The Decline of Manufacturing in America: A Case Study

One frequent and frustrating line that often crops up in the comments section of this blog is that American labor has no hope, it should just accept Chinese wages, since price is all that matters. That line of thinking is wrongheaded on multiple levels. It assumes direct factory labor is the most important cost driver, when for most manufactured goods, it is 11% to 15% of total product cost (and increased coordination costs of much more expensive managers are a significant offset to any savings achieved by using cheaper factory workers in faraway locations). It also assumes cost is the only way to compete, when that is naive on an input as well as a product level. How do these “labor cost is destiny” advocates explain the continued success of export powerhouse Germany? Finally, the offshoring,/outsourcing vogue ignores the riskiness and lower flexibility of extended supply chains.

This argument is sorely misguided because it serves to exculpate diseased, greedy, and incompetent American managers and executives. In the overwhelming majority of places where I lived in my childhood, a manufacturing plant was the biggest employer in the community. And when I went to business school, manufacturing was still seen as important. Indeed, the rise of Germany and Japan was then seen as due to sclerotic American management not being able to keep up with their innovations in product design and factory management.

But if you were to ask most people, they’d now blame the fall of American manufacturing on our workers. That scapegoating serves to shift focus from the top of the food chain at a time when executives have managed to greatly widen the gap between their pay and that of the folks reporting to them.

Let me give you an all too typical example of how American management has contributed to the demise of our industrial competitiveness, namely, the former Mead Corporation paper mill in Escanaba, Michigan, which is now part of NewPage, owned by Cerberus.

The Escanaba mill makes coated paper. Coated paper is shiny paper, the sort you find in most magazines, catalogues, and art books. Coated paper is fussy to manufacture, which makes it daunting in a continuous process setting like a mill. In a highly-capital intensive continuous process business, downtime is hugely expensive.

In 1969, Mead added a #3 machine in Escanaba. Paper machines are very long-lived; you’ll find machines over 100 years old in use, since older, well maintained, well-located machines (as in with access to comparatively cheap power and pulp) can be competitive on grades of paper which are made in small runs (as in the slow speed of the machine is not a negative). The #3 machine was world class at the time of its installation. There was no reason to think it could not be highly competitive through 2020 or 2030 if properly maintained.

Starting up a new machine, however, is not an easy process, and the #3 machine was not operating at the expected efficiency level. Management nevertheless pressed forward with a further mill expansion in 1970-1971, of a kraft-recovery system. The best workers on the #1 machine were moved to the #3 machine which did not solve the problems on #3 and worsened the results of the #1 machine. It took an over two year turnaround effort to get the mill operations up to a good level of productivity.

By the mid 1970s, the Escanaba mill had gone from being the dog to the star. Mead had reorganized to be decentralized, so the Escanaba mill had its own sales force and a true stand-alone P&L Escanaba was one of 40 divisions yet produced the majority of Mead’s free cash flow. Mead added added a #4 machine in Escanaba in 1982. The mill was recognized as one of the best coated paper makers in the US, and demanding publishers such as National Geographic, Smithsonian, and Playboy sought out its product

Mead has also had troubled period with its unions, in particular a bad strike in 1975-6. But a real turn came in the later 1980s. Mead had had a series of record-breaking profit years, each higher than the last, yet sought to squeeze the unions in 1989.

The 1980s were the heyday for papermakers. By the later 1990s, Mead had started scrimping on shutdowns, which is when the plant’s equipment gets maintenance and repairs. Twice a year shutdowns were replaced by annual shutdowns.

In 2002, Mead merged with WestVaco to form MeadWestVaco. The shallow dot-bomb era recession led to further reductions in reinvestment. A $5 million shutdown budget for Escanaba was reduced to under $2 million, even as the departing Mead CEO received a $30+ million golden parachute.

Cerberus acquired the Escanaba mill along with four other MeadWestVaco mills in 2005, forming the company now known as NewPage. Cerberus set return on invested capital targets that were, to put it politely, audacious for the paper industry, which led it to scrimp even more on keeping the plant operations up to snuff.

Cerberus also, in a remarkably bone headed move, bought some troubled mills from Stora Enso, apparently on the hope that it would be able to corner the coated paper market. Consistent with that strategy, Cerberus prefers to shutter mills that don’t meet its return targets rather than sell them, apparently out of the misguided view that it can remove enough capacity to affect its pricing power (this logic is questionable for a second reason: paper grades are specific, and the mills sold may not wind up being competitors of remaining NewPage operations). From CapeCod Today:

Some revealing statistics: NewPage shut down six mills in 2008. It closed its paper mill in Niagara, Wisconsin, the only major source of employment in a city of 1,800. The mill provided 319 jobs, with workers averaging $60,000-a-year. According to local officials, the plant had two potential buyers, but NewPage let the mill sit idle. Wrote newspaper columnist Ed Lowe at the time, “The hardship of the mill closure here parallels that of Kimberly (Wis.), where 600 well-paying paper mill jobs were scuttled as part of the evolving business plan of NewPage…Both mill closures devastated their communities…Some lifelong residents of Niagara worry that their city’s future ended with the production at the mill.”

In Kimberly, NewPage refused to sell to two buyers and declined the support of the Governor to keep the plant open. “This is a case of a corporation taking a productive, profitable plant and closing it, and refusing to sell it to anyone else,” Andy Nirchl, president of the United Steel Workers local, said at the time.

It tried putting through a 60% price increase in 2009, and was forced to roll it most of the way back as its competitors implemented only modest price hikes. This took place when the standing of the mills was falling. Escanaba was shipping product that had breakage problems; its quality had gone from being among the best to middling to low. In 2010, NewPage has had three CEOs, including the notorious Bob Nardelli, who has been named one of the worst CEOs of the 2000s and the worst CEO of all time by CNBC. Paper industry incumbents have not thought much of Cerberus’s management acumen. From Paper and Other Absolute Truths:

President and CEO, E. Thomas Curley, had barely learned the most efficient traffic routes to the office, when he was handed a check for $1.265 million, told not to come back, and, by the way, “don’t forget that you ‘resigned’”. Not a bad four month gig – I doubt that Lady Gaga does that well.

I believe that Mark Suwyn, Chairman and company Director, had been with NewPage from the “Cerberus” beginning. NewPage lost money every year under Suwyn, and was the worst managed company in the business. For that performance, Suwyn will walk away with a cool $2 million.

As an aside, it was reported that Suwyn engaged his son’s consulting firm in 2009, at a cost of $747,000, to provide training for “improving communications skills, consensus building and problem solving abilities.” (NewPage 2009 SEC Form 10-K, at 117). That is so disappointing, and in such bad taste. The program apparently didn’t work either.

The very good news is that there is no upper level management of NewPage. There is no Chairman. There is no President. There is no CEO. If this were allowed to continue for a few years, some real progress could be made.

Robert Nardelli, who has a big Cerberus title, is responsible for the NewPage performance, and is now the non-executive chairman of NewPage. That non-executive title is very important. It means he shouldn’t be in a position to make any decisions.

This entire mess was created, of course, by Cerberus mismanagement. They hired the wrong people, gave them impossible marching instructions, and have continue to play an expensive game of musical chairs at the highest levels of the company. The initial strategy of “pump and dump” didn’t work, and now Cerberus is relegated to actually operating a company. This is not their strength. But then, what is their strength?

If you think this criticism sounds overly harsh, read some earlier posts on NewPage (see here and here). Independent of the bad management, the paper industry is a poor candidate for an LBO, since it has high operating leverage, high ongoing reinvestment needs, is cyclical, and does not offer high returns even at the best of times. Unless you are confident you’ve bought at the bottom of a cycle, it’s one of the worst conceivable industries for a private equity investment.

NewPage lost $88 million in the first quarter 2011, which is an improvement over the $175 million loss for the same quarter in 2010. Its second quarter loss widened to $132 million. NewPage has held up payments to contractors, apparently to preserve dwindling cash.

Cerberus is negotiating a restructuring of the NewPage debt and may file for bankruptcy. The financiers will all get their cut and will move on to the next deal. Yet the workers at these mills and the communities they anchor, like Chillicothe, Ohio and Luke, Maryland (two other places I lived when I was growing up) will suffer the consequences of this rent extraction.

This post originally appeared at naked capitalism and is reproduced here with permission.