On July 9, The Wall Street Transcript interviewed C. A. "Chip" Dillon, a Managing Director at Citigroup Investment Research and the senior North American paper and forest products industry analyst in the equity research department. Key excerpts, including his Paper and Forest Product sector picks, follow:
TWST: Who do you like in this space at this point?
Mr. Dillon: Our favorite stocks right now are Smurfit-Stone Container (SSCC), Bowater (BOW) and Weyerhaeuser (WY). What these three have in common is a heavy exposure to these brown grades. Containerboard is very important to both Smurfit-Stone and Weyerhaeuser, and newsprint and coated groundwood are very important to Bowater, number one. Number two, we certainly like the valuations. Both Smurfit-Stone and Bowater are trading much closer to their historical 15-year lows than they are to their highs. On the other hand, Weyerhaeuser has moved up quite a bit, but we still see quite a bit of additional upside due to the potential restructuring that we see at that company.
Bowater is trading in the low-to-mid $20s and we see upside to $30 within 12 months based on the market's gradually anticipating the benefits of the Abitibi-Bowater merger, coupled with what we see as an improving global newsprint market as we go through late 2007 and into 2008. We also see Smurfit-Stone, which is trading around $12.50, moving to $16 within 12 months based on strengthening markets in containerboard on a global basis. In both newsprint and containerboard, US prices are at virtually all-time negative spreads to the global pricing we see in these grades, and it's just a matter of time before our pricing catches up with the rest of the world, given the global nature of my industry.
For Smurfit-Stone, though, and for that matter Bowater, there could be upside to our price targets based on attainment of merger synergies in the case of Bowater and in the case of Smurfit-Stone, some of the pending mergers and acquisition activity that we see in the industry. They could certainly see benefits from any synergies that would come out of any possible deal that they might be involved with. So we would point that out as being sources of possible additional upside in those two names.
Weyerhaeuser we like because we believe that they are in the process of gradually converting to a more tax-efficient structure, most likely a real estate investment trust. They have to be careful in terms of making the transition from their current state to being a REIT, and the reason for that is that they do not currently qualify for this structure. To qualify for this structure, they need to make several divestitures, but they have to have shareholder value creation as the reason for doing any divestiture as opposed to tax planning, and they have to be careful with how they present themselves, but as they have moved ahead and have shown a willingness to divest assets that aren't in keeping with earning their cost of capital or in terms of maximizing shareholder value, it seems to me that it's just a matter of time before they make this transition. By transitioning to a REIT, we believe they could create $20 to $30 per share in value, merely by being more tax efficient and, of course, if they were to do this, they would not be a pioneer. In fact, they would be actually the last one on the train, so to speak, because Weyerhaeuser is the last major C-Corporation left that owns substantial timberlands. All the other C-Corporations have either divested or announced they will divest their timberlands.
TWST: Is there anything else we should touch on?
Mr. Dillon: One other name that we also have recently downgraded to sell is Domtar (UFS); their new symbol UFS stands for uncoated free sheet, their biggest product. The marketplace seems to be very enamored with Domtar and uncoated free sheet due to the transaction with Weyerhaeuser and the fact that you now have two North American players, Domtar and International Paper, that control 60% of the North American capacity for uncoated free sheet paper. The problem the bulls have is that they view this capacity and this grade in utter isolation, and this is not a Tom Hanks movie on an island. No paper grade, in fact, is a total island unto itself and uncoated free sheet is heavily tied to market pulp. It touches market pulp because you have varying degrees of integration backward from uncoated free sheet in the pulp across players and across mills and across regions, number one.
Number two is, in a situation where the pulp market is strong, any time you have a weakness in paper demand, an integrated player can just turn off their paper driers and instead dry their fiber as pulp as opposed to paper and therefore, protect the uncoated free sheet market and keep it from being oversupplied. On the other hand, when the pulp market falters, which we discussed earlier, we think then it will be tempting for these paper makers to continue to make paper. And lastly, when you look at the customers for uncoated free sheet, the offset customers certainly have the option of buying groundwood substitutes from the likes of Bowater and Abitibi-Consolidated.
On the other hand, you've got the potential for the cut-size buyers, that is copy paper, to go overseas to get products if pulp prices cause uncoated cut-size prices to drop overseas. It at some point might become more attractive for the big box office retailers to go overseas and buy more paper there. So we think the market is underestimating the tie between market pulp prices on one hand and uncoated free sheet prices on the other and instead are viewing uncoated free sheet as a market that is going to see prices continue to move up. We don't think that's the case. So for Domtar, which is $11, we think it can drop to single digits within a year if we are right about pulp and paper pricing.
TWST: So it really has become a worldwide market and buyers can go wherever they want?
Mr. Dillon: It always has been a worldwide market. You often don't see a lot of trade, because why go somewhere else when a few phone calls can convince buyers and sellers to do the rational thing and make the prices, since it is not attractive to go somewhere else. But, if a supplier in a soft market tries to hold the line and I am a major office supplies retailer, I am not going to just ignore the fact that I've got people who can ship it from Europe or from Asia or Latin America and in the process maybe help me get better deals down the road from my domestic suppliers. That condition doesn't exist today, but, again, when pulp starts to fall, it has always been the case that uncoated free sheet prices have come down, especially overseas, and that's why we think, given our pulp scenario for the second half of 2007 and into 2008, uncoated free sheet is overrated on Wall Street right now.