Seeing the Forest Through the Trees?

 | Dec 12, 2012 | 12:30 PM EST  | Comments
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According to a filing with the Securities and Exchange Commission (SEC), Fairfax Financial Holdings recently bought another 2.1 million shares of Resolute Forest Products (RFP). Fairfax's 13F filing for the end of September had the holding company owning 19 million shares of the $1.2 billion market cap paper company. After its most recent purchase, the position is approaching 26 million shares. Resolute shares are down 20%, year-to-date. The stock reached its current market price in May, and has been quite volatile since then. Fairfax is managed by Prem Watsa, who has been called "the Warren Buffett of Canada" for his approach to investing.

In the third quarter of the year, Resolute's revenue declined compared to a year ago but its cost of sales increased. Operating income was down significantly and the company could not attribute this to high closure costs, as it did in the first half of 2012. A notable improvement in operating income occurred in newsprint -- still the company's largest source of revenue -- which was offset by weaker numbers in segments such as pulp and coated papers. However, earnings per share (EPS) came in at $0.32, which is quite strong for where the stock is trading. Annualizing the figure for last quarter generates a P/E multiple of 9. Of course, there is no guarantee that Resolute will be able to continue performing that well, but it's a plus to see that the company only has to maintain its financials rather than grow. The third quarter was responsible for essentially all of the company's earnings for the first nine months of the year. However, in previous quarters, Resolute had recorded special charges.

Wall Street analysts predict that Resolute will earn just over $1 per share in 2013, placing the stock at 12x their forward estimates. Given the company's performance last quarter, that figure is quite plausible. We're pessimistic about the newsprint business and doubt that the company can increase sales in that area. But even with a 14% decline in newsprint revenue from a year ago Resolute managed to grow its operating income for the segment. Sell-side expectations for a moderate decrease in EPS next year sound fair. While we would hesitate to invest in a shrinking company whose stock is trading at 12x earnings, if Resolute manages to outperform expectations -- which would only require holding net income steady -- it would prove undervalued at the current price.

Domtar (UFS) looks to be Resolute's closest peer. Its earnings multiples are quite comparable, though Domtar doesn't seem to have had as poor results in the first half of 2012: The stock's $2.8 billion market cap places it at trailing and forward P/Es of 14 and 11, respectively. Its revenue was down 2% in the third quarter compared to the same period last year, and earnings fell dramatically. We would note that the gap between the trailing and forward multiples seems to suggest that Wall Street analysts expect an improvement at the company next year. That's opposed to what appears to be a weakening performance at Resolute (the trailing P/E at that company is 42, but that seems to be due to closure and impairment charges (which are now insignificant ) impacting earnings in the first half of this year. At first glance, that seems to be an odd reading of the industry -- if Domtar improves on the bottom line, we would expect Resolute to do so as well and vice versa.

As a result, unless Domtar's business significantly underperforms Resolute, it seems like it could be a better buy. But it may be a good idea to watch the stock to see how well it does in the current quarter.

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