Once-moribund industry sprouts new demand and higher share prices.

A the adage goes, the best time to plant a tree is 20 years ago; the second best time is now.

Ideally, investors planted their money into forestry early enough to see their money grow along with the recent surge in commodity and equity prices.

But the second best time to invest money smartly in the sector is now.

Over the past three years, Canadian forestry has suffered through one of the worst periods in its history. And for an industry already facing seasonal decline, there were several possible factors that could have aggravated the problem. Most of them came true.

In late 2006, the U.S. housing bubble popped, sparking what analysts have come to lament as the “lumber depression.”

In 2008, Canada’s forest, paper and packaging sector was the global industry’s worst performer, with the biggest companies accounting for half of the sector’s losses of US$8-billion. That year, Canada was the only country in the world to post a negative return on employed capital.

For companies focusing on building products, 2009 was no better. Severely curtailed demand drove about one-third of building material suppliers out of business, estimates Paul Quinn, a RBC Capital Markets analyst.

The supply chain is empty.

Extremely low inventory levels, when combined with even the modest uptick in demand in recent months, have sent market prices through the roof and the equities of Canadian forestry companies skyward.

The swift and stunning turnaround is evident in the share-price gains of industry leaders over the past year: Canfor Corp. and West Fraser Timber Co.’s have more than doubled to about $10 and $40, respectively. Shares of Fortress Paper Ltd. are up almost 400% to about $22. Now at about the $70-mark, Domtar Corp.’s shares have risen more than 650%. And Canfor Pulp Income Fund is trading at about $15, more than 11 times higher than in May 2009.

With much uncertainty in demand and prices, the challenge for investors is predicting which forestry stocks are poised to be cut down, having risen too far, too fast, and which still have room to grow.

The answer probably depends on investing style. Put money into lumber for long-term gains, says Daryl Swetlishoff, an analyst at Raymond James. For momentum traders looking to capitalize on inflated prices, pulp and paper are probably the best bet.

The fortunes of a Canadian lumber outfit are, of course, intimately tied to the fluctuations of the U.S. housing market. And in 2009, housing starts in the United States totalled 553,000, down almost 75% from the 2005 peak.

“In housing materials, it was really a depression,” Mr. Quinn says. Companies closed sawmills and curtailed production.

This year, a marginal increase in housing starts has combined with emerging demand in China to put some upward pressure on lumber prices.

But depleted inventories have been the true driving force, Mr. Swetlishoff says. “It’s more of a supply-side event.”

According to price tracker Random Lengths, the composite price for western spruce/pine/fir stands at about US$320 per thousand board feet, up more than 50% since the end of 2009.

“The big question in the building material space is: Are today’s high prices sustainable? And have the stocks gotten ahead of themselves?” Mr. Swetlishoff says.

With much variation in recommendations, most analysts monitoring lumber stocks have “hold” or “sector perform” recommendations on large solid-wood companies.

However, Mr. Swetlishoff says he believes those equities are currently trading at mid-cycle valuations and still have room to run. He has “outperform” recommendations on Canfor, West Fraser and International Forest Products Ltd.

“Our take is that if you’re looking at these stocks, it’s not for a six-month trade, because we see an emerging cycle in lumber products.”

Those less optimistic about the sector believe prices are due to fall and compress valuations.

“To the extent that forest-product stocks need ongoing lumber-price gains to outperform, we are doubtful that the recent spurt of share-price strength will persist,” said a report by Montreal-based think-tank BCA Research Inc.

The lack of consensus reflects a great deal uncertainty around market forces. The timing of the U.S. housing recovery is far from a sure bet, with some predicting a surge of shadow inventory from foreclosures and a double dip in prices.

But the price of lumber may be somewhat insulated from demand fluctuations by other supply constraints, including the destruction wrought by the mountain pine beetle, Mr. Swetlishoff argues.

“Until flying over the B.C. central interior and seeing nothing but red (dead) trees for hours, it is difficult to grasp the scale of the disaster that is the … beetle,” Mr. Swetlishoff said in a note.

Also, the reduction in capacity over the past three years is not immediately reversible, even though demand has picked up. And a strong loonie offsets some of the incentive to crank up production, despite the allure of high prices.

“While restarting mills is relatively easy, a strong Canadian dollar would prolong the lean supply backdrop. The latter raises the break-even cost of restarting Canadian mills and/or adding capacity, given that lumber is priced in U.S. dollars,” the BCA report said.

In fact, Mr. Swetlishoff goes so far as to apply the theory of peak oil to timber, predicting that a number of demand and supply factors will combine to produce a lumber “super cycle.”

That will lead to “sustained elevated pricing associated with structural supply deficits,” he wrote. On that front, he recommends International Forest as a small-cap pick, as well as West Fraser and Canfor.

While the peak lumber theory applies to the long term, Mr. Swetlishoff also predicts that the seasonal industry decline expected in the second half of 2010 will not push prices below break-even levels, and thus will not strip his stock picks as recommendations for deep-value investments.

Without the reliance on U.S. housing, pulp and paper companies were better able to weather the recession, but are still enjoying a recent run in prices due to supply constraints.

After a number of pulp mills closed last year, the earthquake in Chile wiped out about 7% to 8% of global capacity. Pulp is expected to hit US$1,000 per tonne soon, an increase of almost 60% since last May.

In that sector, Domtar has consistently beat earnings expectations, attacked its debt levels and recently announced the reinstatement of its dividend.

And even with big gains already realized, Domtar’s equity is considerably undervalued, Mr. Quinn says.

“Domtar’s our favourite story,” he says. “We love it.”

His share-price target is $100, well above Domtar’s current price of about $70.

“It’s balance sheet is underleveraged, it’s going to generate some significant free cash, almost $10 a share in our estimate in 2010,” Mr. Quinn says.

As a unique pulp and paper investment opportunity, Mr. Swetlishoff has a strong “buy” recommendation on Fortress Paper.

The B.C.-based producer of security and specialty papers recently acquired a hardwood pulp mill and converted it to a facility producing dissolving pulp, which is used in the production of rayon, a substitute for cotton with a large market.

“That is one I do not have to stress my model at all, and I get a lot of upside,” he said. “A lot of the other stocks I cover, I run pretty hard.”

In the wood-panel market, Norbord Inc. continues to garner “buy” recommendations on the strength of an extraordinary price environment for oriented strand board, whose price has soared to the highest levels in five years.

“At this price, they’re making lots of money,” Mr. Quinn says.

By: Tim Shufelt, Financial Post
Source: National Post