Saturday, October 14, 2006

Trees and Paper-The Rodney Dangerfield of Commodity Stocks

Rodney Dangerfield (may he rest in peace) was known for his line, “I don’t get no respect.” He drifted from job to job doing everything from working as a singing waiter to selling aluminum siding. He later said that he was so little known then that, "When I quit, I was the only one who knew that I quit!" His headstone reflects the no respect reads, "Rodney Dangerfield - There goes the neighborhood."

It seems that forest products or trees are treated this way by the market nowadays. It seems nobody wants to own them.

Little wonder...profitability sucks, capacity is being shut down, balance sheets in some cases are precarious, and the housing outlook, a major driver of lumber demand, is iffy and uncertain.The Canadian industry, which has generally been quite efficient, suffers from the high valuation of the Canadian dollar.

In an interview in The Wall Street Transcript (subscription required,) Paul Quinn, of Canadian broker Salman Partners describes the need to reduce capacity:

“I talk to all of the companies on a pretty regular basis, and they are all definitely going to get pretty sharp with the pencil come fourth quarter. I am expecting a flurry of announcements, at least on the Canadian side, and you see drips and drops on the US side where even producers in the US are losing money with the way things are going. The housing market has come off so strong and there is so much negative sentiment around it. People have the expectation, which I think is correct, that there is still a good 12 to 18 months of hurt coming in front of these companies. In terms of the buyers of lumber and panel products, there’s just no rush to buy any product. They know there is excess capacity out there and they know that mills can feed them just in time. So the inventories are low in the pipeline, but they are low for a reason, and that’s the demand slowdown.”

But there is some hope at the end of the tunnel. The long US/Canadian dispute over soft lumber has come to an end. Some 80% of the duties collected by the US government during the multi-year dispute will be refunded to the Canadian producers. These duties have been collected since 2002. For some of these companies, this amounts to a fairly substantial injection of capital. For example Canfor (CFP-Toronto) will be receiving some $3.80 per share after-tax according to Mr. Quinn, or about 33% of its current price. The company has earned a paltry ROIC of about 2% over the trailing twelve months. The company has realized some value by spinning off 80% of its pulp subsidiary as an income trust.

This past week, we have seen some rumblings in the housing stocks that suggest a turnaround. I think it is far too early and premature to start to get involved in the homebuilders.However, some really smart investors are seeing the clouds part and seeing valuation opportunities.

Amit Wadwhany, a fellow Canadian, was one of the best Wall Street (or at least its Canadian version Bay Street) paper and forest products analysts. He earns an honest living now...and deservedly, a very good one, with Marty Whitman’s Third Avenue Funds where he presides as the portfolio manager of the Third Avenue Global Value Fund as well as the Third Avenue International Value Fund. His interview with TWST can be found here. Amit is getting excited about the newsprint producers, a view that should be respected by its uniqueness and stark contrast to the consensus viewpoint. The jaundiced, condescending view that the consensus casts on the newspaper publishing business with its significant cash flow is only magnified when newsprint suppliers are mentioned. But, Amit observes:

“One of the things that we found quite exciting actually is the area of paper and forest products companies worldwide. Producers of paper, in particular newsprint producers, have become very cheap around the world. And necessarily, this is something that finds a very sizable, and potentially increasing, representation in our portfolio.”

He adds:

“Something that we find very exciting today, as I mentioned before, are newsprint companies. Not newspapers, but the companies that make the paper that newspaper companies use — the newsprint producers. Forest products companies generally are fascinating; they have so completely fallen out of favor that you can buy them at fractions of replacement cost. When I talk of fractions, in some cases it is $0.20 and $0.30 on the dollar, and that I think is quite exciting. Now, the reason why we think that is exciting is because it is not easy to find mature stands of trees, or sources of fiber, or cheap electricity, or to get the government permits in place to build these large operations which are extremely capital intensive.”

Be careful...there are lots of balance sheets that should cause trepidation and should be avoided. Abitibi Consolidated (ABY) has some terrific assets but, as a result of acquisitions in happier times, has a stretched balance sheet. They have just shut down 4 Quebec based sawmills cutting 20% of their output. Bowater (BOW) also has a rather stretched balance sheet. Both Abi and Bowater are single B+ credits. If such a credit rating has you nervous, it is difficult to justify owning the residual equity beneath it!

As always, great values abound when the industry situation is difficult. Patience is always required for such cyclical and controversial ideas. A pick-up in housing would help a lot...after five years of great housing stats, it seems a little too much to hope for. Weakness in oil may make the Canadian dollar a lot less exalted as a petro-currency. That would help both trees and papers. The asset values are there as Amit surmises. Takeovers may become a factor in the forest products producers as Paul Quinn surmises. These deep cyclicals are getting very interesting in my opinion.

Disclaimer: Neither I, my family, or clients have a current position in any of the names mentioned in this post.


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