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Executives

Henry Ketcham - Chairman, Chief Executive Officer and President

Gerald Miller - Chief Financial Officer and Executive Vice President of Finance

Edward Seraphim - Chief Operating Officer and Executive Vice-President

Analysts

Sean Steuart - TD Newcrest Capital Inc.

Stephen Atkinson - BMO Capital Markets Canada

Paul Quinn - RBC Capital Markets, LLC

Daryl Swetlishoff - Raymond James Ltd.

Pierre Lacroix - Desjardins Securities Inc.

West Fraser Timber (OTCPK:WFTBF) Q2 2011 Earnings Call July 22, 2011 11:30 AM ET

Operator

Good morning, ladies and gentlemen. Welcome to the West Fraser Timber Co. Ltd. Second Quarter 2011 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 depend on a number of assumptions and are 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 as 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. Hank Ketcham, Chairman, President and Chief Executive Officer. Please go ahead.

Henry Ketcham

Thank you, operator, and good morning, and welcome to West Fraser's second quarter conference call. Today, I'm joined by all our vice presidents, including Gerry Miller, our Executive Vice President, Finance and CFO, who'll be retiring at the end of this month after 25 years with the company.

Yesterday, we reported net earnings for the quarter of $10 million and EBITDA of $62 million. Gerry will discuss our financial performance more fully in a few minutes. Our major operating divisions performed well during the quarter with the exception of our U.S. sawmill division, which continues to be hampered in many instances by a lack of investments in efficiency enhancing technology over the years.

We've embarked on a capital program to modernize many of these mills to substantially improve their relative cost positions.

Our Canadian sawmill division continued to run at full capacity and performed well during the quarter. The benchmark lumber price expressed in Canadian dollars declined by 20% during the quarter, primarily as a result of increased North American production and the strengthening Canadian dollar. Log cost increased by 17% during the quarter due to spring breakup when our overhead costs are not offset by log deliveries. Manufacturing cost in our Canadian sawmill division were flat quarter-over-quarter, while lumber recoveries improved somewhat. Lumber shipments were slightly above production for the quarter. Direct and indirect shipments to Japan and China accounted for over 30% of our overall shipments, representing our strongest period of lumber exports ever.

While Japanese shipments remained stable quarter-over-quarter, our shipments to China increased substantially.

Unseasonably wet weather in many of our Canadian operating areas is significantly impacting log supply at several of our sawmills. While we don't anticipate any unscheduled downtime due to lack of logs, our inventories are quite low at certain mills. While the Canadian mills operated at full capacity during the quarter, our U.S. mills operated at 78% of the capacity, up from 75% in the first quarter. The discrepancy in operating rates between our Canadian and U.S. mills represents the difference in technology and efficiency between the 2 divisions.

As I've said, we're focus on significantly improving the performance of our U.S. assets as quickly as possible. During the quarter, benchmark southern yellow pine prices declined by 14%. Shipments were up fairly significantly, while manufacturing costs declined slightly and log costs remained stable.

Our panel division, which includes plywood medium-density fiberboard and laminated veneer lumber, continues to be challenged due to historically low housing starts in the U.S. and the strong Canadian dollar, which has resulted in a significant increase in U.S. plywood imports into our home market. This has driven plywood prices down by 20% versus the same period last year, while log prices have increased by about 12% over that same period of time.

MDF and LVL prices have remained steady, and our 3 plants are operating on a reduced basis to match production with demand.

Our pulp division also performed well during the quarter. Production and shipments were slightly better than the previous quarter, even though we took our planned 13-day maintenance downtime at our joint venture Cariboo pulp mill. In addition, we lost 8 days of production at our mechanical pulp mill in Slave Lake, Alberta, as a result of the forest fire in May. Kraft pulp prices were up 4% quarter-over-quarter on a Canadian dollar basis.

Since the end of the second quarter, kraft pulp prices have declined due to reduced purchasing from China. BCTMP prices were down slightly during the quarter. Our BCTMP business continues to be quite profitable. The price gap between BCTMP and kraft pulp has widened significantly since the second quarter of 2010, which has had a material impact on our pulp earnings.

Our joint venture newsprint mill ran well during the quarter. Newsprint pricing declined 2% in Canadian dollars. In our pulp and paper division, fiber costs were up by 7% and our net electricity costs were substantially higher due to lower revenue from our Alberta power purchase agreement.

We expect to fully commit the $88 million of green transformation funding to several high payback capital projects at our pulp mills, which will reduce our overall energy cost. Spending on these projects will be completed over the next 9 months and will further enhance the competitive position of this division.

Our capital spending program is progressing well, and we expect we will spend about $180 million by the end of the year, excluding spending related to the Green Transformation Program. We spent $48 million to date, net of Green Transformation fund reimbursements from the federal government.

Subsequent to the end of the second quarter, we closed the sale of our -- in our sawmill assets and expect to complete the sale of our remaining Eurocan assets in the next several months. With respect to the pending softwood lumber arbitration filed by the U.S. against the B.C. interior lumber industry, we're working closely with our provincial and federal governments to aggressively defend our interests. The arbitration is scheduled to take place in the latter part of February 2012. While we believe we have a very strong defense, it's not possible to predict the outcome or potential liability at this time.

The mountain pine beetle epidemic continues to affect our bottom line due to reduced grade recovery, lumber recovery and efficiency. In Alberta, the beetle outbreak continues to grow, albeit, at a significantly slower rate than we experience in British Columbia due to colder winters and a more aggressive response by the Alberta government and industry.

In June, a devastating forest fire destroyed parts of the town of Slave Lake, Alberta, where we operate both a veneer mill and a pulp mill. While our mills were not damaged, many of our employees lost their homes and possessions. Thanks to the dedication and hard work of our -- all of our employees, all of whom are dealing with their own very significant personal issues, we only lost 7 days of production at our veneer mill and 8 days at our pulp mill.

Looking forward, we don't see a recovery in the U.S. housing market in the near term. As a result, we'll probably continue to see some volatility in lumber prices until we see a more sustained recovery. We believe Chinese consumption will continue to grow as their economy develops. We're excited about this growing market, and West Fraser will continue to devote all necessary resources to expand our business in China and throughout Asia.

With respect to pulp pricing, we expect BCTMP prices to stabilize at current levels for the next few months, while kraft pulp prices could weaken a bit more through the end of the year.

We expect our cash flow will continue to support our strong capital spending program through 2012, while maintaining a very strong balance sheet.

I'll now turn it over to Gerry Miller.

Gerald Miller

Thank you, Hank, and good morning, everyone. For the second quarter, we reported earnings after discontinued operations of $10 million and basic earnings per share of $0.24. The diluted earnings per share calculation has changed significantly under IFRS from previous Canadian generally accepted accounting and for this quarter results in a dilutive loss of $0.09 per share.

IFRS requires that the recovery on the revaluation of our cash-settled share option plan be deducted from earnings and calculating the numerator in the calculation. I refer you to Note 14 of our interim financial statements for details related to the earnings per share calculation.

Note that in periods where there is an expense on the revaluation of outstanding share options, diluted earnings per share are not increased as diluted earnings per share cannot be in excess of basic earnings per share.

Earnings per share adjustments renewed long-term equity based compensation, the foreign exchange gain on long-term debt and the Eurocan discontinued operation was a loss of $0.09 per share in the quarter. EBITDA for the quarter was $62 million compared to $80 million in the first quarter. Adjusting EBITDA to remove the long-term equity based compensation announcement results in an adjusted EBITDA of $48 million in the second quarter compared to adjusted EBITDA of $106 million in the first quarter.

The majority of the EBITDA difference was due to sharp lumber price declines in the quarter and higher Canadian log costs. Log costs are normally higher in the second quarter than in the first quarter as the company expenses its fixed forestry cost in the second quarter as log deliveries in Canada in the second quarter are reduced significantly due to spring breakup conditions.

The company's effective tax rate for the quarter was 35.6% compared to a statutory rate of 26.5%. The full reconciliation of the tax rate is in Note 12 to the interim financial statements, but the 2 main items are that the equity based compensation recovery is primarily nontaxable and a change in the tax evaluation allowance in the quarter of $5 million was recorded.

IFRS requires the company to revalue its defined pension benefit plans at each period end with actuarial changes flowing through comprehensive earnings. For the quarter, the net impact of the revaluation was a charge net of income taxes of $39 million. For the year-to-date, the charge was $8 million net of taxes. The actuarial gain or loss will fluctuate the changes in long-term interest rates and the return on planned assets.

Cash generated from operating activities during the quarter before working capital changes was $54 million and after including working capital changes, cash generated was $115 million compared to the previous quarter where cash generated before working capital was $33 million, and cash used after working capital changes was $57 million.

The most significant change quarter-over-quarter was the cash provided by the reduction in log inventories during the spring breakup period and the payment of income taxes in the first quarter of the year.

In the quarter, we invested approximately $35 million net of Green Transformation funding received in capital improvements. The majority of this investment relates to the capital investment program that we announced in the fourth quarter of last year. Liquidity at June 30 remains very strong, with cash on hand of $134 million and the net debt-to-capital ratio of 9%.

Hank, that concludes my comments. I'll turn it back to you.

Henry Ketcham

Okay, thank you, Gerry. And we'll open it up for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We do have a question from Daryl Swetlishoff with Raymond James.

Daryl Swetlishoff - Raymond James Ltd.

First question is just related to -- if you could give some more color on log costs, the delta, how much of that would be due to diesel and other things with what we could expect to be ongoing? And how much would be variable with respect to, say, lumber pricing and stumpage?

Gerald Miller

Daryl, it's Gerry. I think the largest part is related to the kind of our period cost from the second quarter where we don't have an inventory to roll that through, so it gets charged directly in earnings. And, of course, we're also cutting logs that are in inventory, and those have -- those kind of cost -- in their cost from previous quarter. So the second quarter, there's always an increase in our log costs as a result of that.

Daryl Swetlishoff - Raymond James Ltd.

Okay. Maybe asking just slightly different. Can we get some guidance on what you expect the delta might be in subsequent quarters, third quarter, fourth quarter?

Henry Ketcham

We think log prices in Canada are going to go up relating to fuel costs, haul distance and general pressure on the contractor community. So we do expect to see log costs rising throughout the rest of the year.

Daryl Swetlishoff - Raymond James Ltd.

Okay. Switching gears just a little bit. Hank, could you comment on just logistics with respect to getting your part to market? I know you mentioned some of the issues with respect to shipments in the quarter, but I'd also be interested in some of the measures you've taken to try to improve the flow of lumber to offshore markets like Asia, China for instance.

Henry Ketcham

Well, there's a ton of product going over there from a lot of producers. So there's some pressure, but we're doing some great bulk shipments to China to take the pressure off the container business. But currently, we're able to ship what we need to ship over there.

Daryl Swetlishoff - Raymond James Ltd.

Given the growth rates that we've seen and just based on your comments where you think that markets could keep growing, any concerns down the road in terms of the ability to service that market, just again, from not a production point of view, but logistical or you think you'll be in good shape?

Henry Ketcham

Well, no, I think there's always going to be -- there's going to be pressure, so we're just going to have to continue to look for alternatives and make sure that ports in Prince Rupert and in Vancouver are doing the stuff that they need to do to give us the capacity, work with the railroads, work with the trucking companies. So obviously as shipments grow, we're going to have to continue to find ways to make sure that they move smoothly. But as I said, at the current time, shipments are moving the way they need to.

Daryl Swetlishoff - Raymond James Ltd.

Last question. Given the weakness in the U.S. market, obviously, China is a bigger factor now. If you have to guess, what do you think the impact of China is on the Western SPF posted price today? Is it $30, $50, $60, $1000? What's your guess?

Henry Ketcham

I don't think we'd want to guess at that. Certainly taking the pressure off the North American market, but I would not hazard a guess on that.

Operator

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

Paul Quinn - RBC Capital Markets, LLC

Just a couple of questions and maybe a clarification, just to start. I understand, Gerry, that log costs were up for Q2, and I understand the reason behind that. But it sounded like Hank was saying that he expects rising log costs for the balance of the year. How do you reconcile those 2?

Gerald Miller

Sorry, Paul, just ask that again.

Paul Quinn - RBC Capital Markets, LLC

So we had a higher log cost, and it looks like we're up 12% primarily on fuel in Q2 in these forestry expenses. Are we seeing a delta between our log cost between Q2 and Q3? And then what's the expectation that log costs move up from Q3 to Q4? Is that the way I should read that?

Henry Ketcham

Well, I think it's 2 pieces. The period costs when we're really not bringing in any logs, there's no fuel in there. I mean, those are kind of variable costs with bringing logs in. So it's kind of a fixed cost thing that we allocate or we're taking to the P&L. As we get into Q3 and Q4, we start logging again, then we're going to see the pressures of higher fuel costs and all those things. So it's kind of 2 different cost items, and I don't know in Q3 whether we're going to see higher log costs necessarily than Q2, but certainly there's going to be pressure from rising fuel and other costs as we get into a new logging season.

Paul Quinn - RBC Capital Markets, LLC

Okay. Then a question on the BCTMP. In the MD&A, you mentioned impending new supply in China. I was just wondering what that was. And then, could you get a read on your long-term or actually even your medium-term outlook for BCTMP on both supply and demand?

Henry Ketcham

Let Ted Seraphim.

Edward Seraphim

Paul, in terms of new supply, the new supply has been coming on in China. BCTMP, I think it's ramping up. The BCTMP has brought on a fair amount of capacity and that's ramping up and a few others are bringing the capacity on. And in terms of your second question, in terms of -- what's your second question again with pricing?

Paul Quinn - RBC Capital Markets, LLC

Just if you could give me a feel for your medium long-term supply-demand outlook for BCTMP? Is that going to be balanced? Is it going to be short? Is it going to be long?

Edward Seraphim

Well, I think that's a difficult one to answer. I think at the end of the day, it's not a large market, about 4-million-ton market. So if demand does not meet capacity, we will see capacity come out. It doesn't take a lot of capacity to come out. I mean, our whole view is being focused on being a low-cost producer and with that expectation, we believe that it will be a good business for us to be in. If demand is not there, high-cost folks demonstrated that they will go away.

Paul Quinn - RBC Capital Markets, LLC

Okay, I get your point. Okay. And just switching back to lumber finally here. Hank, you mentioned this lawsuit [ph] lumber dispute. I understand early August, it looks like the U.S. will file their petition. What are we expecting in terms of the dollar figure?

Henry Ketcham

We don't have the faintest idea, but really can't predict that at this point in time. But you're right, it'll be a lot clearer mid-August and we got -- we're really -- we got all of the forces we have here in Canada working on this, and we think we have a strong, strong defense, and we're going to defend it right to the end.

Operator

The next question is from Sean Steuart with TD Securities.

Sean Steuart - TD Newcrest Capital Inc.

A couple of clarification questions, I guess, for Ted. Just revisiting BCTMP, I appreciate your color on the market there. Just wondering if you can reconcile Hank's comments in the early part of the call, saying he expects prices to sort of settle out where they are now and versus what we're seeing in softwood, which I would argue is seasonal correction and inventory destocking. Maybe just talk a little bit about what you're seeing in your order books for BCTMP that differentiate the expectations in price momentum for that grade versus softwood.

Edward Seraphim

Well, I think first of all, as Hank noted, I think that BCTMP prices fell quite dramatically actually, second half of 2010. And I think we're at the point now where the price differential is quite large, even though NBSK prices are falling. And because of that, we've seen frankly, -- because of the large grade differential, we've seen very strong order books in our BCTMP business throughout this year, and we see that at least through the third quarter.

Sean Steuart - TD Newcrest Capital Inc.

Got it. And then just a point of clarification. I won't go through the log costs rationale for the increase again, but I heard a couple of different numbers. Hank, were log costs up 17% quarter-over-quarter? Is that the right number?

Henry Ketcham

I believe so.

Operator

[Operator Instructions] Your next question is from Pierre Lacroix with Desjardins Capital Market.

Pierre Lacroix - Desjardins Securities Inc.

A question coming back on the log cost, sorry about that. But in the U.S. South, have you noticed any kind of impact coming from the fuel pressure?

Henry Ketcham

U.S. South log comps are pretty flat.

Pierre Lacroix - Desjardins Securities Inc.

Okay. So basically the fiber itself is offsetting the pressure coming from the fuel, I guess.

Henry Ketcham

Try that once again?

Pierre Lacroix - Desjardins Securities Inc.

But the fuel is the same, I guess, in the U.S. South, so I guess it's offset by some other items for the overall log costs is pretty much flat, I guess?

Henry Ketcham

Yes, that's correct. Something's kind of offsets the increase in fuel costs.

Pierre Lacroix - Desjardins Securities Inc.

Okay, perfect. Just want to have your view on the panel profitability now. We are on the negative territory. I think it's the first time for many years that we see that. How do you see the outlook for the profitability going in the next couple of quarters and into 2012, especially that the currency still pressure your results there? So can you give us some kind of outlook there?

Henry Ketcham

I hesitate to do that. I mean, currency is unpredictable. It's strengthening, so we don't really know where that's going to go. But obviously, our rising currency on the short term affects profitability. We have not been -- I don't think anybody has been a very good predictor on lumber consumption. So I don't think we're going to try to do that either. I think we just have to take it quarter by quarter. And again, I think we have to read this with you that we're really focused on being low-cost producer, have great plans, modern, efficient. We got a large capital spending program that is going to drive costs even lower. We're well in the middle of that right now. And in the U.S. South, we're really focused on turning some of those higher cost mills into low cost mills. In the South, it's going to take a little bit longer because we've got a lot of capital we've got to spend. But in Canada, both in our pulp and lumber divisions and panel divisions, we've got great assets. And I guess all I can say is we're just going to keep doing what we do.

Operator

Your next question is from Stephen Atkinson with BMO.

Stephen Atkinson - BMO Capital Markets Canada

To begin with, in looking what's going on with the log costs, were you -- historically, I would say, the profitability of the U.S. South assets would be similar to Canada. Certainly, if you have a 17% increase in log costs and you got a currency running up, I think it would make more sense to increase production in the South and when appropriate, pull back in Canada. Is that a good way to look at things?

Henry Ketcham

Well, we just -- I'd say we look at this weekly as to where we can -- what our operating rates should be in every single one of our mills, and what our cost structure is and that's just a weekly process for us, Stephen.

Stephen Atkinson - BMO Capital Markets Canada

Okay, but I guess it would be safe in saying that the U.S. South is going to be a low-cost area considering what's happening with currency and Canadian log costs.

Henry Ketcham

Well, you got to take into account lumber selling prices down there as well, and they've been tough.

Stephen Atkinson - BMO Capital Markets Canada

Okay. And how much -- are you able to tell us how much you're shipping to China and Japan right now?

Henry Ketcham

In terms of actual volume?

Stephen Atkinson - BMO Capital Markets Canada

Yes, or just percentage or whatever you're comfortable with.

Henry Ketcham

Well, I think we're roughly -- it's hard for us to accurately predict, because some of it is indirect, some of it is direct. But our direct shipments are somewhat around 25%, and then we got indirect shipments on top of that, which I mentioned earlier in the call. We estimate somewhere around -- it's just an estimation on our part, but somewhere around 30%, 35%.

Stephen Atkinson - BMO Capital Markets Canada

Overall?

Henry Ketcham

Overall.

Stephen Atkinson - BMO Capital Markets Canada

Okay, out of BC and Alberta?

Henry Ketcham

Yes, out of the Canadian operations.

Stephen Atkinson - BMO Capital Markets Canada

Yes, right. Were there any inventory write-downs in the lumber or panels or anything?

Edward Seraphim

No, not very significant, Stephen.

Stephen Atkinson - BMO Capital Markets Canada

How about the impact of Slave Lake, are you able to quantify it? Is that significant or were some -- any costs covered by insurance?

Henry Ketcham

No, it's not really significant, probably nothing covered by insurance. Seven days of downtime at veneer and pulp. And then we had to shut down our -- we took a little bit of time out of our plywood plant in Edmonton, but it's not like we're making a lot of money in those businesses right now. So it hasn't had -- not a really material impact.

Operator

That concludes today's Q&A session. I would now like to turn the meeting back over to Mr. Ketcham.

Henry Ketcham

Okay, thank you. I guess just to clarify log costs, they were up 17% in the quarter. That's not the base on which they're going to be rising going forward. I hope you understand, it was a fixed cost. They're not covered by volumes. So we expect a much more modern increase in log costs from a base in the first quarter. I think I just wanted to clarify that.

And I guess, finally, if there are no more questions, I think all of us, as vice presidents, we're here to wish Gerry Miller a great send out. He's been with us for 25 years. He's been an outstanding part of our team. And fortunately, he's left a bunch of outstanding people to fill in for him. So again, we want to thank you for joining our call, and we'll talk to you next quarter. Thank you.

Operator

Thank you. The conference has ended. Please disconnect your lines at this time. And we thank you for your participation.

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