Skills exercise

Corporate Finance, Spring 2011

Professor Walther

North Central Lumber

North Central Lumber is a forest products company. It owns large tracts of forest land in the U.S. and Canada, and its primary business consists of logging. That is, it cuts down trees, sells the trees to its customers, and then replants its forests. 80% of its trees are of the species Hypothetica Malum (Malum for short). It has smaller holdings of pine, maple and ash trees. Its customers are located in both the U.S. and Canada, and the revenue from its forest products division is split nearly evenly between U.S. and Canadian dollars. It also owns several pulping facilities. A pulping facility is a manufacturing plant, typically located on a river, that processes trees into wood pulp, which is an intermediary product in paper production. That is, it sells its wood pulp to paper manufacturers, who use the pulp to produce paper. All of its pulping facilities are located in Canada, although it sells pulp to some U.S. manufacturers. As for January 1, 2011, approximately 25% of its pulp revenue came from sales into the U.S., whereas 75% were located in Canada. Finally, it has two plywood manufacturing facilities, both located in the U.S. Plywood production takes whole logs and cuts them in a way that produces thin layers of wood. The thin layers are then glued together to create the worlds most popular manufactured wood product. The plywood facilities are tightly integrated with North Centrals forest products operations; they are located on the same site as the forest products sawmills, and the company usually supplies its plywood plants with the lumber it cannot sell on the spot market at attractive prices. Hence the timing of its plywood production is uneven and varies from month-to-month, although it always makes sure to meet its annual production targets. Plywood is most commonly used in residential construction, and due to the recent decline in the residential construction market, plywood prices dropped throughout North America. In fact, they dropped beneath North Centrals plywood production costs, which are somewhat higher than average for the industry despite their efficient integration with the forest products division. As a result, North Central closed its plywood facilities as of June, 2009. They can be reopened at a cost of 3M USD. North Centrals CEO is Mateen McCanns. He has been at the helm since 2002, and during his tenure, the senior management team has been very stable with little turnover. The period from 2003-2007 was the most profitable in the companys history, and McCanns engineered several large acquisitions of forest reserves in these years. For each transaction, he (and the other senior executives) received substantial acquisition bonuses in the form of stock and equity options. The North Central board of directors has since discontinued the practice of awarding acquisition bonuses. From 2008-2010, McCanns has earned a salary of ~ $ 2M USD per year, with a bonus that ranging from an additional $750-1,250K USD per year. The other three senior executives (Chief Financial Officer, Chief Operating Officer, and General Counsel) earned base salaries and bonuses of about half that amount. Together, the four most

Skills exercise

Corporate Finance, Spring 2011

Professor Walther

senior executives hold about 14% of North Centrals outstanding equity, and options which, if exercised, would bring the collective ownership stake to 23%. The options have a weighted average strike price of $19.4, and expire in 2014. II. North Centrals current financial woes stem from a failed climate hedge and a beetle infestation in its Malum forests. About 10 years ago, North Central was able to quantify a relationship between its forest production and temperature cycles. It developed a measure called the Three Year Annual Mean (TYAM), which for any given year is essentially a measure of the average temperature over the previous three years. For instance, the TYAM for 2010 is a function of temperatures from years 2007, 2008 and 2009. North Central noticed that warmer weather makes its trees grow faster, and so its production was higher in years with higher TYAMs. Thus, it entered a swap with an energy broker that produced positive cash flow in years with below-average TYAMs and required North Central to pay cash in years with above-average TYAMs. Fortunately for North Central, its energy advisor structured the swap to take account of warming trends, and so the benchmark for what constitutes an average TYAM would rise over time, according to projected temperature trends. Unfortunately for North Central, it did not foresee that a particularly hot three year period would give rise to a nefarious beetle infestation that devastated its Malum forests in 2009. To contain the infestation, it had to burn approximately 40% of its forest, which destroyed a forest inventory of approximately 300M USD (see financial statements below for exact figures). In 2010, it did not have to burn any forests, but its expenditures on pest detection and control increased dramatically and it is unknown when the infestation will be sufficiently controlled that detection and control expenses can return to normal levels. To add insult to injury, because of the warm weather, it owed $35M on its climate swap in 2009, and the swap was in a loss position in 2010 as well. In November, 2010, North Central paid $31M to close out the swap position. III. All is not lost for North Central. The beetle infestation was hardly confined to its forests, as most logging companies experienced losses; some companies timber losses were more severe than North Centrals (although only North Central had the burden of the failed hedge). The combined effect was to create an acute shortage of Malum wood in the market a shortage that pushed many wood consumers such as homebuilders and furniture designers to switch to a slightly different wood species called Imaginarium Bene. Bene (pronounced Ben-ay) turned out to be extremely popular, and in some circles, quite fashionable. Many industry insiders predict that Bene will continue to gain market share at Malums expense, even after Malum wood supplies recover from the effects of the infestation. This is an opportunity for North Central, because Bene is a finicky species. It thrives only in certain climactic conditions, which are present at many of North Centrals

Skills exercise

Corporate Finance, Spring 2011

Professor Walther

Malum land tracts but not at those of most of its competitors. Thus, it could reseed some of its Malum forests especially ones that have already been burned -- with Bene and reap substantial profits from selling the more profitable (and pest-resistant) Bene wood. Only a few other companies will be able to enter the rapidly growing Bene market. However, replanting a forest requires capital and patience. To achieve full economies of scale, the company would have to spend at least $300M USD to seed the forest, and then wait until the trees have grown to begin logging them. Fortunately, Bene (like Malum) is a fast-growing species, but it will still be five years before North Central will able to obtain any revenue from Bene stocks planted today, and it will likely be at least ten years before its Bene profits will be sufficient to recoup its initial investment. After that point, North Central expects its Bene lands to generate a consistent, very positive cash flow, upwards of $100M per year in good years. Its internal projections, conducted by a respected industry consultant, have determined the Net Present Value of the Bene project to be north of $500M USD. Of course, none of these estimates can be made with precision or confidence, because they require visibility far into the future. In addition, there is always a risk of an unexpected beetle infestation. Scientists are currently unaware of any beetles indigenous to North America that affect Bene trees, but there are some beetle species elsewhere in the world that could adversely affect the forests if they were somehow introduced to North American ecosystems in sufficient quantity to adapt to the new environment. The forest management authorities of Canada and the U.S. control and inspect all imports of wood products to prevent the introduction of foreign pests, but no inspection system is perfect. However, in order to take advantage of this opportunity, North Central requires an influx of capital. It is currently losing money, and its cash flows are insufficient to service its existing debt. It has been making its debt payments with proceeds that it recovered from an insurance policy that it had held on some of its forests, but that money will soon run out. IV. North Central has begun negotiating a financing arrangement with a group of potential investors mostly pension funds, some of whom collectively own approximately 52% of North Centrals outstanding long-term debt. There is no interest on either side of the negotiations for a straight equity investment; McCanns believes that selling equity at a depressed stock price would unfairly dilute its equity holders, whereas the pension funds generally do not invest in straight equities. They prefer investments with more consistent and predictable cash flows, because they need the cash to service their obligations to their pensioners. McCanns is looking for an investment of between $340-400M USD. All things equal, he would prefer an investment on the high side of that range ($400M being the target figure), but only if that amount makes financial sense. North Central has provided its investors with its financial data (the selected details of which are provided below), along with an internal valuation study conducted in November 2008 by a third party auditor. That study valued the forest products business at around $740M USD, the pulping business at about $220M, and the plywood business at around $100M USD. These valuations were based in part on certain assumptions that the auditors took into account most notably, that the plywood facilities were tightly integrated with North Centrals logging operations, and that the plywood market was

Skills exercise

Corporate Finance, Spring 2011

Professor Walther

known to be cyclical, with highly variable cash flows. The company has publicly expressed its belief that plywood prices will recover, and when they do, the plywood business will be reopened and can achieve profitability levels almost as high as their 2006-2008 peak. The major independent forest products industry analysts have issued price and demand forecasts that are largely consistent with North Centrals predictions. V. Your job is to design a financing package that will enable North Central to maintain its solvency and acquire the capital it needs to restock its Malum forests with Bene trees. To this end, you should prepare two memos. The first memo should be addressed to McCanns and the North Central board of directors. It should specify in detail the financing provisions that you recommend and explain how and why they meet North Centrals needs. Here you have two competing objectives. You are writing the memo for the McCanns, who wants to see an attractive proposal with favorable terms that he can offer to the investors as an initial foray into what will surely be an extended and spirited bargaining process. At the same time, you should be aware of what can be realistically obtained from a group of sophisticated investors, who will not enter a deal unless it is financially advantageous to them and who will have sophisticated legal counsel able to bargain for contractual provisions to protect their clients interests. They are likely to simply walk away from the negotiations before they even begin if they receive an initial proposal that is unreasonable. Your second memo should be addressed to the investor group, and should evaluate the financing package from their perspective. You should endeavor to point out all of the risks that accompany the investment, and you may suggest mechanisms to mitigate those risks. Primarily, those mechanisms will take the form of provisions in the financing contract with North Central, but you may also rely on either the pension funds or North Centrals access to broader capital markets. Either type of mechanism should be explained in detail. For contractual provisions, that means drafting the provisions themselves in language that could be inserted into the contract. You will have access to a financial advisor named Professor Walther, who will be able to price various types of securities or financial instruments for you via email. You must specify in full all but one of the parameters of the instrument in question, and he will provide the missing term. He works on a retainer, so you will not be charged per consultation but keep in mind that his retainer is not unlimited and it is possible for you to begin to incur advisory charges if you consult him too frequently. McCanns and the investor group have both indicated to you that they would like to see the memos in their inboxes by May 1, 2011.

Skills exercise

Corporate Finance, Spring 2011 North Central Financial Statements, 2008-2010

Professor Walther

Columns A, B, C: Fiscal Years ending December 31 of the years 2008, 2009 and 2010 respectively.

Selected Balance Sheet Data & Statement Of Equity (all numbers expressed in millions of USD or millions of shares, except where indicated). FY ending Dec. 31: Cash or cash equivalents PPE* Forest Reserves Receivables TOTAL ASSETS: LONG TERM DEBT:*** Stockholders Equity Shares Outstanding Book Value per share Market Value per share, as of December, 31 2008 50 96 737 49 932 600 332 10 $33.2 41.02 2009 207 62** 402 32 703 600 103 10 $10.3 18.1 2010 124 58 441 44 663 600 63 10 $6.3 10.9

Selected Statement of Cash Flows Operating Profit Capital Expenditure Working Capital Adj.**** Interest Cost NET OPERATING FLOW Extraordinary Items***** CHANGE IN CASH 88 (15) (10) (54) 9 0 9 38 (12) 9 (54) (19) 176 157 23 (9) (12) (54) (52) (31) (83)

Legend: * PPM = Property, Plant and Equipment ** Value diminished by a write-down of the value of the North Central Plywood facilities, whose value was considered impaired as June 1, 2009

Skills exercise ***

Corporate Finance, Spring 2011

Professor Walther

The debt is a simple 20-year indenture with a 9% coupon and no sinking fund, conversion or call/put features. Its maturity date is June 1, 2018 **** Working Capital Adjustment is the change in accounts receivable minus the change in accounts payable. It represents a change in the amount of profit that has yet to be realized in cash. ***** In 2009, the extraordinary item adjustment included the receipt of $211M from insurance on the burned forest, minus the outlay of $35M on the climate hedge. The extraordinary item adjustment in 2010 was an additional $31 million outlay to close out the climate hedge position.

Selected Financial Data By Business Segment FY ending Dec. 31: Operating Profit Pulping Forest Products Plywood Legend: * The company benefited in 2008 from having entered a long-term forward sale agreement with a major customer. This agreement required the customer to purchase a large amount of plywood from North Central at the average 2006 price. Either party could opt out of the forward sale agreement at the end of any calendar year, provided they had given notice of their intent to do so by June 1 of that calendar year. On May 31, 2008, the customer notified North Central of its decision to opt out of the agreement as of December 31, 2008. Subsequently, the parties agreed to cash-settle their remaining obligations without requiring the physical delivery (or receipt) of the plywood. The 2008 profits of the plywood business in 2008 cannot be compared on a oneto-one basis with the profits from earlier years, because the company expanded its plywood capacity significantly in 2007. However, the gross and profit margins realized by the plywood business in 2008 were approximately the same as in years 2006 and 2007. 2008 2009 2010

20 57 11*

in millions of USD 17 18 24 9 (3) (6)