Newsprint Sector Will Reward the Patient

As a result of the tight inventory control, as well as the strength in the Canadian dollar, prices already have begun to move higher. Although most newsprint sold is denominated in the U.S. dollar, 60% of North American capacity is based in Canada and therefore has a Canadian dollar cost base.

Newsprint producers attempted to raise prices by $50 per ton earlier this year, but just $30 of that has stuck so far. Even so, current prices are back to $560 per ton, up from an average of $503 for all of 2003. According to a recent report by CIBC analysts Don Roberts and Herve Carreau, U.S. consumption would have to increase 4% to absorb the 535,000 tons of idled capacity and restore industry operating rates to a 98% level from May's 90%, which typically supports higher prices.

Demand Could Increase

Strong advertising trends in the newspaper industry indicate that an increase in newsprint consumption finally could be close at hand, although it has remained elusive so far. Total newspaper advertising revenue grew 3.2% in 2003 and is expected to be up in the 6% to 7% range now for 2004, although the increase in May decelerated to just 4% year over year. Help-wanted advertising finally has turned the corner thanks to the improvement in the labor market. In May, help-wanted classified revenue rose 17.4% on average for the newspaper industry. That's the fastest rate of growth in a long time and the fifth consecutive monthly increase since the growth rate turned positive in January of this year.

Thanks to years of consolidation in the industry, Abitibi and Bowater combined control 50% of the North American newsprint market. Therefore, they have the most to gain (or lose, which has been the case recently) from an upturn in the newsprint market. For now, investors may have to endure a few more ugly, nail-biting quarters, as both companies have fairly stretched balance sheets with net debt-to-capital ratios in the 60% range.

On the other hand, the stocks are cheap -- the cheapest in the paper universe, trading at less than half the price-to-earnings ratio of 8 that they typically are valued at during the peak of a cycle, according to Wilde. So assuming that newsprint demand follows its historical pattern of being a later-cycle play, patient investors could be well rewarded.