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Executives

Edward R. Seraphim - Chief Executive Officer, President and Director

Larry S. Hughes - Chief Financial Officer, Vice President of Finance and Secretary

David P. Lehane - Vice-President of Woodlands

Analysts

Daryl Swetlishoff - Raymond James Ltd., Research Division

Paul C. Quinn - RBC Capital Markets, LLC, Research Division

Sean Steuart - TD Securities Equity Research

Stephen Atkinson - BMO Capital Markets Canada

Mark Kennedy - CIBC World Markets Inc., Research Division

David Elstone - ERA Forest Products Research

West Fraser Timber L (OTCPK:WFTBF) Q2 2013 Earnings Call July 18, 2013 11:30 AM ET

Operator

Good morning, ladies and gentlemen. Welcome to the West Fraser Timber Co. Ltd. Second Quarter 2013 Results Conference Call.

During this conference call, West Fraser's representatives will be making certain statements about potential future developments. These forward-looking statements are intended to provide reasonable guidance to investors, but the accuracy of these statements depends on a number of assumptions and is subject to various risks and uncertainties.

Actual outcomes will depend on a number of factors that could affect the ability of the company to execute its business plans, including those matters described under risks and uncertainties in the company's annual MD&A, which can be accessed on West Fraser's website or through SEDAR, and is supplemented by the company's quarterly MD&As. Accordingly, listeners should exercise caution in relying upon forward-looking statements.

I would now like to turn the meeting over to Mr. Ted Seraphim, President and CEO. Please go ahead, Mr. Seraphim.

Edward R. Seraphim

Thank you. Good morning. Joining us this morning is our CFO, Larry Hughes, and a number of our senior management team.

West Fraser earned $109 million or $2.54 per share in the quarter. Adjusted earnings for the second quarter were $107 million or $2.49 per share as compared to $103 million in the first quarter.

EBITDA in the quarter was $178 million, or 20% of sales as compared to $141 million in the first quarter. Our lumber business generated $125 million in EBITDA, a decrease of $21 million from the first quarter. We produced 1.3 billion board feet in the quarter, roughly similar to our production in the first quarter. We've increased our lumber production compared to the first half of 2012 by approximately 150 million board feet.

As I mentioned during our first quarter results call, the increase in production is primarily due to the acquisition of the Edson mill and the fact that some of our capital projects are up and running in the U.S. South.

Lumber prices dropped substantially during the second quarter from the high achieved during the first quarter. High lumber prices in the first quarter reflected increased demand as U.S. housing construction improved. In addition, our first quarter results were affected by weather-related Canadian railcar shortages and most producers undershipped their production.

Our shipping limitations were overcome in the second quarter. Supply gradually outpaced demand, resulting in a decline in average pricing of approximately 14% from the first quarter. Our earnings were also negatively affected by higher purchase log cost at our Canadian operations.

We have a significant capital plan on our lumber business for the remainder of 2013. And we're in the process of commissioning one of the mills curtailed since 2008 located at McDavid, Florida. We expect that the mill will restart on a one-shift basis before the end of 2013. Construction is also progressing on the rebuild of our Edson sawmill and it is expected to begin production late in 2013.

Our panels business generated $10 million in EBITDA, a decrease of $8 million from the previous -- from the first quarter. Plywood markets are under significant pressure due to a weaker Canadian housing market, as well as inventory destocking in the quarter. As a result, the average plywood price declined 17% compared to the previous quarter.

Our pulp and paper business generated $13 -- $31 million in EBITDA, an increase of $23 million from the first quarter. Improved earnings this quarter reflected improved NBSK prices, a weaker Canadian dollar and higher income from selling power, under Alberta power purchase agreement.

In addition, despite the scheduled 2-week maintenance shutdown and our joint venture at Cariboo pulp mill, we generated improved results in our NBSK business, as the operating performance at both the Hinton and Cariboo mills improved from a difficult first quarter.

Although the U.S. housing recovery continued in the second quarter, with housing starts in North America running at a rate of approximately 200,000 units higher than the first half of 2012, the increase in North American production has outpaced the growth in lumber demand. To the end of April 2013, North American production increased by 8% compared to the same period of 2012 or approximately 4 billion feet on an annualized basis this year.

Lumber and plywood pricing have improved during the first half of July. Nevertheless, we're still very early in the recovery of the housing market. And as such, we should expect some volatility in lumber and panel markets through the remainder of the year. We expect prices of our pulp and paper products to remain similar to the second quarter as the current global excess supply of pulp is likely to persist.

With this, I'll turn the call over to Larry Hughes.

Larry S. Hughes

Thanks, Ted, and thanks to everyone joining us today. Please refer to the advisory contained in our quarterly MD&A concerning our use of terms such as EBITDA, adjusted earnings and adjusted basic earnings per share.

As Ted indicated, for the second quarter, we reported earnings of $109 million or basic earnings per share of $2.54. The table on Page 3 of our MD&A describes and quantifies several nonoperational items which affected our results. If we adjust the $109 million earnings to subtract the $12 million recovery related to equity-based compensation and add back the $11 million loss related to the translation of U.S. dollar-denominated debt, the result on an after-tax basis is adjusted earnings of $107 million or adjusted basic earnings per share of $2.49 for the quarter.

The equity-based compensation recovery reflected a weakening of the company's share price over the quarter and the loss on the U.S. debt resulted from a weakening of the Canadian dollar against the U.S. dollar in that period. On a similarly adjusted basis, results of this quarter were similar to those of the previous quarter, with adjusted earnings of $103 million and adjusted basic earnings per share of $2.42.

From an operating earnings and EBITDA perspective, our lumber and panels results declined in the previous quarter, but our pulp and paper results were much better as prices improved and income from power sales made a strong contribution. Our defined benefit pension plans are revalued as at the end of each quarter and the result this quarter was an actuarial gain of $77 million or $58 million after tax.

This actuarial adjustment will fluctuate with changes in long-term interest rates and the return on plan assets. For this quarter, the gain was due to an increase in the applicable discount rate, which was partially offset by lower-than-anticipated earnings on the plan assets.

Cash generated by operating activities during the quarter after working capital changes was $256 million, which included the seasonal reduction of the log inventories at our Canadian solid wood operations.

Capital expenditures for the quarter totaled $74 million, bringing our total to date for this year to $123 million. We are projecting capital expenditures for the total year to exceed $300 million, which will include approximately $100 million related to power production projects. Our balance sheet remains strong with a net debt to capital ratio of 5%.

I'd like to make one clarification. In our news release, we indicated that stumpage increases were set for this quarter for B.C. and Alberta. This is correct with respect to B.C., but a stumpage increase for Alberta is dependent on future lumber prices. And so although we expect an increase, it is not technically set at this time.

That concludes my comments. And operator, we're prepared to open the lines up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Daryl Swetlishoff with Raymond James.

Daryl Swetlishoff - Raymond James Ltd., Research Division

Just a first question. Ted, in your opening comments, you mentioned that purchase log costs were higher in the quarter. We noticed in our model that log costs in general were higher. Could you give any color from any other cost buckets that you saw?

Edward R. Seraphim

Well, I think, log costs were the -- we're talking about the lumber side of the business obviously, Daryl. But I mean, log costs -- and again, our R&M and our labor costs are up as well because we're spending a tremendous amount of money on dust control in the company. And so that's been a significant focus for us as well, so -- and then, we -- electricity costs were somewhat higher than the previous quarter as well in our Alberta operations.

Daryl Swetlishoff - Raymond James Ltd., Research Division

Okay, that's helpful. Are you seeing much log cost inflation in the U.S. South at this point?

Edward R. Seraphim

No, it's been very muted up until now.

Daryl Swetlishoff - Raymond James Ltd., Research Division

Okay. Just switching gears a bit. Your pulp segment, how are the pulp mills running today?

Edward R. Seraphim

Today. Actually, our BCTMP mills and our Alberta newsprint mill, they run very solid day in, day out. They are much simpler processes. In terms of our NBSK mills, Cariboo, we did have trouble there in the first quarter. We have to fix something during our -- our maintenance shutdown, but that mill has been running very well since our maintenance shutdown in May -- or sorry, in April, I apologize. And Hinton, as I've said many times, it's -- we want to see it run well for a year before we get really excited about it. But that mill has been running quite well for the last couple of months.

Daryl Swetlishoff - Raymond James Ltd., Research Division

And lastly, Ted, can you give us a bit of color on what West Fraser is seeing in the Chinese lumber market and maybe a bit of how you expect shipments to that market to evolve in the next few months?

Edward R. Seraphim

Sure. Well, I think first of all, we've seen fairly robust demand over the last few weeks. And with the drop in lumber prices, the Chinese have definitely come back into the market. So we expect demand to be quite strong over the next quarter in China.

Operator

The next question is from Paul Quinn with RBC Capital Markets.

Paul C. Quinn - RBC Capital Markets, LLC, Research Division

Just a question. You've highlighted the higher-than-expected power realizations in Alberta, maybe you could quantify that.

Edward R. Seraphim

We don't quantify those things, Paul. But I think, power prices in Alberta, those are -- I think the pool price in May was in the 200-megawatt range. So obviously, May was a strong month for us. So I think that's about all I'm prepared to share on it. But it was a strong quarter for power, but not that unusual. The first quarter was just very unusually up or -- so the second quarter was maybe, more typical of what we would normally see in that period of the year on an annualized basis.

Paul C. Quinn - RBC Capital Markets, LLC, Research Division

Okay. Then just on the lumber realizations, which is I think where I was low for the quarter, I'm just trying to understand that. I mean, I understand the law -- the lag with some of your market prices as prices are moving up and obviously, there's a lag on the way down. Does that explain all of it, or is there a little bit of a mix shift within the quarter?

Edward R. Seraphim

No, I think it's primary really lag, Paul.

Paul C. Quinn - RBC Capital Markets, LLC, Research Division

Okay. And then the last question Daryl asked on cost, just if you'd look at cost going forward, I mean, I've got your cost up 13% year-over-year, which is significant. And I can understand that the dust control mitigation efforts and some of the log price inflation that you're seeing in the Canadian operations. What's your expectations on cost going forward if we looked out a year?

Edward R. Seraphim

Well, I think as we look at the main elements, the most critical element is really our log cost, primarily in British Columbia. And so as we see those going forward, for example, in July, B.C. stumpage increased somewhere between $5 and $7 a cubic meter. So again, that's dependent on the market for both logs and also dependent on where lumber pricing is going. So we expect log costs to go up in British Columbia. We expect that our costs in our -- from an operating standpoint, will likely start to stabilize because we're doing a tremendous amount of capital throughout our -- throughout the lumber business in the company. And when we do that, naturally, our costs go up, our R&M goes up. And over the next year, we're optimistic that we'll see some of that revert back to normal. So I think the main issue is really around log cost -- in B.C.

Operator

The next question is from Sean Steuart with TD Securities.

Sean Steuart - TD Securities Equity Research

A few questions. Larry or Ted, maybe you can just give us an idea, the restart of the McDavid sawmill, what sort of capital are you guys looking at for that restart?

Edward R. Seraphim

I think, actually, to get the mill started up, the capital is very modest. But to make that a successful mill longer term, we're going to be spending some capital there. But it's $10 million to $15 million.

Sean Steuart - TD Securities Equity Research

Okay. And it's a 200 million board foot mill on a full-shift basis, is that right, Ted?

Edward R. Seraphim

Yes. On a 2-shift basis, it will be in that area, maybe just slightly less.

Sean Steuart - TD Securities Equity Research

Okay. And thoughts on potentially starting up your other idle sawmill in the South?

Edward R. Seraphim

Well, I think from our perspective, it really comes down to 2 things, markets and priorities for our -- for spending. So we've got tremendous amount of capital that we're spending in the U.S. South. Now we decided to start up McDavid because the capital involved in it isn't significant and we feel fairly comfortable about the wood basket in that area. So we've got one more mill down Folkston and we continue evaluate that. But at this time, we don't have any plans to start it back up.

Sean Steuart - TD Securities Equity Research

Okay. And then -- and Ted, just, I guess, broader perspective on CapEx plans. Even with higher spending this year, you're going to transit -- you have an overcapitalized balance sheet now and it continues to improve even with higher CapEx. Can you speak to, I guess, what you see in terms of further fast payback opportunities across your asset base and how you balance that, maybe with acquisitions going forward?

Edward R. Seraphim

Sure, Sean. I think in terms of capital, I think when we sit down and talk with investors and analysts over the last quarter or so, I think whether it's Larry or myself or others, we're really saying that we have a significant amount of catch up capital to do in the company. And we've got tremendous -- we've got a lot of power projects and a number of other things that we're working on. So our view is our run rate for capital is about $150 million to $200 million a year and we're going to significantly exceed that this year. And we've got -- we're going to exceed that probably in 2014 and 2015 as well. So I think we've got a pretty robust program over this year and the next 2 years, probably somewhat in the order of $800 million plus or minus on a 3-year basis.

Sean Steuart - TD Securities Equity Research

Okay, that helps. And then just finally and I'll let you go, can you give us an update of where things stand with respect to, I guess, new labor agreement negotiations? I think you had some expiries happening this year.

Edward R. Seraphim

Yes. I think, we have some labor agreements expiring in British Columbia in terms of our solid wood business. We aren't the first ones up to the plate. Canfor is in negotiations right now. And we expect that we'll be talking shortly after Canfor completes negotiations.

Operator

The next question is from Stephen Atkinson with BMO Capital Markets.

Stephen Atkinson - BMO Capital Markets Canada

Sorry, I just -- I couldn't find my question, but I got it now. In terms of the energy projects, we're talking about $100 million going forward still to be completed, is that correct?

Edward R. Seraphim

Well, we have 4 projects that we're in process of building. And so 2 of them are 2 energy projects that are 2 B.C. sawmills at Fraser Lake and Chetwynd. And when we announced those, we said that was $90 million in total. Those need to be completed by midyear next year. We've got our large joint venture project at our joint venture Alberta newsprint mill, that's a 63-megawatt gas-fired engine power producer, and that will start up mid-fourth quarter. And then we've got a biogas project that will be starting up, I think late next year or early the following year at Slave Lake. So as Larry said, it's $100 million this year, but there'll be still more spending next year.

Stephen Atkinson - BMO Capital Markets Canada

And I'm assuming the -- rightly or wrongly, the biogas project is probably your least profitable, if I may put it that way?

Edward R. Seraphim

No, I think we believe it will be a good project. Again, it's a $40 million project, of which $15 million of it was through the support I think of Alberta and federal governments. So no, it's a -- it will be a very good project for us.

Stephen Atkinson - BMO Capital Markets Canada

Great. And do you have any tax losses, or what is your position with regard to tax losses in the U.S. and in Canada?

Larry S. Hughes

Stephen, it's Larry. We -- at year end, we indicated that we had $335 million of loss carryforwards. And I think if you refer to the notes, our tax note in the financial statements, you can see what we have been recognizing. So that will give you an indication of where we're at with those tax losses.

Stephen Atkinson - BMO Capital Markets Canada

Okay, that's great. Yes, yes. And so finally on Hinton, I know that sometimes it runs well and sometimes not as good. Are you able to give me a bit of color on the second quarter, how it ran?

Edward R. Seraphim

I mean, I think, first of all, when -- your comment on sometimes it runs well, sometimes it doesn't, I think our view on it is slightly different. And that is we did a very large capital project there in late 2011. And it was really around the pulp dryer. And we had trouble making that run. That pulp dryer is running very well now. So the issues we had in the mill in the first quarter and that kind of spilled over in the early part of the second quarter, more around the kind of the front end of the mill in -- with some issues in the digester and a few other areas which we haven't had typically since we bought that mill. So I think we're fairly optimistic. Let's call it guardedly optimistic that we've got most of our issues behind us. But again, this is a kraft pulp mill and things do happen and we're working very diligently on preventive maintenance there. So our goal is to make sure that, that operation is as stable as the rest of our operations. So we got lots of work to do, Stephen, but I feel like we're moving in the right direction.

Stephen Atkinson - BMO Capital Markets Canada

So that -- obviously, you're going to improve the fiber supply with the lumber expansions in Alberta, so that -- can I assume, once you're finished, that this would be a first quarter mill [ph] certainly for Canada?

Edward R. Seraphim

That is our expectation for sure.

Operator

[Operator Instructions] The next question is from Mark Kennedy with CIBC World Markets.

Mark Kennedy - CIBC World Markets Inc., Research Division

I have a few questions, just want to get a little further clarification on. So I guess first of all, with your comment there, about $800 million of CapEx over the next 3 years, is that total CapEx or is that discretionary CapEx?

Edward R. Seraphim

I don't quite follow your -- but it's really our total and that's really a ballpark figure, I mean, depending on markets, cash flow. And these are projects that we see in front of us. We continue to look for more projects. So it really comes back -- this is primarily payback projects. We still have $30 million to $50 million a year of maintenance capital that we have to spend. So everything over and above that is payback.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay, okay, all right, that's helpful. And just on the stumpage issue in B.C., you're saying you're seeing stumpage costs go up sort of $5 to $7 a cube here on July 1. How does that formula work? Like given the pullback in pricing, do you think you see any stumpage relief as you move out into the latter part of this year or early part of next year? Or is this sort of generally going to be more of a one-way train?

Edward R. Seraphim

No, I think that given where lumber markets are today, if they stay where they are today, we will see some relief in the fourth quarter.

Mark Kennedy - CIBC World Markets Inc., Research Division

It's about at least a 3-month lag or so?

Edward R. Seraphim

That's correct, yes.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay. But it's my understanding, the way the formula works though, as far as the increases, you get the biggest increases in July every year, is that right?

Edward R. Seraphim

I think, to give you the best answer, we've got Dave Lehane who is our VP of Woodlands. And I think maybe Dave could give you a more detailed answer than I could, Mark, if that would be helpful.

Mark Kennedy - CIBC World Markets Inc., Research Division

Sure, that would be great.

David P. Lehane

Mark, I think as you're pointing out, the B.C. stumpage system is updated in 2 ways. And once a year, the regression or the formula is updated based on bidding behavior in the B.C. timber sales program. That update occurs on July 1. And in addition to that, there is a market update every quarter. So what we saw on July 1 was a combination of a new equation, as well as an update based on lumber markets. So we saw an average in the interior of $5 to $7 increase. And that lumber market is based on a 3-month average, with a 2-month lag. So when you look at -- look forward to October 1, there will be another adjustment in October. And our outlook based on market is that we'll see in B.C. a stumpage decrease across the interior.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay. Yes, that's very, very, very helpful, David. Okay. And then just a question, Ted, I guess, coming back to your mills in the U.S. South, could you just give us an update sort of as to -- would you say you're now -- like I think you've got what, 13 now, soon-to-be 14 operating sawmills there. And would you say that half have been updated at this point? Or how far are you in terms of their modernization program?

Edward R. Seraphim

Well, first off, we have 14 sawmills in the U.S. And then with McDavid starting up, we'll have 13 running. So 13 out of 14. And then in terms of our capital spending, by the end of this year, we'll probably be around 2/3 completed in terms of the capital we're spending. And our goal is to have this completed like -- largely by late 2014 or early 2015.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay. And then in terms of just the U.S. market tone you're seeing now, are you seeing sort of stronger takeaways in the last month kind of thing, relative to where we were earlier in Q2? And also, if you can just give any color as to where you think the inventory levels in the distribution system are there as well?

Edward R. Seraphim

Well, I think in terms of the market, we have seen a pretty positive increase since late June in the marketplace. Futures, the July futures were around $2 -- they closed around $2.90 and September futures today are around $3.30. The cash market is up about $35 from late June. And so what we're seeing is in terms of -- and again, the data in the lumber market is, as you know, in terms of inventories is not as clear as it is in say pulp and in other grades. But fundamentally, we do think that inventories are moving in the right direction. And we're relatively optimistic, but again, we still believe we're early in this recovery. So we do believe there is going to be bumps ahead as we look at the remainder of the year.

Operator

The next question is from David Elstone with ERA Forest Products.

David Elstone - ERA Forest Products Research

So I just want to -- not to belabor the stumpage question, but when you -- when we have the increase of the $5 to $7 cubic meters on July 1, does that -- will you feel the impact in that quarter or how does that filter through based on your purchasing of logs?

Edward R. Seraphim

Dave, do you want to answer that question?

David P. Lehane

Yes. And certainly, the $5 to $7 is an average across the interior. And that'll be -- that will move depending on mix and haul distance and operating area. And it is -- it's in place for log deliveries from July 1 and it will also, if you look at our results, be somewhat muted by inventory.

David Elstone - ERA Forest Products Research

Well, so it'll be more of a filtered process, not immediately, you won't see the full impact in Q3 there?

David P. Lehane

That's right.

David Elstone - ERA Forest Products Research

Okay. And just to look at the -- your log costs in general, just based on the B.C. Ministry of Forests, B.C. Interior log prices, in Q1 or in Q2, the trend is a jump of about 20% before that stumpage increase. Do you anticipate that log cost to -- that trend to continue? And then what's been sort of the drivers behind that, you said the jump in delivered log costs?

David P. Lehane

There's a number of factors and certainly, there are rate pressures. We have a good mix of contractors. The contractors are under pressure for labor costs and labor availability and that flows into rates. That's not a big number, but it certainly has an impact. We're seeing in certain parts of B.C. aggressive bid behavior in the private wood sector. And we're also starting to see increases in stumpage. So I think we've seen a big increase in log costs and over time, I think that's going to flatten.

David Elstone - ERA Forest Products Research

Okay. Is there any impact from the beetle with regards to the beetle having an impact on the costs or...

Edward R. Seraphim

David, it's Ted. I think in terms of -- for this call, if you'd like to have more detail, maybe you should just give us a call afterwards. But generally speaking, again, for our company, about 45% of our production is in British Columbia and we are very focused on what's going on here in British Columbia. But what gives us, I guess comfort is one, we're spending money in investing in our mills in British Columbia. And secondly, we've got a significant exposure in Alberta and the U.S. South. But B.C. will be a challenge. There's no question as we manage supply and -- but ultimately, it's very difficult for us to predict where log costs are going to be going because a lot of it has to do with behavior of our competitors as well as ourselves.

Operator

[Operator Instructions] There are no further questions registered on the telephone lines at this time. I'd now like to turn the meeting back over to Mr. Seraphim.

Edward R. Seraphim

Well, again, thanks everybody for participating. And if you've got any further questions, we're available to answer them through the rest of the day. And enjoy your summer and we'll talk to you in a few months. Thank you.

Operator

Thank you. The conference call has now ended. Please disconnect your lines at this time. Thank you for your participation.

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