Earnings Call Transcript - MERC Q1 2022

Operator, Operator

Good morning, and welcome to Mercer International's Fourth Quarter 2021 Earnings Conference Call. On the call today is David Gandossi, President and Chief Executive Officer of Mercer International; and David Ure, Senior Vice President, Finance, Chief Financial Officer and Secretary. I will now hand the call over to David Ure.

David Ure, CFO

Good morning, everyone. I would like to remind you that in this morning's conference call, we will make forward-looking statements. And according to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, I'd like to call your attention to the risks related to these statements which are more fully described in our press release and in the company's filings with the Securities and Exchange Commission. This quarter, we achieved record revenue and near-record EBITDA due to strong sales volumes and robust pricing for all of our products. Similar to Q4, we did not have any major maintenance in Q1, and our results also benefited from having the Rosenthal turbine running for most of the quarter. Overall, our mills ran well this quarter, although our Peace River mill lost some production due to limitations of rail service to certain regions. To mitigate this issue, we've had to use extra trucking, which has the effect of increasing our freight and warehousing costs. As expected, we also experienced higher costs for several of our major inputs, including wood, energy and chemicals. Our near-record EBITDA in the first quarter was almost $155 million compared to EBITDA of about $165 million in Q4 last year. As a reminder and to put our Q1 results into perspective, our record Q4 EBITDA result benefited from the recognition of almost $32 million of business interruption insurance proceeds related to the Peace River mill's recovery boiler repair. Our pulp segment contributed quarterly EBITDA of roughly $114 million, and our wood products segment contributed near-record quarterly EBITDA of $44 million. You can find additional segment disclosures in our Form 10-Q, which can be found on our website and that of the SEC. On average, softwood and hardwood pulp prices in Q1 were higher than Q4 in all of our major markets. The most significant increases were in China, where the Q1 average NBSK net price was $899 per tonne, up $176 from Q4. European list prices averaged $1,330 per tonne in the current quarter compared to $1,302 per tonne in Q4. NBSK remains at a considerable premium to hardwood with the average Q4 net eucalyptus hardwood price in China at $668 per tonne, up $106 from Q4. In total, average pulp sales realization movements positively impacted EBITDA by almost $17 million compared to the prior quarter. Despite the railway restrictions, pulp demand was solid in the quarter, which led to higher sales volumes compared to the previous quarter and much lower finished goods inventories. Our Q1 sales totaled 555,000 tonnes, which was up about 39,000 tonnes from Q4. We had no planned major maintenance downtime in either Q1 or Q4. But as I had mentioned, our Peace River mill reduced production by about 35,000 tonnes due to continued limitations on the CN rail system. In Q2, we are planning for 39 days or about 51,000 tonnes of major maintenance downtime at our pulp mills. Our lumber realizations remain strong but mixed this quarter compared to Q4. In the U.S., we experienced significant price increases. The Random Lengths' benchmark for Western S-P-F #2 and Better averaged $1,274 per thousand board feet in Q1, which was up $563 from last quarter. Our average European sales realizations were down approximately $90 per thousand board feet compared to Q4. Since the end of the quarter, U.S. pricing has come off noticeably, and the benchmark lumber price in the U.S. is currently about $1,040 per thousand board feet. Our wood products segment continues to perform well. We sold about 110 million board feet of lumber in the quarter, which was up slightly compared to our Q4 sales volumes. Our electricity sales reflect our strong generation and elevated prices in Europe, where prices in the range of $200 per megawatt hour are twice those of a year ago. Exports to the grid totaled about 219 gigawatt hours in the quarter, which was up relative to Q4 due to the return of our Rosenthal turbine to service after being down for all of Q4. We reported net income of $88.9 million in the quarter or $1.35 per basic share compared to net income of $74.5 million or $1.13 per basic share in Q4. Cash generated in the quarter totaled approximately $65 million compared to cash generated of about $7 million in Q4. Our cash generation in Q1 was the result of strong EBITDA being partially reduced by working capital movements, primarily in the form of higher accounts receivable balances, a consequence of some improvements in logistics channels which began to open up late in the quarter. We invested roughly $33 million of capital in our mills this quarter. We are on target to invest about $175 million to $200 million in our operations this year. David will provide an update on our CapEx program in a moment. At the end of the quarter, our strong liquidity position totaled about $692 million, comprised of $411 million of cash and $281 million of undrawn revolvers. Our liquidity position will support our planned working capital movements, along with our ambitious 2022 high-return capital spending program. And as you will have noted from our press release, our Board has approved a quarterly dividend of $0.075 per share for shareholders of record on June 29, 2022, for which payment will be made on July 7, 2022. That ends my overview of the financial results, and I'll now turn the call over to David.

David Gandossi, CEO

Thanks, Dave. Our solid Q1 operating results were essentially an extension of our Q4 results. Our mills ran well, and we have benefited from particularly strong market conditions for pulp, lumber and green energy. Although we experienced considerable cost inflation pressures, particularly in natural gas and shipping, the diversity of our products, our locations and end markets, along with solid cost control measures, allowed us to take full advantage of the strong pricing conditions for our products. Our mills' strong production this quarter, combined with overall steady demand for our products, were key factors in our Q1 results. Global pulp supply-demand fundamentals remained tight through Q1. As a result, relative to Q4, average pulp prices were up in all markets with the largest increase coming in China. Chinese demand continues to be negatively impacted by pandemic conditions. In other markets, demand has been steady, and logistics bottlenecks in certain regions have created extremely tight conditions. In addition, supply reductions due to the finished pulp and paper industry strike recently announced reductions in NBSK capacity, along with the commencement of the traditional major maintenance season, continue to support price increases that have continued into Q2. European hardwood pulp supply will also be negatively affected by the sanctions-related reduction in supply of Russian birch wood. We believe that pulp consumers have low inventory levels, forcing some producers to use additional NBSK in their furnish or slow their machines. Lumber markets also remained strong in the quarter. U.S. lumber pricing approached the near-record levels of 2021 before weakening again late in Q1. While average lumber pricing in Europe weakened modestly during the quarter, both markets remain at historically high levels. The midterm backdrop for U.S. lumber pricing conditions remains positive with relatively low housing inventory, strong housing expectations supported by recent statistics and constructive homeowner demographics. At the same time, the current market volatility is the result of a number of factors, including rising borrowing costs, construction being constrained by inflexible supply chains, labor and home construction supply shortages and inconsistent lumber supply from Canada. Looking ahead, positive homebuilder sentiment remains despite the expectation that mortgage rates will rise further in 2022, which is consistent with our view that despite these short-term factors, we will continue to see strong lumber demand based on expected steady U.S. home construction. European lumber prices, which often lag those of the U.S., moderated in Q1. But with the expected strength of the U.S. market, we believe pricing conditions remain favorable. We will continue to optimize our mix of lumber products and customers. In Q1, 42% of our lumber sales volumes were in the U.S. market with the majority of the remainder of our sales in the European and Japanese markets. Although we feel our logistic strategies put us at a competitive advantage to many of our competitors, we experienced some freight cost increases in Q1. This is primarily the result of increased use of trucking, along with higher warehousing costs in North America, caused by pandemic and extreme weather-related shipping delays which continue to negatively impact the availability of railcars, particularly on the CN network. While we expect this condition or situation to ease over time, the lack of railcar availability will likely persist in the near term as the railway works through its shipping backlogs. Our turbine generator at Rosenthal was put back into service in mid-January, and our Q1 results reflect having this asset back online. The current conditions highlight the benefits associated with our modern assets. Fossil fuels are a relatively small source of energy for us, primarily used in our lime kilns as part of our chemical recovery process. While we have been impacted by higher prices for natural gas, our ability to sell electricity at market prices, which have increased significantly, acts as a powerful hedge against rising gas prices. Our wood products segment achieved another solid production result, producing almost 116 million board feet of lumber in Q1, up 5 million board feet compared to Q4. We're also making great progress on our value-add strategy, employing modern transfers, grading, trimming and sorting equipment. In Germany, we continue to see strong demand for both pulpwood and sawlogs. Demand for pulp logs is being driven by pallet producers as high European energy prices are creating more demand for wood-based heating solutions, which is creating upward pricing pressure. While sawlog demand and supply appear to be in balance, we are expecting modest upward pricing pressure for both pulpwood and sawlogs in Q2. In Western Canada, as expected, increased harvesting activity and fewer COVID restrictions helped ease pricing pressure, and we expect only modest upward pricing pressure in Q2. As Dave noted, we're off to a good start on our 2022 CapEx program, which could approach $200 million, the majority of that being on high-return projects that will drive new product development, ESG advances, productivity improvements and input cost reductions. We expect our 2 new woodrooms at Celgar and Peace River to be completed in the second half, and we will be making additional investments in our German wood procurement infrastructure that will add to our competitive advantage. We have one more sorter to add at our Friesau mill to maximize the benefits of our new planar by allowing for even greater grade differentiation. And while most of the Stendal740 pulp expansion project is complete and running as expected, we will complete the final element, some modest modifications to the pulp machine wrapping line in 2022. Now in keeping with our carbon reduction strategy, we are developing a lignin development center as we expect to commence construction of a lignite extraction pilot plant, a leading-edge technology and team that will allow us to look at commercialization of derivatives of lignin. And of course, remain committed to our approach to solid wood products expansion, we are developing an investment strategy for our mass timber plant in Spokane that will expand that mill's product mix and profitability. While full ramp-up of the plant will continue for several more quarters, we are progressing well with our long-length finger-joint material, and we have delivered our first CLT project. On the human resource side, we've been very actively building out our business development, engineering and design teams to take advantage of the continued growth in the mass timber space. As we think about climate change and the rapid shift occurring regarding carbon products like lignin, mass timber, green energy, extractives, lumber and pulp, are all products that will play increasingly important roles in displacing plastics and carbon-intensive products, products like concrete and steel for construction, plastic packaging, fossil fuel-generated electricity and synthetic fragrances and flavors, even synthetic textiles. All products that are releasing carbon are ending up in our oceans or our food chain. Fundamental to our strategy is to operate modern facilities and encourage innovation. As you may have seen from our recent press release, our carbon reduction initiatives were recently validated by the Science Based Targets initiative, the leading evaluator of sustainability performance. We're looking forward to the pending release of our 2021 sustainability report which will be published soon. Our 2022 annual maintenance schedule will be significantly less intensive than 2021 due to the Peace River recovery boiler rebuild being behind us. We did not have any planned maintenance downtime in Q1. The timing of our scheduled downtime for the remainder of the year is as follows: In Q2, Stendal will take a 3-day mini shut, Celgar will have its regular 15-day shut, Peace River will have a 15-day shut, and Cariboo has a 6-day maintenance shut. In Q3, Rosenthal has its regular 14-day shut plan. And in Q4, Stendal has a 14-day maintenance shut scheduled. In total, we are planning for about 67 days of major maintenance in 2022. And now before I turn the call over for questions, I'd like to take a quick moment. On a personal note, as many of you know, I am retiring effective May 1 as Mercer's CEO and President. I'm excited about this next chapter in my life, and I'm looking forward to spending more time with my family. I leave Mercer with a very strong management team, and my successor, Juan Carlos Bueno, is a proven leader in our space. I believe the company is well positioned for future growth. I'll be watching its progress closely, albeit from a distance. I would like to thank our Board, my management team and all of the Mercer employees for their support and dedication. Thanks for listening. Be safe. And now I'll turn the call back to the operator for questions.

Operator, Operator

Our first question comes from the line of Kasia Kopytek from TD Securities. The next question comes from Hamir Patel from CIBC Capital Markets.

Hamir Patel, Analyst

David, first off, congratulations on your retirement.

David Gandossi, CEO

Thanks, Hamir.

Hamir Patel, Analyst

David, I wanted to ask about lumber prices in Europe. Hoping you could comment on how they've evolved since the conflict in Ukraine began and what level of pricing improvement you might be expecting in coming months as pricing terms are reset.

David Gandossi, CEO

Yes, hard one to call just at the moment, Hamir. I mean, as I don't think there's been anything really dramatic yet as a result of the conflict. In my history, ignoring the conflict, I mean, history has shown us that the European market tends to follow the U.S. market, both up and down but maybe with less volatility. That's a bit of what we've been seeing in the recent past. There will be a shortage of lumber and certain types of products in certain sectors. But with our main customers in Europe, I don't think we're seeing direct impact just yet.

Hamir Patel, Analyst

Okay. Great. And David, I know Mercer has been pushing for the reopening of the rail line near Rosenthal and Friesau that was cut off almost 70 years ago. What type of cost savings could that represent if you're able to get that reestablished?

David Gandossi, CEO

I don't have a specific number for you, Hamir. We are already in a low-cost freight environment, but the primary benefits will be carbon savings and reduced site costs by using rail instead of trucks.

Operator, Operator

Next question comes from the line of Andrew Kuske from Credit Suisse.

Andrew Kuske, Analyst

David, I guess your Monday morning is going to be a bit different than Monday mornings in the past. But maybe just on the business positioning that you're leaving and you think about the CLT business and just the broader positioning within a decarbonization theme. As you get greater build and scoring towards lead status focused on the carbon cycle and mass timber, how do you think about Mercer's positioning with the CLT business? And just sort of more broadly, how big could it become for Mercer itself? And then how big do you think the market opportunity is to sort of overall?

David Gandossi, CEO

I'm really excited about Mercer's mass timber initiative. The Spokane plant is quite large and well-equipped, with over $150 million invested in new machinery for grading, sorting, and planing. Initially designed solely for CLT production, we're shifting our approach to include glulam and other engineered wood products, as we have the machinery to support this. While CLT will continue to be a key aspect, we'll also produce catalog products of engineered wood, ensuring the plant remains busy and profitable. We aim to leverage CLT to enhance margins as new projects arise. We're currently expanding our team and have had great success with both our marketing and engineering efforts. Over the next few years, we plan to invest in high-return capital projects at the facility, which should lead to steady profitability improvements that will be noticeable in a couple of years. This plant will serve as a significant platform for growth, and with our expanding team, we aim to pursue additional opportunities as they arise.

Andrew Kuske, Analyst

Got it. That's helpful. And then, I guess, philosophically, do you see that CLT businesses having maybe a lower volatility than we see in pulp markets, and then you get a higher baseline steady amount of predictable cash flows or more predictable cash flows over a period of time to draw higher multiple?

David Gandossi, CEO

Yes. I'm not sure about the volatility aspect. It will resemble the lumber industry somewhat. The plant will be engaged in producing catalog engineered wood products and large CLT panels, either through catalog channels or custom designs, depending on where the margins are. Our vision involves offering a broad range of products; for instance, long-length timber 2x4s are currently an engineered wood product. Railcars of lumber arrive at the plant, go through sorting and planing, and get finger-jointed, allowing us to sell an average of 28-foot long-length finger joints as a product shipped out in railcars. We will also have various other products, including glulam and beams of different sizes and dimensions for builders to purchase off the shelf. Ultimately, this will evolve into a high value-added lumber product. It will react to market changes, so as lumber costs fluctuate, the value or cost of engineered wood products will also vary accordingly. We'll be a major player in this area, giving us a competitive advantage throughout market cycles.

Andrew Kuske, Analyst

Very helpful. And if I may, just one final one. Given what's happened in Europe with power prices in Germany in particular and your exposure there, do you think about engaging in a longer-term contract or just a contract to lock in cash flows?

David Gandossi, CEO

Well, we do have our tariff still on Stendal, the green tariff, we call it the EEG. But we can flip off that when the market prices are higher, and so the EEG tariff is our floor. And when spot prices are higher, we take advantage of that. We're not intending to lock in any kind of forwards on that at this point in time. The world is just too unclear to us. But we believe that having the very modern and expansive generating capacity that we have means that we don't buy power ever, other than in start-up, and we enjoy very high electricity prices when the conditions are as they are now.

Operator, Operator

Next question comes from the line of Andrew Shapiro from Lawndale Capital Management.

Andrew Shapiro, Analyst

Just a few questions. On the Rosenthal turbine business interruption insurance claim, which there wasn't enough visibility on in the last call, are you able to provide a range of the claim size at this time yet?

David Gandossi, CEO

No, Andrew. I don't think I can. We've filed with the insurance company. I think we did that in early April, and we haven't heard back. And we don't know what their position is going to be, so it would be premature of me to give guidance on that.

Andrew Shapiro, Analyst

Okay. Including even a range?

David Gandossi, CEO

Yes, yes. We're not going to provide...

Andrew Shapiro, Analyst

And the 35 tonnes of pulp logistically delayed from Canada to Asia in the fourth quarter that went out the door in Q1, can you approximate the amount of revenue shift into the first quarter of '22 that we benefited from this?

David Gandossi, CEO

Yes. No. It doesn't really work that way. What Dave was saying is that during the first quarter, we needed to slow down the Peace River mill because we didn't have enough freight equipment to move the pulp to customers. So that was about 35,000 tonnes that we left on the table.

Andrew Shapiro, Analyst

Okay. Lastly, with the transition happening, I want to express that it has been a genuine pleasure to work and engage with you for over a decade since your time as CFO, and I will truly miss you. At some point, we will have the chance to meet Juan Carlos. Do you or David have any information about the current plans for virtual or in-person investor relations activities in the next few months and the rollout with the new CEO?

David Gandossi, CEO

We have a comprehensive transition plan for Juan Carlos, which includes meeting all the employees and touring the mills to help him get acclimated. I'm collaborating with him and other senior team members during this transition. Dave will continue with investor relations activities, and it's still uncertain how much Juan Carlos will be able to participate in that. It's a bit early for us to make any commitments on his involvement, but I am confident he will get up to speed quickly.

Andrew Shapiro, Analyst

Okay. Well, very good, and I hope we can stay in touch during your retirement. Going to miss you.

David Gandossi, CEO

Great. Thanks, Andrew. You too.

Operator, Operator

Next question comes from the line of Sven Carlin, a private investor.