West Fraser Timber Co., Ltd Q3 FY2020 Earnings Call

Good morning, ladies and gentlemen. And welcome to the West Fraser Q3 2020 Results Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. During this conference call, West Fraser's representatives will be making certain statements about potential future developments. These forward-looking statements are intended to provide reasonable guidance to investors, but the accuracy of these statements depends on a number of assumptions and is subject to various risks and uncertainties. Actual outcomes will depend on a number of factors that could affect the ability of the company to execute its business plans, including those matters described under risks and uncertainties in the company's annual MD&A, which can be accessed on West Fraser's website or through SEDAR and as supplemented by the company's quarterly MD&As. Accordingly, listeners should exercise caution in relying upon forward-looking statements. This call is being recorded on Tuesday, October 27, 2020. I would now like to turn the conference over to Ray Ferris. Please go ahead.

Thank you, Operator. Good morning, everyone, and thank you for joining us. With me today is our Chief Financial Officer, Chris Virostek; Chris McIver, our Vice President of Sales and Marketing; and several other members of the West Fraser executive team. Before I turn the call over to Chris to go over financials, I'm deeply saddened to report that in the early stages of a major shutdown at our Hinton pulp facility, Norman Hatami, a scaffolder working for Aluma Systems, suffered a fatal fall from height while erecting scaffolding inside a vessel. This is a difficult period for all impacted, and our deepest sympathy goes to Norman Hatami's family, his friends, and fellow workers. With that, I'd like to acknowledge that we recently posted our updated ESG responsibility report, and it is now available on our website. It references the Sustainability Accounting Standards Board, Global Reporting Initiative, and includes information recommended by the Task Force on Climate-Related Financial Disclosure. With that, I'm now going to turn the call over to Chris Virostek.

Thanks, Ray, and good morning, everyone. A few months have certainly made a dramatic difference in things. When we last reported earnings in July of this year, we were just a couple of months into the restart of many of our facilities coming out of the first wave of the pandemic. Strong demand for lumber from new home construction and for renovation applications, coupled with lean channel inventories and a limited ability for a supply response, drove a significant pricing reaction in wood products. Our lumber segment adjusted EBITDA increased to $552 million, eclipsing the $467 million recorded in the second quarter of 2018, which was the prior high point of pricing in recent years. Our panels segment rebounded as well, ramping back up production and shipments with significantly improved plywood pricing. Adjusted EBITDA for the panels segment increased to $51 million. While adjusted EBITDA in pulp declined to $5 million in the quarter, principally due to price, we offset a significant amount of the price headwind with lower costs through improved reliability and production rates. Consolidated adjusted EBITDA rose to $605 million, and operating earnings were $487 million. Finance expense declined as we repaid debt during the quarter, and interest rates declined as well. We recorded earnings of $350 million for the quarter. Improved wood products pricing, reduced costs, and increased production volumes all contributed to better earnings. While the progression from Q2 to Q3 involved a healthy dose of price adjustment amounting to $430 million, of which $424 million was attributable to lumber, we also made progress on the cost front, not only from increased production but also from the benefits of capital we've spent in prior years and continued close management of fiber costs. Volume was a slight drag overall in the quarter, coming mostly from reduced shipments of SPF, partially offset by higher SYP and plywood shipments. SG&A costs increased in the quarter due principally to increases in provisions for variable compensation along with slightly higher wage costs resulting from pandemic-related staffing actions. Our prior quarter also included $7 million of insurance recovery that did not carry over. Turning to the comparison of the first nine months relative to last year, there's been a remarkable turnaround in wood product markets. Pricing in lumber and panels has increased significantly, partially offset by softness in pulp markets. We are particularly pleased with the progress we have made on cost in each of our segments over the prior year. Through continued focus on safety, operational excellence, and management of fiber costs, we've improved costs by $169 million over the comparable nine-month period. Timing of pulp shutdowns year-over-year did provide a benefit as well. SG&A changes year-over-year were largely attributable to the fact there was no variable compensation recorded in the prior year period, given the earnings performance. Year-to-date adjusted EBITDA of $916 million has drawn more in line with the $819 million and $1.4 billion of adjusted EBITDA for the comparable periods in 2017 and 2018. Lumber production for the quarter increased by 125 million board feet, as SPF production increased by 8% and SYP production increased by 9%. Shipments were down slightly in the quarter. However, for the full year, shipments are slightly ahead of production as we reduced inventories during downtime earlier in the year. Plywood shipments reflect a full quarter of operating near capacity. Cash flow from operations was $613 million, as improved earnings and favorable working capital both contributed. In the quarter, we paid down a number of the COVID-19 related deferrals that were put in place earlier in the year, notably on stumpage and property taxes. Capital spending was in line with the prior quarter, and we expect the full year to be towards the higher end of our previous guidance as we brought forward a few small projects. Net debt declined by $563 million, and net debt to capital is now at 12%. During this quarter, we have repaid our operating loans and increased our cash by $179 million. Our cumulative duties on deposit grew to US$495 million. If the duty rates adjust as anticipated in Q4, we will record a US$93 million recovery in Q4 in respect of overpayment of duties for the 2017 and 2018 periods. Evaluation of 2019 duties is currently underway. Liquidity continued to improve and is now approximately $1.3 billion with the majority of that comprised of undrawn bank lines. We remain well on site with our financial covenants and have no near-term maturities. We are currently entering the period of seasonal inventory accumulation of logs in Western Canada, which will carry on through March of next year. With that, I'd like to turn it over to Ray for some comments on market perspective and recent developments on some of our capital projects.

Thanks, Chris. And I'm going to keep my comments fairly brief. First, just a little bit about the pulp business. Our pulp operations, again, had a solid operating quarter. However, the impact of COVID is obviously resulting in an acceleration of the decline in printing and writing demand, which has only been marginally offset by growth in tissue and packaging. We expect continued difficult markets for pulp in the short term before production becomes aligned with overall demand and market preference. Hinton pulp and QRP, Quesnel River, both completed shutdowns in early Q4. As Chris noted, and further to his comments, with respect to the dynamics of lumber demand, reasonable housing starts combined with good repair and remodel activity with export volumes, although down from previous years, remain at a similar level to the last half of 2019. On the supply side, it's important to note that North American production in the third quarter of 2020 remained below similar periods of record pricing in early 2018, partly due to permanent capacity closures in British Columbia that were not fully offset by increased capacity in the U.S. South. Import volumes, although flat over the previous year, are up roughly about 100 million board feet per quarter over 2018 and 2019. This stronger-than-expected demand and limited supply response contributed to record pricing in the third quarter. As everyone has multiple sources of housing forecasts for the balance of '20 and 2021, I did not intend to repeat them here, except that consensus appears to indicate that housing starts are expected to continue to improve, saying that demand can be hard to predict. But we do have a good understanding of supply, and that the difficulty in adding supply has been a driving factor in the price response and the respective short-term fluctuations of price, saying that we believe it is not coincidental that we have experienced record pricing twice in the past two years. When the long-term evolution of lumber prices is examined for a long period of relatively stable prices from 2011 through 2016, the last four years have seen a markedly higher trend in pricing as the current supply and demand dynamic has influenced lumber pricing. The last three cycles in both Southern yellow pine and SPF have resulted in successively higher floors and higher ceilings. So what is the impact of potentially higher pricing on home affordability? At peak pricing in September, FEA estimated the increased cost could average at around $10,000 to a median home. While that is not insignificant, this appears manageable and should not be a significant impediment to builders and homeowners. Pricing has retreated from September levels, and critical gaps in supply have been mitigated. Short interruptions in the supply chain in the past few years have not been quickly overcome. As we've done in the past few quarters – moving beyond supply and demand, as we've done in the past few quarters, we thought we'd update you on another step in our modernization journey in the U.S. South. We've owned Joyce, which is in Louisiana, since 2001. The log handling and merchandising systems were built in the early 90s and were quite inefficient and lacked the technology to meet current expectations. Although I have to tell you there was a delay in the crane delivery, the USD$30 million project was essentially delivered on time and near budget. The project eliminated the high-cost bottleneck in the operation, and we’re pleased with the results that our Joyce team has delivered, which has met or exceeded our payback expectations. We're continuously focused on the improvement of all of our segments and particularly our lumber segment. In 2007, we made a significant investment in the U.S. South by buying 13 mills from IP. The first few years were difficult as we endured the most significant collapse in the housing construction industry and the turmoil of the Great Financial Crisis. As we started to emerge from that difficult time, we continued to grow through acquisition and invested capital to keep our assets low-cost and to improve the operations where we have the opportunity to do so. Our work is not done yet. And we remain convinced of further upside. While it may seem obvious that lumber profitability comes with inherent volatility, the 10-year average EBITDA margin for our lumber business is just under 15%. And the trend has been increasing. In three of the last four years, our lumber EBITDA margin has been in excess of 20%. Tightening supply, increasing demand, the prudent deployment of capital, and a focus on operational excellence have all played a role in margin improvement. Over time, our consistent strategy has worked, and we remain focused on our key priorities. Since the peak of the last housing cycle in 2005 to the significant downturn through the late 2000s and into recovery over the last decade, our total shareholder return has been above the comps and ahead of most of our directly comparable peers. So a few wrap-up comments before I turn it back to the operator. We expect that British Columbia production, including West Fraser, will continue to shrink over the next few years, as the industry continues to rationalize to the available and the accessible timber supply. We also expect that our U.S. South modernization and operational improvement focus will continue to deliver and improve our relative cost structure. Our modernization and operational improvement runway in the U.S. South will continue to be a focus area for disciplined capital. Record and unexpected pricing in our wood products business has significantly improved our balance sheet. However, as the past few quarters have demonstrated, it would be prudent to be prepared for further volatility and uncertainty, as the impacts of COVID continue to play out. We will be conservative with respect to our balance sheet, are well-positioned to further invest in the growth and performance of the company; and as conditions allow, responsibly return capital to shareholders. Finally, all injuries and serious incidents are preventable at West Fraser. And although our injury and incident rates have improved to record lows, we have more work to do to eliminate all life-altering incidents for our employees and contractor partners. With that, I will turn it back to you, Operator, for follow-up questions.

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. So your first question comes from Sean Stewart from TD Securities. Sean, please go ahead.

A few questions. I gathered from the MD&A that you're content to let liquidity build on the balance sheet in the near term. We're forecasting a transition in that cash at some point next year. Ray, can you give us some context on priorities for capital allocation, growing the asset base versus potential returns of capital to shareholders as we move into 2021?

Thanks, Sean. I'll address that and let Chris add his thoughts as well. Our capital allocation strategy hasn't changed significantly. Our main focus is to invest in our own growth. We see substantial opportunities, especially in the U.S. South, to modernize our assets, and we will be careful in how we approach this. We want to ensure we are making decisions that align with our objectives as we manage significant capital investments while aiming for continued growth in that region. As we navigate our priorities in capital allocation and gain more clarity on what the upcoming quarters might bring, we will evaluate other opportunities for returning capital to shareholders. Chris, would you like to add anything?

I think that's a great summary. The only other couple of things I would point out is, we are entering a period of time in the year when demand is a little bit seasonally slower, at the same time as we're building log inventories through March of next year to carry us through breakup into the summer. And that usually consumes some liquidity as we work through that. And I think, while the fundamentals that we all talk about around housing and interest rates, and repair and renovation, the fundamentals are all good. There's still a fair amount of uncertainty out there when you look at the case counts that are going on and all the other factors that may impact the market. So I think we're going to take a measure of caution now. I think that measure of caution in the past has done us well. It has allowed us to keep our dividend and not touch our dividend through the darkest part of this pandemic in May and June of this year. And so being cautious, I think given the backdrop of uncertainty, even though the fundamentals are good, is the right strategy for now. But as Ray said, our balanced approach is over time, as opposed to a quarter-by-quarter kind of assessment of things. So, when we think fundamentally, things really changed.

Thanks for that guys. A question for Chris McIver. Wondering if you can give us some context on the pullback we've seen in lumber the last five or six weeks. I suppose some of that was to be expected after a run like we had through the second and third quarter. Can you give us a sense of how your order files have trended, perspective on inventory through the channels right now? And any sense on if we're headed for a bottom anytime in the next little while?

Sure. Good morning, Sean. Well, as you said, I don't think this is entirely unexpected. Prices got way ahead of us for a while. We're seeing a bit of a pullback. But we’ve really got both our lumber businesses are a bit different. Certainly, we saw our Southern pine business run first, and probably a little further. SPF took a little while to get going. We were able to build a bigger order file in SPF. So we're still winding that down a bit and trying to get our last orders out. We are hearing from our partners in the field that their inventories are very low, whether it's retailers or pro dealers distribution. So that is a difference compared to what we saw in 2018 going into 2019. We are selling better in the South right now than we are in Canada, which is quite usual. Usually, the South picks up a bit earlier. But I can't say we’re at a bottom. We're beginning to build an order file for SYP, and we are going to need to build an order file for SPF in the next little while. So, what that volume is? I don't know. I would suggest it's higher than the bottom we've seen earlier this year. Again, back to the comments Ray and Chris had, we see the fundamentals for next year as pretty strong. Our partners are saying the same thing. So, we'll see where it goes. I couldn't give you a price. But I think we're close to seeing things turn a little bit.

Your next question comes from Hamir Patel from CIBC Capital Markets. Hamir, please go ahead.

Ray, Alberta has announced some plans to increase harvest levels in the province. So, what sort of production uplift could that represent for West Fraser and what's the timing of that?

Good morning, Hamir. That's a good question. I think we will have to wait and see how things develop. About a year ago, the Alberta government challenged the industry and itself to look for ways to increase the annual available cut. There's a significant opportunity there, as they've proposed a 30% increase. While that may seem ambitious, it's definitely a positive approach, and it is feasible on the land base. The impact will vary across the province, depending on the region, including for West Fraser. We are actively engaging with the government on this, and it’s encouraging. Rather than focusing on whether the increase is 5% or 30%, I believe the important takeaway is the opportunity to engage with those looking to enhance access to the land base. Overall, it’s a positive direction that will support our growth in Alberta.

Thanks for that, Ray, that’s helpful. And do you have any directional guidance you can give on CapEx for 2021?

Well, I think as we've said all year, we've had a couple of big years of capital. We've got a lot of stuff in the U.S. South in 2018 and 2019. This year, we've had a big focus on operationalizing that and getting the benefits of that. We’ll be bringing Dudley online next year. I think, next year capital is probably somewhere between where it was this year and where it was in the couple of prior years. But I don't think we are set on a final number and final list of projects yet. Our focus right now is really on squeezing all the benefits out of the capital that we've spent over the last couple of years, more so than it is tackling a whole bunch of new stuff.

Your next question comes from Mark Wilde from Bank of Montreal. Mark, please go ahead.

Good morning, Ray. Good morning, Chris. Just back on the capital allocation front, I would like to get your thoughts prospectively on any share repurchase activity. I mean, your leverage is quite low. The stock is more than $25 below where you did that accelerated repurchase back in '18. My question would really be, why not just take a portion of this extraordinarily windfall that we're getting here in the second half, maybe 20% or 25% and just put that capital to opportunistic share repurchase, because the market doesn't seem to think your prospects are as good as I do when I think they probably don't think prospects are as good as you think they are?

Sure. So Mark, I think it's a fair question. I think all the options are on the table for us. Executing on an NCIB is something that can be done in reasonably short order. I think our approach, as we said earlier, has been that there's still uncertainty there. I don't think we would disagree with your assessment that it probably doesn't seem to be reflecting a more common outlook of the market, but there's still uncertainty in the background. I think we have to balance all those things together. The amount of cash we're holding right now is not that much different than what we were holding at the same point in time in 2017 or 2018. So, 2019 was a pretty tough year. Holding that liquidity and preparing for what may come out of the different eventualities is top of mind for us right now. There was only kind of six months ago when people were scrambling to raise additional liquidity and get facilities and couldn't do it. It's been a great return since basically the end of May, but it's only been four months. We just have to be mindful of where things could go and make sure we're prepared for all the outcomes and how we best add shareholder value over the long term.

I think that's fair enough, Chris. I mean, don't get me wrong. I'm not pushing for a real aggressive program. I think in a cyclical business, a strong balance sheet makes a lot of sense. But I also think we've got kind of a very unusual second half of the year here by any historic measure. So I'm just saying when you've got kind of a mismatch with the fundamentals in the business versus your share price, things like taking a portion of that cash and putting it to share repurchase could be a very good use of capital.

Sure, Mark. With respect to M&A opportunities, I mean, we're plugged in every day to every opportunity. And so that is built into our DNA. It's a little bit quiet. But there's always something going on, and there's always opportunities out there. I would say that we tend to look at many things, but quite frankly, they need to be something that we see synergies in and that can make the company better, either in the short term or in the mid-term. There's opportunities out there; I think there's still valuation as a major obstacle. With respect to others that are out there building greenfield projects, I think I saw one that was announced. I think, look, there's a great opportunity in the U.S. South. You've got good ample timber supply. I think there's always money out there to venture into these things. We've seen that over the last number of years, whether it's lumber or OSB. I would just say that those opportunities come with a significant amount of risk, both financially and in execution. You need to have a well-thought-out home for your residuals. We think those things will continue to happen over the next few years. I would just say that we should expect that and – but understand that building a greenfield and running a greenfield mill, and finding a home for residuals creates some headwinds. It takes quite a while for that production to actually land in the marketplace in a meaningful manner.

It would just seem like if you're not in the lumber business already, it might be doubly challenging. Just one final one for me. Alberta newsprint joint venture, I mean I've always understood that maybe the lowest cash cost Newsprint mill in North America. Is the strategy there just to be kind of last man standing, right?

In response to your comment, Mark, for a large company like West Fraser, which is close to being perfect, we have a considerable number of skilled and resourceful individuals. It can be a challenge for us to initiate operations and meet our execution goals. Regarding ANC, although we don't manage it, they have an exceptional and thoughtful team that has consistently succeeded in implementing their business plans year after year. Their cost structure is certainly enviable to many. I'm not convinced that the strategy of being the last one standing is ideal. However, I believe ANC is generating profitability from several areas beyond newsprint, such as energy and transloading, among others. It's a very innovative group, and I think that's a fair assessment.

Okay. So it appears there are no further questions. Please proceed.

Well, thanks for everyone for joining the call, and we look forward to talking to everybody sometime in February. Thank you. Bye now.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.