Where has all the paper gone? To Brazil, of course! At least that's where the most successful paper producers are heading these days, thanks to Brazil's tropical climate, fertile forest land, and profusion of the fast-growing eucalyptus tree.
There's no question that Brazil has a significant competitive advantage in the production of pulp. Brazilian eucalyptus forests have an average harvest cycle of 3.5 times faster than that of the average American forest. And their annual yield per unit of land is five times greater.
What makes Brazil an even more attractive destination for pulp and paper companies is that when you combine the superior wood production with the country's favorable labor and energy costs, you get production costs that total approximately half of what American competitors have to pay out.
So which companies are taking advantage of Brazil's lush leafiness? Finnish paper products giant Stora Enso (NYSE:SEO), for one, announced plans this week to significantly expand its existing operations in South America. According to the company's press release, Stora Enso plans to invest up to $100 million for 2005 acquiring land in both Brazil and Uruguay for the development of eucalyptus and pine forests, ultimately to be harvested for the production of pulp and paper. This is in addition to a eucalyptus pulp mill the company already has in Veracel, Brazil.
Other pulp and paper producers, such as UPM-Kymmene (NYSE:UPM), have also announced plans to expand into Brazil. International Paper (NYSE:IP), the largest paper-products company in the world, maintains 1.2 million acres of land in South America, by far its largest forestry base outside the U.S.
These enormous cost advantages are evident in the superior operating results of Brazilian producers Aracruz Celulose (NYSE:ARA) and Votorantim Celulose e Papel (NYSE:VCP). While other pulp and paper makers, such as competitor Neenah Paper (NYSE:NP), have struggled to turn a profit amidst a tough pricing environment, Aracruz and Votorantim churned out profit margins of 18% and 28%, respectively, over the past 12 months, according to Capital IQ.
This vast divergence in earnings power has created some interesting investment opportunities. Valued on the basis of their assets, as commodity producers often are, the Brazilians are richly valued. However, valued on the basis of their earnings, as most businesses are, the Brazilians are valued pretty cheaply. Aracruz is valued at 13 times projected 2005 earnings, while Votorantim is valued at a paltry eight times projected 2005 earnings.
Why do these companies trade at such attractive prices despite holding favorable market positions? One factor is that Brazil's economic markets are not as developed as those in the U.S. or Europe, and thus these investments demand a "country risk" premium. But consider also that the Brazilian agricultural markets are among the most successful in the world -- the country is a worldwide leader in coffee, sugar, and soybean exports, and it dominates the markets with its low-cost production. It is not hard to imagine the pulp and paper markets following a similar trajectory.
It will take many years for foreign producers to realize the benefits that the Brazilian paper makers currently enjoy. Meanwhile, Aracruz and Votorantim will keep generating superior profits, garnering a larger share of the market, and should continue to make for solid investments. As an investor, you can live vicariously through their successes in the dense Amazon. After all, where else can you find the most profitable and fastest-growing businesses selling at such a significant discount to their peers?
For more on the exciting world of pulp and paper, check out:
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Fool contributor Gerald Kim does not own shares of any of the companies mentioned.
