West Fraser Timber Co., Ltd Q3 FY2022 Earnings Call

Good morning, ladies and gentlemen, and welcome to the West Fraser Q3 2022 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 West Fraser's future financial and operational performance, business outlook, and capital plans. These statements may constitute forward-looking information or forward-looking statements within the meaning of Canadian and United States Securities Laws. Such statements involve certain risks, uncertainties and assumptions, which may cause West Fraser's actual or future results and performance to be materially different from those expressed or implied in these statements. Additional information about these risks, factors, and assumptions is included both in the accompanying webcast presentation and in our 2022 annual MD&A and annual information form, which can be accessed on West Fraser's website or through SEDAR for Canadian investors and EDGAR for United States investors. I would like to remind everyone that today's call is being recorded, Thursday, October 27, 2022. And I would now like to turn the conference over to Ray Ferris, President and Chief Executive Officer. Please go ahead, sir.

Thank you, Michelle. And good morning, and thank you for everyone for joining our third quarter 2022 earnings call. As Michelle noted, I'm Ray Ferris, President and CEO of West Fraser. And I'm joining today's call from Greenville, South Carolina, which is home to West Fraser's Advanced Controls and Development Center. Joining me on the call from Greenville is Chris McIver, our Senior Vice President, Marketing and Corporate Development, along with a few other senior leaders. Also joining us from Vancouver, British Columbia is our Senior VP and Chief Financial Officer, Chris Virostek. If you give me a bit, I'd like to take a few minutes to describe just what our team in Greenville does and the role we expect them to play in support of our broader efforts to further improve our operational and cost performance as we continue our transformation into a leading global wood products company. For background, the Advanced Control Center was an initiative launched by the Norbord team in 2020 to support the 12 North American OSB facilities in best-in-class safety, operational performance, and the sharing of best practices. Following the completion of the Norbord acquisition in February 2021, our platform has now grown to 13 OSB operations and specifically 22 sawmills in the US South. Although the center will support other regions, we believe the critical mass we now have in the US South is an important strategic advantage of scale upon which to execute and support technology transfer to more rapidly advance the highest safety, automation, and operational efficiencies, which are key to further driving our low-cost strategy. To do this, it's important that we have the best people and processes in place, and that's where the Advanced Control Center comes in. From this center, we have a team of engineers and control specialists that are wired into many of our operations to directly support our on-site teams. At a high level, the advanced controls and development center's key objectives are to train, educate and develop our employees to deploy and utilize best-in-class automation and control skills, to share in real-time best practices on safety and operational excellence, and to be a leader in developing and implementing the latest automation and robotic technologies. Doing this should also result in a work environment that attracts and retains the most engaged and talented people for our company. We are pleased with the energy and progress our US South leadership team has accomplished so far in this initiative. And we are excited about the opportunities ahead as we drive competitive advantages through people and technology to support our safe, low-cost, and highly efficient operating philosophy. With that, I will now give a brief overview of key financial highlights of West Fraser's Q3 results and then pass the call to Chris Virostek for additional comments. In the third quarter, West Fraser saw a further improvement in transportation constraints that had challenged our financial results earlier this year, while concurrently, we saw market demand weaken with rising mortgage rates impacting near-term housing affordability. Against this backdrop, we achieved solid financial results for the quarter, generating $426 million of adjusted EBITDA, representing a margin of 20% of sales. In terms of capital allocation, we invested nearly $150 million in capital equipment this quarter while continuing our track record of returning significant capital to our shareholders by repurchasing $182 million of our shares and also paying out $27 million in quarterly dividends. The company has now repurchased approximately 39 million common shares through our normal course issuer bids and with the completion of two substantial issuer bids since early 2021, representing approximately 72% of the shares issued in respect of the Norbord acquisition. Notwithstanding this return of capital and softening market demand, our balance sheet continues to offer significant financial flexibility, which remains a key priority for us in our capital allocation strategy. With that, I'll now turn the call over to Chris for additional details and comments.

Thank you, Ray. And a reminder that we report in US dollars and all my references are to US dollar amounts, unless otherwise indicated. Our North America EWP segment generated $215 million of adjusted EBITDA, down from $623 million in the prior quarter. While lumber generated $160 million of adjusted EBITDA, a decline from $449 million in the prior quarter. Note that the lumber segment benefited from an $81 million duty recovery of the Administrative Review Period 3 export duties during the third quarter. The Pulp and Paper segment generated $29 million of adjusted EBITDA and a significant improvement from recent quarters. Notwithstanding this progress, we continue to focus on long-term solutions to improve the health segment, which includes our Unbleached Kraft Pulp strategy. In Europe, adjusted EBITDA was $24 million versus $54 million in the second quarter. Price was the single largest driver for the sequential EBITDA change across our North America's lumber and engineered wood products businesses in North America and Europe. Cash flow from operations in the third quarter was $433 million, while cash net of debt increased quarter-over-quarter to $789 million, even as we repurchased $182 million of our common shares in the quarter. I'll now shift to our 2022 operational outlook. While we did experience a notable improvement in transportation in the third quarter, particularly in Western Canada, we are reducing our annual SPF guidance, lumber guidance. We now expect SPF shipments to be modestly below the bottom end of the prior guidance range of 2.83 billion board feet, maintaining our guidance for SYP shipments, which we expect to fall within the range of 3 million to 3.2 billion board feet this year. We're also reiterating our North American OSB annual shipment guidance of 5.9 million to 6.2 million square feet on a 3/8-inch basis. In Europe, we are seeing a continuation of the slowing demand we discussed last quarter. And as such, we now expect OSB shipments to be at the bottom end of the guidance range of 1 million to 1.2 million square feet on a 3/8-inch basis this year. Lastly, given the rate of expenditures in the first three quarters of 2022 and because we now expect project spending to carry into 2023 for a number of our projects that are underway, we are tempering our 2022 capital expenditures guidance to be approximately $450 million as compared to the prior guidance range of $500 million to $600 million. We continue to see weakening demand for a number of our products, particularly for those serving new home construction markets as rising mortgage rates appear to be impacting affordability. And while we still see positive medium to longer-term market supply and demand fundamentals for our key products, we are acutely aware of these near-term headwinds. Given this uncertainty, further changes to operating schedules across our production platform may be required to manage raw material supplies, inventory levels, transportation, and our integrated fiber supply chain. Consistent with recent quarters, across much of our supply chain, we continue to experience greater-than-usual inflationary cost pressures and availability constraints for labor, energy, and raw materials, such as resins and chemicals, and to a lesser extent, transportation. We expect these cost pressures and availability constraints to remain elevated through the remainder of 2022 and into early 2023. With that overview, I'll now turn the call back to Ray.

Thank you, Chris. I'll make a few comments about West Fraser's exposure to new home construction markets in the US. As Chris mentioned, we certainly recognize the uncertainty surrounding rising interest rates and the potential impact that these and other factors may have on near-term housing affordability and the potential for short-term fluctuations in demand for our building products. However, it's important to note that while new home construction is a key market for our company, today's West Fraser is much more diverse and resilient than the West Fraser of the past, in part because of our deliberate actions that we've taken across the company. Not only do we have exposure to different geographic markets today, but the relative mix of our demand drivers has changed over time, with significant growth coming from segments that are not tied to new home construction. To this end, market exposure for our lumber segment, as you can see on slide 8, shows that repair and remodeling markets have become much more significant drivers of industry lumber demand over the past 20 years. Comprising just one quarter of industry demand in 2000, those same repair and renovation markets now represent nearly 40% of North American lumber demand. Similarly, on slide 9, it is clear that both repair and renovation and industrial markets are now much larger contributors to North American industry demand for OSB. Demand from these two end markets has increased substantially over the last 20 years, growing from just 22% to approximately 33% of total OSB demand over that period. What this data tells us, industry data shows us, is that while new home construction will continue to be a key driver of building products demand in North America, repair renovation and industrial markets have become more significant drivers of overall demand for our products. Further, the repair renovation industrial end markets historically tend to have significantly less demand variability through the cycle than that of new home construction. We believe that this is important to note as it shows we're better positioned today to enter future cycles in the US housing market. I would now like to update you on the announcement yesterday that we'll be undertaking a brownfield mill modernization of our Anderson Texas Lumber facility. Much as we did with Opelika and Dudley projects, we will continue to operate the existing mill as we construct a $255 million state-of-the-art lumber manufacturing complex at Henderson. Undertaking this type of brownfield project allows us to pursue our low-cost strategy while leveraging the current mill's existing ecosystem, including a skilled workforce, abundant fiber, close proximity to strong end markets, and an existing outlet for our mill residuals. And of course, including, importantly, the local transportation infrastructure. Construction will begin this fall, and we expect the mill's ramp-up curve sometime in the second half of 2024. Once completed, the Henderson Mill's capacity will nearly double, and at full production, we estimate the mid-cycle EBITDA will increase by almost four times the current mid-cycle EBITDA. In summary, while demand markets were challenging in the third quarter, and we see near-term headwinds impacting the business, we remain confident in the foundation we have in place. In addition to our geographic and product diversity, our balance sheet remains strong. We have the necessary liquidity to allow us to navigate current and future challenges and benefit from the opportunities that may arise. Just as important, we have the people and the talent to continue to move the company forward and create value, whether organically or through acquisitions if and when attractive M&A opportunities arise. Overall, we remain optimistic about the company's longer-term prospects as well as continued growth in the use of sustainable and renewable products. With that, we'll turn the call back to the operator and ask for questions.

Thank you, sir. Ladies and gentlemen, we will now begin the question-and-answer session. Your first question will come from Sean Stewart of TD Securities. Please go ahead.

Thank you. Good morning, everyone. Ray, a question on the Henderson project. The capacity multiple looks rich versus other recent new sawmill announcements. Can you reconcile the capacity multiple, which looks like it's almost $930 per thousand board feet with the 12% IRR target? That IRR looks pretty similar to what you guys would have targeted for Dudley and Opelika, and I'm just wondering if you can reconcile that transparency for me.

Well, Sean. Chris and I will work together on this one. Chris, would you like to begin, and I'll add my thoughts at the end?

Sure, Sean. There have been several announcements lately, and the construction of mills varies. We've built on our experiences from Opelika and Dudley, and we’ve had significant success in Angelina, which I believe is a fair comparison from a valuation perspective. Our view on mid-cycle conditions has been conservative, and we aim to perform better in these situations. While I won’t go into too many specifics about our assumptions, our modeling approach has remained consistent. We’ve been very pleased to exceed our expectations with the green and other brownfield projects, and we’ve approached this one with similar caution. Ray, do you have anything to add?

I would just say that it's important to recognize that not all situations are the same. For West Fraser, considering our operations and future goals, this aligns with our strategy in East Texas and, to some extent, in Arkansas. We see the advantages that this brings to us, and it is significant for our company. Additionally, we tend to adopt a conservative approach, especially regarding pricing and ramp-up schedules. While we hope to perform better in both aspects, this reflects our company’s nature and our strategic focus. It's not merely about a mill; it's about our regional strategy and our overall approach. I hope that clarifies your question.

I appreciate that context. For my second question regarding log costs in the U.S. South, it was noted in the MD&A that there has been inflation in that area. I understand that costs can vary significantly from state to state and even within states. Could you provide an overview of the average log costs in the South, including how much they have increased on a percentage basis, either quarter-over-quarter or year-over-year? Additionally, what are your expectations for the latter part of the year?

I don't have specific figures, but they may not be very significant anyway. What I can say is that we've observed regions recovering more quickly, which could be due to weather conditions and factors related to pulp and other materials. However, there has been a noticeable change in certain areas. I believe looking at the industry data, Sean, would be the best way to get accurate information.

Okay. That's all I have. Thanks very much, Ray.

Thanks, Sean.

Your next question will come from Hamir Patel of CIBC Capital Markets. Please go ahead.

Hi, good morning. Ray, some of the charts in the investor presentation indicate that the company's perspective is that North American lumber and OSB markets are aligned with 1.5 million US housing starts. However, 2023 is projected to be significantly lower than that. Do you anticipate an acceleration of some of the permanent closures that might be expected in BC? Additionally, how do you assess your own capacity base in the province moving forward?

Thank you, Hamir. I appreciate your attention to the charts, which I'm sure will please Robert Winslow. I don't want to focus on specific regions, as conditions can vary. However, I can say that we will adapt based on the economic delays, the transportation resources we have, and the purchasing preferences of our customers. This can differ from one region to another. For instance, British Columbia has higher costs, and we've implemented many changes there. Nevertheless, our operating philosophy remains consistent: we need to consider economic factors, ensure we have transportation that can handle customer orders, and maintain access to wood. We'll adjust our operating plans as necessary to address any of these factors.

Okay. Thanks for that. That's helpful. And just turning over to Europe, not preferable to quantify how OSB prices change there in Q3. And any comments about what you might be seeing on the pricing front in Q4?

I find it challenging to provide detailed insights on that. Generally speaking, energy and fiber costs are concerns across Europe. The market has definitely cooled off quite a bit. In terms of pricing forecasts, there's a lot to observe in where it heads. However, I am pleased with how our team is managing both fiber and energy while adapting to demand. From that standpoint, we'll see where pricing trends go, but it's difficult to gain clear visibility in Europe.

Fair enough. Thanks, Ray. That’s what I had all. I’ll get back in the queue.

Thanks, Hamir.

Your next question comes from Mark Wilde of BMO. Please go ahead.

Good morning, Ray, Chris and Chris. First question I had is, Ray, I wondered if you can just help us at all, in how you're thinking about demand over the next few quarters. We know the builders have had a pretty healthy backlog that they're presumably working their way through now even as the buyer traffic drops off. How do you see demand playing out over the next few quarters based on what you know right now?

Well, Mark, so Chris and Chris don't think we're getting to answer enough questions. I'm going to turn this one to McIver.

Yes, good morning, Mark. Yes, that's a very difficult question to answer, quite frankly. But what we're seeing is single family as nobody surprises beginning to drop off. But repair remodel is holding up very robustly, both in panels and lumber. Where it goes from there, we really don't know.

Yes. I guess what I'm just trying to get at, Chris, is how much of a buffer this is creating in the short term just because the builders have a lot of backlog to work through. And how significant a drop-off we might see somewhere out in the first half of next year.

Yes, we really don't know. I would say that our inventory levels for both panels and lumber are quite comfortable, and we'll see what happens.

From my viewpoint, we all analyze the same completion and start figures. In the short term, whether it’s this quarter or the next, demand appears to be stronger than some of the numbers suggest. The uncertainty lies in how much interest rates will rise, how quickly they will increase, and at what level they will stabilize. It's challenging to forecast the potential impact, but there should be some cushioning available.

Okay. A couple of other questions. One, you've been quite clear as you work down at Allendale that you're going to start that up and you see the market being there for the product. I wondered how you're currently planning for that start-up at this point? In other words, are you hiring and training a workforce for the facility for kind of a late Q1 start-up, or is that on pause for right now?

I'm going to provide two answers, Mark. First, we've made this investment based on what we believe are strong long-term fundamentals. Starting up any of our facilities, including Allendale, involves long-term projects that take two or more years to reach our desired outcomes. Any decisions made regarding these will also be long-term in nature. A general comment is that as we review our portfolio, we will ensure that we have the right logs at the appropriate price, a facility with the right cost structure, transportation that supports it, and customers ready to purchase the product. Any of these factors could lead us to adjust our operating platform across the portfolio. Therefore, rather than specifically addressing Allendale, whether we begin operations in Q1 as planned or make adjustments will depend on ensuring all the necessary fundamentals are in place throughout our operating portfolio.

Okay. Last one for me. I'm just curious, Ray, if we look out over the next three to five years, we're seeing capacity shrink a lot out in BC. We're seeing capacity grow a lot in the Southern US. Would you expect that we see a little change in the relationship between Western Grade lumber and southern grades over time?

Can you be a bit more specific, Mark?

Yeah. I'm just trying to think, we have less SPF supply. It's clearly preferred for some markets. At the same time, we've got a lot more southern pine capacity. It tends to go to somewhat different markets and has much lower cost. I'm just trying to figure out whether the sort of the historical pricing relationship between those two grades, it's going to shift a bit, whether a rebound in southern prices might be smaller, or whether you might see SPF prices rise to a newer and higher level on a trend basis?

Well, thanks, Mark. I’m going to let Chris here take that one.

Hey, Mark, you are correct in that typically you see slightly different end uses for both SYP and SPF. But there is a fair bit of overlap. And we do see arbitrage on certain products. I'll give you an example. When we trust manufacturers, they will go back and forth between SYP and SPF. And I expect over time as there's more availability that's why we'll begin to be using more end users. That's just what we're seeing, but it's pretty much anyone's guess as to where it ends up.

One thing I might add, Mark, would be I think we agree with your thesis or how you support that thesis. I think one of the things that cause that is that the supply chain has been very tight, and the supply chain out of Canada with transportation challenges creates dynamics that's hard to unpack that question. I think we'll have to see how that plays out in the marketplace.

Okay. I'll turn it over. Thanks, Ray.

Thank you.

Your next question comes from Paul Quinn of RBC Capital Markets. Please proceed.

Yeah. Thanks very much. Good morning, guys.

Good morning, Paul.

Just wondering if you've noticed the effect of the Russian wood products export down, I think that came in early July, and whether you've noticed that in tightening up Europe slightly despite the weakening economy as well as North America?

Look, we did expect to see something, and particularly as we get into August, that's been very difficult to see with things that are going on there. I do think that we will see that impact. I think our view would be it has to have an impact on Europe. It certainly had an impact on fiber costs in certain regions, but less so on overall demand. But I think in a couple of quarters, we're going to have more visibility on exactly what the impact of those sanctions has been.

Okay. And then you guys have better highlighted the resin cost up year-over-year. I guess that's with energy. Just what's the percentage change in resin costs? And is it comparable between North America and Europe?

Yes, it's difficult to establish a clear comparison. Energy costs have increased slightly more in Europe than what we've observed generally in North America. However, this varies regionally and it's challenging to make broad generalizations. The same is true for North America, where we may see regional variations that can fluctuate. The last few quarters have illustrated this variability, and we anticipate further changes in the next three quarters.

Okay. And then just lastly, I mean, with slowing North American housing market here and just wondering your ability to pivot to export markets with either lumber or Northern panels?

Paul, it's Chris. I'll keep that one for now. I would say that all of our offshore markets have been slower than historical for sure, including Japan. And China, in particular, has been very challenging and kind of for three reasons. We believe there's very a bit of Russian and European lumber squeezing into that market for the same reason their markets have slowed. Obviously, Russia is a good example, we've seen a depressed market in China. And then there are geopolitical concerns as well that market access has been a problem from Canada. So, the export markets have been tough, and we expect them to continue to be tough.

Sorry, that's all I had. Best of luck and thanks.

Thanks, Paul.

Your next question comes from Mark Wilde of BMO. Please go ahead.

I have just two quick follow-ups. First, I'm curious about the $255 million figure in Henderson. Is that amount after accounting for any incentives from local or state government? I've noticed that with some of the new projects announced in the industry, there have been significant incentives impacting capital costs.

It might be on you. Sorry, go ahead, Chris.

Yes. I mean the local community has been very supportive of us there, but that $255 million is the total capital cost.

Okay. All right. And then, Ray, just one other one. Any progress on the trade issues as markets get tougher because it really seems like it's been quite quiet over the last few years. And I just wonder if the prospects of more challenging markets are bringing people back to the table at all?

Well, it's a great question, Mark. And I think the answer is simple: There's really nothing going to happen until we get through the mid-term elections. So, there really isn't anything going on today. But I would say, historically, you need to get beyond the mid-term elections. And I guess, if there was an opportunity for whatever the factors are that might create a catalyst to have discussions, my guess or opinion would be at some time later next year.

Okay. All right. Sounds good. Thanks, Ray.

Yeah. Thanks Mark.

At this time, there are no further questions on the phone line. So, I will turn the conference back to Mr. Ray Ferris for any closing remarks.

Well, thank you, Michelle, and I really appreciate everyone's time on the call. As always, Chris and I, along with Robert, our Director of Investor Relations, are available to address any additional questions. Thank you for participating, and we look forward to speaking in Q4. Thank you for now.

Ladies and gentlemen, this does conclude your conference call for today. We would like to thank everyone for their participation, and you may now disconnect your lines.