Lumber Companies: Big Idea

[Viking]

Over the past couple of years it has been clear that insurance pricing was in the process of shifting from a soft to a hard market. Investors who have taken the time over the past couple of years to get positioned in the best run companies have done pretty well return wise. More importantly, as pricing continues to harden these investments should do even better as profitability improves and the multiple the market assigns to the sector increases... we will get a double whammy and this often results on a stock doubling in price in a very short time period. We are still in early days for insurance with the big money still to be made. My learning is the key is to get exposure to the best run companies when pessimism is high and to simply sit and wait (yes, perhaps years) for the opportunity to play out. I have also learned that trying to 'time' things too cutely (trade in and out depending on macro events) is not possible. Stocks will increase in price when you do not expect and then you sit and wait for a correction before investimg and the stocks continue higher as fundamentals improve and you get left behind. Do your homework; establish a position in the best companies; do not sell due to short term factors; hang on for the long term (years).

 

Another sector that I am spending more time on are the BC lumber producers (WFT, CFP, IFP-A). Looking out 5 years I see profitability improving dramatically and I see Mr. Market giving the sector a much higher multiple. This is not a 3 month or one even one year play.

 

Why do I like lumber producers so much? Demand for lumber is growing again (thanks to China) and will spike when US housing starts return to normalized levels. Supply of (quality) lumber will be shrinking in the coming years as the allowable cut in the BC interior shrinks (as Mountain Pine Beetle volumes shrink and what wood is left is much lower quality). 

 

US housing: I have followed Calculated Risk blog for years. His read is we have reached the bottom in the US in terms of lows for single family housing starts. Now we may stay at a very low level for another couple of years. Or we could be closer than people think. When forcasting the future most people overweight what has happenend in the recent past. My guess is the turn in US housing will catch people by surprise. Regardless, US housing starts are much too low and will need to increase materially in the coming years.

 

China: I have not been following the China story too closely the past few years. The Chinese governemnt is now embracing wood in construction. The result has been an explosion in volumes (for BC producers shipping to China) from pretty much zero a couple of years ago. How big are we talking? Volumes to China actually exceeded volumes going to the US at one point in 2011 http://www2.news.gov.bc.ca/news_releases_2009-2013/2011JTI0091-000888.htm. Think about that for a second. Volumes to China are expected to continue to increase in the coming years. See pages 8 & 9 of the Canfor presentation, page 17 of the West Fraser presentation or pages 25-28 of the IFP presentation linked below for a little more information on China (or listen to the CIBC Whistler Roundtable linked below).

 

Softwood Agreement: was recently extended from 2013 to now end in 2015. This was a great move for Canadian producers as the agreement will now be re-negotiated when the demand/supply relationship will be much more in their favour.

 

BC Lumber Companies (WFT, CFP, IFP-A):

1.) profitable today: business is not great; it is good enough to allow the companies to continue to invest in their operations, buy out weaker competitors and muddle through until better times come.

2.) low debt: 10 to 15% of market cap is debt; these companies are not leveraged plays.

3.) low cost operations: they have invested heavily the past 5 years and the BC interior is recognized as the lowest cost operators in NA; higher prices will make them free cash flow machines.

4.) consolidation: the strong players continue to get bigger by purchasing the smaller/weak players. This should result in more 'rational' behaviour on the part of producers in future years and improve industry profitability (with less destructive competition).

5.) ownership: Jimmy Pattison has been buying CFP for years and now owns 38%; Mackenzie Cundill owns 14% and Jarislowsky Fraser owns 11%; three players control 63% of CFP shares. Ketcham family owns a bunch of WFT. Fairfax purchase IFP years ago and I am assuming they still hold their position. These players are long term holders. The supply of tradable stock for BC lumber companies is low; when investors and analysts jump on the bandwagon there is going to be a big demand/supply mismatch in available shares.

 

CIBC Whistler Forestry Roundtable (Jan 2012): http://webcasts.welcome2theshow.com/whistler2012/forest

West Fraser: http://www.westfraser.com/news/docs/Investor-Presentation-October-2011.pdf

Canfor: http://www.canfor.com/documents/webcasts/Investor-Presentation-2012FINAL.pdf

International Forest Products: http://www.interfor.com/pdf/Investor/Presentation/Investor_Update_2012_Jan.pdf

 

If anyone has come accross any presentations they found informative on this topic can you post? Thanks!  ;)

[Guest Hester]

Volumes to China are expected to continue to increase in the coming years.

 

Because it's "expected" you assume it's true?

[Viking]

Hester, of course anything can happen. If this was 2006 and the Canfor CEO said they would ship 1 million board feet of lumber into China in 2011 he would have been laughed at. The fact that BC producers were actually shipping more volume into China than the US at one point in 2011 is amazing. Given that CFP and WFT say they will ship more volume to China in 2012 than 2011 (and this has been the case every year since 2006) then this is what leads me to say that I expect shipments to China to increase in the coming years. Here are 2011 softwood lumber numbers from the BC government for China: http://www.newsroom.gov.bc.ca/2012/02/softwood-lumber-exports-to-china-shatter-record.html

 

If you look at slide 8 of the Canfor presentation you will see details of volumes they have shipped into China: they have gone from zero in 2006 to almost 1 million board feet in 2011 and they are forcasting 1.2 million board feet in 2012. The CEO for Canfor was actually in China during their earnings conferencye call last week with the Canadian gov't meeting with senior Chinese officials. Canfor has been in China for the past 10 years trying to grow the wood market (this is not something they just started). Slide 9 of their presentation summmarizes the Chinese opportunity well.

 

If you look at slide 17 of the West Fraser presentation you will see details of volumes they have shipped into China: they have gone from zero in 2006 to more than 2 million board feet in 2011. The growth each year has been consistent. During the WFT conference call today the CEO said in Q1 they have once again resumed shipping significant volumes into China and prices have started to improve (from Q4 lows). This is very good news as total volumes and prices into China dropped in Q4.

 

To get a little more perspective on China I suggest you listen to the Whistler conference link below.

 

The bottom line is China is a very difficult market to predict with any certainty for any commodity. And for some reason products get stock piled, orders disappear and prices collapse which result in some wicked price swings from year to year. What I learned with pulp is to trust that the China story, once established, is real. My only prediction is lumber volumes in China will continue to increase in the coming years as their economy continues to grow. China does not have the fibre to supply this market. BC producers appear to be in the best position to satisy this growing demand. Here is a good summary of what the current outlook is for China: http://www.evri.com/media/article;jsessionid=o15ojyi7tmsn?title=Lumber+sales,+prices+rise+as+Chinese+buyers+return+to+B.C.&page=http://www.vancouversun.com/business/Lumber%2Bsales%2Bprices%2Brise%2BChinese%2Bbuyers%2Breturn/5889231/story.html&referring_uri=/organization/west-fraser-timber-co.-0x70abf%3Bjsessionid%3Do15ojyi7tmsn&referring_title=Evri

 

And, yes, lumber is wickedly cyclical. Volumes and pricing move a crazy amount. My point is I think we are at the point in the cycle where demand is low and prices are low. As US demand picks up in the coming years (housing recovery) and if demand from China continues to grow (current trend continues) we will have very strong demand for lumber.

 

In the coming years we will also see pressure on the supply side with fibre supply actually shrinking. I think Resulute communicated lately that the Quebec gov't will once again be reducing the allowable timber harvest in the province. In the BC interior the allowable cut will be shrinking in the next few years as the pine beetle logs are depleted (see West Fraser presentation page 20).   

 

Growing lumber demand at the same time wood supply shrinks. I wondered why Jimmy Pattison was purchasing Canfor starting years ago. I think this is likely what he has seen all along (with the recent China growth being a bonus). Jimmy is a long term, value investor (similar to Buffett). His Canfor investment could end up being one of his best ever. And like Buffett's best moves it plays out over a 5 to 10 year period.

[rogermunibond]

Timberwest was taken private a few years ago by CIBC and BC pension money (?).  Probably a good starting point to figuring out if current valuations are good. Thanks for the idea.

 

How exposed are these other BC timber lands to pine beetle?  Timberwest is entirely Vancouver Island with little pine beetle exposure.  Plus they have potential land improvement potential.  Do these other companies have that?

[Viking]

The BC government has a web site with lots of great information on the Mouintain Pine Beetle http://www.for.gov.bc.ca/hfp/mountain_pine_beetle/faq.htm#10.

 

Here is a map of BC showing the devastation: http://www.for.gov.bc.ca/hfp/mountain_pine_beetle/maps/BCMPBv72009Kill.pdf

 

For those who have driven in central BC (worst hit area) it is freeky to see entire forests coloured a solid red (as all the trees are dead) instead of the usual green. This area also has extreme forest fire risk as forest fires hit the dead timber.

 

The key question is what the useful ecomonic life (in years) of a dead tree is... fortunately the lumber companies are smart and with improved technology have been able to still get good value out of older dead trees. FYI, as the dead trees age they get more brittle making it more difficult to extract quality 2x4's. Much of the #2 AND #3 quality 2x4's going to China is pine beetle trees.

[Guest Hester]

Viking; Thanks for the detailed response, although I have to disagree.

 

Really nothing you said gives any reason to think lumber sales to China will be higher in say, 5 years. Most of your comment highlighted the fact that lumber exports to China have soared in the past 5 years. That's a fact, but it's irrelevant to what will happen in the next five years.

 

"Hester, of course anything can happen. If this was 2006 and the Canfor CEO said they would ship 1 million board feet of lumber into China in 2011 he would have been laughed at."

 

This is a non-sequitor. I could of stood there in early 2007 or 2006  or even 2005 and said that anyone in 2001 who said the US subprime housing market or mortgage securitization would become the huge, hot market it is now would have been laughed at. So what? It didn't bode well for investors. Pricing history is not good evidence that these trends will continue.

 

Getting your opinion on China housing from Canadian lumber companies a mistake. What are they supposed to say? What are the odds that Canadian lumber executives have a clue what will happen to the Chinese RE market over the long term? Just because they have their finger to the pulse of the current lumber demand from China, doesn't mean they know where it's going.

 

I have no position in any of these stocks but I am short some stocks that look cheap, some are selling at single digit p/e, but most of their earnings come from this booming Chinese RE market.

 

If I were you I would google and get on Youtube, and find every Jim Chanos presentation/speech/interview on China/Chinese RE, which is the opposite viewpoint, and try to see if you can kill the idea. I say Chanos just because he is the most vocal and articulate China critic. Take all the information/data he gives and take it into account if it is a real risk to future lumber exports.