Lumber: The Joys of Instability

The Joys of Instability

DR Horton's most recent conference call included the words stability, stabilizing, stabilization etc. 34 times. They did so particularly in relation to pricing, costs and demand. One problem... The price of lumber is too low for lumber producers to make money.

There are companies where you can model out earnings for years and pretend you know what the future will look like... Then there are commodity stocks. I can't tell you how many successful commodity stories started with, "Well, they're not making any money right now...but...." There's a reason for this. Central banks say they target price stability. I think that's funny because price stability is impossible. Especially in certain areas, you either have too much or not enough. The prices that make companies 'make more' or 'make less' are so far away from each other that price instability is necessary. Or, if you prefer, to use a Druckenmiller concept, invest 18 months out into the unknowable future because everyone knows today.

This thinking has me caught on lumber. I can point to EXACTLY why I believe the price has perpetually been in the doldrums for months. Even still, I can't say when that will end. I don't even know what the sector will be worth when it ends. Best I can do is shrug and say "probably a fair bit more... IF..."

What's Wrong?

To me the two part answer is:

1: The decline in single family housing starts. Direction is important, at any given level production can adapt and price can balance out. If the demand keeps shrinking the market needs to keep sending the "We need less" signal.

2: The reason for declining single family housing starts has likely been the higher prices and higher mortgage costs. This weighed on the marginal buyer and probably has some waiting for lower prices, lower rates, a magic recession that will provide them with an almost free house at a perfect time... the usual.

For me, the primary question is: when do things stop getting worse in SFHS? I believe that once that happens a number of aspects will fall into place in the sector. We need to get through the re-adjustment period.

While I can point to what's wrong with lumber, the valuation on some of the equities seems beyond recent lumber woes. On that subject I can only speculate:

Recession or housing bust story?

Lack of clarity around duties?

Lack of recognition of how big the recent boom was & what that means?

Thinking that big boom = big bust?

No dividend= who cares?

Simply

I believe the lumber price is unsustainably low. Lumber producers are burning value. Negative earnings!!! Are you excited yet? Didn't think so. It's a bad situation to be in... Today. My interest is similar to the chicken's interest in going to the séance... To get to the other side... (Blame the Bing chatbot for that joke... I had to hear it and because of that, you had to hear it). Anyway, like many interesting investments, what's special about them is the ability to visualize what they may be able to look like on the other side of today's issues.

If there's no extreme outcome along the way (bankruptcy or forced asset sales of some sort) the asset value and earnings power will likely shine though eventually. That should in one way or another, convert into value.

How Much Value?

I already told you... I have no idea... But for arguments sake, let's say I had to pretend to know. 

Some angles I might approach the problem from would be.

1: Historical price to book multiple at point X

Over the last decade 1.2-2.5x book has been the common trading range. It depends if they're profitable at that time.

In the post 2005 bear market valuations traded from 1.5x book down to 0.5x. Of note West Fraser's AGM had a slide titled something like "This is not 2005" pointing to the vastly different supply dynamics vs then. Lumber supply never recovered anywhere near 2005 levels. (see further down)

While perhaps the most stable measure book value literally changes every quarter & doesn't really account for balance sheet torque. What I'd imagine for a reasonable price in a difficult environment might be ~1x book. Then as things turn, if ROE can bounce back to 20% you might see something closer to 1.5x Book... with book being 20% higher.

So if we say the group is at 0.66x Book today,

Scenario 1: 10% loss over NTM = 0.9x current book target or 0.9/0.66 = 1.3636 (36% upside) then 20% ROE in following 12 months. 1.3636*1.2=1.6363 (at 1xBook) at 1.5X new book we'd get 1.6363*1.5 = 2.45 (145% upside)

Scenario 2: Loss losses, less gains... Breakeven this year, 15% ROE next. 1.3 X Book (1.15*1.3/0.66)= 126% upside

Scenario 3: Bankruptcy = 0 (100% loss)

Scenario 4: Breakeven 2023, 30% ROE 2024, 1.7x book. (1.3*1.7/0.66) = 3.35 (235% upside target)

Basically, if you get a re-rating without too much damage, I think more than a double is in store. Getting no rerating, would be historically rare for profitable times but would result in potential for high yielding capital returns. The problem with me making a case at this point in the cycle is that I can always postulate that 'It might be different next time' & 'you might not get the rerating and have to hold for multiple cycles to fully reflect the value.' It's possible, it's always something to consider.

2: M&A or Capex replacement cost

This one is more of a judgement call, not all assets are equal. Prices shift with different price environments too. 

Looking at the recent Interfor acquisition of EACOM acquisition they paid roughly CAD$500/Mbfm (before other factors) across eastern Canada.

Green First recently sold 245k of capacity at CAD$385/Mbfm.

Canfor has two capex projects underway at US$640 DeRidder (250MMBFM) and US$840/Mbfm Alabama (250MMBFM) For their greenfield growth.

In the most bizarre example so confusing that I checked twice, West Fraser is spending ~$1850/Mbfm on a brownfield expansion.

Here it is if you want to do the math yourself. P.S. Their cursor not mine.

So capacity can be anywhere from $350 to $1000+ any questions? ... Oh now you care about pulp and OSB capacity...

3: EV/EBITDA at different potential margins.

Ignoring that normal doesn't exist let's have a look.

Over three companies and a dozen years I could easily come up with too many number to keep straight so I'll simply.

Interfor's 10 year average EBITDA margin is: ~$135

Last 3 years average EBITDA margin is: ~270

A number that ignores windfall years and looks reasonable to me is: $90

(Top left, but I just want to take a second to admire how good this slide is overall... it's all there)

Given that multiples depend where we are in the cycle, it might look something like:

(Using Interfor's 4.5BBF because it's the only pure play)

(10 year average) 4500*$134  = $603M EBITDA *4?

(3 year average) 4500* $270 = $1.215B EBITDA *2?

(Old profitable years) 4500* $80 = $360M EBITDA *7?

This is possibly even more arbitrary than the M&A. As the good years come in, shares can quickly be bought back to make prices pretty stale by the month. for instance holders of shares of some of these companies over the last 2 years may own a ~50% greater stake as nearly 1/3 of the shares have been repurchased. I've sold this kind of thing in the past at a multiple that felt frustratingly stupid to sell at. It was... but a few months later at virtually the same multiple it wouldn't have been.

All of these require various levels of creativity in assumptions. They all also have significant problems.

1: Losses & lack of consideration of future upside potential

2: these values change and really only matter if the company is going to be acquired.

3: lol it's a commodity business... I've seen 1x multiples or infinite multiples... Plus a 'normal' margin is often an imagined concept.

Supply Comments

There's another factor in the back of my mind. I could be way off base here but BC capacity has been a bit of a pain & I'd be a bit more cautious towards it. The mountain pine beetle has been... A plague might be harsh... But a blight on the local industry.

Production is down in the region, costs are up etc. it's not ideal. We may be passed the worst of it or not. If not it's bullish other areas. Most majors are diversified enough that it's not a huge concern but it's what comes to my mind on the subject.

Lumber supply has actually been flat longer than that and never regained 2007 levels despite the strong recent housing numbers.

The Recent Boom

The recent volatility that had lumber at $1000 isn't something that is in a base case to happen anytime soon. I do want to address what it meant for the companies. Those companies were able to add a tremendous amount of fundamental value per share very quickly. The acquisitions, buybacks, capex, special dividends... you name it, are something that I'm not sure is adequately represented in a long term stock chart or examination of many individual aspects. I think some of the recent valuation decline may be the 30000 foot view stock-chart looking at just another lumber cycle.

The stocks are trading at something like 2018 or even 2015 levels whereas the book value added since isn't even close. Good time pricing vs bad time pricing I guess...

Duties

The elephant in this industry is the trade dispute. Companies have hundreds of millions of dollars tied up trade duties. This uncertainty is unfortunate especially considering our countries existing trade partnership background. It's a potential persistent headache or potential windfall. I don't know how to quantify it because while I can reference how much money is on deposit and what that could amount to, I'm not sure I can handicap if, when, or to what degree a resolution is possible.

But Fundamentals...

Some events shape a generation. Some booms develop into bubbles and people use their 100% experience to tell you all booms develop into bubbles. Some busts are one in 100 year events. If that constitutes all your experience with downturns then every potential downturn will look apocalyptic. Ok, but why am I going on this random tangent in a post about lumber whose demand is linked to hoooooook.

Nothing I say about fundamentals matters to someone who believes or wants to believe that 2008 is coming. Or even, someone who believes that this ends like 2008. There are a lot of such people.

Remember how I started this post? DR Horton's most recent conference call included the words stability, stabilizing, stabilization etc. 34 times. They did so particularly in relation to pricing, costs and demand. People can't and won't believe that this isn't 2008. They're incredulous about the recent performance of homebuilders. Listening to the builders however it sounds like they think they've seen the worst of it last year and things have... Stabilized.

If (big IF I guess) they have, and the next direction is an improvement in volume, it could be quite positive for lumber. No, I'm not saying +$1000 lumber is around the corner. I'm simply suggesting that in any kind of stable market, the biggest and best lumber producers should be able to turn a profit. In my opinion, they currently aren't priced for that.

In relative terms I suppose it has stabilized. Also, and this can change quickly, the recent relative performance of the sector has been somewhat ok. Perhaps that's just within my crappy portfolio. But we have seen some insider buying in a few names over the past quarter. Not as much as the last time I followed insiders into the lumber trade but enough to get me thinking more seriously about the idea.

As for a minor commentary on some of the names I looked at:

West Fraser has long been the leader through multiple cycles. They do have a premium price to go with the paid for quality. They have OSB and pulp exposure so it isn't pure lumber price as a factor.

Canfor would be the defensive way to play it. They're sitting on a lot of cash. Enough to account for a significant portion of their market cap. This means less leverage to near term price upside but if things go poorly or take longer it might mean more opportunity for them. They also have pulp exposure.

Interfor is the pure play. It's debt is laddered out many years and should have plenty of near term liquidity. Of the three I'd say it has the best leverage to an improving market or downside in a deteriorating one. Their performance has arguably been slightly better this recent cycle.

Conclusion

For this to work out... At least as a bull... Change is needed. They lost money last quarter and likely Q1 as well. Either costs come down or price goes up. Until that happens value is lost. If it doesn't happen for months or years they might not be a bargain... If they survive at all.  Obviously I believe they will without too much damage. I also believe that buying at the perfect timing won't be obvious. Structuring when and how one might be willing to leg in is likely worth some consideration.

Hope you enjoyed!

Disclosure: I am long lumber equities in various forms including multiple names mentioned in this article.  This isn't investment advice. Please see Can Do Investing: Ground Rules for more details.