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Industry analyst forecasts transition year

The Plenary Session Feb. 5 provided much food for thought as TD Newcrest’s Paper and Forest Products Equity Analyst Sean Steuart, CFA, presented his forecast for the year to come.

His presentation, Outlook: An Industry in Transition, was a perfect partner to PaperWeek International’s theme for 2008, A Bridge to the Future.

Steuart explained that the pulp and paper industry in the United States and in Canada has a poor reputation in the investment community, partially because of its failure to meet performance expectations in the past few years, but also because of the way brokers emphasize the pros but neglect to stress the cons of investing in the sector.

Since 1999, capital has been down 6%, with a more pronounced trend since the Canadian dollar started rising. As a result, the industry is losing relevance in the investment community, as Canadian, U. S. and European investments in the sector account for less than 1% of the equity market.

“I think there’s a credibility issue both on the analyst side and the industry side,” said Steuart. “We definitely get the sense that investors want to see how this unfolds in the next couple of years.”

In 2008, only five Canadian P&FP companies were listed in the S&P/ TSX Composite Index. That’s a huge drop from 1995, when 23 companies were represented. One major factor is the mergers and buyouts of the past few years, as traditionally Canadian companies like Abitibi and Domtar became listed as U. S. companies.

Steuart looked back at the downturn of the past year and provided short-, mid-and long-term trends, focusing primarily on the Canadian market.

“We estimate that the weighted average cost of capital for Canadian companies is 13%,” said Steuart of the current situation. “I wouldn’t say that U. S. and European companies have been better, but they’re certainly better than Canada. Companies have been withholding investments and share prices have gone down as a result.”

Steuart also addressed the recession fears in the U. S., claiming that although a broad recession might not take place, various commodities in this sector are already in recession.

Wood products were hit especially hard in 2007 and over the past five years, mitigated by actual demand improvement but also because of factors such as the U. S. housing crisis. New technologies will also play a role in the long term.

“A couple of products are in structural demand decline for North America,” said Steuart, “especially newsprint and uncoated freesheet. This reflects the trend in the way people are accessing information, especially with new technologies.”

Most wood-product companies have a negative cashflow, especially in Canada, and further consolidation is inevitable, according to Steuart.

“Prices have fallen so much because companies with good balance sheets have decided to push their assets too hard and burn cash instead of sitting back and balancing,” said Steuart.

As for market pulp, prices are still rising across most grades and regions. The market remains tight, especially for hardwood, but momentum is decreasing due to the short-term fibre scarcity caused by issues such as weather, closures, and union disputes. In the long term, there will be a steady demand growth with closings of high-demand price mills as new greenfield pulp mills open in the Southern Hemisphere. China remains a big driver, as shipments to that country account for 20% of the 19 major companies’ exports.

Prices for newsprint, primarily a Canadian commodity, have started increasing, he said.

“A number of the smaller companies were waiting for Abitibi to finish their merger and proceed with expected closures. And they sort of sat on the sidelines and waited, and prices went down,” explained Steuart.

“It’s been a very tough few years, but I think we’ve turned the corner,” said Steuart. “Part of the reasons we’re positive is that the big publishers in the States appear to be aboard and understanding our struggles.

“We’re going to see the worst data in Q4 that we’ve ever seen. It’s going to be a tough quarter,” Steuart warned.