Canfor is a Canadian-based lumber company which provides integrated lumber-based products, primarily softwoods, to the US and Canadian markets. The company owns assets in British Columbia, Alberta and the US, primarily in the Southeastern states. Most of their sales go to a diversified set of end-markets and retailers including Home Depot and Lowe’s as well as the homebuilders.
We think the growth in single-family home sales in the US is likely to drive higher lumber demand and prices benefiting Canfor. The shares sold off after their fourth quarter results and did not recover following the first quarter earnings release despite strong demand. We think this is an opportunity for investors as they digest some recent bolt-on acquisitions in the Southeast US creating upside to their cash flow generation.
Tailwinds To The Business Compounding
The company is clearly levered to the US and Canadian housing markets which we believe is slowly gaining traction. In Canada, the housing market saw another strong and steady year with starts above the 20-year average. This was offset by some softness overseas, namely in China and Japan with the former a bit weaker from slower economic growth and the latter due to an implemented consumption tax.
Other issues that have affected the performance of the business have been the Mountain Pine Beetle infestation on their fiber acreage in British Columbia leading them to shutting their Quesnal Sawmill. This was in conjunction with the sale of the Daaquam mill in Eastern Canada. The latter was a high-cost operation that utilized spruce-pine-fir lumber. In all, the company has been rightsizing their cost structure towards being a low-cost provider- which they label as a top quartile margin performance.
With 2013 and 2014 all about reducing their cost footprint, adding the right capacity, and taking advantage of industry dynamics, the company is set to benefit from strong trends that are likely to drive performance. In 2012, the company had one of the lowest EBITDA/Mfbm of the top five producers but after the above adjustments of their operations, saw that ratio rise to the top by late 2013 and 2014.
We think US housing starts are a key factor but not the only one. US housing starts have been significantly below trend for more than half a decade and now have more than accounted for the overcapacity added during the 2000-2008 time period. We believe that housing starts will continue to mean-revert to the long-term average around 1.4 million starts. In May, housing starts did pull back a bit to an annual rate of 1.04 million units after hitting a seven-year high in April. However, permits, a leading indicator for starts, surged another 12% in May to an annual run rate of 1.3 million, the highest since August 2007. We think this will lead starts higher over the next several months.
We believe the fundamentals of the US housing market are continuing to slowly improve as job gains, income gains, and pent-up demand coupled with still very low mortgage rates are creating significant upside pressure to new home building. We also think some easing of access to credit has finally materialized and is helping those without top tier credit scores to get a mortgage.
But aside from housing starts, demand from other sources like renovation activity, industrial demand, mobile homes, and non-residential industry strength are also strong drivers for lumber demand. RISI, a high-quality third party researcher, estimates US lumber demand rising from 40 billion board feet in 2014 to 53.5 billion by 2019, a 6% CAGR.
But outside of the US is where a significant portion of the growth has been and will likely continue to occur. China has been one of the main importers of lumber in the last decade but we think the shift in product mix towards high-grade fiber is likely to drive results for Canfor. In 2007, China’s imports consisted of 93% low-grade and 7% of #2 grade (second lowest grade). Last year, those figures changed radically with 59% coming from low grade, 19% from #2 grade, and 21% coming from prime. This is opening up an opportunity for companies like Canfor who primarily operate within the prime fiber categories to export greater quantities even if there is a slowdown in overall Chinese demand
Southern Lumber Company Purchase And Integration
In September of last year, the company announced the acquisition of the operating assets of Southern Lumber Company. The purchase included new sawmill assets located in the Southern US, which has a capacity of 90 million board feet. We think the business is likely to add significant cash flow possibilities as well as expand margins due to the high-quality fiber supply location in addition to substantial export opportunities available. The company used USD $50 million of cash on hand to finance the acquisition.
The acquisition follows one late last year of Beadles and Balfour assets in Georgia which consisted of two sawmills with a combined capacity of 210 million board feet. This is another strong performing asset in a high-quality and sustainable location of fiber. The acquisition takes place over two years with 55% being acquired as of Jan. 2015 and the balance after a two-year period.
We think the two acquisitions, along with another 2014 acquisition in Alabama, will be beneficial in two respects. Integration of these assets is ongoing with it being combined with their assets in the Carolinas and Alabama. The high-quality fiber in the region should help expand margins in addition to the synergies realized through the integration process. We think cash flow should increase markedly given the ~15% increase in board capacity overall. Secondly, these acquisitions give them more opportunity to export to overseas markets. We believe the company can benefit from the rising global demand for high value grades of lumber with exports to China, India, and other emerging markets rising substantially.
Canadian Dollar Advantage
The company now has 55% of its sales in the United States and approximately 45% in Canada. This means the weakness of the Canadian dollar over the past year, with USD/CAD going from ~CAD$1.03 to over ~CAD$1.25 per dollar, has been beneficial to their Canadian export operations. We calculate that every penny drop in the Canadian dollar adds another $15 million in EBITDA for the company.
In the first quarter of 2015, the company’s lumber sales realization reflected that favorable impact as the Canadian dollar weakened another 9%, or US$32 per Mfbm, to US$308 per Mfbm in the current quarter. This helped more than offset some lower US dollar lumber prices which we think is likely to reverse from the adverse weather-related issues that plagued the US in the first quarter.
Should the Canadian dollar rebound, something we don’t foresee without a significant rebound in crude price- results could be likewise effected. However, the beauty of the operation is that they can initiate exports from their acquired assets in the US or simple reconfigure their supply to the most beneficial structure to the current currency environment.
The shares are cheap despite being a commodity business trading at just 10.5x forward earnings and 7.2x ttm EV/EBITDA. Compared to their primary competition, the company trades at a discount to their peer group. The median average for the comp group is 8.9x ntm EV/EBITDA compared to 6.7x for Canfor, a 26% discount. Some of this can be attributed to their Canfor Pulp Products (OTC:CFPUF) business which is in the papermill business. However, this piece is approximately one-quarter of the business and we think the pressure applied to the share price of Canfor is too strong.
We are modeling that the tailwinds we discussed above should boost EBITDA to over $600 million from $425 million this year. Even using the weaker multiple than we feel is warranted, the intrinsic value comes out to over $31, a significant premium to the current trading price. Any multiple expansion given their premium efficiency of their operations would be additive to that number.
We think the market is missing the strong upside potential in some of these lumber operations. Canfor is one of the premier names operating in the high-end grades which carry better margins and are increasingly in higher demand in Asia. The company completed an operational restructuring last year reducing their cost footprint. With 45% of their operations in Canada, the weaker Canadian dollar is providing a strong tailwind to their results. Additionally, the slew of recent acquisitions in the US South are in the process of being integrated and should become cash flow contributors in the next few quarters. We see an opportunity for the shares to reach $30 over the next several quarters.
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