A Compelling Story in Newsprint

With demand expected to rise as the newspaper ad market recovers, S&P likes industry giant Bowater

By Bryon Korutz

A firming U.S. economy is expected to boost spending on newspaper advertising -- and the consumption of newspapers themselves -- in the second half of 2002. And this rebound is expected to strengthen further throughout 2003. That's a welcome development for newsprint manufacturers like Bowater (BOW ), as it is likely to boost the demand and prices for newsprint. Bowater, a leading North American manufacturer of newsprint and related products, carries S&P's highest investment rating of 5 STARS (buy).

The company is divided into four business segments: newsprint (59% of 2001 sales), coated and specialty papers (20%), market pulp (16%), and forest products (5%).

Bowater's North American facilities are capable of producing about 3.2 million metric tons of newsprint annually, representing some 20% of total North American capacity. It is the largest newsprint manufacturer in the U.S. with about an 18% share of the market. Its worldwide production capacity is about 3.5 million metric tons, or about 9% of global capacity. Bowater sells its North American newsprint production through company-owned regional sales offices located near metropolitan areas.

Bowater also makes coated and uncoated specialty papers (about 1.3 million short tons annual capacity), which are used in magazines, catalogs, books, advertising, coupons, and direct mailings. With plants capable of turning out about 1.3 million metric tons of market pulp annually, and an 11% share of the market, Bowater is the third largest manufacturer of market pulp in North America.

Through its lumber division, Bowater produces pulpwood, saw timber, construction-grade lumber, and wood chips at 13 lumber mills in the U.S. and Canada. As of Dec. 31, 2001, Bowater leased, owned, or held cutting rights on over 34 million acres of timberlands in southeastern U.S. and Canada.

Bowater bolstered its presence in the North American newsprint and pulp markets -- and expanded its paper offerings -- through its September, 2001, acquisition of Alliance Forest Products. The Alliance deal added two low-cost, modern paper mills, and a recently modernized newsprint mill used to produce 100% recycled newsprint.

Newsprint producers had a difficult time in 2001. The demand for newsprint fell 10.9%, about 11.6 million tons, according to the Pulp and Paper Products Council. The weak demand has extended into early 2002 as well, thanks to a decline in newspaper advertising spending and linage. However, with media advertising starting to exhibit signs of recovery -- usually a leading indicator for print advertising -- S&P expects newspaper advertising spending and consumption to firm in the second half of the year. S&P's forecast is for newspaper advertising spending to rise by as much as 5% in 2002, with a strong second half, and more robust growth in 2003.

Although Bowater should be a leading beneficiary from any improvement in newsprint demand, it may not reap the benefits immediately. Since most newsprint is bought on long-term contracts, we feel that it is unlikely that a price increase will occur immediately. It's much more likely to happen later this year. And newsprint demand has started to show signs of firming. According to Pulp & Paper Week, the April operating rate of mills in the U.S. was 84%, compared to the year-to-date average of 82%. The publication also noted that the April price of the benchmark 30-lb. newsprint remained stable at $455 per ton in the U.S., which marked the first time in a year that prices did not show a month-to-month decline. These factors point to a recovery in newsprint in the later portion of 2002, with a further strengthening in 2003.

In the near term, Bowater is likely to be aided by improving pulp markets. In mid-May, 2002, it announced price increases for four of its pulp grades. Bowater should also benefit from synergies from the Alliance acquisition and a continued focus on cost reductions. And it has a favorable cost structure, with fairly modern, low-cost newsprint mills, and efficient lumber production facilities in eastern Canada. These factors, combined with the expected recovery in newspaper advertising and the weakening U.S. dollar, improve the outlook for Bowater.

What do we see ahead for Bowater's results? S&P expects its revenues to rise by approximately 10% in 2002 because of improved demand and contributions from the Alliance acquisition. However, with the pricing and demand for newsprint still near their lowest levels of the current cycle, though improving, and continued downtime at its facilities, we expect Bowater to post a $1.90 a share loss in 2002.

But S&P sees the tide turning in 2003, with revenues projected to rise about 15% to 16%, and operating margins to widen as demand and pricing recovers and cost containment initiatives continue. We see EBITDA (earnings before interest taxes, depreciation, and amortization) margins likely increasing to 23% in 2003, from 17% in 2002. With results benefiting further from lower interest expense on reduced debt levels, we see Bowater returning to profitability in 2003, with earnings of $2.70 a share.

As for the company's stock, S&P has a 6 month to 12 month price target of $60, based on the application of a reasonable p-e multiple of 22 to Bowater's $2.70 estimated EPS in 2003. Using another valuation measure, S&P's discounted cash flow analysis supports an intrinsic value of $60 to $62 for the shares. That's a significant premium to the May 31, 2002, closing price of $52.38.

Analyst Korutz follows paper and forest products stocks for Standard & Poor's

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