2006 in review

Benj Gallander and Ben Stadelmann
Friday, December 15, 2006

Last February, when we wrote glowingly about the performance of our investment in Air France-KLM, we opined that the airline would fly higher. Indeed it did, gaining altitude steadily, hitting the target of $30.75 (US) and keeping right on going. The stock wobbled a little when the idea of merging with ailing carrier Alitalia was bandied about again, but it is now cruising comfortably at $41.37.

The warrants, which were a “bonus” feature to shareholders of KLM to sweeten the merger terms, have turned out to be a huge windfall. Trading at $2.15 last February, they have shot up to $10.29. That’s a long way from our own sale price at $4.49, and a reminder of just how far the pendulum of sentiment can swing.

When we purchased in September 2002, it seemed you had to have a hole in your head to invest in the airline sector. The aftermath of 9/11 was obviously a huge factor, but far more than that was in play.

The entire industry was plagued by overcapacity, rising costs, cutthroat competition, a lower volume of business traffic, labour unrest and unfunded pension liabilities.

But despite the dire situation, one salient fact remained: airlines are a necessity, so some enterprises would survive and prosper.

The inevitable question is: What industry is in as bad shape today as the airlines were in 2002? That unenviable booby prize would have to go to the forestry sector.

The softwood dispute with the United States and the rising Canadian dollar have been the main culprits, but these issues have just exacerbated deep structural problems.

Many pulp and paper mills are old and inefficient; they use too much electricity and produce too much pollution. Labour costs are high and many companies have serious deficiencies in their pension plans.

And though the paperless office is still a chimera, there is no doubt that the digital age is lowering the demand for paper, especially newsprint. Meanwhile, lumber prices are tumbling, as the slowdown in US home building deepens.

The damage to stock prices has been wide and very deep. Abitibi-Consolidated was more than $20 (Canadian) a decade ago; now it’s $2.75. Domtar, which also traded above $20, is down to $9.37. Catalyst Paper was over $8 and now trades at $3.12. Tembec has crashed from over $18 to a lowly $1.48. A relative newcomer, the SFK Pulp Fund, made its initial public offering in August 2002 at $10 a unit, but is now trading at just $4.18.

When we chose KLM, we basically wanted the best run and strongest player in a weak field. If we were to use the same strategy now, British Columbia timber producer Canfor would be a prime candidate.

It is a favourite of Canada’s two brilliant value-investing billionaires, Jimmy Pattison and Stephen Jarislowsky. But, largely due to the involvement of this dynamic duo, Canfor has not plumbed the contrarian depths that we seek. Consequently we’ve placed our bets on Abitibi, at an average buy price of $3.71; the target is $14.84.

We like Abitibi’s focus on reducing debt and its an excellent asset base of forestry lands in eastern Canada.

But the corporation is in a desperate race to shut down surplus capacity and improve margins to manage its still-heavy debt load. It faces competition not only from low-cost producers abroad, but from western Canada, where a surplus of wood fibre has reduced raw material costs.

Though the current turnaround in airlines is very impressive, don’t forget that there is a lot of debris along the road. Air Canada, Delta, Northwest, Swissair, United and US Airways all fell to bankruptcy along the way. Solid management, good foresight and a generous dose of good luck helped Air France-KLM evade that fate.

We fully expect to see bankruptcies in the forestry sector as well in the next few years. We’re counting on Abitibi to avoid that road and eventually prosper.