Canfor's (CFPZF) CEO Don Kayne on Q2 2016 Results - Earnings Call Transcript

| About: Canfor Corp. (CFPZF)

Canfor Corp. (OTCPK:CFPZF) Q2 2016 Earnings Conference Call July 27, 2016 11:00 AM ET

Executives

Don Kayne - CEO

Alan Nicholl - SVP, Finance and CFO

Wayne Guthrie - SVP, Sales and Marketing

Brett Robinson - President, Canfor Pulp

Analysts

Sean Stewart - TD Securities

Ketan Mamtora - BMO Capital Markets

David Quezada - Raymond James

Hamir Patel - CIBC

Paul Quinn - RBC Capital Markets

Stephen Atkinson - Dundee Capital Markets

Operator

Good morning, ladies and gentlemen, and welcome to the Canfor and Canfor Pulp Second Quarter Analyst Call. A recording and transcript of the call will be available on the Canfor and Canfor Pulp Web-sites. During this call, Canfor and Canfor Pulp's Chief Financial Officer will be referring to a slide presentation that is available in the Investor Relations section of each Company's Web-site. Also, the companies would like to point out that this call will include forward-looking statements, so please refer to the press releases for the associated risks of such statements.

I now would like to turn the meeting over to Don Kayne, Canfor and Canfor Pulp's Chief Executive Officer. Please go ahead, sir.

Don Kayne

Thank you, operator, and good morning everyone and thank you for joining the Canfor and Canfor Pulp Q2 2016 results conference call this morning. I'll make a few brief opening comments about the quarter and our outlook before I turn things over to Alan Nicholl, our Chief Financial Officer, for both Canfor and Canfor Pulp. Alan will provide a more detailed overview of our performance in Q2, and then we will take questions from analysts.

In addition to Alan, with me today are Brett Robinson, President of Canfor Pulp; Mardy Grossman, our Director of Sales for Canfor Pulp; and Wayne Guthrie, our Senior VP of Sales and Marketing.

As we noted on our last call, Canfor Pulp had significant planned regulatory and maintenance shuts in the second quarter. Outages at all three of the Prince George kraft mills made for a challenging quarter, but all work was completed successfully with total production down approximately 42,000 tonnes. With the outrages behind us and the mills ramped back up to full rates, the team is focused on returning to normal productivity levels at all of our mills.

Pulp market showed positive momentum in Q2 due to the seasonal shuts and increased buying, particularly from China. Our softwood pulp markets are stable and inventories are at the lower end of balanced. The risk to pulp pricing continues to be the addition of new capacity and we expect to see more production coming online over the next several quarters from previously announced investments. That being said, we expect that our low cost structure and high-value and quality focus will continue to benefit the Company and carry us through any temporary periods of oversupply.

Turning to the Lumber side of our business, in the second quarter we continued to see the benefits of our U.S. South business and our specialty product mix. Pricing was stable for our high-value products and spreads for our wider profile of products improved over the previous quarter, a trend we expect to continue in Q3.

Our operations in the U.S. South have performed well and the mills we have acquired over the last three years continue to exceed our expectations. Our Canadian mills also continued to perform well in Q2 with another solid operational quarter and increased benchmark Western SPF pricing across most grades boosted profitability for that region.

We continue our ramp-up to full capacity, and with the inclusion of our latest acquisition of Wynndel, I believe that by the end of 2017 we should be producing roughly an additional 200 million to 250 million board feet of lumber, the vast majority of that in the U.S. South.

In terms of offshore markets, particularly China and Japan, we've seen steady demand in the quarter and we continue to diversify our product offerings to those markets. In North America, we continue to expect a gradual recovery through the balance of the year. Our major customers in the homebuilding and repair and remodeling businesses are seeing strong demand so far in 2016, and with inventories relatively lean, we expect that business to continue to be strong.

Later this week, we will be completing the final phase of our purchase of Scotch & Gulf Lumber as we acquire the remaining 50%. These mills have been strong contributors to our bottom line.

And finally, we continue to monitor the discussion around the new Softwood Lumber Agreement with the United States. We remain hopeful that a deal can be completed before the end of the stand-still period, but we are well-prepared for all potential outcomes.

So with that, I will turn the call over to Alan Nicholl to provide an overview of our financial results.

Alan Nicholl

Thanks, Don, and good morning to everyone. As usual, my comments this morning will focus principally on our financial performance for the second quarter of 2016 by reference to the previous quarter. Full details of our results are contained in the Canfor Pulp and Canfor news releases, both of which were issued yesterday.

As always, you'll find an overview slide presentation on both the Canfor and Canfor Pulp Web-sites in the Investor Relations section under Webcasts. The presentation highlights consolidated and segmented results and I'll be referring to this presentation during my comments.

For the second quarter of 2016, Canfor reported shareholder net income of C$36 million or C$0.27 a share, up from net income of C$26 million or C$0.20 a share reported for the first quarter of 2016 and net income of C$11 million or C$0.08 a share reported for the second quarter of 2015.

On Slide 3 of our presentation, we highlight various non-operating items, net of tax and non-controlling interests, which affect the comparability of our results between the quarters. In the second quarter of 2016, the most significant adjustments were for our legal settlement gain related to our pellet business of C$7 million or C$0.05 a share and a positive mark-to-market adjustment on derivative instruments of C$2 million or C$0.02 a share.

After taking account of these adjustments, the second quarter adjusted shareholder net income was C$27 million or C$0.20 a share, compared to similarly adjusted net income of C$21 million or C$0.16 a share for the first quarter.

Results for the Lumber segment are highlighted on Slide 5 of our presentation. The Lumber segment recorded operating income of C$72 million, a C$39 million increase from the C$33 million operating income reported for the previous quarter. Excluding the aforementioned legal settlement gain, operating income was C$56 million, up C$23 million versus Q1.

The increase reflected improving U.S. dollar denominated benchmark lumber prices, net of a stronger Canadian dollar. Solid price gains were seen across most grades of Western SPF and Southern Yellow Pine, with price increases for wide dimensional products of Southern Yellow Pine in particular seeing strong gains.

Overall, unit manufacturing costs were in line with the previous quarter and up slightly compared to the same quarter of 2015, primarily due to the high value product mix produced at our recently acquired facilities, offset in part by improved productivity.

Our shipment and production volumes remained in line with the prior quarter, and compared to the second quarter of 2015, shipments were slightly lower, reflecting record offshore shipped volumes to China after the U.S. West Coast port strike in the first quarter of 2015.

Canfor's Pulp and Paper segment comprises the results of Canfor Pulp Products Inc. As you can see on Slide 6 of our presentation, Canfor Pulp reported net income of C$2 million or C$0.03 a share, compared to net income of C$23 million or C$0.34 a share for the first quarter and net income of C$18 million or C$0.25 a share for the second quarter of 2015.

Canfor Pulp's operating results are summarized on Slide 7. The lower Pulp and Paper segment operating income reflected maintenance outages, as Don mentioned, at all three NBSK pulp mills which reduced our production by approximately 40,000 tonnes compared to the first quarter. Pulp sales realizations were slightly lower in the quarter, reflecting a stronger Canadian dollar and a higher proportion of shipments earlier in the quarter, both of which more than offset moderate U.S. dollar price increases and an increased proportion of our sales volume into North America during the quarter.

Total Pulp shipments were 10% lower than the previous quarter, for the most part reflecting timing of shipments and the aforementioned maintenance shuts. Higher manufacturing costs were also principally attributable to the scheduled maintenance outages.

Results in the Paper segment were down C$3 million from the previous quarter, largely as a result of the stronger Canadian dollar and to a lesser extent increased shipments to China. Unit manufacturing costs were relatively flat.

Capital spending in the second quarter totalled C$66 million, of which C$46 million was in the Lumber business and C$19 million for Canfor Pulp. 2016 capital spend is currently projected to be around C$160 million for Canfor and C$75 million for Canfor Pulp, with similar amounts currently anticipated for 2017.

As Don mentioned, we will also be closing the purchase of our remaining 50% of Scotch Gulf business on July 29, at an estimated cost of US$50 million.

During the second quarter, Canfor Pulp repurchased approximately 1.8 million of its common shares at an average price of C$10.60 per common share. There were no shares repurchased by Canfor, recognizing the Company's continued focus on debt reduction through 2016 after the significant growth that was undertaken in 2015. For the first quarter, Canfor Pulp's Board of Directors also approved the continuance of a quarterly dividend of C$0.0625 per share.

At the end of the quarter, Canfor excluding Canfor Pulp had net debt of C$386 million with available liquidity of C$221 million. Canfor Pulp had net debt of C$25 million with available liquidity of just over C$100 million. Net debt to total capital excluding Canfor Pulp was 22%, for Canfor Pulp it was 5%, and on a consolidated basis it approximated 20%.

And with that, Don, I'll turn the call back over to you.

Don Kayne

All right, thanks, Alan, and operator, we'll now open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question will be from Sean Stewart at TD Securities. Please go ahead.

Sean Stewart

Few questions. You mentioned, Alan, that – you noted that you hadn't bought stock back at the Canfor Corp. level and you're focused on deleveraging this year. How do you think about capital allocation at the Canfor Corp. level, I guess beyond this year? You have a reasonably strong balance sheet probably exiting this year. How much of your capital allocation decisions are dependent on the trade file and some clarity on that front and how you think about things beyond this year?

Alan Nicholl

So to your point, I think we're pleased with the cash flow that we generated through Canfor Corp., and to your point, we didn't make any share repurchasing, and as I mentioned, that's principally as a result of our debt reduction focus. And clearly some of our cash flow reflected the seasonal reduction in harvesting activities and crystallizing some of our working capital, if you will. And we are still committed to that debt reduction focus. I think we've guided before to 20%. It's at the higher end of where we typically want to be in terms of debt-to-cap and we're still a little bit above that for Canfor Pulp.

To your other question around just guidance on capital allocation, as we said a good number of times now, sustaining our mills at the top quartile is priority number one. We're committed to continuing our investment in our facilities, both North and South of the border. To that end, the U.S. South growth, as you will have noted, we still got about C$100 million of committed money there to close the purchase to get 100% of Scotch Gulf and Beadles & Balfour in the next 12 months as well.

So, I expect our balance sheet will be stronger at the end of the year, but I also expect that our focus will continue to be on the aforementioned areas. I'd like to think that despite the uncertainties around the trade file, that we'll remain committed to those end goals and the strength of our balance sheet will support that end goal as well.

Sean Stewart

Thanks for that, and further to those comments, can you give us some qualitative commentary, Don, with respect to the sawmill M&A environment right now? One of your competitors suggested that things have slowed down a little bit, at least in terms of the opportunity sets out there. Is that consistent with what you are seeing and are you guys still considering further M&A opportunities in the sawmill side?

Don Kayne

For sure, Sean. I mean after, just to add on what Alan spoke about and aside from the continued focus on just our debt reduction, in terms of the M&A side, I mean I would say that we'd probably face – I'll make a similar comment that there's not – certainly the activity levels is decreased quite a bit and it's not to say that we're not getting the odd inquiry and so forth, but right now – and I expect that probably over the next little while, we will probably be in the same situation here for probably the next 6 to 12 months, but certainly it's quieter than it's been for sure.

So we are going back a little bit to what Alan said. Definitely our priority now is, we've got such great assets we believe and they are performing well and we've got a real focus here to make sure that when we have excess cash, we're using that money as much as we can on making sure that the mills we've got, we sustain that top quartile status, because we really believe that we've pretty much achieved that now and the opportunities just inside the Company we see as very, very strong. So, anyway, that would be comments on that, Sean.

Sean Stewart

Thanks very much. That's all I have. Thanks guys.

Operator

Your next question will be from Ketan Mamtora at BMO Capital Markets. Please go ahead.

Ketan Mamtora

First question for Alan, Alan, can you, if possible, quantify what was the EBITDA impact from maintenance in the second quarter in the Pulp business? You mentioned about 40,000 tonnes.

Alan Nicholl

So I think when I look at the operating performance for Q2 relative to Q1, I would say, just to kind of give you some perspective on it, about two thirds of that gap we see would be largely attributable to our scheduled and maintenance effort there and the other third would really be tied to shipments and the stronger Canadian dollar. So hopefully that helps you to get a little bit more context on the order of magnitude.

Ketan Mamtora

Yes, it does. That's very helpful. Second question, Alan, what do you have kind of for log cost inflation in the second half, both for BC and U.S. South?

Alan Nicholl

So I think today we're sort of expecting to see a 4% to 5% increase year-over-year, Ketan. So we are obviously focused on annual cost as well as just any quarterly movements there. But just to give you some guidance, in Western SPF, around 4% to 5% year-over-year in terms of log cost. I think in the U.S. South, it's pretty much flat, just simply put.

Ketan Mamtora

Got it. And then last question for Don, in your press release, just seeing your comments on the softwood trade agreement, it seemed like you pointed to discussions have been progressing. Any sort of thoughts, color? It looked a little more positive than I thought it might have been. So any thoughts or color might be helpful.

Don Kayne

Just to make sure, with respect to the Softwood Lumber Agreement?

Ketan Mamtora

Yes, that's right. In the press release, you point to discussions have been progressing.

Don Kayne

Right. I guess I mean what I would say there other than what I mentioned in the initial comments is just that, I mean I guess what we are encouraged by is that definitely there has been some solid communication between the province and the Feds and also between government and industry in the U.S. side also. So I mean certainly there is a long way to go. I mean, I think that we're – I guess to some degree, we're encouraged that they are still speaking, but like I said, there's a lot of ground to cover yet, and whether we're able to get a solid fair agreement in place, we're certainly prepared for the possibility that it doesn't occur and I guess we're very well prepared for that also. So we'll see what happens. But above and beyond that, I can't really comment more than that, but there is one good thing, there is still some good communication being conducted between the two governments.

Ketan Mamtora

That's helpful. Do you expect these discussions to slow down as the U.S. moves into the election season?

Don Kayne

Perhaps. I mean at the end of the day though I think that we've got enough – so far, the engagement has been solid on both sides. And so, from what we understand, that they are expecting that this can continue right through into October. But again, it is a risk and we'll see what happens, but so far we haven't heard that indicate, we haven't encountered that issue.

Ketan Mamtora

Okay, that's very helpful. I'll turn it over. Good luck in the back half.

Operator

Your next question will be from David Quezada at Raymond James. Please go ahead.

David Quezada

My first question just on demand in the U.S., and we know that the U.S. housing market is gradually getting better. I wondered if you could provide just a little bit of commentary on how the other end markets are looking, such as industrial and repair and rental.

Don Kayne

For sure, David. I'll turn it over maybe to Wayne and he can give you some good color around on our key markets, and Wayne, maybe I'll turn it over to you.

Wayne Guthrie

Sure. Thank you. Good morning. If you look at U.S. consumption, total U.S. lumber consumption, it's actually up more than the housing start number for sure and even the single-family housing start number. So that would indicate that the repair and remodeling industrial segments are actually growing even a little bit faster than the housing. Really good news, it's a broad-based lumber consumption recovery down there, so a little bit ahead of our expectations. Talking about customers, expect that trend to continue through the second half of the year. So industrial, which has historically been quite flat, is stable to a little bit better. Repair and remodel is definitely better than we expected going into 2016.

David Quezada

That's great. Thank you very much. I guess my only other question was, I noted, it seems like the Chinese market demand has been pretty solid lately. What is your sense of how inventories are over there and are other regions that you hear about, more supply from Russia, is that filling up the supply chain there at all?

Don Kayne

Wayne, why don't you continue with that one as well?

Wayne Guthrie

Sure. So, I'll answer it two ways. The SPF inventory is very, very in good shape, it's not heavy at all, it's a little bit light compared to historical, although maybe consumption is a little bit lighter on the SPF side. So we think that's balanced. We're not concerned at all about the SPF inventory. The Russian import volume has definitely been more than we thought it would be. They are taking more market share, no doubt about it. Not sure, I think those export numbers from Russia are subject to a lot of revisions, so you kind of have to take a little bit of a longer term view there.

I think you will see that on the low-grade side, we can still compete. On the high grade side, we can still compete. Russia will take some of the mid-grade volume and have a lot of that volume more likely end up in the U.S. So I don't think we'll see the rate of increase from Russia anymore, but I think you will continue to see them over the short term here over the next while continue to maintain that market share that they've got.

David Quezada

That's good. That's very helpful. Thanks Wayne. That's all I had.

Operator

Next question will be from Hamir Patel at CIBC. Please go ahead.

Hamir Patel

Don, you guys announced I think Licella biofuels JV about two months ago. Can you help us understand what you guys are doing there, and it sounds like it's sort of a multiyear initiative, but maybe what's the sort of option value upside associated with that?

Don Kayne

For sure, Hamir, and we're certainly excited about that and we're looking forward to that opportunity going forward, but I think maybe the best there to give you a better color or more color at least for sure is Brett, and maybe Brett, you could speak to Hamir a little bit about Licella and what your views are there?

Brett Robinson

Sure. So Licella is really in early stages of the development. We are focused on regulatory design and off-taking for our technology. We are pretty excited about it but this is a scale-up and we are ways away from actually starting to break ground on this.

Hamir Patel

Fair enough. Thanks Brett. And just a final question I had for Wayne, we've seen some reports in Random Lengths of BC's lumber mix tilting more to 2x6 in recent months with mills cutting more Hem and Hem-Fir and Fir. Have you seen that play out in your business and can you remind us what your grade distribution is in BC between 2x4, 2x6 and some of the wide widths?

Wayne Guthrie

I'm not sure we disclose that in detail. I can say, we really haven't seen any material change for us in our spread between 2x4 and 2x6. The spread that you saw, the negative spread for 2x6 you saw last quarter was certainly wider than we anticipated it being. The Fir one is good speculation, that it's potentially having an impact. I would suggest maybe that there was a bit more 2x6 2&Btr. went to China earlier last year and even in the first quarter, and some of that came back due to stronger prices in the U.S. and maybe put a little bit more volume into the U.S. than we were anticipating. Then the 2x6 price in the U.S. wasn't able to keep up with the 2x4, if you follow what I'm saying. So, I think that's kind of straightened out.

Seasonally, 2x6 closes the gap on 2x4 in the third quarter. Whether or not that will go right back to where we've seen it even go to a premium, I doubt that this year, we doubt that this year, but we do think the spread will narrow as we go into the second half of the year. A lot of moving parts there.

Hamir Patel

Thanks Wayne. That's helpful. I'll turn it over.

Operator

Next question will be from Paul Quinn at RBC Capital. Please go ahead.

Paul Quinn

Just a couple, just really one easy question, just with the final 50% acquisition of Scotch & Gulf and then also the remaining piece of Beadles & Balfour, can you give us some help on the incremental financial benefit you will see from those in the balance of the year?

Don Kayne

Alan, why don't you take a shot at that one?

Alan Nicholl

Typically, we don't go into that level of detail, although Paul, you'd be aware that because we control both those entities today, we do show their contribution in EBITDA and operating income. Of course, the minority interest comes before we take our earnings per share component, but suffice it to say, as Don mentioned earlier, we're really pleased with both acquisitions delivering very strong margin ahead of our targets.

Paul Quinn

Okay, that's all I had. Best of luck, guys.

Operator

Next question will be from Stephen Atkinson at Dundee Capital Markets. Please go ahead, sir.

Stephen Atkinson

In terms of the, and you maybe touched it already a bit, but as you know the Asian market was very weak at the beginning of the year, can you talk about how things are now in Japan and in China?

Don Kayne

For sure. Wayne, why don't you give Stephen an update there on the China and Japan?

Wayne Guthrie

Sure. I'll do Japan first. Not much to report there other than we've been able to maintain our shipments. We actually think we'll see a little bit of an uptick here in Q3, modest but a little bit of an uptick. At the end of the year, in talking to our customers and in looking at the order files over there for housing and as well as some of the new products we've been able to make, we think our volume there will be the same this year as it was last year and maybe even up a little bit next year. So, with some of the work we're doing on diversification, we are pretty happy with what we're seeing out of Japan.

On the China side of the business, as we've said, we are actually going to make a little bit less low-grade, as we reported last quarter, because we got a little bit better log going through our sawmills. So our volume to China will be down a little bit and there is some competition for sure out of Russia. That said though, as I mentioned earlier, the inventory is in good shape on SPF. Our customers are looking for a very modest Q3. So it's really rainy there, we're having a difficult rainy season. But to sum up [indiscernible] for Q4 in China, that business will start to pick back up again and consumption will start to pick back up again.

So very cautious on our outlook on China, but I think the reduction that we have seen out of Canada going into China, that's probably as far as we're going. I think you will see steady volumes going forward there in the next year.

Stephen Atkinson

That's great. Thank you for that insight. In terms of the product line though, I guess you have changed your market to some extent?

Wayne Guthrie

In China?

Stephen Atkinson

Yes.

Wayne Guthrie

Yes, so China, we're already focusing on higher-end products going into the domestic furniture business as well as other high-end applications for lumbar. What we're trying to do is quite frankly find markets where we don't have to compete head to head with that increase from Russian volumes going down.

Stephen Atkinson

Okay. And in terms of your South and your acquisitions there, do you still have to spend more money or are you happy where you are, if you know what I mean?

Don Kayne

You're talking Stephen more on, you're talking capital-wise?

Stephen Atkinson

In terms of both capital and also the mills, like obviously you had to come in and should we say optimize your operations, and to my understanding you have done very well. Obviously you've done a great job in Canada. I was wondering whether there was more required for the South.

Don Kayne

I think I'll let Alan talk to it, but I think on this one, I mean clearly we've put some capital into those mills for sure, but they were also, for the most part the ones that we purchased were in pretty darn good shape frankly and in most cases real good shape, but we have spent some money particularly on kilns, and the CD case, it continues dry kilns particularly, and a few other projects, and we'll continue to do that to make sure we sustain them at that top quartile margin that we've been speaking about continually. But for the most part, those mills are all performing really, really well for us with the focus that we've had on the overall value side and then the margin side, because clearly they are able to produce a lot of higher value type products. So overall though, there will probably be, I don't know Alan, if we – I'm not with you there but I'm not sure if we actually separate that in terms of BC or Canada versus the United States in terms of total CapEx going forward.

Alan Nicholl

No, we don't disclose it, but to pick up on what you were saying there, Don, and for your benefit, Stephen, the mills and the operations we have acquired are really solid operations, and as I mentioned earlier, we're very pleased with the contribution they are making and how they are running. The opportunities on the capital side are more incremental, smaller type projects that will just help with our margin focus, and to Don's earlier point, we see a number of opportunities to get not insignificant volume, additional volume but not at the expense of margin. So overall, I'll say, lots of smaller opportunities but no major overhauls and no major capital upgrades that we are contemplating or need to contemplate.

Stephen Atkinson

That's great. Thank you so much.

Operator

Thank you. And at this time, Mr. Kayne, we have no more questions. So I would like to turn the call back over to you for your closing remarks.

Don Kayne

Thank you very much, operator, and thanks everybody that participated and enjoy the rest of the summer, and looking forward to talking to you in Q3. Thank you.

Operator

Thank you. Ladies and gentlemen, this concludes your conference today. Thank you for participating and you may now disconnect.

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