Newsprint Sector Will Reward the Patient

Sometimes the most beautiful ideas can come from the ugliest places. At least, one can only hope that's the case when it comes to the newsprint sector.

Few cyclical groups have performed as badly as newspaper stocks. Even though the Dow Jones Forest Products and Paper sector in general is neck-and-neck with the 2% return on the S&P 500 so far this year, shares of North America's largest newsprint producers -- Abitibi-Consolidated(ABY Quote) and Bowater(BOW Quote) -- have been a bust. Since the beginning of this year, Abitibi's shares are down 17%, while Bowater's shares have lost almost 11% of their value.

Lagging Recovery

With the economic recovery having been clearly in place for several quarters in a row now, the market appears to have lost patience waiting for demand to pick up in the newsprint sector. But based on past cycles, recoveries in newsprint typically lag not only growth in gross domestic product, but also a turn in other paper markets, according to a recent report by Raymond James Canada-based paper analyst Daryl Swetlishoff.

As a result, even though Abitibi and Bowater haven't earned an operating profit in almost three years, they may be on the cusp of doing so soon -- if trends in newspaper demand follow their historical pattern. Assuming that's the case, both stocks still look like pretty good buys. Using estimates from Deutsche Bank analyst Mark Wilde, Abitibi and Bowater are trading at price-to-book value ratios of 1.4 and 1.5, respectively, compared with the industry average of 1.8, or price-to-peak earnings ratios of 3.4 and 3.8, respectively, compared with 6.4 for the paper sector overall.

Rising Prices

Unfortunately, the latest data on newsprint demand has yet to confirm that a turn is imminent. Total U.S. consumption is still negative, falling a disappointing 1.3% year over year in May, the 12th consecutive month of declines and slightly more than the year-to-date decline of 1%. If there's any good news to be had, it's in inventories, which fell 14,000 tons year over year, thanks in large part to the discipline on the part of producers in idling capacity. Between 2003 and 2004, roughly 9% of North American newsprint capacity will have been idled or shut down.