West Fraser Timber Co., Ltd Q1 FY2023 Earnings Call

Good morning, ladies and gentlemen. Welcome to West Fraser Q1 2023 Results Conference Call. Please note that all lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be 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 because Fraser's actual future results and performance may be materially different from those expressed or implied in these statements. Additional information about these risk factors and assumptions is included both in the accompanying webcast presentation 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. Thank you. Mr. Chris Virostek you may begin your conference.

Thank you, Julie. Good morning, everyone, and thank you for joining our first quarter 2023 earnings call. I'm Chris Virostek, Chief Financial Officer of West Fraser. And joining me today are Ray Ferris, our President and CEO; and Matt Tobin, our Vice President of Sales and Marketing; and other members of the executive team. I'll begin with a brief overview of West Fraser's Q1 2023 financial results, and then pass the call to Ray, who will give an update on the business as well as provide a few concluding remarks before we transition the call to Q&A. Our comments today will be brief as we recently provided a company update at last week's Annual General Meeting. As a reminder, we report in U.S. dollars and all references today will be in U.S. dollar amounts unless otherwise indicated. West Fraser generated $58 million of adjusted EBITDA in the first quarter. This was largely comparable to the $70 million of adjusted EBITDA generated in the fourth quarter, which included a one-time $7 million benefit of carbon credits from our EU business as well as a $14 million insurance recovery from our North American engineered wood business. Our North American EWP segment generated $31 million of adjusted EBITDA, down from $109 million in the prior quarter. This Q1 result included a $15 million inventory write-down, while the prior quarter had benefited from the $14 million insurance recovery just noted. The lumber segment had zero adjusted EBITDA improving from negative $77 million in the prior quarter. You recall that the prior quarter included a $39 million inventory write-down recognized as lumber prices reached a near-term low at the end of last year. The Pulp & Paper segment generated $7 million of adjusted EBITDA in the first quarter versus $15 million in the prior quarter. While in Europe, adjusted EBITDA was $20 million in the first quarter, down from $30 million in the fourth quarter. A period that has included a one-time $7 million benefit from the sale of carbon credits. Price decreases were the largest driver of the sequential EBITDA declines across our lumber and North American EWP businesses. Cash from operations was a use of $198 million for the quarter, though our cash position remained very healthy. Cash net of debt decreased to $309 million in the first quarter from $625 million last quarter as we paid $25 million of dividends, spent nearly $100 million on capital expenditures, and invested seasonally more than $200 million in our working capital build. In terms of our outlook for 2023, we are reiterating our operational guidance for the year, as detailed in our earnings release, including ranges for key product shipments and our planned capital expenditure. Capital allocation is an important part of how we run our business every day at West Fraser. Our capital allocation strategy is a durable three-pronged approach where we reinvest in the business, maintain financial flexibility that allows us to pursue inorganic and organic growth opportunities and return excess capital to shareholders. This strategy has served us well over the years. And frankly, we think it is this balanced and prudent approach that has put us in a position of strength today despite softer market conditions. Sticking to the specifics for a moment, since 2016, a period that has seen both up and down cycles, we have generated more than $8.5 billion of cash from operations. Nearly one-third of that cash flow has been invested in the business through capital projects and acquisitive growth. Approximately 10% has been allocated to repay debt and build a cash buffer and more than 50% or nearly $4.5 billion has been returned to shareholders through share buybacks and dividends. Slide 9 provides a snapshot of a few of our key balance sheet and liquidity metrics further highlighting the success of our patient and balanced approach with capital. Note, West Fraser has raised investment grade by three key rating agencies. We also continue to have strong liquidity with combined cash and bank lines approaching $2 billion, and our debt ratios remain well within the balance of our lending covenants. As we look ahead, West Fraser remains committed to investing in the business and we have reiterated guidance of $500 million to $600 million of capital expenditures in 2023, including an estimated $100 million that we plan to spend on the sawmill modernization in Henderson, Texas. With that overview, I will now pass the call over to Ray.

Thanks, Chris. As mentioned, in Q1 2023, we experienced soft demand, particularly in North America as the rapid increase in mortgage rates in 2022 continued to have an impact on overall consumption. I will note that as the first quarter unfolded, we did see many of our production costs come down and the trajectory of our demand improve. This demand improvement was particularly true for our U.S. South lumber and OSB segments, which allowed us to return to a more normalized operating environment when compared to the significant production downtime we took in the fourth quarter. In Western Canada, specifically in BC, where we have an integrated operating strategy, our business decisions can be more complex as we evaluate profitability in the aggregate across our lumber, pulp, plywood, and panels segment, while also trying to balance short-term decisions with the long-term considerations of preserving key aspects of our manufacturing, fiber procurement, and staff ecosystems. As a result, our overall BC business in the aggregate was profitable in the first quarter due to our downstream integration, as mentioned with MDF, plywood, and pulp. In terms of our more important longer-term strategy, while the first quarter SPF production was flat to slightly up in Q4, the historic downward trend in our BC production has been from 2018 through 2022, our West Fraser BC lumber production declined by more than 40%, representing a reduction of nearly 1 billion board feet through that period, reflecting our continued adjustment to available economic fiber and customer demand. With ongoing government policies such as old growth deferrals, species at risk, and other potential further reductions due to policy, we expect annual allowable cuts to continue to be constrained. We reiterate our optimism about our U.S. growth strategy for the long-term aspects and prospects for our lumber business. With respect to outlook, the wood building products industry may continue to face challenges ranging from further rate hikes by central banks, ongoing labor constraints, and the potential for muted product demand due to the apparent constraints that consumers face with regard to housing affordability, at least in the short term. That said, inflationary cost pressures have moderated across much of our supply chain, but the raw materials such as energy, resins, chemicals, and fiber, and we believe this trend will continue through the remainder of 2023. On the demand front, we are seeing some positive signs in the spring building season, much due to the public homebuilder commentary that is in the marketplace and the upward trend in mortgage rates that we experienced much of last year appears to be slowing or easing. Both of these factors are helpful for driving new loan construction and consumption of our wood building products. In closing, while near-term uncertainties exist across the industry and our business, we remain confident in the foundation we have built. We have been through these cycles before and it is not by accident that we have the talent assets and the financial flexibility to position us well to handle both the challenges and the opportunities that lie ahead. We have been disciplined in our approach to capital allocation and preserved capital in the event that we have a down market like the one we are currently experiencing. As this discipline has positioned us to be able to execute on our strategy to invest and improve our assets through all market conditions as well as be ready to take advantage of growth opportunities if and when they arise. As we look ahead, we will continue to focus on our core strengths of being low cost, remain true to our capital allocation strategy, and we look forward to a future with growth in demand for the types of sustainable renewable wood products for which West Fraser is known. With that, I'll turn the call back to the operator, and we'll take Q&A. Thank you.

Your first question comes from Ketan Mamtora from BMO. Please go ahead.

First question, I was hoping you can provide some additional color around the timing of the Allendale restart. I noticed that the release from last evening still says that it's a potential restart. Are there any indicators that you are watching or we should be watching that could have an impact on when the mill would start up? I know you've talked about potential at the end of sort of Q2?

Ketan, thank you for your question. Our previous guidance on this matter remains the same. We are satisfied with the progress the team has made, and we anticipate starting as mentioned. We still expect to be on the same timeline, targeting the end of Q2 or early Q3.

Understood. Okay. No, that's helpful. And then switching to capital allocation, you guys renewed the NCIB late February, but haven't repurchased any shares since then. Was there any kind of blackout periods or anything else that we should be thinking about in terms of why you didn't repurchase shares?

Thank you for the question, Ketan. I think the program lasts for 12 months. This year, the number of shares we can take up in the program is smaller than in the past because we've significantly reduced our share count over the last couple of years. We will look for opportunities to participate when it makes sense for us, considering various factors like the economic landscape, our liquidity, and current trading conditions. We have been disciplined in executing that NCIB over the past couple of years and will continue to be. The pace of those purchases may vary throughout the year. The renewal happened at the end of February, so not much time has passed since then. That's about all we can share on that topic.

Got it. No, that's helpful perspective. Chris, just a final question before I turned over. The 2023 CapEx, Chris, can you talk a little bit about what flexibility you have to either dial up or dial down depending on market conditions? And let's say, if the back half of the year turns out to be kind of softer, what flexibility do you have there?

Chris and I are looking at each other to decide who will answer this. I believe we have significant flexibility to adjust our approach based on our balance sheet and the capabilities of the Company. We have shown in the past that we can increase or decrease our efforts based on what we believe is best for everyone involved. At this moment, we are fully committed and focused on executing our capital program. We view these times as opportunities to position ourselves well for a future turnaround. Therefore, we are fully committed to our plans.

Yes, I think we have consistently communicated over the past couple of years that as we manage our capital allocation, particularly with the significant amounts generated recently, we will be patient and deliberate. We understand that these market conditions are not permanent, and we want to avoid a scenario where we are forced to decline high-return investments due to market constraints. Ideally, we would prefer to engage in those investments during weaker markets to prepare for the eventual recovery, which will come. Therefore, this year’s spending reflects our enthusiasm for several projects, and we have maintained our balance sheet over the last two years, despite share buybacks and other activities. We have preserved our balance sheet and liquidity, allowing us to avoid cuts to our capital expenditures. We can continue executing our strategy in both favorable and challenging market conditions.

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

Ray, I was wondering if you have any thoughts as to what's driving the large premium we're seeing for Southern Yellow Pine to SPF?

I understand the question, and I can share our best estimates. We'll have more insights as the next quarter progresses. We were surprised to see the current gap, and I believe many others were as well. Our perspectives are as follows: there seems to be a slight slowdown in demand. One key aspect is the strength of Southern Yellow Pine; we think product substitution is occurring due to supply chain concerns, as people are hesitant to take risks with their inventory. The supply chain appears to be quite lean from our observation, and SYP can reach the market quickly. Also, it's unexpected to see European imports at their current levels, and we'll see how sustainable that trend is. Additionally, the decrease in Spruce Pine Fir seems surprising. The influx of European imports early this year has indeed created some balancing effects. Furthermore, significant announcements from British Columbia regarding both temporary and permanent curtailments have occurred, which might not yet be reflected in the market. The impact of these reductions will become more apparent in the next month or two, leading to a supply constraint in SPF from Canada. These are the three main factors we are considering. We are starting to see the gap narrow, which was previously around 200, but has decreased since then. We believe this is a temporary dislocation and expect it to correct over time.

Okay. That's helpful. And then kind of sticking with BC, it seems like there's a lot of pulp downtime coming throughout Western Canada, given the decline in pulp prices. Do you think that's going to further weigh on costs for the BC industry? I'm just thinking if there's risk that chip prices fall materially here?

Well, Hamir, I can only speak for us in British Columbia. We've announced our Caribou curtailments, primarily due to the difficulty in sourcing enough fiber, which has been impacted by the numerous sawmill curtailments. There is definitely a cost implication based on the sources of fiber and the distance one is willing to travel for it. We've made certain decisions regarding that, but at this moment, it's more about the availability of fiber than about the costs.

Great. And just the last question I had on the OSB side, we're seeing more idle capacity being converted or planned to be converted to siding in coming years. Do you see any opportunities for West Fraser to participate in growth in that siding market?

First of all, I want to mention our excitement about the Allendale facility and our current position, as well as our startup and expectations regarding the cost curve and our strategy. Regarding other products, we are pleased with our product strategy, and we continuously seek opportunities to expand our customer portfolio. As for siding, I cannot provide specific comments on that, as there are other companies excelling in that area. However, we feel confident about our current strategy with OSB.

Your next question comes from Sean Steuart from TD Securities. Please go ahead.

First question on the balance sheet. You touched on the ample liquidity position you have, but you are churning through it through this extended trough. Just wondering, Ray or Chris, if you can speak to your appetite for leverage on the balance sheet, updated thoughts on that front, and how potential M&A ambitions factor into that outlook for the Company?

Sure. So, I think what we've got to keep in mind about the first quarter, Sean, is that, that consumption of cash and liquidity in the first quarter is really around the working capital build and the log decks, right? So probably $200 million of that consumption was around that seasonal inventory build and that typically unwinds in the second and into the third quarter. So probably some of that, a good portion of it gets clawed back here over the next couple of quarters. So we're pretty comfortable with where we think liquidity is going to end at the end of the year even in a fairly conservative outlook for the market. So I don't think the addition of leverage for us is a real pressing issue right now that we have to go out and secure leverage because of tightness of liquidity. In respect of capacity, what I would say is we're carrying the same debt level that we carried prior to Norbord at $500 million with a substantially larger company that's more diversified across products and geography. So, we operated at that $500 million number in a much smaller and much different environment. And so, if the right opportunities are out there for us to continue to improve the Company, I'm confident we'll find a way to finance those things the right way.

Yes, I'm not concerned about your liquidity situation but I want to understand the scale of the M&A opportunities in relation to your current liquidity position. I think I have a sense of that. One follow-up question about Allendale: as you consider the restart in the coming months, I understand this will be a gradual ramp-up. However, one of the historical challenges with that asset and that region has been significant labor shortages. How have labor conditions improved, and are you confident that you will have the necessary staffing for a prolonged ramp-up of that asset?

Well, Sean, thanks. So, I think we've got about 85 people on site, something like that right now, and it might be a little bit more in that. That's going actually better than we expected. And I can only take my hat off to the team that's worked extremely hard in the last year to get it to that stage. If you'd asked me a year ago, I would have been cautious on my comment. I think we've got a lot more confidence today than we did a year ago and so, we're seeing that as a much lower risk than we would have a year ago. But look, it remains throughout North America, and particularly the U.S. South. Skilled and unskilled labor is constrained and you need to work hard to ensure that people want to come work for you and stay for the long term. So that remains a challenge. And at this point, I wouldn't put Allendale at a different risk than any one of our other U.S. South assets, quite frankly.

Your next question comes from Andrew Kuske from Credit Suisse. Please go ahead.

I guess maybe a broad question, but it comes back to the balance sheet. You've got ample flexibility despite the market environment we're in right now. And you've mentioned mass timber in the past as really being a driver of wood products demand. To what degree or what extent do you find that market just interesting fundamentally given the growth potential for you actually being involved in end market mass timber?

Well, Andrew, I'll provide some context. West Fraser has played a significant role in the development of softwood lumber markets in North America for the past twelve years, contributing millions of dollars to create opportunities in that space. We're excited about the growing demand for wood products, particularly mass timber, which is driven by its sustainability and ESG qualities. The growth of mass timber in recent years has been remarkable, and we are very supportive of that industry. We see ourselves as potential suppliers to the CLT manufacturing business. Regardless of our direct involvement, it highlights the rising demand in wood products. Depending on whom you ask, estimates suggest that if mass timber is highly successful, it could represent between 3% and 10% of the overall market. It’s still early, but we believe this reflects a demand for wood products that was not present ten years ago when we began considering future supply and demand constraints.

That's helpful. So maybe just for an additional point of clarity. So on the CLT, not saying not of that industry, but it's just sort of early right now, it's stimulative for your core business, but it could be an interesting opportunity longer term, should it become bigger?

Your next question comes from Paul Quinn from RBC Capital Markets. Please go ahead.

Challenging quarter. Just wondering if European OSB prices have stabilized here? Or what's the expectation for the balance of the year?

Energy costs have decreased, which has helped to offset some challenges related to fiber. The market, including Europe, remains volatile, but it has performed better than we anticipated. It's difficult to predict how this will evolve in the upcoming quarters, but when we review the past couple of months, the situation has been more favorable than expected. We'll have to see how the rest of the year unfolds, but that's all I can share at this time.

Okay. And then I'm looking for a sort of update on softwood lumber. I know the industry was trying to get that on the agenda when true to set down with Biden. Where are we at on that and where we are on the, is it trade WTO NAFTA processes as well?

The WTO, litigation, and trade processes are extremely complex, requiring the expertise of multiple professionals to fully understand. We are disappointed that our political leaders have not made this a priority to advance. Currently, we're just managing the annual administrative review process. Our statements provide a clearer picture of the situation than I can articulate. From a negotiation perspective, I'm not aware of any significant developments, and I don’t believe a resolution is likely in the near future.

Okay. And then just lastly, just looking at your M&A opportunities here. What do you see in the marketplace right now? Or are you guys getting more realistic on pricing given the drop in overall commodity prices?

Yes, thank you, Paul. Reflecting on the recent periods, there are still opportunities available to pursue. Our focus will be on quality and initiatives that we believe we can successfully execute, achieve meaningful synergies, and place ourselves within the top quartiles. Therefore, we often choose to decline opportunities rather than accept them. The market remains active, and I expect it to continue being so. Regarding value, I believe many share our optimistic outlook for the future, and expectations seem to suggest that assets in good condition are being viewed positively. In general, I would say there's a bullish sentiment for the mid- to long-term outlook.

Presenters, there are no further questions at this time. Please proceed with your closing remarks.

Well, listen, thanks, everyone, for tuning in today, and we look forward to talking to you at the end of Q2. Thank you.

Ladies and gentlemen, this concludes your conference call for today. We thank you for joining, and you may now disconnect your lines.