Interfor Corporation (OTC:IFSPF) Q1 2016 Earnings Conference Call April 29, 2016 11:00 AM ET
Duncan Davies - President & Chief Executive Officer
John Horning - Executive Vice President & Chief Financial Officer
Martin Juravsky - Senior Vice President, Corporate Development and Strategy
Bart Bender - Senior Vice President, Sales & Marketing
Mark Wilde - BMO Capital Markets
Paul Quinn - RBC Capital Markets
Sean Stewart - TD Securities
Hamir Patel - CIBC Capital Markets
Good day, ladies and gentlemen. Welcome to the Interfor First Quarter 2016 Analyst Call. Today is Friday, April 29, 2016. As a reminder, this conference is being recorded.
At this time all participants are in a listen-only mode. Following the presentation we will conduct a question-and-answer session. [Operator Instructions]
I would now like to turn the meeting over to Mr. Duncan Davies. Please go ahead sir.
Thanks very much Ileana. Good morning everyone and thanks for joining us. I'm here this morning with John Horning and Martin Juravsky, our CFO and Senior Vice President of Development and Strategy respectively to provide an overview of Interfor’s first quarter 2016 results.
Also joining us is Bart Bender, our Senior Vice President of Sales & Marketing, who will comment on the current state of the lumbar market, and on our outlook for the next few quarters later in the call. I know this is a busy time for you, so I'm going to keep my remarks as brief as I can. I will turn the meeting over to you for questions quite quickly.
From a bottom-line standpoint the first quarter of 2016 was for all intents and purposes flat versus the fourth quarter of 2015, despite higher production and sales volumes and higher product prices. EBITDA calculated to exclude one-time items and the effects of long-term incentive compensation accruals was $33.4 million versus $35.8 million in the fourth quarter last year.
Factors which constrained EBITDA in the first quarter included lower log production and sales volumes in our B.C. Coastal operations, due almost entirely to seasonal factors; higher log production costs in the same region due to an increase in the percentage of helicopter logging; and changes in the sales mix, again on the B.C. Coastal, which had the effect of reducing sales values and profitability in that region.
We also had some unusual variances in quarter-end log and lumber inventory reserve adjustments driven by technical accounting rules, which had the effect of favoring our fourth quarter results versus those in the first quarter to the tune of about $3 million.
Production was up 50 million board feet in the first quarter versus the fourth quarter to 618 million board feet, primarily as a result of the ramp-up of productivity at Castlegar, and the return to a more normal operating schedule at Georgetown, South Carolina, which was hampered in the fourth quarter by the severe flooding that occurred in that region in early October.
The increase in production at those two facilities accounted for a little more than 40% of the volume increase delivered in the first quarter. The balance was due to a combination of additional operating days in the first quarter and higher productivity levels at a number of other mills.
From a production and capacity standpoint, our mills in the US South produced 265 million board feet in the first quarter, which equates to an operating rate of a little more than 80%. Our interior mills produced 171 million board feet, which equals 92% of rated capacity. The Northwest 143 million board feet or 88% of rated capacity and the coast 39 million board feet or 49% of rated capacity. Total sales in the quarter were 637 million board feet, including 28 million board feet of wholesale or commission product.
From a pricing standpoint the SPF Composite was up $6 US or 2% in the first quarter, while the Yellow Pine Composite that was up $20 or 6%. The stud market, which is an important market for us in the Pacific Northwest was mixed for the first quarter.
Hem-Fir 2x4 kiln dried 9 foot, which we use as our normal benchmark was up $38 or 13% in the quarter, while 8 foot kiln dried 2x4 was up $6. Green Hem-Fir studs 8 foot 2x4, which is a key product at our Longview mill was down $33 quarter-over-quarter.
All in, average sales returns were up 4% quarter-over-quarter to $548 per thousand board feet. From a cash flow standpoint, Interfor generated $31 million from operations before changes to working capital [Indiscernible] after changes at working capital were considered.
Capital spending amounted to just less than $18 million in the quarter, down from $25 million in the fourth quarter and almost $28 million in the first quarter of 2015. The primary projects in the first quarter included $2.7 million of the Castlegar rebuild, $2.3 million on an auto grading system at Swainsboro, $1.4 million to replace the log ladder at Port Angeles, and $1.8 million on a multifaceted project to upgrade the drying systems at Preston.
Our current estimate of capital spending for 2016 is in line with prior guidance of $76 million. Net debt in the quarter fell by $24 million to $428 million, largely under evaluation of US dollar denominated debt. Liquidity at the end of the quarter was $148 million. The sale of the former Tacoma mill site is on track to close in the fourth quarter.
At this point I'm going to pause, and I'm going to let Bart provide his update on the lumber market as we see it. Bart.
Thank you Duncan. I will provide comments on our short-term to medium term market outlook. In Q1 2016 the demand for lumbar remained stable with US housing starts quarter-over-quarter showing similar numbers. Single-family starts did show an increase of 4.6 quarter-over-quarter, highlighting the volatility we can see on the multi-family side of this leading indicator.
Our export markets continue to stabilize with steady demand from Japan and Korea, and increasing demand from China. Specifically regarding China, enquiry level has increased through Q1 and into Q2, a trend that is expected to continue through the quarter. Market inventories are stable and in some situations considered low. Market prices have stabilized and improved through Q1 into Q2 although on some products pricing lags are North American equivalent.
Regardless of that we continue to support the strategic market accordingly. Our business in China continues to improve. In Q1 2016 pricing across both our western SPF and [Indiscernible] buying composite benchmarks increased relative to Q4 2015.
With Interfor’s diversification we have several key product groups in our overall mix to discuss. [Indiscernible] pine lumber, a relatively mild winter has encouraged sustained demand as we enter quarter two. Modest in market inventory levels combined with robust seasonal consumption have kept this momentum even at times when wet weather has been a factor.
Demand for 2x4 and 2x12 remain strong as we continue to see elevated prices for these widths. Western dimension lumber markets were active throughout Q1 2016. We are expecting consistent demand through Q2 2016 although from a pricing standpoint we will see volatility. The last 2 to 3 weeks are no exception.
Our Japanese markets present stable demand for our Douglas fir and hemlock squares and SPF J Grade products. This market is expected to remain stable for Q2 2016. The cedar business continues to provide us strong sales value as we enter into the seasonally active months of the year.
Upward momentum on pricing will continue as on most products. We are on allocation basis with our customers. Supply of railcar and trucks across the network has been stable. As we move further into the summer months, we continue to be encouraged by the overall demand level for our products in both North American and overseas markets. We continue to expect volatility in pricing as we navigate continuous shifts on currency values and uncertainty related to the softwood lumber agreement.
Duncan, back to you.
Thanks Bart. A few more comments and then I am going to turn the session over to questions operator. So over the last few years Interfor has grown very rapidly and undertaken a couple of major mill rebuilds. We have gone from no presence in the US South to become one of the largest producers in the region.
In growing as rapidly as we have, we put our arms around some significant opportunities to increase profitability of those assets over and above the run rate at the time of acquisition, by driving improvements in mill performance and sales returns by taking advantage of the synergies that exist from owning nine mills at a relatively tight geographic area.
We made some progress, but the pace of improvement has not been at the rate I expected when the transactions were completed or believed is possible. And this issue is not restricted to our mills in the south. Our focus is being directed to capturing these opportunities and a number of steps have been taken in recent months to advance this initiative.
In December, Ian Fillinger, who has been with us since 2006, who most recently served as the senior vice president of our B.C. operations, was appointed to a newly created role as head of operations with responsibility for all of our manufacturing woodlands, timber procurement and capital projects activities both in Canada and in the United States.
Ian has an outstanding track record in the industry and has done a tremendous job for us in the last 10 years. Some of you may know him from his time at Adams Lake, where he was instrumental in the design, construction and startup of that operation. He was also part of our team at Castlegar, and in the improvements in our B.C. Coastal business in recent years.
Ian’s mandate is to drive improvements in performance at all of our operations with a specific focus on the margin expansion opportunities in the South, and to ensure a higher degree of consistency in standards and approach across our full operating platform.
A number of other personnel changes have followed Ian’s appointment and I am confident we now have the leaders and organization in place to deliver on our margin expansion agenda. We fully understand though it is results that count. We will be quantifying and reporting on our progress in this regard in the quarters ahead.
On that note operator, I would like to turn the session over to questions.
[Operator Instructions] The first question comes from the line of Mark Wilde of BMO. Please go ahead.
I guess the two issues I would like to have you address are just kind of talk about the impact of the recent rise in the Canadian dollar on the business, and then just give us your perspective on where we fit vis-à-vis this trade deal right now?
I'm surprised it took so long for the SLA to become a question mark. I would be happy to – well, the dollar obviously has moved significantly. It was in freefall in January and then turned around and has moved up significantly through the balance of the quarter, and was the biggest factor in the reduction in debt posted in the first quarter is the revaluation of our US dollar-denominated debt and the Canadian dollars.
But from an operating standpoint it clearly changes the cost curve in Canada relative to that in the US, both when the dollar is declining in value and when it is increasing in value. So I would tend to expect with the rising Canadian dollar, it will tend to support pricing, more than is the case when the currency is weak. And it will have an affect on our Canadian business in relative terms compared to our US business as a result of that.
As I think most products other than in Canada are sold in US dollars, so the translation of US dollar revenue back into Canadian dollars won’t have the same impact. From Interfor’s standpoint, we have got two-thirds of our assets located in the US and by far and away the US is our largest market. So it won't be impacting the top line of those assets. It will be impacting the translation of the margins back into the business. So I would expect we would have less impact of a rising currency than some other companies might have that have a larger percentage of their assets in Canada. That is number one.
Number two, in terms of the SLA, I know that discussions, preliminary discussions are underway between officials in the Canada and US. We all saw the Canadian US summit in early March when Canada's new Prime Minister and the President of the US talked about softwood lumber. I have been disappointed at the pace of progress on this.
I continue to be a supporter of the ’06 SLA. I think it did good things for producers in both Canada and the US. I think a bottom in the market structure is the right design, especially when markets are weak and currencies are weak. I thought it would have been possible to make more progress than has been made. Up to this point quite frankly I'm disappointed that more progress hasn't been made.
Interfor continues to be a supporter of negotiations. We are more than prepared to support the modernization of the SLA, but there is limits on how far we are prepared to go, and if this thing doesn't move forward more constructively over the next [Indiscernible] and we move back into the process of defending our situation, we are more than prepared to do that if we can find a reasonable solution to it.
And Duncan, what would be your view on whether a quota could ever part of a solution?
Mark, I am not in favor of quota arrangements. I don't think they work. I just don't think they work. We saw that during the ’96 SLA, where a quota structure was put into place. There is all sorts of difficulties when it comes to allocation of quota to different parties. Politically it is really difficult for the people that have to make those decisions.
I think it is counterproductive in that it doesn't work well when markets are strong, it restricts available supply, and has adverse price consequences, which I don't think are helpful to our industry longer-term given that we have to compete against other products. I think when markets are weak it tends to exacerbate the pricing structure because people push volume regardless of price just to maintain their quota position, and I don't think it works when you deal with third country imports. And all you do is you open the door for others to compete in your marketplace.
So I think it is really short sighted as a structure. The bigger issue that relates around softwood is is what happens when markets are weak, and particularly when currency is weak, and there are far better mechanisms to deal with those issues than a quota structure is. And I am quite surprised that other folks can't see through that a bit more clearly and focus their attention on what is really a system that works better for everybody like the SLA did in ’06.
Okay, well actually I agree with you on FX, I was a little surprised that is not a bigger piece of sort of solutions that are looked at. I wondered Duncan just turning to putting Ian in that new role, can you talk about sort of the kind of two or three main levers that he would be focusing on and I am assuming from your comments that there hasn't been any change in sort of the throttle back approach that you have adopted in the southern US operations. So if you could just confirm that?
Yes – no, I will be happy to do that. From my standpoint and I know Mark you have met Ian when we toured Adams Lake at that time. Ian has established himself in my opinion as one of the best [stockowners] in our industry. He has got a tremendous work ethic. He really understands log supply and saw milling and products and the like. And I just think he has got very, very standards. He has got a collaborative style of management, but very, very high standards from a performance standpoint, and works very well not only with the other groups inside the company but particularly with the sales and marketing group.
So, I think after watching our group very carefully over the last couple of years it became very apparent to me that Ian was the guy that had all of the potential to be able to lead our operating – the operating side of our business on a go forward basis. And so by putting him into place, Ian brings lots of history and he is able to pull people together really effectively to focus on specific issues, and we are seeing that as we speak now over the course of the first quarter.
Ian has been able to pull a bunch of people together and get them refocused and reassigned to deal with the assets where we think there is the biggest opportunity to drive improvement, which I'm really excited about. So that is number one.
Yes, the question about the throttling back of the US capacity and you will recall back in September when the Yellow Pine market was weak, we pulled back our production rate by about 20% in the US South, by curtailing in a number of mills where we were having some challenges, which I think was absolutely the right thing to do with time given what was happening in the market.
But it was also designed to give us an opportunity to get at some of the reliability, productivity, cost issues at those facilities, and there has been less progress – there has been some progress made at a couple of those facilities, which I am quite pleased about, but there has been less progress made at others, and we will inch that capacity back on-stream when we have confidence that we have – two things, that we have been able to deal with the reliability and cost issues that were plaguing those operations, and when we are confident that there is a market capable of absorbing the incremental production.
And so in some facilities we have inched some back, in other facilities we have left them where they there when they were taken down. For the suggestion that it is – we permanently reduced the capacity of those operations. It is not the case. I'm still completely confident that over a period of time, especially with this initiative that we have now got underway that we are going to be dealing with the issues and we will be moving the capacities back to a number that is much closer to the capacity figure that we have established for the US South, which is 1.3 billion.
Okay, that is really helpful. I will turn it over Duncan.
Yes, thanks Mark.
The next question comes from the line of Sean Stewart of TD Securities. Please go ahead.
Thanks. Good morning everyone.
A couple of questions Duncan, just want to make sure I'm thinking about your business optimization initiatives in the right context, the additional margin improvement opportunities you are talking about, is this stuff that was already envisioned in your Capex budget this year, or should I think about this as incremental initiatives on top of that that are just coming to surface now?
Sean, it is not capital related primarily. I mean maybe little bits of pieces are capital to deal with certain issues, but this is not a capital initiative. This is a management initiative, which is always the best way to do it because that returns on capital employed are infinite through improvements in management.
And we believe establishing better standards, higher degrees of reliability, better uptime, higher per hour productivity, better recovery levels, better coordination between product mix and market demand are the key elements of running a business successfully.
If you look at the operating rates and all those other factors in our more established businesses, it is significantly higher than they would be for example today in our newly acquired operations. And so what we are trying to do is bring the standard of management performance to the level that we have achieved in our operations in other jurisdictions.
And once you have done that and I think those opportunities are significant in the South. Once you have done that then you can start addressing the technology question through additional capital. So the vast majority of what is going on in the South now is maintenance capital or in some cases money allocated to things like auto grading systems, which are relatively small, or kiln projects, which on each individual kiln was a relatively small project. And it really isn't the kind of dollar mover that we expect to get from higher standards.
Okay, understood. And second question I have is on capital allocation, it was only a few months ago investors were worried about leverage, some were I guess with respect to Interfor, but with better free cash, extra heads, lower Capex, proceeds from Tacoma et cetera, have you guys given any thought to potential share buybacks. A number of your larger competitors have active programs in place, does an NCIB fit into your potential plans given recent sharp price weakness?
Sean, it is something we talk about all the time internally with our board. Our focus here over the last while has been zeroing in on improving performance, finishing off the Castlegar project, generating free cash flow and using that free cash flow to reestablish financial capacity, which then gives us the choice of whether we want to go forward with what I would call a strategic external opportunity or a share buyback program, or some other kind of an activity.
But it is all hinged on having the financial capacity to be able to do that. And it is not that we are uncomfortable where we sit right now, but we are at the upper end of the level that we have established as our own internal leverage limits, and we are focused on bringing that down to give us more flexibility going forward.
Okay. That's all I had. Thanks guys.
The next question comes from the line of Paul Quinn of RBC Capital Markets. Please go ahead.
Yes, thanks very much. Just wanted to follow up on Sean’s question on balance sheet concerns, you got a nice tailwind on FX in the current – in Q1, I'm just wondering if you have any concerns given the rise in the Canadian dollar, what that is going to do to the balance sheet and the debt situation going forward?
If anything it is the reverse Paul. A significant portion of our debt is US dollar denominated, but we are Canadian dollar reported. So as the Canadian dollar rises in value, our debt in Canadian dollar drops, and that is what happened in the first quarter. I don't have any concerns about our balance sheet as it stands right now. Net debt to invested capital sitting at 38% at the end of quarter as it was at the end of the fourth quarter last year.
The way we have got our debt structured with the tranches of long-term debt, the extension of the bank facilities that was negotiated earlier in the first quarter, I think it was – and the liquidity that we have got today gives us lots of insurance and a utilization of balance sheet that from a leverage standpoint, which I think which is good. We also know that we got Tacoma coming later on this year, which is going to give us that additional boost.
What I want to establish is the flexibility to go in a variety of different directions as we see profitability and free cash flow improve, the balance sheet apparently gives us the ability to compare and contrast and choose between a whole variety of different options from a capital allocation standpoint that we think will drive the best returns for our shareholders. And so it is not a concern as it sits today, it is a desire to create more flexibility to allow us to proceed with our value creating initiatives.
And that clarifies that. Just maybe you could give us some more color on the Capex spend of $76 million for 2016, breakdown between US and Canada, and any big projects within that budget?
We are basically done in Canada. We rebuilt the three mills over the last six or seven years, Adams, Grand Forks, which was finished in ’12, and Castlegar, which is finishing currently. So there is nothing – anything significantly planned for Canada other than maintenance projects and the odd small add-on discretionary project.
The US is the biggest piece of the puzzle for us. The kiln project at Preston is a significant one, and it is in Canadian dollar terms around $20 million, which will be completed this year. So it is a really good project for us and helps bring that facility into total compliance from an environmental standpoint.
Okay, and just lastly whenever you see sort of investors’ concern on SLA, it seems like the whole Canadian lumber space gets hit, and it doesn't seem that people sort of understand your less exposure on that file, why do you think that is and how do you clear that up?
Well, I don’t – I think that is true. I think people tend to look at the SLA as it was a black and white issue, either if you are a Canadian producer that ships into the US market, you have got an exposure. We have got two thirds of our asset base in the US. I think it is something like 15% or 17% of our total production was Canadian shipment into the US.
So from an exposure standpoint relative to other Canadian companies, we would have much less exposure on any trade action than anybody else would have, which quite frankly was done by design. Having lived through the last couple of trade disputes, we concluded a long time ago that it would be smart or strategic at least to position ourselves where we had less exposure to those kinds of unpredictable and unquantifiable matters.
It is folks like you that translate to investors as much as anybody else what the relative exposures are. When we talk to people we make sure they know what the facts are and people can reach wrong conclusions. But it is – I don't think it is A, it is not right that everybody is affected the same way because they are not; and luckily, I think we are less exposed than most others are.
All right. That is all I had. Best of luck.
Yes, thanks Paul.
The next question comes from the line of [Indiscernible] of Raymond James. Please go ahead.
Thanks. Duncan, just following-up on Paul’s question about the SLA exposure, I think it is pretty obvious that you have a lot of assets in the US, and that immunizes you to certain extent against duty potential, I mean the other key thing obviously is cost structure of your Canadian mills, and you mentioned there is not much more to do, after the Capex at our Canadian mills, where would you say that they stack up on a benchmarking basis vis-à-vis the other mills in B.C. and then the other mills in Canada East of Rockies as well?
Well, there is no perfect information on that. I think certain of the margins we generated at Adams Lake, and Grand Forks I think they are really good. I mean, we got some really good [fiber baskets] and really competitive operations in [Indiscernible]. And everything we see about Castlegar is it is going to be right in the same range as the other two. So I think we are in pretty good shape from that standpoint.
And then just from – am I right in terms of timing in net to Interfor, sometime in the second half and around 20 million bucks, is that right US?
I think that is pretty close, and it is fourth quarter is our expectation.
Thank you. I will turn it over.
[Operator Instructions] We have a question from the line of Hamir Patel of CIBC. Please go ahead sir.
Hi, good morning.
Duncan, just following up on I guess [Indiscernible] question on the SLA, I mean, I would figure that if we see duties, you are going to see higher cost capacity in Canada come out and that would have positive implications for lumber prices across North America, I mean, obviously it is hard to say whether certain grades in certain parts of the US moves to the same degree as Western SPF, but when you, look at that do you think you might actually see a net benefit from duties?
Well, people can do the calculation of what the impact to duties are on our Canadian business, and what the impact of higher prices would be both in terms of offsetting some of that duty for the capacity that isn’t affected in Canada, and on the business in the US. And so with two thirds of our asset base in the US, and three very good facilities in the B.C. Interior and the high value cedar business on the B.C. Coast, we think we are in pretty good shape.
It is just hard to calculate what the net effect would be, but I think in relative terms we are certainly better off than I think just about anybody else have, and you should just basically leave it at that.
Right, fair enough. And just a final question on the cedar market and this might have been posed already, I just joined on late, but we have seen I think that Mary’s lumber mill shut. I know it is a relatively small-market for you, but are you seeing any pricing momentum for some of those cedar grades?
Well, cedar has been a very strong market and I think supply has been restricted both from the primary source, which is in British Columbia. We have also seen operations like Mary’s River fall by the wayside. So it has been a really good product line for us, and we expect that is going to continue.
Okay, great. That is all I had. Thanks Duncan.
[Operator Instructions] Okay, Mr. Davies, there are no further questions in the queue at this time. Please continue.
Great. Thanks Ileana. Thanks everybody. We really appreciate your interest in our company. I am around for the rest of the day. I think John is as well. Marty is here for a bit before he has to take off. If you got any follow-up questions don't hesitate to give one of us a call, and we will do what we can to fill you in on the answers. Anyway, thanks again. I appreciate your time. Look forward to talking to you again at the end of the next quarter. Thank you.
Thank you ladies and gentlemen. This concludes the conference call for today. We thank you for your participation, and you may now disconnect your line and have a great day.
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