Pulp Fiction: A Paper-Stock Story
Finding deep value is tough these days. Many cyclical sectors of the market, even those that were hardest hit after Sept. 11, such as airlines and lodging stocks, have snapped back.
That said, the cyclical group still has some opportunities left. In particular, paper stocks look attractive. The paper index is still down 20% from its short-lived 1999 peak. International Paper (IP), for one, is 30% off its highs and is about flat for the year.
The earnings of paper companies (and, in turn, the fates of their stocks) are tied to the price of wood pulp, the basic material from which paper is made. One indicator of industrial activity, the Commodity Research Bureau index (CRB), suggests that prices for commodities such as pulp may be bottoming. While the CRB doesn't track pulp prices, it does measure prices for 13 different industrial commodities such as copper and steel. (You can access the CRB weekly for free on www.yardeni.com..)
The chart below shows the performance of the CRB through last week.
|CRB Raw Industrial Spot Price Index
Price of commodities such as pulp may be bottoming
|Market Pulp Prices vs. S&P
Paper Stock Relative Performance
|Source: AF&PA, Morgan Stanley Research|
There isn't a lot of excess supply in the marketplace to cause prices to plunge. Inventories are at five-year lows at the producer level, and possibly at eight-year lows at the customer level. This rarely occurs at this stage of a downturn.
Capacity is coming out of the system. The industry is consolidating and plants are being closed. Matt Berler, Morgan Stanley Dean Witter's paper analyst, estimates that more than 11% of North American uncoated free sheet capacity will have been shut down between 2000 and early 2002. Worldwide, capacity has been growing below trend line, he says.
Returns on capital can improve once demand picks up. The paper companies have demonstrated more discipline about spending this cycle. Berler estimates that capital expenditures as a percentage of sales are 5% at most paper companies; that's an all-time low.
Pickup in demand will improve operating rates and set the stage for firmer pricing. Berler estimates that pulp demand will be down 6% this year, but could swing up to between 6% and 8% next year. That could cause industry operating rates to jump to 92% to 94% from their current level of 87%. Berler notes that, historically, the higher level has given pricing power to producers. In fact, Berler says that pulp and paper shipments already have begun to turn positive on a year-over-year basis.
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