The Canadian forest products industry may be sinking like a deadhead as U.S. housing starts shrink, pulp and paper demand drifts and credit markets freeze up. But there are many companies in the sector whose long-term outlook is as solid as oak.

Analysts are optimistic about the future of some parts of the industry. Demand for timber is cyclical, they acknowledge, but it won’t disappear. And during a downturn, live inventory is left to grow, which increases its future value. In addition, people will always have daily needs for tissues and toilet paper.

The forestry industry is facing some serious challenges in the near term, however. Wood producers are reducing supply in the face of softening demand from the U.S. housing industry. Newsprint, pulp and office paper producers are also contending with declining demand.

Another setback for the Canadian industry came in November 2008, when Russia shelved an 80% export tax on logs that had been intended to stem the tide of its timber exports; Canadian producers had been hoping to pick up some of the Russian companies’ customers.

As a result, the losses are piling up. A PricewaterhouseCoopers LLP international net earnings report for the six months ended June 30, 2008, called the Canadian forest products industry “awash in red ink.” By the third quarter, another PwC report notes, restructuring and asset-impairment charges had resulted in third-quarter losses of US$529 million for the Canadian industry, vs losses of US$173 million during the same period the year prior.

So, the industry must do more painful restructuring in the near term to stem the flood of negative earnings results.

“This is going to be down and dirty for at least the next two to three years — no question,” says Don Roberts, a managing director and forestry sector analyst with CIBC World Markets Inc. in Ottawa.

The immediate outlook is particularly grim for those producers with high debt/capitalization ratios, says Kurt Niquidet, a researcher at the University of Victoria and an expert on British Columbia’s timber policy. “You’re going to see more shutdowns needing to happen just to adjust to that reduced level of demand,” he says. “Over the short term, things are pretty bleak.”

CONTRIBUTION TO GDP

Forestry companies have even lobbied for a federal aid package, arguing that it’s not fair that the industry has been left on the sidelines while the automobile sector gets bailed out. According to the Forest Products Association of Canada, Canada is the world’s largest exporter of forest products, with the industry contributing 3% to the country’s gross domestic product, or about $84 billion annually. (The recent federal budget did offer the industry some relief.)

Some major savvy institutional investors have turned their eyes toward the industry’s eventual recovery — for example, Toronto-based Brookfield Asset Management Inc. , the Ontario Teachers’ Pension Plan Board and the Alberta Treasury. They are putting their money into private timberlands.

Although these private timberlands are off limits to retail inves-tors, there are publicly traded companies that are trading at a discount that have sizable holdings of timberland. Some examples include Nanaimo, B.C.-based TimberWest Forest Corp. , which is negotiating with developers about its land on Vancouver Island, and Toronto-based Acadian Timber Income Fund, a company with operations in Maine and New Brunswick whose majority shareholder is Brookfield.

Prospects could be good for these companies. Despite the current slump in housing, immigration and household formation rates indicate an inevitable future need for new-home construction and, therefore, lumber.

“Lumber demand in North America will come back,” says Avrim Lazar, president and CEO of the FPAC in Ottawa. “People will want to live in houses.”

But housing is not the only reason to invest in timber. Overall, world demand for wood is on an upward trajectory. For instance, China’s net wood deficit is expected to double to about 160 million cubic metres by 2020, says Roberts, noting that this is almost as much as Canada alone cuts annually. (Canada cuts 200 million cubic metres annually.)

Beyond China, there are also new types of demand emerging as the food, fuel and fibre sectors converge. Land in developing nations such as Brazil and Indonesia could soon be used for biofuel rather than wood, leaving more space for Canada as a major producer.

On the flip side, the deadly mountain pine beetle is cutting supply in the B.C. Interior, nearing crisis proportions. But prices could climb as supply drops.

@page_break@A company that is in a good position to respond quickly to renewed demand, Roberts says, is Vancouver’s International Forest Products Ltd. , which has coastal operations in addition to its B.C. Interior operations. Other big names include Canfor Corp. and West Fraser Timber Co. Ltd., both of which have operations in the Interior.

THE PINE BEETLE

Despite West Fraser’s struggles with the pine beetle, it is “one of the few investment-grade names in the sector,” says Pierre Lacroix, vice president and materials and diversified industries analyst with Desjardins Securities Inc. in Montreal, partly because of its relatively healthy net-debt position and its strong balance sheet.

The outlook for newsprint, pulp and fine white office paper is not as clear-cut. Newsprint is produced by Montreal-based AbitibiBowater Inc., which, Lacroix says, bears a “cumbersome financial burden.” Its net debt is US$5.8 billion, which was about 80% of its capitalization in October 2008. About a third of that debt matures before 2011.

Office paper, or “uncoated free sheet,” is produced by Montreal-based Domtar (Canada) Paper Inc. Lacroix says Domtar is better positioned than AbitibiBowater.

That said, newsprint, pulp and fine white office paper producers have been consolidating and closing operations in efforts to cut costs. Many others will go under entirely, Roberts warns: “There’s more blood on the ground to come for a number of these companies.”

Roberts has an “underperform” rating on Canfor, Toronto-based Fraser Papers Inc. and Montreal-based Tembec Inc. However, Toronto-based Norbord Inc. , which produces oriented strandboard used for building homes, and West Fraser and Montreal-based Cascades Inc. have better prospects, he says.

For value investors with a three- to five-year outlook, Lacroix likes Canfor, which has a decent balance sheet despite being hit by the housing slump, and West Fraser, which has a solid balance sheet, a good credit rating and prospects for good cash flow once the economy recovers. Cascades, which makes packaging, has benefited from recent decreases in input costs, he adds, such as pulp, recycled paper and energy.

Producers will have to follow one of two strategies to be successful, adds Dave Thompson, a partner with PwC in Edmonton: become low-cost producers by getting bigger and benefiting from economies of scale, or be niche players producing high-value-added goods.

Although it’s going to be difficult over the short term, Thompson says, “Over the medium to long term, there is a lot of upside potential. A lot of weaker players are being taken out of the industry right now and, when the market does rebound, those that are left have the potential to be very profitable.” IE