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SECTOR SCOPE by James A. Anderson June 7, 1999

Papermakers May Be Ready to Print Money
Thanks to improving fundamentals, the sector's recent rally looks to be for real

Let the market swoon over tech stocks and Net IPOs if it wants (both on the way up and down). Halfway through 1999, one of the hottest sectors around isnít online filling stations, flashy communications gadgetry, or nifty software. Itís paper.

Pardon the pun, but paper has been on a tear since April, when the group's stocks showed a gain of 25.8% for the month, according to a 22-stock index Standard & Poorís uses to track the forest products industry. Amid the first blossoms of spring, Westvaco (W), International Paper (IP), and Bowater (BOW) each rose 35% or more, leaving the likes of Microsoft, Pfizer, and even AOL in their wake. Paper stocks rose again last week on expectations of strong second-quarter earnings.

At first glance, you might want to chalk the move by paper shares up to old fashioned sector rotation, a general move out of higher-priced tech shares and into grittier cyclicals with lower price-earnings ratios, such as chemicals, mining, and steel. But there's more in the way of fundamentals behind this move than that. Asiaís first steps toward recovery, coupled with continued strength in the U.S. economy, are combining to improve the outlook for many basic material companies. "Cyclically, it looks like the group is starting to turn the corner," says Mark Wilde, an analyst with BT Alex Brown.

DEEP DISCOUNT. Yet the turnaround is new enough that paper stocks may still be a bargain. Even after Aprilís rally, the group's p-e multiple is still parked in the high teens, based on year 2000 earnings estimates. In other words, paper stocks still trade at a 30% discount to the S&P 500, which fetches a multiple of 26.

As cheap as they may sound, it's worth remembering that paper stocks have disappointed investors over the past few years with a number of false starts. Back in the fall of 1995, prices for some paper grades fell as much as 30%, and paper stocks crumbled. The next year, with inventories falling, a recovery seemed certain. But no sooner had price hikes taken hold in the spring of 1997 when overcapacity and Asiaís financial follies tripped up the paper industry. Paper shares averaged a 1.9%.slip in 1998.

This time, though, the groupís rally may be no origami tiger. For one thing, Asiaís bounceback does wonders for demand for everything from corrugated cardboard to copier stock. Warburg Dillon Read analyst Frances Loo estimates that while Asia accounts for about 21% of the worldwide demand for paper, it has actually made up nearly 50% of the global demand growth for paper and board products.

In the U.S., if the industry has learned anything from its start-stop fits of recent years, itís that it needs to plan capacity expansions more carefully. Indeed, in the past the group has often fallen victim to its own product cycles. When times were good, execs would splurge on new mills, flood the market with product -- then watch helplessly as demand and prices slid during down cycles.

LESSON LEARNED? If current trends are any indication, however, management now seems more prudent. According to a survey by the American Forest & Paper Assn. (AFPA), the industryís trade group, domestic paper companies look to limit capacity increases to a meager 0.9% annually, over the next three years. According to Standard & Poorís analyst Michael Jaffe, that compares with an average yearly increase of 2.5% the 10 previous years -- and it's the lowest rate of expansion in the 40-year history of the AFPA.

At the same time, a number of players have snapped up competitors to cement their positions in key paper categories. In April, International Paper put the wraps on a $6.6 billion deal with Union Camp. That merger places IP firmly at the head of all producers of uncoated free sheet, the 8 1/2 11 stock filling office copiers and printers, and in second place among container-board makers. Jefferson Smurfitís $6.5 billion merger with Stone Container to create Smurfit-Stone Container (SSCC) positions that company as the leading packing-board producer.

Add disciplined planning and mergers and you get pricing power. Last year, surplus capacity and weak overseas demand worked to force prices for most paper grades down 10% to 30%, according to Value Line analyst Perry Roth. Now, prices for most grades of paper are bottoming out, says Warburg Dillon Read's Loo. Starting next year, she says, prices for newsprint, linerboard, and coated and uncoated free sheet should rise between from 10% to 12%. Meanwhile, manufacturers of container board, the cardboard stock used for packing boxes, pushed through 10% to 15% price hikes in March and are looking for more increases in July.

COMEBACK TIME. A rebound in container-board prices bodes well for Smurfit-Stone, which this year is cutting annual production by 1.1 million tons, or 15% of its U.S. capacity. Wall Street looks for the company to post a loss equal to 29 cents a share this year, according to Zacks Investment Research, as it adjusts to the new union. Still, Smurfit-Stone looks to be poised for a comeback: Analysts polled by Zacks expect it to earn 26 cents a share during the second half of 1999 and $1.69 a share in 2000. Currently, all nine analysts who follow Smurfit-Stone rate the company a strong buy or buy, according to Zacks. BT Alex Brownís Wilde looks for Smurfit-Stone's stock to reach the mid-30s in the next 12 to 18 months, up from Fridayís close of $23.50 a share.

The largest papermaker around, International Paper, also stands to benefit from its recent merger with Union Camp. Company officials should be able to slash $400 million in annual costs by mid-year, says Value Line analyst Lars Bainbridge. A pickup in container-board prices should also help IP, and Wilde says the company's other core businesses, such as bleached paperboard and uncoated white paper, are starting to pick up. "I like the company from a risk/reward standpoint," says Wilde. "The stock has backed off 10 points the last few weeks, and investor expectations might be a bit low." All told, Wilde thinks IP can reach a $70 target price in the next 12 to 18 months (the stock closed at $50.44 on Friday). Currently, 8 of the 14 analysts who follow IP rate the company a buy or strong buy. Wall Street looks for $1.06 in per-share earnings this year, then $2.58 in 2000.

As weak as newsprint prices have been, analysts say Bowater may be a good turnaround bet. Within the past year, the South Carolina company has moved to bolster its role in the business with a $2.4 billion takeover of Canadian newsprint maker Avenor. In 1999, Wall Street sees Bowater still hamstrung by a weak marketplace, with earnings projected at 70 cents a share, down from $2.30 in 1998, according to Zacks. Next year, though, analysts expect the company to get back on track with earnings of $3.40 a share. "In two years, with strong management at the helm, this could be a $100 a share stock," says Wilde (it's currently at $53.75). Of the 15 analysts who follow Bowater, 12 rate the stock a strong buy or buy.

For fund investors, Fidelityís Select Paper & Forest Product Fund (FSPFX) is as pure a play on the group as you could wish for. The fund invests at least 80% of its portfolio in paper, packaging, and forests product companies, and it has mirrored the ups and downs of the sectors. This year, the fund has generated a total return of 22.05% as of June 3. Over the past three years, the fund suffered with the sector, averaging an annual total return of 7.93%.

James Anderson, who teaches journalism for the City University of New York, writes Sector Scope every other week for Business Week Onlin

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