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Companies in the Paper & Forest Products Industry primarily operate in the paper, lumber/building supply, and timberland markets. Those serving the paper segment produce various products used in magazines, envelopes, containerboard, and food and beverage packaging. Others in the building materials category supply commercial and residential construction companies with oriented strand board, siding, engineered and composite wood items, plywood, paneling, and particleboard. Industry members focused on the timberland market have vast forest tracts in the Pacific Northwest, Southeast, Canada, and overseas (e.g., Brazil), and manage them as valuable commodities and real estate holdings. A good number of these are structured as Real Estate Investment Trusts (REITs).

Investments in production machinery, harvesting equipment, land, and distribution make the industry capital-intensive. The sector, having a long history, is mature, but company operating results are dependent on the macroeconomic cycle. Paper & Forest Product stocks, with their high payout ratios and dividend yields, have a tradition of stability, albeit interspersed with substantial volatility during severe swings in business activity. The REITs, which are required to pay out nearly all their earnings as dividends, offer the best yields.

Top-line Influences

Fortunes of the paper market are closely tied to general, global economic conditions, particularly those in the Americas, Europe, and Asia. More specifically, demand for durable and non-durable consumer goods influence paper product sales to the industrial companies and various other businesses.

The top-line performance of companies under our review operating in the lumber/building products area is highly correlated to the level of residential construction activity, especially that in North America. Employment rates, the cost and availability of borrowing (i.e., mortgages, lines of credit), and the supply/demand balance of homes all impact sales of construction-related materials.

Timberland companies generate sales by harvesting trees, manufacturing forest products (lumber, plywood, wood fibers, pulp), and selling global real-estate assets under their control. Broader business activity and the housing sector are major influences here, as well. Genetic advances in tree seedlings, improved fertilization, and sustainable forest management help to improve land yields over extended time periods, further boosting top-line growth. Additionally, prudent land purchases can support long-term sales expansion.

There is ample production capacity in the Paper & Forest Products Industry, and this can be a problem, especially in tough economic times when product demand is soft. Competition is significant, and pricing is often sharp. Most companies will continue producing products through downturns, as long as prices are sufficient to cover variable operating costs. Indeed, the costs associated with shuttering capacity can be quite large. However, when the market situation is particularly challenging, managements will temporarily slash production to bring supply in line with weak demand.

Successful enterprises in this sector are able to optimize the leverage of their scale, product array, geographic reach, production efficiency, and distribution. Market diversity, manufacturing innovation, product differentiation, and effective land management help to smooth the peaks and valleys of the business cycle.

Profitability

Factors determining the profitability of these companies include sales volume, pricing, labor expense, equipment cost, and debt interest. Notably, outlays for raw materials and energy can have a substantial impact on the bottom line. Many Paper & Forest products require petroleum-based chemicals, imported timber, fiber, pulp and other inputs, the prices of which are often volatile, for their manufacture. Transportation costs can also be onerous. Too, environmental and conservation regulations can measurably add to input costs. Generally, the industry’s ability to hedge input costs is limited. There is a heavy reliance on the spot market for purchases.

Importantly, electricity is a major expense in the production of products. The price of power is dependent on the local utility’s access to low-cost fuel types, be it oil, natural gas, coal, or nuclear. Some Paper & Forest companies consume so much energy that they have found self-generation to be the best option. Commonly, they utilize an alternative generation technology fueled by their own manufacturing waste and by-products.

Lastly, foreign exchange rates pose a risk to profitability. Customers can source products from around the world, and a richly valued domestic currency is a competitive disadvantage.

Cost Of Capital

Paper & Forest product manufacturing is capital-intensive. Significant outlays for advanced equipment are necessary for a company to offer competitive, relevant products. Also, environmental regulations sometimes require meaningful investment for compliance. Acquisitions of land and/or other companies will frequently add to financing needs. In the industry, debt levels are worth investor consideration. During a cyclical upswing, it’s not uncommon for managements to increase balance sheet leverage with the aim of maximizing sales and earnings. This can mean trouble when things take a turn for the worse, and the companies find they need to drastically reconfigure operations or finances.