally the

expansion of the packaging portion of the company. “MeadWestvaco is involved in packaging

resources, consumer solutions, consumer and office products, and the specialty chemicals

businesses (MeadWestvaco.com).”

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MeadWestvaco is comprised of many separate industries. The main industries are

packaging and consumer solutions, and paper manufacturing. MeadWestvaco is also involved

in: the specialty chemicals industry, and the timber and real estate industry. Most of the

competing firms have also diversified into these fields (MeadWestvaco.com).

MeadWestvaco Corporation has operations in Asia, Europe, Latin America, Mexico,

Canada, and the United States. The company has had seven percent growth of profits from

primary business segments from 2006-2007. Half of all packaging sales are outside of North

America. Their center for packaging innovation is more than 65,000 square feet. They also

have more than four thousand granted patents worldwide. There are more than twenty five

states in the U.S. with MeadWestvaco locations. The company’s products are marketed in over

a hundred nations. There are over a hundred and fifty different product lines and ninety five

different international operations. Their sustainable business practices include 1.8 million acres

of forestland under sustainable management and five consecutive years on the Dow Jones

Sustainability World Index (www.WallStreetJournal.com).

*in millions 2003 2004 2005 2006 2007

Total Assets* 12,487 11,646 8,908 9,285 9,837

Net Sales* 7,553 6,060 6,170 6,530 6,906

Sales Growth 4.3% -19.8% 1.8% 5.8% 5.8%

Industry Overview

MWV is in two main industries, the paper manufacturing industry and the

packaging and consumer solutions industry. MeadWestvaco has over 24,000

employees worldwide. Their current market cap is 4,683.63 million. MWV’s primary

competitors include Graphic Packaging Company (GPK), Smurfit-Stone Container

Corporation (SSCC), International Paper Company (IP), Bemis Company Incorporated

(BMS), and Temple Inland Incorporated (TIN). (www.ibisworld.com)

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Paper Manufacturing Industry:

About sixteen percent of MeadWestvaco’s sales are in the paper manufacturing

industry (meadwestvaco.com). The paper mill industry participates in the

manufacturing of paper from pulp. The companies can either manufacture or purchase

pulp. Additionally, the businesses may convert the paper they make into other products.

The process of making paper categorizes a business into this industry despite the

output. The paper (including newsprint) is sold in reams and rolls to producers of paper

products like stationery, printing and writing paper, paper bag and coated/treated

paper manufacturers, newspaper publishers, and paper wholesalers

(www.ibisworld.com).

MeadWestvaco is not the largest company in this industry. MeadWestvaco

competes very closely with the opposition. According to the data, MeadWestvaco is

third to International Paper Company and Bemis Company Incorporated in total assets.

The company’s net sales are finally increasing after their downward spin in 2004.

Total Assets (In Millions)

2003 2004 2005 2006 2007

MWV 12,487 11,646 8,908 9,285 9,837

BMS 751.9 873.7 987.8 1,093.7 1,136.9

SSCC 10,102 9,583 9,114 7,777 7,387

IP 35,525 32,217 28,771 24,034 24,159

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Packaging and Consumer Solutions Industry:

Seventy four percent of MeadWestvaco’s sales are in the packaging industry

(meadwestvaco.com). This business encompasses establishments largely engaged in

changing paperboard into containers without manufacturing paperboard. The industry

acquires paper, paperboard and old corrugated containers from mills and converts them

into paperboard containers, which are used to house a range of consumer

manufactured goods, from food and beverage to car engines and footwear. The

containers are bulk-produced and sold to producers of such consumer and industrial

goods. The containers produced range from corrugated and solid fiber boxes to folding

paperboard boxes, non-folding sanitary food containers and other comparable

paperboard packaging. Other products made by these companies include corrugated

sheets, pads, pallets, paper dishes, and fiber drums and reels (www.ibisworld.com).

MeadWestvaco is currently second to International Paper Company in total

assets. There has been a steady decrease in assets across this industry. Net sales for

MWV have taken an upward curl recently.

Net Sales (In Millions)

2003 2004 2005 2006 2007

MWV 7,553 6,060 6,170 6,530 6,906

BMS 2,635 2,834 3,473 3,639 3,649

SSCC 7,722 6,716 6,812 7,157 7,420

IP 22,138 20,721 21,700 21,995 21,890

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Total Assets (In Millions)

2003 2004 2005 2006 2007

MWV 12,487 11,646 8,908 9,285 9,837

GPK 538 538.3 557.9 564.3 586.3

TIN 21,331 20,144 21,630 20,474 5,942

IP 35,525 32,217 28,771 24,034 24,159

Net Sales (In Millions)

2003 2004 2005 2006 2007

MWV 7,553 6,060 6,170 6,530 6,906

GPK 1,683 2,386 2,294 2,321 2,421

TIN 3,501 3,860 3,843 4,185 3,926

IP 22,138 20,721 21,700 21,995 21,890

THE FIVE FORCES MODEL

The five forces model is a tool that can be used to better understand the

competitive landscape of an industry in which a business operates. The model is a

framework composed of five different forces that influence an industry. The model is

broken down into two separate groups which are the degree of actual and potential

competition and the bargaining power in input and output markets. The degree of

actual and potential competition can be further divided into three separate subgroups:

rivalry among existing firms, threat of new entrants, and threat of substitute products.

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These three forces take an in-depth look at a firm’s competitive position and value the

firm’s future profitability in their industry. Bargaining power in input and output

markets can are separated into two more specific categories which include bargaining

power of buyers and bargaining power of suppliers. These two groups focus on the

relationships of both suppliers and customers and their ability to impact the overall

profitability of the firm. By analyzing these five forces a company will be able to

identify the structure of the industry and be able to capitalize on particular

characteristics of their industry.

In a perfect world a firm would compete in only one industry, but this is not the

case for many firms. Due to MeadWestvaco’s diverse and wide production processes

and product mix, the firm operates in several different industries. These include the

paper products manufacturing and packaging/consumer solutions industries. The

following charts are a compilation of the five forces in both the paper and packaging

industries.

Paper Industry

FIVE FORCES COMPETITION

LEVEL

Rivalry Among Firms High

Threat of New Entrants Low

Threat of Substitute Products Low

Bargaining Power of Customers Mixed

Bargaining Power of Suppliers Low

Overall Mixed

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Packaging Industry

FIVE FORCES COMPETITION

LEVEL

Rivalry Among Firms High

Threat of New Entrants High

Threat of Substitute Products Low

Bargaining Power of Customers Mixed

Bargaining Power of Suppliers High

Overall High

Rivalry Among Existing Firms: Paper Products Most firms gauge their profitability by the degree of competition among existing

firms within their specific industry. When an industry is highly competitive, firms are

competing on price. They must sacrifice higher prices in order to be a threat to

competitors. When a firm is forced to lower the price of their product, the profitability

of the firm and the industry will suffer. Other firms, who do not compete on price,

must create a competitive advantage position in their industry by focusing their

business on product differentiation, product development, and cost control systems.

The eight fundamentals used to determine rivalry among existing firms within an

industry are as follows: Industry growth rate, concentration, differentiation, switching

costs, economies of scale, learning economies, fixed and variable costs, excess

capacity, and exit barriers. The objective of analyzing current competition within an

industry is to better understand and act upon possible opportunities or threats created

by a firm’s existing competitors.

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Industry Growth Rate

Measuring a firm’s growth rate is ineffective when analyzing competition, until

it is compared to the industry as a whole. Comparing industry growth rates between

companies give an individual firm an idea of how they rank among their competitors.

When an industry is growing rapidly, the demand for the product outweighs the supply

of the product; therefore, the industry does not struggle with price pressures. In the

absence of price wars, firms are able to focus on expansion rather than having to

attract customers with low prices. Likewise, if an industry’s growth begins to decline,

firms actively fight for market share by lowering prices in an attempt to steal customers

away from competitors. Two helpful tools used to measure industry growth rates are

industry sales and production volume.

Percentage Change in Sales: Paper Industry

2002 2003 2004 2005 2006 2007

MWV -16.2% 1.2% 2.3% 4.8% -10.6% 6.4%

IP -2.9% 9.4% 2.5% 0.4% 7.4% 11.9%

SSCC -4.7% 4.7% 9.9% 7.6% 5.1% 3.7%

BMS 4% 12.4% 7.1% 26.9% 5.1% 0.1%

INDUSTRY -4.9% 6.9% 5.4% 9.9% 1.7% 5.5%

The table and chart above illustrate the paper products manufacturing industry growth

rate over a six year span. The industry as a whole has been profitable over the past six

years averaging a growth rate of 4.08% a year. Over the last several years production

volume has risen from 47.99 million tons in 2003 to 51.23 million tons in 2007

(www.ibisworld.com). With these statistics it is logical assumption that the paperboard

industry will continue to see rising sales of industry products as long as demand for

nondurable manufactured products and consumption remain at high levels.

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Percentage Change in Sales: Packaging Industry

2002 2003 2004 2005 2006 2007

MWV 3.2% 8.4% 19% 1.5% 5.5% 6.4%

IP -2.9% 9.4% 2.5% 3.2% 7.8% 8.5%

PKG 3.8% 3.4% 36.1% 0.3% 0.9% Merged

TIN 2.2% 4.4% 1.3% 3.3% 5.4% 3.6%

INDUSRTY

AVG

1.5% 6.1% 5.9% 2.8% 6.1% 6.1%

The packaging industry has also steadily grown over the past six years averaging

a growth rate of 4.75%. The industry usually grows along with domestic production of

consumer and industrial goods, as producers require paperboard containers to

transport their final goods to wholesale and retail markets (www.firstresearch.com).

Population growth and increased consumption are key factors to growth in this

industry; therefore stable economic conditions will allow the industry to continue to

expand.

Concentration and Balance of Competitors

To determine the concentration of an industry it is important to look at the

number and size of firms competing in a market and the distribution of the market

share they control. When only a few firms hold a high percentage of the market share,

the industry is said to be highly concentrated. Firms competing in an industry that is

highly concentrated usually set a price that all competitors are willing to adhere to,

therefore avoiding destructive price wars between competitors. Conversely, when there

are many of about the same size firms, organizations are competing in a low

concentrated industry. In this case, firms aggressively battle over low pricing policies

because they are fighting for the same customers and supply of resources. Both the

paper and packaging industries have over 1,500 firms operating in the U.S.

(www.meadwestvaco.com), but only a hand full have obtained a high percentage of the

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market share, consequently these two industries possess a low level of concentration.

About 36.2% of the total market share in the paper industry is owned by four major

operators, while 25.7% of revenues in the packaging industry were generated by the

top four firms (www.ibisworld.com). Concentration has seemed to increase over the

last several years due to several mergers between top operators in both industries. For

example, International Paper’s acquisition of Weyerhaeuser’s packaging segment in

2008 increased International Paper’s, already high, market share

(www.weyerhaeuser.com). The trend of large producers increasing their market share

through acquisitions is one reason for the increased level of concentration in the paper

industry, therefore increasing the level of competition within the industry.

Market Share as a Percentage of Total Industry Sales

2003 2004 2005 2006 2007

MWV 19.3% 16.1% 17.8% 18.3% 19.4%

IP 56.5% 61.9% 62.6% 61.6% 60.4%

SSCC 19.7% 22% 19.6% 20.1% 20.5%

PKG .003% .005% .006% .006% .006%

Industry

Sales

35,427 37,711 34,684 35,684 36,218

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Differentiated Products

A firm’s ability to produce differentiated products allow the firm to defend their

prices and become more profitable. When businesses produce identical commodities or

offer similar services it becomes difficult to retain customers unless they are offered at

the lowest price. Firms that lack differentiation tend to compete solely on price. It is

difficult to differentiate products in the paper manufacturing industry because most of

the firms sell similar products making this industry highly price competitive. The

packaging and container industry have more creative freedom in their production

process. Product differentiation is still difficult to attain in this industry resulting in a

low amount of differentiation and a more intense rivalry. Firms in the packaging

industry also compete heavily on price.

Switching Cost

Switching costs are costs related to a firm’s decision to end existing operations

and using their resources to try and produce a different good. High switching costs

usually involves firms with expensive equipment that performs highly specialized

functions. Large and expensive plant equipment usually cannot be converted for other

Market Segment Share

Publishers

Paper Bag Manufacturers

Stationary Product Manufacturers

Paper Wholesalers

Export

Other

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uses making it difficult to sell assets and recover losses. Low switching costs decrease

competition because the business can do something else with their assets at a

reasonably low cost. Switching costs are high in both the paper and packaging

industries because of the expensive and customized equipment used in the production

process. The high switching costs in these two industries bind the firm in the industry

and increase competition because it would be too costly to take on other operations.

Learning Economies

Businesses where knowledge and learning are the crucial factors to be successful

are characterized as learning economies. Firms with high learning economies are more

likely to be profitable and gain market share. Patents, high technological equipment,

and degreed employees’ are just a few examples of factors used to measure the level of

learning economies. For example, Smurfit Stone Container Corp. invested $384 million

in 2007 and expects to invest an additional $400 million in 2008 to modernize their

facilities’ equipment (http://library.corporate-ir.net). MeadWestvaco opened up new

facilities in the Chicago and Los Angeles areas and also made large investments to

upgrade or buy operating equipment (MeadWestvaco’s 2008 10-K). The paper and

packaging industries are both capital intensive. They have invested in new

technological machinery enabling them to flexibly meet customer’s changing needs and

cut the production process time in half (www.ibisworld.com). MeadWestvaco has a

moderate learning economy in both the paper and consumer packaging industry. The

firms competing in these two industries mainly focus on quality and price; but in order

to stay afloat in a growing industry they also have to make technological advances in

order to remain competitive. They must make technological developments in order to

maintain speedy production times, produce mass volumes of their product, and to

maintain their competitiveness. Both the paper and packaging industries also use their

proprietary trademarks and patents, technology, and product design in order to uphold

a competitive position in the industry.

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Economies of Scale

In many industries, the size of the company is crucial to the firm’s ability to

succeed and be profitable. High economies of scale tend to occur in industries with

high capital costs because the initial investment can be spread out over a larger number

of production units driving the cost per unit down.

Total Assets in Millions: Paper Industry

2003 2004 2005 2006 2007

MWV 12,470 11,646 8,908 9,285 9,837

IP 35,525 34,217 28,771 24,034 24,159

SSCC 9,956 9,583 9,114 7,777 9,956

WY 28,599 21,411 22,046 21,896 21,381

Total Assets in Millions: Packaging Industry

2003 2004 2005 2006 2007

MWV 12,470 11,646 8,908 9,285 9,837

IP 35,525 34,217 28,771 24,034 24,159

GPK 3,200 3,111 3,356 3,233 2,777

TIN 10,102 10,805 9,114 7,777 7,387

As shown in the tables above, firms in both industries have large investments in

their assets. For firms to compete on a high level in these industries the firms must be

large and dominant to maintain a presence. Investment in plant and equipment in the

paper industry has been substantial in the five years to December 2008 (averaging

4.3% of revenue), and is expected to increase at an average annual rate of 2.2% to

approximately $930 million in 2008. The packaging industry has also substantially

increased investment in production machinery over the last five years to December

2008; the value of new industry capital invested is expected to rise at an average

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annual rate of 15%, to about $2.82 billion (www.firstresearch.com). Due to the

growth in capital investment the previous two industries do exhibit large economies of

scale which causes the industry to be highly competitive on price.

Fixed and Variable Costs

The level of competition in an industry is also influence by a firm’s fixed and

variable costs. The firms within both the paper and packaging industry have high fixed

costs, so to maintain the highest level of profitability they must constantly attempt to

reduce these costs. In order for a firm to thrive it must be able to effectively manage

its costs. The firms within both the paper and packaging industry have high fixed costs,

so to maintain the highest level of profitability they must constantly attempt to reduce

these costs. For instance, International Paper’s fixed costs accounted for 27% of their

total sales. Organizations with high fixed costs must produce at capacity in order to

cover the hefty expenses. The paper and packaging industry both have high fixed costs

due to their plant equipment which leads to increased competition because competitors

engage in price wars in order to attract customers and sell large volumes of inventory.

Excess Capacity:

Excess capacity also plays a role in determining prices in an industry. High

excess capacity reflects a low demand for the firm’s product in a market. The presence

of excess capacity in an industry forces firms to decrease prices in order to relieve the

firm of the surplus capacity on hand. The demand for products in both the paper and

packaging industries has experience growth over the last several years. The intensity

of the rivalry increases when plant capacity exceeds demand. An addition of capacity

creates high competition between firms. With the high level of demand for the products

in the paper manufacturing and packaging industry most firms do not suffer from

overcapacity, thus decreasing the level of rivalry.

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Exit Barriers

Barriers to exit a market significantly limit a firm’s ability leave an unprofitable or

unsuccessful market. Firms may be forced to continue operations even when earning

low or even negative returns. Companies that have highly customized production

equipment struggle to find an alternative use for their assets, therefore face significant

costs when exiting a market or abandoning a product. Firms who are able to leave an

industry and recover their losses are said to have low levels of exit barriers and face

lower levels of competition. Both the paper and packaging industries have highly

specialized production assets creating an exit barrier and increasing competition among

firms.

Conclusion

The paper manufacturing and packaging industries both have the same

characteristics. The packaging segment is a bi-product of the paper manufacturing;

therefore the two industries are very similar competitively. The paper and packaging

industry both have high industry growth, high economies of scale, undifferentiated

products, large amount of fixed costs, and high switching costs. All of these factors

contribute to the intense rivalry between firms in this industry. Despite the industries

high concentration the firms are still very competitive. Since competition is excessive in

these two industries, firms focus on cost control and other pricing strategies in order to

offer prices lower than their competitors.

Threat of New Entrants

The threat of new entrants pertains to the ease and probability of new

companies entering the industry. When a new company enters an industry it increases

competition and reduces available market share. When industries become too

competitive, price wars may begin causing a significant drop in profitability for all

companies involved. Threats of new entrants are a cyclical process. First, a company

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creates a new industry or market using a Blue Ocean Strategy. Other businesses soon

see the potential for high profits and start to shift into the industry. At this point the

threat of new entrants is extremely high due to a large untapped market, high profits,

and most likely low regulation. New entrants continue to move into the industry making

it progressively more competitive. Soon, the top companies emerge as majority market

holders and it becomes a Red Ocean industry. Now, the industry is highly competitive

and there are many barriers to entry. Throughout this cycle there are many factors that

determine the difficulty of a company to enter the industry. These include economies of

scale, first mover advantage, distribution access, relationships, and legal barriers.

Economies of Scale

Economies of scale pertain to how the size of an industry’s companies can be a

barrier to entry for new entrants. Large established companies can produce in very

large quantities, making the profit needed from each unit of production less. They also

have had time to establish significant research and development. A new entrant would

have to invest heavily initially to even compete against these kinds of companies. In the

paper and paper products industry companies tend to be very large with a significant

amount of established assets. This would be a large hurdle for a new company to try to

overcome and compete.

As you can see in the chart above the average company size is extremely large

and a small company would have a lot of difficulty breaking into the industry. Small to

medium companies can find small market niches. One instance is in the newly

expanding China market. The Wall Street Journal reported that, “…the companies have

lost a major market in China, which, having ramped up its own paper production, has

become a net exporter of paper itself.” When the industry first started entering China,

China was not capable of supporting their paper demand. But, because of China’s

recent economic development they can not only compete within their country but start

exporting. However, this is an exception to the rule and smaller companies rarely can

compete with the larger companies on a global scale.

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On the other hand, in the packaging industry very little capital is needed to start

a competitive business. Only a few large companies are in the market and this leaves

plenty of space for small to medium sized companies to compete. The packaging

industry consists of about 85% of smaller companies with only 15% of market share

belonging to a handful of companies (www.ibisworld.com). The packaging industry is

still a crowded industry with intense competition for contracts, but with the right market

niche companies are able to break into the industry relatively easily and begin to

compete on a large scale.

First Mover Advantage

As I mentioned earlier, the first entrants into a Blue Ocean industry have an

advantage of an untapped market and no price competition. This is referred to as

having a first mover advantage. These companies can keep other companies from

entering the industry in several different ways. One way is that first movers have had

time to establish business ties with the cheapest suppliers. They also have the

advantage of an unregulated industry environment. Governments take time pass

regulations and even realize there is a need for new legislation. First movers also are

able to have already had experience in the industry by the time competitors begin to

enter; this means that all new entrants will have to experience an expensive learning

curve. In both the paper and paper product manufacturing industry and the packaging

industry, the option of being a first mover is almost non-existent. The industry is

crowded and highly competitive, and because there is very little research into

developing new technologies there is little possibility of becoming a first mover based

on a technology development.

Distribution Access and Relationships

Another barrier to entry is the limited access to distributers by new entrants. In

larger industries the only distributers capable of distributing your product may already

be doing business with an established industry company. Even if a company decided to

be its own distributer, there would be a very high initial investment in assets to start.

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Other companies in the industry have also had time to set up relationships with

customers, governments, and companies that your industry does business with. This

can make it difficult for entrant companies to establish business and customer ties. In

the paper and paper production industry distributers play an important role, especially

in the international markets. In order to compete in this industries today you must be

global. International distributers and contacts are very valuable. A new company in the

paper and paper products industry will have a difficult time finding new distributers

overseas to do business with.

In the packaging industry only 15% of the industry is large companies. This

leads to easier access into the market by competing on a local level and expanding.

There are many distributers working with the industry capable of handling small to

midsized distribution loads. This allows new companies to be able to break in and find a

company to distribute their products with relative ease.

Legal Barriers

Legal barriers come in the form of existing patents and copyrights that existing

companies have already developed. This is very common in industries such as

pharmaceuticals where there is intense competition and a very high investment in

research and development. Legal barriers can also come in the form of limited permits

granted by government entities. In the paper and paper production industry there are

many legal barriers due to environmental regulations. In 1998 regulators passed the

Pulp and Paper NESHAP laws. (www.pinellascounty.org) These laws put stricter

specifications on air and water pollution created by the paper industry. A new company

would have to spend even more money making their infrastructure meet these

standards which would increase start up costs. In the packaging industry there is light

regulation and few copyrights and patents that make a significant impact on the

industry. Therefore, a new entrant can easily enter the industry without acquiring hard

to get permits.

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Threat of Substitute Products

Substitute products are any product that could be used in place of the good that

an industry is producing for a similar price. In some industries, research into substitute

products can play a substantial role in how well a company performs. In fact,

companies can lose significant market share if a competing company patents a

significant new technology that they cannot duplicate.

Relative Price and Performance

In other industries there are few to no products to replace the original. These

types of goods are often called commodities. The paper industry is one such industry

where there is a very low threat of substitute products. The companies in the paper

industry still do research but not as much for advancing a product than to develop

technologies to improve production capabilities. In fact, in MeadWestvaco Corp’s 10k it

states, “While, in the aggregate, intellectual property rights are material to our

business, the loss of any one or any related group of such rights would not have a

material adverse effect on our business…” This shows from the company’s lack of

concern for the loss of patents and trademarks that every player in the industry has

mostly the same technology.

Customer Willingness to Switch

Since paper is a commodity product, there are few threats to the industry of a

new product emerging and changing competition in the industry over a large scale. In

recent years the only two products to cause any concern was the increased use of

plastic bags in place of paper and the internet. The Wall Street Journal reported that

“The cyclical downturn comes as production costs rise and ever-greater Internet use

curbs the need for paper.” The increased use of the internet for email and documents

has decreased the demand for plain paper. Plastic bags have become more and more

popular since the early 90’s, which decreased demand for paper. But, because of

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increased environmental awareness, we are seeing an increase in paper bags being

used again (www.ibisworld.com).

Conclusion

In the packaging industry there has been is little significant advancement in

technology since the invention of the assembly line. The only developments in this

industry have not been in new packaging products but in production processes to

increase productivity. There is no foreseen product or technology that will replace

current packaging methods.

Bargaining Power of Suppliers

Generally speaking, the ability of a firm to remain competitive and profitable in

any industry is largely affected by the firm’s relationship with its supplier of raw

materials. The total bargaining power of firms supplying input materials to an industry

can be decomposed into two categories, price sensitivity and relative bargaining power.

Inherent industry conditions determine the relative level of bargaining power and the

sensitivity to changes in price on the part of the firms supplying raw materials to an

industry. The balance of bargaining power between producing firms and suppliers of

raw materials is primarily dictated by the level of switching costs associated with the

next best alternative for the respective parties, the level of product differentiation, the

importance of the input product to the overall cost and quality of the output product,

the number of firms supplying input materials to the industry, and the volume of raw

materials supplied by each firm.

More specifically, within the paper and paper products industry, many large

firms, such as MeadWestvaco, International Paper Company, Smurfit–Stone Container

Corporation, and Temple-Inland Incorporated, manufacture paper from timber, or

“pulpwood”, and also convert their manufactured paper into packaging and containers

for a wide range of consumer products.(www.ibisworld.com) Evidence of paper

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manufacturers increased willingness to vertically integrate into the packaging industry is

found in International Paper Company’s recent acquisition of Weyerhaeuser’s packaging

business for $6 billion in cash.(Wall Street Journal, March 17,2008) With the exception

of a small amount of polymers and bleaching chemicals, pulpwood is the only raw

material necessary for the modern mass production of bulk paper

(www.paperonweb.com). Although most of the larger firms in the paper industry now

hold large assets in pulp-wood forestland which are often managed internally by the

paper producers themselves. Pulpwood contracts through small independent

contractors such as West Frasier Timber Co. Ltd., Longview Fibre Company., and

Allegheny Wood Products Inc. are still very common in today’s paper industry due to

the time lag associated with growing pulpwood.

In addition to the paper/paper products industry and the packaging industry,

many companies like MeadWestvaco also compete, to a much smaller extent, within

periphery industries, the specialty chemicals industry for example, to extract additional

revenue from otherwise useless byproducts of the paper making process. Although the

smaller periphery industries, such as the specialty chemicals industry, where many

paper producing firms operate are value added in the sense that they extract additional

revenue for the paper producers from paper making byproducts, the size and scope of

operations within these industries is miniscule compared to the two primary industries

in which paper firms compete. Consequently, the following analysis of the bargaining

power of suppliers will be strictly limited to the paper/paper products industry and the

packaging industry since these are the two primary value driving industries for most

paper producing firms.

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Price Sensitivity

The degree to which firms care to bargain on the basis of price, collectively

known as price sensitivity, depends primarily upon the level product differentiation, the

importance of the product to the consumer’s own cost structure, and the importance of

the input product in relation to the overall cost and quality of the output product. In

relation to the paper and packaging industries, switching cost for a paper producing

firm is essentially the cost associated with switching pulpwood suppliers, or from the

pulpwood supplier’s perspective, the cost associated with selling pulpwood to the next

paper producing firm in line. In industries with low switching costs and many suppliers

selling very similar commodities, or undifferentiated raw materials, producing firms are

more likely to become very sensitive to changes in the price of these input materials.

Conversely, if the industry supports only a small number of suppliers, or if the

producing firms require very specialized or scarce input materials, producing firms may

tolerate high input prices. Much of the theory behind the price sensitivity analysis of an

industry directly corresponds to basic economic models relating the levels of supply and

demand through price. The idea of price sensitivity is essentially the same notion as

price elasticity in this context.

Relative Bargaining Power

The relative bargaining power of specific firms within an industry depends

primarily upon how many suppliers there are in the market, how similar the suppliers’

products are relative to other suppliers, the importance of the suppliers’ product to the

overall quality of the producers’ end product, and how easily producers can switch

between suppliers. As discussed above, a thorough understanding of the price

sensitivity of both suppliers and producers in an industry is an essential step in making

an accurate conclusion regarding the overall bargaining power of both parties. Within

the paper and packaging industries, a complete analysis of the relative bargaining

power of both pulpwood suppliers and paper producers can be combined with the price

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sensitivity analysis as described above to formulate an accurate conclusion as to which

market participant, either pulpwood suppliers or paper producing firms, holds the

majority of total bargaining power within the industry.

Paper Products Manufacturing Industry

Within the paper and paper products manufacturing industry (paper industry),

the total bargaining power held by pulpwood contractors can be decomposed into the

price sensitivity of pulpwood contractors and the bargaining power of pulpwood

contractors relative to paper producing firms. In general, the paper industry of today is

characterized by relatively strong bargaining power and moderately high price

sensitivity on the part of the producing firms. The five factors that will be addressed

within the industry to help make an informed decision regarding the total bargaining

power of pulpwood contractors in the paper industry are as follows: the level of

switching costs to pulpwood suppliers and to paper producing firms, the level of product

differentiation between individual pulpwood contractors, the importance of pulpwood to

the overall cost and quality of paper, the number of pulpwood contractors in the

market, and the volume of pulpwood supplied by each contractor throughout the

industry.

Switching Costs

By definition, switching costs are the costs resulting from a switch from one

supplier or marketplace to the next.(www.investorwords.com) Within the paper

industry, switching costs remain lower for paper producers than for pulpwood

contractors. Paper producers can easily switch between small pulpwood contractors

with little to no economic penalties since the pulpwood contractors are often

responsible for delivery of the pulpwood to the paper producing firms. Pulpwood

contractors, on the other hand, may face much higher switching costs in the form of

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transportation costs if their pulpwood is delivered to a different paper producer. The

existence of substantial switching costs on the part of the pulpwood contractors within

the paper industry gives rise to increasing bargaining power on the part of the paper

producers, and greatly diminishes the relative bargaining power of the pulpwood

contractors.

Differentiation

Pulpwood is largely regarded by paper producers as an undifferentiated

commodity. The inability of pulpwood contractors to distinguish their product on a

quality basis has contributed to significantly lower switching costs and significantly

higher price sensitivity on the part of paper producing firms. In fact, the

undifferentiated nature of pulpwood has let pulpwood contractors to engage more and

more in low price competition since low switching costs have allowed paper producing

firms to move freely from supplier to supplier to obtain raw materials.

Importance of Pulpwood to the Cost and Quality of Paper Products

As the most important and the most capital intensive resource to the

manufacture of paper, it is essential for industry competitive paper producers to search

out and exploit the lowest possible price for their pulpwood contracts. Generally

speaking, the higher the cost of the input material relative to the output product, the

more time and effort firms can usually afford to spend searching out lower cost

alternatives. This line of thinking strongly supports higher price sensitivity on the part of

the paper producing firms.

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Number of Pulpwood Suppliers in the Paper Industry

The domestic logging industry, in which pulpwood suppliers operate, is made up

of approximately 11,400 independent companies with no one company comprising more

than 4.5% of market share.(www.ibisworld.com) The sheer number of pulpwood

contractors operating upstream from the paper industry increases the relative

bargaining power of paper producers significantly by providing more alternative sources

from which paper producers can potentially obtain pulpwood. Most of the large

companies in the paper industry including MeadWestvaco and International Paper state

in their 10-K annual reports that they obtain input materials, namely pulpwood,

simultaneously from multiple suppliers around the world. Low switching costs, the

undifferentiated nature of pulpwood, and the industry practice of obtaining pulpwood

from multiple suppliers has largely diminished any relative bargaining power once held

by pulpwood contractors in the paper industry.

Volume of Pulpwood Obtained From Each Supplier

Most of the larger firms in the paper industry now hold large assets in pulp-

wood forestland which are often managed internally by the paper producers

themselves, a detail that increasingly leads to a stronger bargaining position for the

paper producers since less pulpwood has to be obtained from independent pulpwood

contractors. The volume of timber purchased from each supplier continues to be

relatively low across the industry due to the tendency of many paper producers,

MeadWestvaco and Smurfit-Stone Container Corporation included, to sign long term

contracts with several pulpwood contractors in several different regions in an attempt to

hedge the risk of resource destruction by natural disasters.(www.ibisworld.com) As a

result, the relative bargaining power of pulpwood contractors relative to the paper

producing firms in the industry is very much weakened.

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Conclusion

In short, the paper industry is characterized by highly price sensitive paper

producers holding the majority of the relative bargaining power over moderately price

sensitive pulpwood contractors. The existence of many alternative pulpwood suppliers

available to paper producers, low switching costs on the part of paper producers, and

the undifferentiated nature of pulpwood have all contributed to diminished bargaining

power on the part of the pulpwood contractors and increased price sensitivity on the

part of the paper producers. Although pulpwood contractors recognize the importance

of pulpwood to the manufacture of paper, efforts to exert bargaining power over the

paper producing firms have been largely unsuccessful due to the heightened price

sensitivity on the part of the paper producing firms.

Bargaining Power of Suppliers – Paper Industry

Price Sensitivity of Pulpwood Suppliers Moderate

Relative Bargaining Power of Pulpwood Suppliers Low

Overall Bargaining power of Pulpwood Suppliers Low

Packaging Industry

Most of the major firms that compete within the paper and paper products

industry, including MeadWestvaco, International Paper Company, Smurfit–Stone

Container Corporation, and Temple-Inland Incorporated, also compete within the

packaging industry. Significant economies of scale can be achieved when large paper

producing companies vertically integrate and use their own paper to package consumer

products in the packaging industry. Although the capital requirement needed to build a

top quality packaging facility is quite high, input costs can be as low the marginal cost

of producing paper when firms find it economically feasible to participate in both

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industries. Since almost all major packaging firms are vertically integrated with their

own paper producing business segments, bargaining power with suppliers is not an

issue.

Bargaining Power of Customers

Not surprisingly, the following analysis of the bargaining power of customers

closely resembles our previous study of the bargaining power of suppliers. The graph

below (Graph 1) was taken from www.ibisworld.com, and paints a clear picture of the

market for paper products.

As the graph above points out, the customer base in the paper and paper products

industry is primarily comprised of publishers, paper bag manufacturers, stationary

product manufacturers, and paper wholesalers. As for the packaging industry,

customers include a wide array of firms mostly within the consumer products

manufacturing industry. In order to draw an accurate conclusion regarding the overall

bargaining power of customers within each industry we will closely examine the

Market Segment Share

Publishers ‐ 25.6%

Paper Bag Manufacturers ‐18.7%

Stationary Product Manufacturers ‐ 18.2%

Paper Wholesalers ‐ 18%

Export ‐ 15%

Other ‐ 4.5%

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industry conditions that shape the relationship between firms engaged in the paper

industry and the packaging industry and the customers they serve by focusing on price

sensitivity and relative bargaining power. Ideally, paper and packaging firms would like

to enjoy bargaining power over both pulpwood suppliers and customers of their

product. In reality, however, many product related details including product

differentiation, and customers’ perceived quality of the product, as well as many

industry related conditions including customers’ switching costs, number of customers

in the market, and the volume purchased per customer play a major role in determining

how sensitive customers are to price changes and how much relative bargaining power

customers have within the industry.

Price Sensitivity

Price sensitivity in the context of paper producing firms and paper consumers is

affected primarily by the level of product differentiation, level of switching cost to

consumers, and the importance of the paper product to the consumer’s cost

structure.(Palepu & Healy) Since paper is largely regarded by consumers as an

undifferentiated commodity, paper consumers have become much more price sensitive

as they rely more strongly on price than quality as a determinant for consumption. As a

result, paper producing firms have adopted a low cost structure to more enable them to

compete effectively on a low price basis, a reality which greatly contributes to the price

sensitivity of customers and detracts from the relative bargaining power of paper

producing firms, especially if the industry supports low switching costs. In this context,

switching costs are derived from the cost to paper and packaging consumers of buying

products and services from another firm. Intuitively, the greater the proportion of

resources relative to the consumer’s cost structure spent on a product, the more time

and effort the consumer is likely to spend searching out lower cost alternatives,

especially if the product is largely undifferentiated.

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Relative Bargaining Power

Ultimately, the relative bargaining power of consumers relative to producers

depends on the number of buyers and producers in the market, the number of

alternative products available to the consumer, the volume purchased by each

consumer, and the costs to each party of forgoing the transaction.(Palepu & Healy)

When many alternative products are readily available to the consumer, the cost of

forgoing the purchase of a specific product is significantly reduced, and the relative

bargaining power of the producer is eroded. Conversely, when there are few producing

firms and many potential buyers in the marketplace, the producing firms hold the great

majority of the relative bargaining power. Finally, in order for firms to sell their product

to high volume buyers on a regular basis, the producers very often must relinquish a

portion of their bargaining power relative to the buyers. In effect, lower prices often

result from buyers using high volume contracts as leverage to increase their relative

bargaining power over producers.

Paper Products Manufacturing Industry

The paper products manufacturing industry of today is largely characterized by

highly price sensitive customers holding the majority of bargaining power over the

paper producing firms. This should come as no real surprise considering the

undifferentiated nature of the product, the low switching cost to customers, low cost

and uniform quality of the product across the industry, and the large number of

suppliers in the industry.

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Switching Costs

High levels of competition within the paper industry have led to high industry

standard