Paper just can't get any love. Not only is there no longer an industry representative on the Dow Jones Industrial Average but also people are always talking about a paperless office and a paperless society. What's more, paper stocks have been going nowhere fast and were largely left out of the recent Wall Street commodity lovefest.
That may all be about to change. Even though 2004 was hardly a great year for paper, Finnish paper mill UPM-Kymmene Oyj (NYSE:UPM) still managed to post a little bit of growth in both sales and net income (after excluding certain nonrecurring items). What's more, free cash flow came in at about $555 million, and the company announced plans to repurchase up to 10 million shares in the first quarter. While these results weren't spectacular, the company's guidance was far more interesting.
Specifically, the company said that it was looking for price increases of 5% to 10% (higher increases for newsprint, lower increases for coated papers) and increases in volumes shipped. So what? After all, a 5% to 10% increase is no big deal, right?
Well, not exactly.
What makes this interesting is that paper companies have very high fixed costs. When production is at or below a certain threshold, the profitability is quite low. But once revenues exceed that point, income grows disproportionately fast. This phenomenon is not unlike that seen recently in steel companies such as U.S. Steel (NYSE:X) or even railroads such as Canadian National (NYSE:CNI), where recent increases in demand have fueled outsized profit growth from these high operating-leverage companies.
Better still, most paper companies are running at a fairly high capacity. Even small increases in demand, then, will give the companies better pricing power and better profits. UPM has also spent much of the past two years working on a series of restructurings and cost-cutting moves that have left the company leaner and more profitable. As a lean, mean, paper-making machine, UPM could be poised to reap some meaningful profit growth over the next few years.
It is admittedly difficult to buy stocks coming out of cyclical declines, because the P/Es and other valuation metrics often look too high. UPM is no exception; the trailing P/E is about 33, and the EV/FCF ratio is a robust-looking 19. Nevertheless, with paper prices on the way up and the entire industry operating near capacity, adventurous Fools looking to play a new commodity price cycle might do well to consider UPM and the world of paper.
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Fool contributor Stephen Simpson, CFA, has no ownership interest in any stocks mentioned.
