A look at how Koch does busi­ness

The in­dus­try giant is fa­mously se­cre­tive. A look at its largest-ever ac­qui­si­tion of Ge­or­gia-Pa­cific of­fers a rare view into the firm’s man­age­ment style.

The Washington Post Sunday - - DIVERSIONS - B Y CHRISTO­PHER LEONARD

Charles and David Koch are best known for their con­tro­ver­sial po­lit­i­cal em­pire, where they ply their com­bined per­sonal for­tunes of nearly $96 bil­lion into con­ser­va­tive causes and can­di­dates across the na­tion. They’re less known for the busi­ness em­pire that’s en­abled that wealth: Koch In­dus­tries. One of the United States’ big­gest com­pa­nies — whose an­nual rev­enue of $100 bil­lion is more than that of Gold­man Sachs, Star­bucks and Honey­well In­ter­na­tional com­bined — Koch owns brands that are fix­tures of Amer­i­can house­holds, such as Brawny pa­per tow­els and Ly­cra. But be­cause it’s pri­vately held, how it has grown so big has re­mained some­thing of a mys­tery. ¶A year-long look into Koch In­dus­tries’ $21 bil­lion pur­chase of wood and pa­per giant Ge­or­giaPa­cific, in­volv­ing in­ter­views with Ge­or­gia-Pa­cific em­ploy­ees from the fac­tory floor to the ex­ec­u­tive suite, of­fers a rare view into how the brothers run their busi­nesses. The com­pany’s ap­proach, ex­am­ined for a forth­com­ing book, aligns with the brothers’ brand of eco­nomic con­ser­va­tivism, which stresses the power of the mar­ket and skep­ti­cism of gov­ern­ment. At times, its ap­proach is at ten­sion with their phi­los­o­phy.

Charles Koch of­ten frames his po­lit­i­cal giv­ing in eco­nomic terms, say­ing that the free mar­ket is bet­ter able to solve so­ci­ety’s prob­lems than the state. As chief ex­ec­u­tive of Koch, one of his strate­gies has been to shield his com­pa­nies from the mar­ket pres­sures that many public firms face.

That shield also makes it dif­fi­cult for out­siders to judge whether Koch In­dus­tries is a good ste­ward of its in­vest­ments. Out­siders are left to won­der: What does it mean to be­come part of Koch? What can public com­pa­nies learn from Koch’s man­age­ment tech­niques once it takes an­other com­pany pri­vate? What can em­ploy­ees ex­pect if Charles Koch be­comes their boss?

Charles Koch, who did not com­ment for this story, has im­ple­mented deep changes at Ge­or­gia-Pa­cific. Most of them ex­ploit one of Koch’s key ad­van­tages: The com­pany is pri­vately held, with es­sen­tially only two share­hold­ers: the brothers. This gives the firm flex­i­bil­ity to op­er­ate in a way that makes it more nim­ble than many pub­licly traded firms.

Af­ter tak­ing Ge­or­gia-Pa­cific pri­vate, Koch jet­ti­soned an­nual bud­gets and quit fo­cus­ing on quar­terly earn­ings. Rein­vest­ment has sky­rock­eted. Strate­gic think­ing has shifted years, or decades, out.

The strat­egy makes Koch In­dus­tries some­what of an out­lier among ma­jor Amer­i­can cor­po­ra­tions, fight­ing the tide of share­holder-re­turn man­age­ment strate­gies that many crit­ics say have led to an ex­ces­sive fo­cus on short-term re­turns. Charles Koch per­pet­u­ally re­minds his man­agers they want to achieve the high­est re­turn on in­vest­ment, but he’s will­ing to take 10 or 20 years to get it.

“If you need to wreck your bud­get to do what cre­ates the most value, you should wreck the bud­get,” said David Robert­son, pres­i­dent and chief op­er­at­ing of­fi­cer of Koch In­dus­tries, sum­ma­riz­ing his boss’s phi­los­o­phy.

Yet to achieve suc­cess, Koch has at times had to com­pro­mise some of his prin­ci­ples. Koch has used his po­lit­i­cal power to cru­sade against what is some­times called “crony cap­i­tal­ism” — the use of tax breaks and sub­si­dies to ben­e­fit some com­pa­nies over oth­ers. And yet Ge­or­gia-Pa­cific made use of one such tax break to ride out the re­ces­sion.

What­ever the ap­proach, it seems to be work­ing for the com­pany’s bot­tom line. Ge­or­gia-Pa­cific’s debt rat­ing has climbed from junk sta­tus to high in­vest­ment grade. An­nual net in­come av­er­ages just slightly more than $1 bil­lion a year, ac­cord­ing to Koch In­dus­tries, com­pared with $623 mil­lion be­fore the ac­qui­si­tion.

See­ing value oth­ers missed

Like al­most vir­tu­ally ev­ery­thing with Koch In­dus­tries, the deal be­gan in secret. Not even se­nior man­agers at Ge­or­giaPa­cific knew what was com­ing when a small del­e­ga­tion of Koch em­ploy­ees ar­rived in 2003 and started ask­ing ques­tions. Koch had amassed most of its in­flu­ence in the en­ergy busi­ness, own­ing oil re­finer­ies. But its sprawling busi­ness in­ter­ests span agri­cul­ture, min­er­als, ma­te­ri­als en­gi­neer­ing and even cat­tle ranch­ing.

One af­ter­noon, Koch ex­ec­u­tives met with Ge­or­gia-Pa­cific ex­ec­u­tives on the 51st floor — re­served for Ge­or­gia-Pa­cific ex­ec­u­tives and their guests — of the com­pany’s head­quar­ters. Over lunch served on fine china, Wes­ley Jones, who over­saw Ge­or­gia Pa­cific’s wood-pulp mills, ex­plained how they op­er­ated, where it bought tim­ber and where it sold pulp, and the po­ten­tial growth of Asian mar­kets.

One of the vis­i­tors lis­ten­ing was James Han­nan, who worked for Koch In­dus­tries and would be in­stalled as Ge­or­giaPa­cific’s CEO in 2007. (To­day he is an ex­ec­u­tive vice pres­i­dent at Koch In­dus­tries.) He wasn’t used to wear­ing a tie — Koch cul­ture was much more in­for­mal.

Han­nan and his team thought Ge­or­gia-Pa­cific’s pulp mills could push Koch into a new in­dus­try while al­low­ing the com­pany to build on what it did best. Pulp­ing wood turned out to be not all that dif­fer­ent from re­fin­ing oil. At Koch’s oil re­finer­ies, crude oil was pumped in one end and then heated and pro­cessed in big tow­ers, mak­ing ga­so­line and other prod­ucts. At Ge­or­gia-Pa­cific’s pulp mills, truck­loads of pine trees were fed into one end of the mill and cooked down into a fi­brous goo and sprayed into churn­ing ma­chines that make long rolls of dense pulp ma­te­rial.

The Ge­or­gia-Pa­cific mills were at­trac­tive for an­other rea­son. Koch ex­ec­u­tives be­lieved they were un­der­val­ued in a way a pri­vately held com­pany could ex­ploit. The com­pany had been on a decades-long spree buy­ing a lot of busi­nesses that didn’t fit neatly to­gether — Ge­or­gia-Pa­cific made high-profit tis­sue pa­per and lower-profit wood pulp. The mar­kets for tis­sue pa­per and ply­wood were so dif­fer­ent that bank an­a­lysts had a hard time putting a sin­gle value on a com­pany that was heav­ily in­volved in both. The pulp line was cycli­cal and dragged down the value of the con­sumer-prod­ucts busi­ness.

Koch In­dus­tries wasn’t both­ered by the boom-and-bust cy­cles of the wood-pulp busi­ness. Volatil­ity was Koch’s bread and but­ter. Koch bought Ge­or­gia-Pa­cific’s pulp di­vi­sion in 2004 and re­named it Koch Cel­lu­lose. Koch put Jones in charge.

Af­ter Koch took the pulp mills pri­vate, Jones no­ticed an im­me­di­ate change. The big­gest, most ob­vi­ous change was Koch’s will­ing­ness to rein­vest its prof­its.

The art of killing div­i­dends

Ge­or­gia-Pa­cific had been skimp­ing on cap­i­tal spend­ing at its pulp mills for years, Jones said. That was partly be­cause the com­pany had to pay off the roughly $3.5 bil­lion in debt it took on to buy Fort James, a tis­sue maker. The firm had about $8.7 bil­lion in to­tal debt in early 2005. Ge­or­gia-Pa­cific also paid out gen­er­ous div­i­dends to share­hold­ers, a com­mon prac­tice that public com­pa­nies em­ploy to make their shares more en­tic­ing.

The com­pany’s strat­egy was to run its mills as long as pos­si­ble with­out shut­ting them down for re­pairs, Jones said. It de­layed the pur­chase of new equip­ment that might have made the plants more prof­itable. The strat­egy worked for a while, Jones said, but by 2004 the equip­ment was start­ing to show se­ri­ous wear and tear.

“We were try­ing to spend as lit­tle as pos­si­ble,” Jones re­called. He said he was frus­trated with the lack of in­vest­ment. “There’s a lot of smaller stuff that we had to have fixed.”

Un­der Ge­or­gia-Pa­cific, Jones un­der­took a la­bo­ri­ous, bu­reau­cratic process to get new in­vest­ments ap­proved. He was gird­ing him­self for the same un­der Koch. He badly wanted to in­stall a new set of more-ef­fi­cient pro­cess­ing tow­ers at Koch’s pulp mill in Brunswick, Ga. Af­ter the Koch pur­chase, he talked about it on the phone with a Koch ex­ec­u­tive in Wichita, say­ing they had cost $35 mil­lion to $40 mil­lion.

To Jones’s sur­prise, the in­vest­ment was ap­proved. On the phone. That was a first.

“I re­mem­ber putting the phone down and think­ing, ‘Damn,’ ” Jones said, shak­ing his head. “It was like a month or two af­ter the ac­qui­si­tion. I was floored.”

Ex­ec­u­tives at Koch’s head­quar­ters in Wichita were ac­cus­tomed to such quick ap­provals. Charles Koch re­quires that 90 per­cent of the com­pany’s prof­its are rein­vested. He fought a le­gal bat­tle for roughly 20 years against his younger brother Bill Koch, who along with other share­hold­ers wanted to pull more cash out of the firm. Charles Koch re­fused.

To be sure, the re­lent­less drive for prof­its has led to crit­i­cism of Koch’s busi­ness prac­tices in the past. In 2000, the com­pany paid what was then the largest civil fine ever — $30 mil­lion — for vi­o­lat­ing pol­lu­tion laws af­ter its pipe­lines sprung hun­dreds of leaks. Its oil re­fin­ery in Min­nesota was fined for im­prop­erly dump­ing am­mo­nia into lo­cal wa­ter­ways. In such cases, Charles Koch has said, mem­bers of man­age­ment had mis­in­ter­preted the com­pany’s phi­los­o­phy.

As it spent money on Ge­or­gia-Pa­cific’s pulp mills, Koch In­dus­tries liked the re­sults.

“We were able to demon­strate rel­a­tively quickly that the im­prove­ment op­por­tu­ni­ties were there,” Jones said.

In late 2005, Koch In­dus­tries an­nounced that it was buy­ing all of Ge­or­gia-Pa­cific for $21 bil­lion. The tim­ing of the deal could not have been worse.

Rid­ing the crash

Koch took full cus­tody of Ge­or­giaPa­cific just as the na­tion’s hous­ing bub­ble burst. Ge­or­gia-Pa­cific made ply­wood, lum­ber and gyp­sum build­ing pan­els used in ev­ery­thing from apart­ment build­ings to new restau­rants. The mar­ket col­lapsed.

When Ge­or­gia-Pa­cific hit a rough patch in 2009, it made use of a highly con­tro­ver­sial tax credit for a pulp­ing byprod­uct known as “black liquor,” the com­pany ac­knowl­edged to The Wash­ing­ton Post. Crit­ics said the cre­ation of the tax credit in 2007 was a back­door bailout for some wood com­pa­nies in lean times.

“Of all the tax loop­holes I’ve seen in the last three decades, none is more de­spi­ca­ble than the to­tally un­in­tended and un­pro­duc­tive black-liquor tax credit,” Marty Sul­li­van, a tax con­sul­tant and for­mer staff econ­o­mist with the Trea­sury Depart­ment, said in an email.

Karen Cole, a Ge­or­gia-Pa­cific spokes­woman, said: “We did not ad­vo­cate for this tax credit, but ul­ti­mately we did par­tic­i­pate in it — not do­ing so would have put us at a com­pet­i­tive dis­ad­van­tage. We have con­sis­tently op­posed all sub­si­dies, man­dates and pro­grams that dis­tort the mar­ket and will con­tinue to do so, even when they ben­e­fit us.”

The mar­ket col­lapse was par­tic­u­larly bad news for Jose Casanova, a man­ager of Ge­or­gia-Pa­cific’s gyp­sum mill out­side Sa­van­nah, Ga. Casanova said the mar­ket for his prod­ucts tanked just as the plant opened a newly ex­panded pro­duc­tion line. Sales were low for years after­ward. But Casanova, who had worked for Ge­or­gia-Pa­cific since 2000, no­ticed some­thing sur­pris­ing. Koch didn’t pull back its cap­i­tal spend­ing.

Koch in­stalled new safety fenc­ing around the ma­chines, hop­ing to cut down on lost-time ac­ci­dents. The yel­low metal bar­ri­ers would dis­cour­age em­ploy­ees from man­u­ally dis­lodg­ing jammed ma­chines or try­ing to clean around con­veyor belts while they were will run­ning.

“We didn’t think it was pos­si­ble — un­til we im­ple­mented it,” Casanova said. “Now we need to make sure the equip­ment is re­li­able. Then you don’t need to ac­cess the equip­ment and risk get­ting hurt.”

Koch’s ex­pe­ri­ence with volatil­ity cre­ated an­other prac­tice that soon swept through Ge­or­gia-Pa­cific.

In the 1980s, Koch stopped rou­tinely us­ing an­nual bud­gets — those fi­nan­cial doc­u­ments that for many public com­pa­nies are akin to di­vinely in­scribed stone tablets, dic­tat­ing which fi­nan­cial tar­gets would be hit in a given quar­ter. The power of bud­gets was log­i­cal for public com­pa­nies — if sales or prof­its are be­low ex­pec­ta­tions, even for one quar­ter, it can hurt the stock price.

Dur­ing the oil shocks of the 1970s and ’80s, Koch ex­ec­u­tives re­al­ized that bud­gets were all but worth­less — it was all but im­pos­si­ble to pre­dict how much Koch needed to pay for oil six months or a year down the road.

In­stead, Koch uses “plans” for each year, sketch­ing out rev­enue, costs and prof­its it an­tic­i­pates, mainly used so ex­ec­u­tives can bet­ter plan ac­qui­si­tions. Man­agers aren’t judged on how closely they ad­here to the bud­get — just on whether they ex­pand their busi­ness.

“The dif­fer­ence is that many com­pa­nies go to painstak­ing de­tail on ev­ery line item in their bud­get in an ef­fort to, I’ll say, pre­dict the fu­ture,” Robert­son said. “What we de­ter­mined is that we weren’t very good at pre­dict­ing the fu­ture. So why do we want to spend an in­or­di­nate amount of time try­ing to?”

A new cul­ture

Koch’s other changes re­shaped Ge­or­gia-Pa­cific’s cor­po­rate cul­ture. Koch started al­most im­me­di­ately by mov­ing se­nior ex­ec­u­tives out of the lav­ish of­fices on the 51st floor, where Han­nan had re­ceived his first pre­sen­ta­tion on Ge­or­gia-Pa­cific’s pulp mills. Hav­ing a floor re­served for ex­ec­u­tives, where a neck­tie was re­quired for ad­mis­sion, con­veyed too much of a com­mand-and- con­trol men­tal­ity, Charles Koch later wrote.

Merg­ing Koch In­dus­tries’ cul­ture with Ge­or­gia-Pa­cific’s has not been with­out its chal­lenges. The union was a com­pli­ca­tion for Koch, not known for any warmth to­ward or­ga­nized la­bor. The com­pany had union­ized work­ers at some of its op­er­a­tions but noth­ing com­pared with the size and scope of Ge­or­gia-Pa­cific’s col­lec­tive-bar­gain­ing units.

The Na­tion mag­a­zine pub­lished an ar­ti­cle about other cul­tural ten­sions in 2011 with the head­line “Big Brothers: Thought Con­trol at Koch.” Em­ploy­ees were par­tic­u­larly trou­bled when Koch In­dus­tries shared lit­er­a­ture that rec­om­mended vot­ing for Repub­li­can Mitt Rom­ney in the 2012 pres­i­den­tial elec­tion.

One union filed a la­bor com­plaint over Koch’s pol­icy that re­stricted so­cial-me­dia posts for em­ploy­ees. Greg Palle­sen, who rep­re­sents Ge­or­gia-Pa­cific work­ers in the As­so­ci­a­tion of West­ern Pulp and Papers Work­ers, told the news out­let In Th­ese Times that Koch’s pol­icy was hyp­o­crit­i­cal and un­fair to work­ers.

“They don’t al­low their em­ploy­ees to have free speech,” he said. The Na­tional La­bor Re­la­tions Board and Ge­or­giaPa­cific reached a set­tle­ment in which the com­pany backed off the pol­icy.

Still, the num­ber of union work­ers at Ge­or­gia-Pa­cific has de­clined pre­cip­i­tously. When Koch took over, roughly 22,000 of 55,000 Ge­or­gia-Pa­cific em­ploy­ees were union­ized. To­day, that num­ber has dropped steeply, to 11,800, the com­pany said. A Koch of­fi­cial said that sell­ing off its tis­sue busi­ness in Europe and clos­ing some “non­com­pet­i­tive fa­cil­i­ties in the U.S.” con­trib­uted to that drop.

For its in­tense fo­cus on com­pany per­for­mance, Ge­or­gia-Pa­cific has not swept the pa­per mar­ket.

Its re­turns are prob­a­bly av­er­age to above av­er­age when com­pared with com­peti­tors such as Kim­berly-Clark or Proc­ter & Gam­ble, said Chip Dil­lon, a stock an­a­lyst who has cov­ered the forest­prod­ucts in­dus­try for two decades. Both of those firms in­vest heav­ily in con­sumer prod­ucts with higher profit mar­gins and have strong mar­ket po­si­tions.

“I would say that Ge­or­gia-Pa­cific is re­spected. I wouldn’t say they’re feared. I think their com­peti­tors are equal to them in many senses,” Dil­lon said. “They’re not go­ing to take over this busi­ness.”

Han­nan said the best way to stay com­pet­i­tive is to stay un­com­fort­able. Even if the fi­nan­cial in­di­ca­tors for Ge­or­gia- Pa­cific are pos­i­tive — with higher earn­ings, a lower debt rat­ing and more ac­qui­si­tions on the hori­zon — Han­nan said the one emo­tion he tries to avoid is that of self-sat­is­fac­tion.

“The thing you worry most about is that we’re go­ing to feel that way,” Han­nan said, “and then just get dragged down from be­hind and get our throats slit.”

ABOVE: STEPHEN B. MOR­TON FOR THE WASH­ING­TON POST; BE­LOW: GE­OR­GIA-PA­CIFIC

In 2003, Jim Han­nan and his team from Koch In­dus­tries thought wood-and-pa­per giant Ge­or­gia-Pa­cific could push Koch into a new in­dus­try. Koch later bought the com­pany for $21 bil­lion. To­day Han­nan is an ex­ec­u­tive vice pres­i­dent at Koch In­dus­tries.

At the Ge­or­giaPa­cific plant in Brunswick, Ga., above, pro­cessed wood chips are bleached of any nat­u­ral color. Be­low, is a Ge­or­giaPa­cific wood yard. Af­ter Koch In­dus­tries took the pulp mills pri­vate, the big­gest change some no­ticed was the will­ing­ness to rein­vest its prof­its.

PHOTO BY STEPHEN B. MOR­TON FOR THE WASH­ING­TON POST

STEPHEN B. MOR­TON FOR THE WASH­ING­TON POST

A tenet of Charles Koch’s busi­ness strat­egy is a high level of rein­vest­ment. One of the au­to­ma­tion in­vest­ments at the Ge­or­gia-Pa­cific cel­lu­lose mill in Brunswick, Ga., is bar codes that track in­ven­tory and al­low fork­lift driv­ers in the 87,000-square­foot ware­house to load spe­cific rolls into the cor­rect ship­ping con­tainer.

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