With signs that the economy is bottoming and
poised to recover, it makes sense to increase your exposure to the deep cyclical sectors that are still reasonably valued. Typically, these sectors -- basic materials, industrials and consumer cyclicals -- get cheapest during a recession and therefore rebound the strongest when the economy recovers. That's why I keep coming back to paper stocks.
Late last year I
wrote a column about the paper sector, highlighting three names:
. While International Paper is up 8% since that column, both Boise and Domtar have rallied 12%.
That could be just the beginning of a big move in these stocks, and this is why I want to revisit Domtar, North America's third-largest manufacturer of uncoated free sheet, which is bleached, uncoated printing and writing paper used mainly in office copy machines and printers. Domtar has a 13% market share, behind International Paper and
, which recently signed a deal to take over
. Despite its recent move, Domtar still represents great value, particularly compared with its U.S. rivals.
The Supply Situation
Uncoated free sheet is one of the best-positioned segments of the paper market right now, in terms of the supply/demand picture. That market segment is already well consolidated, with the top five producers now controlling 70% of the North American market compared with 52% just three years ago.
Supply has been greatly curtailed, thanks to the discipline of the top producers in reining in capacity. Anna Torma, North American paper and forest products analyst at Merrill Lynch, says that more than 5% of North American capacity was removed from the market in 2001. Managements are being smarter in this cycle by not overproducing and hurting pricing even more.
Inventories are still lean, though they did move up in January. The latest jump is understandable, because this is seasonally the weakest time of the year for demand. However, on its fourth-quarter conference call Jan. 31, Domtar's management said the company would take downtime at its plants in order to control inventories. I think other producers will pursue the same strategy.
Torma says, "The new mantra in the industry is to take downtime rather than allow inventories to grow. That's why we think the rebound will be sharper in this recovery."
Utilization rates also are moving up. Capacity reductions with low inventories should enable operating rates to improve from the low 87% range in 2001 toward 95% over the next two years, as demand continues to strengthen. Earnings should improve dramatically as capacity utilization moves higher.
Representing one of the best ways to play a rebound in the uncoated free sheet market, Domtar is poised to enjoy strong earnings growth over the next several years. The company acquired 1.35 million tons of uncoated free sheet capacity from Georgia-Pacific in 2001. That deal broadened Dotmar's already-strong distribution coverage to the southern U.S. and added a low-cost mill. The acquisition also strengthened Domtar's broad product line, particularly in the higher-margin specialty papers segment.
A Look at the Numbers
Domtar has a low cost structure, thanks to a strong management team committed to ongoing cost savings and the benefit of the Canadian dollar. The company expects to produce a $65 million annual run rate in savings from streamlining the Georgia-Pacific mills by the end of 2002, and achieve another C$100 million in cost savings by the end of 2003 through quality and productivity improvements.
Its balance sheet is solid, and cash flow is strong. The company is holding capital expenditures to just 75% of depreciation. That means it's spending well within its means; its cash flow more than covers its spending plans. Free cash flow was C$251 million (not including C$190 million from a securitization) in 2001. Free cash flow will continue to be used to reduce the debt. Domtar already has reduced its debt-to-capital ratio from 65% in August 2001 to 54% at the end of 2001, close to its goal of 50% by the end of 2002.
Domtar reported earnings per share of 9 Canadian cents for the fourth quarter of 2001, beating consensus estimates of a 4-Canadian-cent loss. Merrill Lynch's Torma expects that with a second-half recovery this year in the paper market, Domtar could earn 80 Canadian cents a share this year, up 38% from 58 Canadian cents in 2001. The consensus per-share estimate for 2002 is 69 Canadian cents. Torma rates Domtar a strong buy, and Merrill Lynch has managed a securities offering for the company in the past three years.
But forget about this year's earnings estimates. We're basically at the trough of a paper cycle. The best way to understand the value in Domtar's shares, particularly compared with those of its U.S. competitors, is to consider what this company can earn at the peak of the next cycle. Torma is using earnings per share of C$2 in 2003 and peak earnings of C$3.20 in 2004. Domtar is trading at a price-to-earnings ratio of just 8.3 times Torma's 2003 estimate and 5.2 times her 2004 number. That's well behind its directly comparable competitor in the U.S., Boise Cascade, which is trading at a P/E of 10.3 times on Torma's 2003 earnings estimates and six times her 2004 estimates.
Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to