Louisiana-Pacific Riding The Rising Tide

Summary

Housing demand and restrained capacity growth have supported robust price increases for OSB, while improving capacity utilization is boosting margins for LPX.

LPX is looking to support its SmartSide business through further capacity additions.

Better behavior among competitors may argue for a slight boost to the EBITDA multiple, but most of the easy money seems to be in hand with LPX shares.

Back in February, I thought Louisiana-Pacific (NYSE:LPX) had upside into the high teens on improving housing numbers and stronger OSB pricing, and the shares are up close to 25% (to just under $19) since then as housing has been healthy and OSB prices have improved. Better still, the industry has remained responsible and restrained with respect to capacity, raising the possibility of even better pricing in the next year or two.

Lousiana-Pacific is closing its profitability gap with Norbord (NYSE:OSB) and Weyerhaeuser (NYSE:WY) in OSB, but also looking to expand its siding business as SmartSide continues to gain share in the market. It's important to remember that this is a cyclical stock (currently in the good part of its cycle), though, and that these good times won't last forever. There's still some upside to fair value based upon a full-cycle EBITDA estimate (and the possibility that more restrained competition will support a higher full-cycle number), but more of the upside in the shares now rests on the Street getting fired up about the housing/building material cycle and indulging in magical "it's different this time" thinking.

OSB Keeps Heading Higher

This year has been a good one for Louisiana-Pacific, Norbord, Weyerhaeuser, and other manufacturers of oriented strand board (or OSB), a key building material for single-family homes. Single-family home starts were up over 8% year-to-date through August, so the demand side is holding up well. On the supply side, companies have been slow to reactivate shuttered facilities or start new projects (Martco is building a new plant in Texas that will add 850mmsf of capacity, but that was announced over a year and a half ago).

That combination of demand growth and limited supply growth has been healthy for prices. In the first quarter of this year, benchmark OSB prices rose between 17% and 23% depending upon the region (to a range of $190 to $225). The second quarter saw prices increase 37% to 59% (to $242 to $264), and prices continued to rise through the third quarter (around 10% in at least one region).

With healthy demand and pricing, LPX has seen its capacity utilization climb toward 90% and that has been healthy for margins. LPX's OSB adjusted EBITDA margins have climbed from losses last year to almost 14% and 23% in the last two quarters. Norbord and Weyerhaeuser are still more profitable in their OSB businesses, but LPX has significantly closed the gap - almost catching Weyerhaeuser in the second quarter and shrinking what had historically been a five-point gap with Norbord to around two points.

The next couple of years should be strong ones for LPX's OSB business and the company should be poised to reap some meaningful cash flow from the business. Assuming that housing construction activity stays healthy, another full-year double-digit increase in OSB pricing in 2017 doesn't seem unreasonable, particularly given that any activities to boost capacity will take time. All of that said, I'm skeptical that this "perfect storm" is going to stay this way. There's close to 5,000mmsf of curtailed capacity out there (including close to 800mmsf each at LPX and Norbord categorized as "temporarily curtailed") and ongoing double-digit price increases and utilization rates at or above 90% are going to lead to some itchy fingers moving toward the "restart" button.

More Growth Opportunities To Explore

The price of OSB is key to LPX, but it's not the only driver for the company right now. The company's SmartSide wood siding product continues to gain share, with volume up more than 20% in the second quarter.

While wood-based, SmartSide is engineered to deliver performance advantages over traditional siding in terms of resistance to rot, termites, sun, and freeze/thaw cycles, while also offering appearance advantages over vinyl and fiber cement and workability advantages over fiber cement. I'm not suggesting Ply Gem (NYSE:PGEM) or James Hardie (NYSE:JHX) are in trouble - engineered wood is still less than 10% of the siding market and still costs about two to three times as much as - but LPX is nevertheless finding a lot of demand for this product.

So much so, in fact, that management is looking to add more siding capacity. From management's comments, it sounds as though they're not optimistic about finding suitable assets out there for a conversion process, so a new plant start may be the choice. There have been reports that LPX is interested in building a siding plant in northern Minnesota, and it sounds as though the price tag will be north of $400 million.

This isn't LPX's only growth option. The company is moving ahead with a third OSB mill in Chile that should further help substitute for imported wood products used in construction in Chile. The South American business is solidly profitable, so expanding what is basically a monopoly business seems like a worthwhile idea.

I'd also note that LPX has other new products beyond SmartSide. The company's new flame-retardant OSB product FlameBlock meets a variety of fire resistance standards and should see wider adoption in areas where wildfires are a persistent threat.

The Opportunity

I believe ongoing double-digit price increases in OSB, better capacity utilization, and ongoing growth in siding will help drive Louisiana-Pacific's EBITDA above $450 million in 2017 and above what I believe is the full-cycle figure. I expect that 2017 will be the near-term peak, but I won't completely dismiss the possibility that responsible competition and a prolonged housing recovery can extend that run. That said, I don't think anything has changed about the fundamental cyclicality of this business; housing demand will eventually wane and competitors will look to exploit higher prices by adding capacity.

These shares don't really work today from a discounted cash flow perspective, but that's normal in this sector (when you can buy LPX at an attractive price relative to DCF, you know you're in an industry trough or your estimates are too high). Looking at EBITDA, though, there could still be some upside. The shares are more or less in line with a 6x multiple to my full-cycle EBITDA estimate, but maybe there is an argument that a slight bump in the multiple (to 6.5x) is reasonable given the lack of capacity additions in the OSB market and the prospect for a more prolonged housing recovery. Doing that would lift the fair value to a little over $20. I'd also note that there could be a "it's different this time" trade if OSB prices remain strong into 2017 that could lead to even higher estimates and a stronger stock price.

The Bottom Line

I think the attractive opportunity in Louisiana-Pacific has largely been captured. If you're an aggressive investor looking to squeeze every dollar of value (or you believe you can leverage a "it's different this time" surge in the next year), I can understand the desire to hang around. As a more value-motivated risk-averse investor, though, I think Louisiana-Pacific has largely moved out of my sweet spot and it's more a stock to watch than to aggressively buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.