Canadian Paper & Forest Products Sector
Overview
Lessons Learned Through Prior Recessions
Q4/08 Earnings Preview and Forecast Revisions
· Commodity price forecast revisions. We have lowered our 2009 average
price forecast for the majority of paper and forest product (P&FP) commodities
to reflect the severity of the demand collapse during H2/08 and Q1/09. The
most significant changes are to our outlooks for softwood lumber (average
2009 price forecast lowered 13%) and market pulp (average 2009 price
forecast lowered 17%).
· Target price and recommendation changes. Based on more conservative
earnings estimates and contracted target multiples, we have lowered target
prices for 14 of 17 companies in our coverage universe. We have made two
recommendation changes: we are upgrading West Fraser Timber Co.
(WFT-T; BUY; 12-month target: $37.00) to BUY from Hold and are
downgrading Cascades (CAS-T; HOLD; 12-month target: $4.00) to
HOLD from Buy.
· Investment thesis: It’s time to start focusing on equities with exposure to
early-cycle commodities. With a few exceptions, we are increasingly positive
on wood-weighted Canadian P&FP equities. Housing start activity typically
bottoms out before the end of associated recessions and lumber/structural
panel-weighted equities usually rally in advance of pulp and paper-weighted
equities. We favour West Fraser and Norbord (NBD-T; BUY; 12-month
target: $0.75) among companies exposed to U.S. housing activity.
· Top picks. Our top picks are weighted towards companies with strong balance
sheets and compelling valuations. Within the wood-weighted group, we
prefer Sino-Forest Corp. (TRE-T; Action List BUY; 12-month target:
$13.00) and West Fraser. Within the pulp and paper-weighted group, our
top picks are Catalyst Paper Corp. (CTL-T; BUY; 12-month target:
$0.75) and Canfor Pulp Fund (CFX.UN-T; BUY; 12-month target: $3.75).

Paper & Forest Product Commodity Cycle:
Apocalyse Now
Just when we thought it couldn’t get any worse, prices for P&FP commodities have
fallen off the rails over the past two months. We’re comfortable that prices for
some early-cycle commodities (lumber, structural panels and to a lesser degree,
market pulp) have limited downside from current levels, but the magnitude of the
demand decline for several grades during Q4/08 was stunning and the industry has
not been able to curtail supply fast enough to avert price declines. In many cases,
U.S. dollar-denominated price pressure has been exacerbated by the weaker
Canadian dollar and Euro, which has lowered domestic producers’ incentive to
close capacity quickly and has effectively dropped the cyclical floor price for most
commodities in the sector. The weaker domestic currency is a positive nearterm
margin catalyst for most companies in our coverage universe, but the
benefit is mitigated by lower commodity prices.
In the first section of this report, we analyze the North American P&FP commodity
cycle over a longer time frame than our typical quarter-to-quarter assessment. It is
important to recognize that there are significant cycle timing differences from
one P&FP commodity to the next, depending on the ultimate demand driver.
The industry has never experienced a broad-based demand collapse on the current
scale, but there are signs of limited price downside for some commodities.
Long-Term Commodity Price Trends: Uncharted Waters for Wood
Products
It is no secret that real P&FP commodity prices are in a long-term downtrend, but
we do not believe that investors fully appreciate the extent of the price decline
since the mid-1990s. Exhibit 5 shows the price history for major North American
P&FP commodities NBSK pulp, newsprint and Western SPF lumber (indexed to
1.0 in 1980). For a pure comparison, we have factored in inflation (i.e., real prices
– not nominal) and have converted pricing into Canadian dollar denomination to
capture the effect of the stronger domestic currency since 2002 (at least until
recently). Shaded areas in this graph represent U.S. economic recessions,
including the current downturn, which started 13 months ago.
We note a few important points:
· Adjusted for inflation, Canadian dollar-denominated lumber prices are at
their lowest point in history (recently surpassing the all-time low reached
11 months ago). This reflects the U.S. housing collapse (during 2008, an
estimated 61% of all U.S. softwood lumber consumption went towards singlefamily
new home construction and residential improvements) and the
fragmented market structure, which we believe leads to a lag in supply
curtailments.

· Over the four most recent recessions, Western SPF lumber prices typically
bottom three months prior to the official end of the recession – in tandem
with the floor in U.S. housing starts. We see limited downside for lumber
and panel prices from current levels; few if any North American producers can
generate positive EBITDA at these prices, even with easing input costs and
more favourable currency trends.