Murry Pitts was passionate about his business. He firmly believed that to survive and thrive in the folding carton industry, Carded Graphics needed to be the leanest, most agile, and most efficient enterprise of its kind. This unyielding commitment was apparent in every aspect of his companyfrom the engaged and enthusiastic employees to the state-of-the-art seven-color Heidelberg printing press that was the centerpiece of his operations. Victory for Pitts was not so much being a better company than others as it was simply ensuring that Carded Graphics was the very best company it could possibly be.

Carded Graphics was a modest-size competitor in the $160 billion U.S. folding carton industry and specialized in smaller and highly customized orders. Manufacturing folding cartons was not a complicated business, and the small-order niche was quickly being dominated by those that could provide a seamless information infrastructure linking client specifications to final products. Speed to market and quality were essential dimensions of competition since competition virtually eliminated price differences.

Despite the growing importance of technology, paper was still at the heart of the folding carton business. Virtually every process was focused on paper, and virtually all the inventory was paper in some stage of processing. The very first step of the carton-making process was called "sheeting," in which paper was cut from multi-ton rolls into appropriately sized sheets for the printing press. A significant decision facing Carded Graphics at the end of 2009 was whether to replace the current sheeter with a newer and higher-capacity machine.

Folding Carton and Paper Industries

Until the late 19th century, product packages were made by hand, held together with tacks and string, and used only for expensive items such as jewelry. With the introduction of mass production, cartons could be cheaply printed, cut, glued, and shipped flat to purchasers, who unfolded the cartons and filled them with their chosen final products. By providing an inexpensive package that displayed information, protected products, and extended shelf life, the folding carton gave rise to the modern packaging industry and became a ubiquitous part of the consumer landscape.

Demand for cartons was driven by commercial activity and population growth. Efficiency of operation was essential given competitive pressures on prices. Generally speaking, there were few economies of scale in manufacturing: Large and small producers operated similar kinds of plantslarge producers just had more of them. The exception would have been firms that specialized in extremely large ongoing orders and that achieved efficiencies by eliminating flexibility and fully integrating the carton production process.

Because the paper used to make cartons and the completed folding cartons themselves were bulky but inexpensive, transportation costs were a significant part of the total delivered cost. The effective sales area for corrugated boxes, for example, was only about 150 miles from the production plant. The industry was fairly capital-intensive, with the average revenue per worker close to $300,000. The technology for making paper products was well known, hence most R&D focused on greater production efficiency. For the past several years, the focus had been on information management solutions that would allow carton manufacturers to integrate their production processes with their clients. For example, software and hardware systems directly linked client graphic specifications to the printing, cutting, and quality management systems. While the industry was still essentially a manufacturing industry, the best companies no longer fit the noisy and dirty industrial stereotype. Given the nature of the market, small companies could compete successfully by making specialty products or serving smaller geographical markets.

Typically, paper made from reprocessed scrap paper was used in most cartons, whilefood containers were made from a lighter and higher-grade sulfate board. The thickness of the board was generally limited to 0.032 inches (0.81 millimeters), and folding cartons were limited to holding a few pounds or kilograms of material.1 Different types of paper were produced by altering the type of raw wood used, the pulping process, the chemicals used and added, and the rolling process. The kraft (strength, in German) chemical pulping process was the most common manufacturing process and used soft woods such as pine to produce paperboard and heavy paper.

About 4,000 companies manufactured paper products in the United States at the end of 2009, with combined annual revenue of $160 billion. The folding carton industry's estimated revenue at the time was $10 billion.2 The industry was only moderately concentrated as a whole, but it was highly concentrated in specific product segments, where the largest 50 companies often held close to 70% of the market. A typical manufacturer of paper products had a single plant with 150 employees and $40 million in revenues.3

A major concern in the industry was the cost of inputs, specifically energy and paper prices. Even though oil and gasoline prices had plummeted in 2009, manufacturers were facing a general trend of rising energy costs, particularly for transportation. New forms of electronic communication and commerce were having a significant impact on demand for many grades of paper. In particular, the newsprint segment had been affected by the switch from traditional newspapers to television and Internet as sources of news and information.4 This had caused a decrease in the demand for paper. This phenomenon was counterbalanced by a general increase in demand for pulp and paper from the developing world. Furthermore, according to the American Forestry & Paper Association, U.S. paper and paperboard production capacity declined nearly 1% per year on average in the period from 2000 to 2008, and this trend was expected to continue. The industry consensus, however, was that in the medium term, pulp and paper prices were expected to remain unchanged.

Within the paper product market, the folding carton industry remained relatively strong for a number of reasons. First was the environmental appeal of cartons. The availability of timber resources (virgin wood pulp) had generally been declining. Thanks to the U.S. government's environmental protection efforts, the industry had dramatically increased its use of recycled fiber. Paper and paperboard recovery was 56% in 2008, up sharply from 39% in 1993. While flexible packaging in the form of plastic films had increasingly been chosen over more rigid materials such as folding paperboard cartons and corrugated containers, for cost reasons (plastic films weighed less and occupied less landfill space at the end of the product's life cycle), consumers still favored recyclable materials.

Second was that the surface of the carton provided "billboarding" opportunities. Graphics and printing were bold and vibrant, and they allowed for enhanced visual effects such as embossing, foil stamping, and holograms. The ability to attract consumers at the retail level remained strongly dependent on the use of color and other eye-catching elements. In fact, a substantial portion of the folding carton market included product displays. Folding carton manufacturers were becoming a critical part of a dynamic and complex supply chain. Doug Rawson, president and CEO of Superior Lithographics, said that "with the growth of Sam's Club, Costco, Best Buy, Home Depot and Wal-Mart, the demand for high-quality graphics and great looking packaging is exploding. Today, the package is the 'display' and the product 'brochure' is on the box."5

Carded Graphics

Carded Graphics provided cartons primarily to the food, medical, and consumer electronics markets. The company operated in a 125,000-square-foot facility with 90 employees just off the major North-South trucking line that flowed along U.S. Route 81. Pitts acquired this facility in 2006, and he consolidated his North Carolina Pell Paper Box operation into this single location shortly thereafter. Financial reports for 2007, 2008, and 2009 are presented in Exhibit 1 (income statement) and Exhibit 2 (balance sheet). Carded Graphics experienced little growth from 2007 to 2008 and saw a tightening of margins that resulted in a loss for the year. The results were due to the slowing economy and the costs associated with bringing new capacity online. In contrast, sales for 2009 exceeded 2008 by over 30%, and operating margins had returned to the 2007 level. Due to increased interest expense, however, net income had not improved at a level commensurate with sales, though profits had returned to nearly their 2007 level.

Driving much of the expected future success of the company was the purchase in 2008 of a seven-color Heidelberg printing press with aqueous coating capabilities. The ability to switch between ultraviolet inks and water-based inks dramatically expanded the company's range of possible graphics and printing substrates, which provided an important competitive edge. The press gave the firm "a value-added sales opportunity for customers looking for higher gloss and different printing substrates," Pitts explained.6 The press was capable of printing 18,000 sheets per hour. Carded Graphics ran the press in two eight-hour shifts, five days a week. The process was so completely automated that the operation required only two people: one to position pallets of blank sheets at one end and to remove pallets of printed sheets at the other end, and one to prepare inks and manage quality control.

Of particular importance to Carded Graphics were the efficiencies associated with the "make-ready" phase of printing: all the activities that prepared the press for printing. This included the preparation of paper, setting up necessary inks, preparing the printer for a given substrate, and ensuring proper color control. The Heidelberg was an exceptionally flexible machine. One could completely change from one multicolor print job to another in 15 to 30 minutes, depending on the number of colors and type of ink and in much less time if the same inks were used. The press also facilitated exceptional control over the printing process to ensure quality. In fact, Pitts often emphasized operating flexibility and quality jointly: "The Heidelberg allows us to swap inks easily, which facilitates smaller jobs, and the integrated Heidelberg image control and inspection systems ensure consistency throughout the process."7 This emphasis on quality was readily apparent from the newly constructed room (part of a 60,000-square-foot recent expansion) dedicated to the printer: Clean, bright, and temperature-controlled, the room was the only one in the United States at that time built to Heidelberg specifications.

Another important part of the printing process was prepress: the activities that occurred before the printing process could be initiated. This included design, graphics, and the preparation of printing plates. This part of the process, which was directly linked to the quality control systems of the printer itself, was the most technologically focused part of the business. In general, one could visualize a folding carton operation as two processes running in parallel: a manufacturing process that followed paper from its arrival to its shipment as a carton and an information process that followed the carton's graphics and design from the client to quality assessment of the final product. These processes are shown in Figure 1. As a critical link between these two processes, Carded Graphics had invested in a Heidelberg platesetter that generated aluminum printing plates directly from computer-generated graphics. Pitts was proud of the integration of these two streams: "Every part of our process, from prepress to finishing, can now connect and work seamlessly to create finished product with faster turnaround and precise color management."8

The vast majority of the Carded Graphics facility simply held paper in one stage of processing or another. As shown in Figure 1, the major phases of the process were sheeting, printing, cutting, and gluing/folding. During sheeting, paper shipped to Carded Graphics on rolls was cut to size and placed on pallets for later input into the press. Of course, not all the paper was cut into sheetssome was purchased already cut to size. After printing, sheets were moved to the die cutter, where the cartons were stamped with a die that both cut out the desired shape and added crimps to facilitate and organize later folding. The freshly cut sheets were then folded and glued in a manner that kept the carton flat but allowed the customer to expand the carton asit was filled. The speed of the printing press dominated other steps, and one could essentially view every other operation as trying to keep up with the press.

Figure 1. Paper and information processes at Carded Graphics.

Note: All operations occurred in-house except for the creation of die-cutting plates. Carded Graphics worked closely with clients on concept development, beyond issues related to implementation of client designs.

Source: Created by case writer.

Carded Graphics was by definition a made-to-order operation; that is, materials were not ordered and work was not done until an order had been placed by a client. This minimized levels of raw-material and work-in-process inventory. But Carded Graphics took on a level of finished inventory management for its clients. Whereas Carded Graphics favored larger production runs to minimize make-ready activities, the company's clients preferred to take delivery in smaller quantities. The end result was that Carded Graphics would often print the full orders clients committed to, but would ship (and invoice for) smaller orders over time. This meant a fairly large finished-goods inventory. Even so, since Carded Graphics had substantial warehouse space at the time, it could provide this implicit level of inventory management to clients at low marginal cost, which provided an additional competitive advantage. In fact, Carded Graphics had become a full-service third-party logistics provider for its biggest client: The company not only maintained stocks of finished cartons, but it also packaged, labeled, and shipped the client's products.

Sheeter Replacement

The decision facing Murry Pitts was whether to replace the current sheeter with a new one that had higher capacity. Exhibit 3 shows a schematic of the proposed new sheeter. At the time, the sheeter was operating at capacity and processing 10 tons of roll paper a day.9 Pitts estimated he could probably increase his use of roll paper by 60% if he had additional capacity. Precut paper cost about $1,010 a ton, whereas paper from rolls cost about $915 a ton.

The new sheeter would cost about $700,000 installed and would be ready to operate in early 2010. Pitts estimated he would use the new sheeter for eight years and then sell it for

$120,000. Despite the eight-year useful life, the new sheeter would be depreciated over five years on a straight-line basis. The new machine would take up more room than the old sheeter (15,000 square feet versus 10,000) and therefore incur an additional overhead fee of $22,500 (at the warehouse rate of $4.50 a square foot per annum).

The old sheeter would be sold for $25,000, which was below the current book value of

$36,000. The old sheeter had had two more years of depreciation left at $18,000 a year. Pitts recognized that comparing a new machine with an eight-year life to an old one almost fully depreciated was not quite appropriate since the old machine would not be expected to last eight more years. Operations Manager Tony Rossi estimated that if he spent $125,000 in both 2011 and 2015 to refurbish the old sheeter, it would last another eight years.

The capacity of the new sheeter would be 40 tons a day running two shifts at 20 tons a shift, more than enough to handle current maximum sheeting needs.10 Variable operating costs (excluding labor) would be $70.25 a ton, which was lower than the current operating cost of

$80.36 a ton. To the extent that the new sheeter could accommodate sheeting needs in one shift rather than two, Carded Graphics would be able to reassign one sheeting employee and thus avoid hiring a new employee, saving $60,000 a year. If production required a return to two shifts, a hire would become necessary.

Rossi estimated that the new sheeter would reduce waste in two ways. First, the waste produced by the old sheeter during sheeting was 3.8% and that would be lowered to about 2.4% with the new machine. Second, the sheeting process also affected waste in later (downstream) processes. Downstream waste for both internally and externally sheeted paper was currently 1.8%. The new sheeter would produce sheets that were far flatter than those produced by the old machine or purchased externally. This would improve sheet handling both in latter operations and reduce waste to somewhere between 0.8% and 1.6%.

The net effect of the sheeter replacement on inventory was not entirely clear. Paper already sheeted would typically arrive four days before it was used. If the paper was bought in rolls, it would spend five days as a roll and then two days as sheets before being used. Thus, there would be an extra three days of physical inventory.11 However, the increase in inventory volume would be offset to some extent by the lower roll price.

An important consideration for Pitts was how volumes and costs would evolve over time. He had seen substantial growth. In the future, he expected a minimum of 3% growth but would not be surprised to see growth of 7% or 8%. In either event, the unused capacity of the new sheeter would soon be employed. He estimated that all costs would increase by about 2% a year except paper. The cost of paper fluctuated widely and was an important source of uncertainty in his business. It would certainly matter in this analysis since the central motivation for the replacement was the cost of paper. Pitts believed that given decreasing demand, the cost of paper would be unchanged over the next five years.

Decision Criteria

Pitts said that his central reasoning for any decision, even a capital investment, was whether "the decision would be good for my operations." This is not to say he was focused on annual cash flows: Any large capital investment was going to hurt cash flows in the near term. It was a philosophy based on a firm belief that to be successful financially over the long run, his firm needed to be at peak operating efficiency at all times. Nevertheless, he recognized the need for careful capital budgeting analysis to be sure that the operating benefits of a project justified the capital outlay. This financial justification was also something he would use to help secure the financing he would need for the purchase.12

Aside from the actual cash flow effects, Pitts believed the sheeter replacement provided one additional capability. As soon as he obtained a customer order, Pitts would order paper. For precut paper, it would take five to seven days for the paper to arrive at his plant. If he had the needed paper type on a roll, he could have it sheeted that day. Even if he had to order a roll, that roll would arrive within the next two days. Thus, he could more quickly print orders that used rolled paper. Of course, this capability would not matter to all orders, but shorter customer lead times, what Pitts referred to as speed to market, was becoming increasingly important. His thoughts were echoed by Rossi, who said, "One question we always ask when making decisions is, 'Will this help us do it faster?'" He also said that "It's hard to put a price on speed and flexibility, but I know that any equipment we run in-house adds to our efficiency."

Regarding capital budgeting analyses, Pitts employed the traditional net present value analysis using an appropriate discount rate. In addition, since his firm was highly leveraged, he needed to be aware of the annual cash-flow implications of any project. To arrive at a discount rate, Pitts would gather cost-of-capital data from a number of comparable firms. In addition, recognizing that his business rose and fell with his customers, he included a sample of firms that captured the general health of the market in which he sold his products. A representative set of such firms is listed in Exhibit 4. A summary of capital market data is provided in Exhibit 5.

As Pitts waited for the actual analysis to be completed, he said, "I know what the right decision is because I know what is right for the business. However, I am curious as to what the numbers will say!"

Exhibit 1

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

Income Statements

2007

2008

2009

Sales

$9,398,775

$10,593,220

$14,100,514

Cost of Goods Sold

$7,410,572

$8,699,476

$11,276,894

$1,988,203

$1,893,744

$2,823,620

Selling and Administrative

$1,159,635

$1,409,408

$1,667,717

Other Expenses

$27,495

$(88,528)

$(70,951)

$1,132,140

$1,497,936

$1,738,668

Earnings Before Interest and Taxes

$801,073

$572,864

$1,226,854

Interest Expense

$415,848

$831,968

$937,967

Income Before Taxes

$385,225

$(259,104)

$288,887

Taxes

$128,918

$(207,373)

$52,689

Net Income

$256,307

$(51,731)

$236,198

Data source: Carded Graphics financial statements.

Exhibit 2

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

Balance Sheets

2007

2008

2009

Cash

$182,493

$32,286

$489,286

Accounts Receivable

$1,050,207

$959,361

$1,229,704

Inventory

$1,761,583

$1,858,447

$2,156,091

Deferred Taxes and Other

$187,370

$221,694

$225,474

$3,181,653

$3,071,788

$4,100,555

Goodwill

$612,968

$688,755

$707,802

Land and Buildings

$88,792

$4,896,565

$4,896,565

Equipment

$5,139,743

$9,096,829

$9,203,126

$5,841,503

$14,682,149

$14,807,493

Accumulated Depreciation

$1,714,099

$2,244,921

$2,951,139

$4,127,404

$12,437,228

$11,856,354

$7,309,057

$15,509,016

$15,956,909

Line of Credit

$1,055,957

$1,093,022

$1,083,330

Current Long-Term Debt

$660,370

$759,846

$986,531

Accounts Payable

$664,027

$1,248,788

$1,837,000

Accrued Expenses

$162,730

$147,293

$213,981

$2,543,084

$3,248,949

$4,120,842

Long-Term Debt, net of Current Due

$2,746,111

$9,552,502

$9,181,349

Deferred Income Taxes

$323,377

$370,190

$389,223

$3,069,488

$9,922,692

$9,570,572

Shareholders' Equity

$1,696,485

$2,337,375

$2,265,495

$7,309,057

$15,509,016

$15,956,909

Inventory Detail

Raw Materials

$242,479

$311,368

$448,040

Supplies

$120,773

$110,974

$157,432

Work-In-Process

$365,655

$224,535

$219,978

Finished Goods

$1,032,676

$1,211,570

$1,330,641

$1,761,583

$1,858,447

$2,156,091

Data source: Carded Graphics financial statements.

Exhibit 3

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

Schematic of Proposed New Sheeter

Exhibit 4

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

Industry Financial Data by Company

Shares

Share

Book

Yield

Revenue

Outstanding

Price

Value

on LT

Debt

Ticker

(millions)

Beta

(millions)

(12/28/09)

LT Debt

Debt

Rating

Packaging Companie s

Graphic Packaging Holding

GPK

$4,095

1.50

343

$3.47

$ 2,892

8.47%

B

International Paper

IP

$23,366

1.45

433

$26.78

$ 8,729

5.47%

BBB

Packaging Corp. of America

PKG

$2,148

1.15

103

$23.01

$571

4.61%

BBB

RockTenn

RKT

$2,812

1.10

39

$50.41

$ 1,293

7.78%

BB+

Sonoco Products

SON

$3,597

1.00

100

$29.25

$462

4.86%

BBB+

Paper Companies

Neenah Paper

NP

$574

1.30

15

$13.95

$264

7.86%

BB-

Temple-Inland

TIN

$3,577

0.88

107

$21.11

$ 2,850

5.87%

BBB

Verso Paper Corp.

VRS

$1,361

0.92

52

$2.61

$ 1,192

8.48%

B

Typical Industry Clie nts

General Mills

GIS

$14,691

0.50

328

$70.81

$ 5,755

3.89%

BBB+

Pepsico

PEP

$43,232

0.60

1,565

$60.80

$ 7,400

3.52%

A-

Target

TGT

$65,357

1.05

753

$48.37

$ 15,118

3.72%

A+

Wal-Mart

WMT

$ 408,214

0.60

3,925

$53.45

$ 36,401

3.71%

AA

Data sources: Company annual reports, moneycentral.msn.com, Value Line, Yahoo! Finance, Bloomberg.

Note: Yields on long-term debt based on maturity close to 2020.

Exhibit 5

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

Capital Market Data as of December 28, 2009

Estimated Market Premium

U.S. Government Bond Yields

6.00%

2-year

1.14%

5-year

2.69%

10-year

3.85%

30-year

4.63%

Corporate Bond Yields (long-term)

AAA

5.26%

AA

5.44%

A

5.77%

BBB

6.37%

Data sources: U.S. Federal Reserve and Mergent Bond Record.

QUESTIONS TO THE CASE

1.What are the key success factors in the folding carton industry at the time of the case? How has Carded Graphics positioned itself to excel?

(15 marks)

2.Describe the value drivers of the sheeter replacement decision?

(10 marks)

3.Calculate an appropriate discount rate for evaluating the sheeter replacement decision.

(20 marks)

4.What are the cash flows associated with keeping the old equipment and with replacing the old equipment? What are the resulting present values for both scenarios?

(50 marks)

5.Which sheeter replacement decision do you prefer? With replacement or without replacement? Why?

(5 marks)