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, Barel Karsan (384 clicks)
Long only, deep value, contrarian
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Many manufacturers of various paper and packaging products are trading at massive discounts to their 52-week highs. Companies such as International Paper (NYSE:IP) (which we discussed here), Catalyst Paper (OTC:CTLUF), Domtar (NYSE:UFS), MeadWestvaco (NYSE:MWV) and Sappi Ltd. (SPP) are all even trading below their book values. As such, many investors wonder if there is value to be found among this bunch. Unfortunately, there are a few reasons that make this a tough industry in which to invest.

First, this is a capital-intensive industry, meaning a large component of costs is fixed (as investments in equipment are constantly required). As a result, small drops in revenue hurt the bottom-line in a big way, as companies can't reduce costs in response. As a result, it's very important that these companies have low debt levels, as they have to be able to cope with negative profits every now and then. Unfortunately, many of the companies mentioned above are riddled with debt, which threatens solvency when economic times are what they are today.

Even if one were to choose the best run company (lowest costs, best operating margins) and one which is conservatively capitalized (a low debt to equity ratio), the outlook is unclear. Usually, value investors love such companies, as they are well positioned to steal market share and bounce back in a big way when demand returns. In this industry, however, there is overcapacity. In such cases, as we've discussed with respect to the airline industry, even the best companies can be hurt due to falling prices, since the products are commodities, and therefore, when companies with spare capacity slash prices, other firms are forced to respond or lose business.

Finally, it’s not clear that demand is only in a cyclical downturn. Often, value investors look for opportunities to buy companies on the cheap in cyclical downturns, but here, we might also be in a secular downturn. Newspapers, which represent large customers to the paper manufacturers, are losing advertisers and readers to other media. Should this trend continue, paper manufacturers would continue to see overcapacity, requiring more mill closures and/or more price wars, neither of which bodes well for these companies.

Disclosure: None

Source: The Paper Industry: Wood You Invest?