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Executives

Henry H. Ketcham - Chairman and Chief Executive Officer

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

Edward R. Seraphim - President and Chief Operating Officer

Christopher D. McIver - Vice-President of Lumber Sales and Corporate Development

Analysts

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

David Quezada - Raymond James Ltd., Research Division

Sean Steuart - TD Securities Equity Research

Bill Hoffman - RBC Capital Markets, LLC, Research Division

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Mark Kennedy - CIBC World Markets Inc., Research Division

West Fraser Timber (OTCPK:WFTBF) Q2 2012 Earnings Call July 20, 2012 11:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the West Fraser Timber Co. Ltd. Second Quarter 2012 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 the statements depends 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 is supplemented by the company's quarterly MD&As. Accordingly, listeners should exercise caution in relying upon forward-looking statements.

I would now like to turn the meeting over to Mr. Hank Ketcham, Chairman and Chief Executive Officer. Please go ahead, Mr. Ketcham.

Henry H. Ketcham

Okay, thank you, operator. Good morning, and welcome to West Fraser's second quarter conference call. Joining me today are Ted Seraphim, our President and Chief Operating Officer; and Larry Hughes, our CFO; and other members of our senior management team.

In the second quarter, we recorded sales of $774 million, which were 14% higher than our first quarter sales. This increase primarily reflects improved pricing in the quarter for virtually all of our products.

EBITDA in the quarter was $82 million versus $19 million in the first quarter, and EBITDA margins were 11% compared with 3% in the first quarter. EBITDA on our lumber division totaled $53 million compared with a loss of $6 million in the first quarter. Our Canadian lumber division ran at 100% of capacity during the period, and we've produced the same volume of lumber as we did in the first quarter. You'll note that Canadian lumber production was up slightly from the same period in 2011 despite downtime related to significant capital upgrades at several of our mills.

Log costs were down 2% in the quarter but up 12% in the first half of 2012 versus the same period last year. Stumpage costs will increase on average, about $3 a cubic meter in the third quarter this year. Benchmark 2 and better SPF prices in Canadian dollars were up 11% compared to the first quarter and 22% versus the same quarter in 2011. Benchmark #3 grade lumber prices were up 25% in the quarter.

Shipments to China are currently trending at the same rate as the last several quarters. We've not noticed any appreciable slowing of demand in that market. Our SPF inventories have increased in the first half as a result of significant capital projects being carried out at several of our planning mills during the period. We expect to begin reducing these inventories this quarter.

Our U.S. sawmills ran at about 80% of capacity in the second quarter, and production was up about 15% from the first quarter. The increased production reflects the completion of capital projects at a few of our mills in the South. Log costs were down slightly in the quarter. Southern Yellow Pine benchmark prices were up about 11% in the quarter and up about 27% versus the same quarter last year.

Our panel division produced $12 million of EBITDA during the quarter. The increased EBITDA for this division is primarily a result of a 14% increase in plywood prices versus the first quarter. MDF prices were up slightly, while LVL prices were flat. We are running our MDF and LVL businesses on reduced schedules due to the continuing weak demand.

EBITDA in our pulp and paper division declined 13% versus the first quarter. Increased pulp prices were offset by lower production and higher costs at 2 of our -- at our 2 Kraft pulp mills. Our Hinton mill continued to be plagued by operational difficulties following our major capital program which we completed at the end of last year. Our scheduled maintenance shutdown at our Cariboo mill was extended by 3 days, which affected production and cost of that plant. Both plants are now running at or near designed capacity.

Our BCTMP plants and our joint venture newsprint mill continue to run extremely well. Pulp prices were up slightly in the second quarter, with BCTMP prices up more than NBSK prices. Our inventories are in very good shape in this division with good order piles. We completed all of our Green Transformation Program projects and have been reimbursed for all of the $10 million to date.

We spent roughly 1/2 of our capital spending budget for the year. 80% of our capital spending this year will be in our wood products division. The mountain pine beetle epidemic continues to seriously affect several of our B.C. operations, resulting in reduced grade outturn, lumber recovery, productivity and profitability. We expect reduced timber availability to begin impacting the interior industry within the next 3 or 4 years, as beetle-killed pine approaches the end of its economic shelf life for sawlogs.

On Wednesday of this week, the arbitration panel hearing the dispute filed by the U.S. lumber industry against the B.C. lumber industry returned a decision that fully exonerated the B.C. industry on all charges.

Looking forward, we expect a slow but steady increase in the U.S. housing starts, which may be partially offset by a potential slowdown in Canadian starts. We anticipate continued penetration of our lumber products in the Chinese market, with some modest growth in other Asian markets. With a slowing economy in Europe and China, combined with significant new pulp capacity in South America, we expect pulp prices to be under pressure for the foreseeable future.

With that, I'll turn it over to Larry Hughes.

Larry S. Hughes

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

For the second quarter, we reported earnings of $27 million or earnings per share of $0.63. The table on Page 3 of our MD&A describes and quantifies several nonoperational items which affected our results. If we adjust the $27 million of earnings to add back the $9 million charge on equity-based compensation and also add back the $6 million loss related to the translation of U.S. dollar-denominated debt, the result on an after-tax basis is adjusted earnings of $41 million or adjusted earnings on a per-share basis of $0.96 for the quarter.

The equity-based compensation loss reflected the strengthening of the company's share price over the quarter, and the loss on the U.S. debt resulted from a weakening of the Canadian dollar against the U.S. dollar in that period.

Results in this quarter were significantly better overall than those of the previous quarter, from an operating earnings and EBITDA perspective. Our lumber and panel segments showed great improvement from the previous quarter, but our pulp & paper segment produced lower results.

Our defined benefit pension plans were revalued as of the end of the quarter, resulting in a charge to comprehensive earnings net of income taxes of $25 million. This actuarial gain or loss will fluctuate with changes in long-term interest rates and the return on plant assets. For this quarter, the main contributor to the adjustment was lower-than-anticipated earnings on the plant assets.

Cash provided by operating activities during the quarter after working capital changes was $143 million, which included the seasonal reduction of the log inventories at our Canadian solid wood operations.

Capital expenditures for the quarter totaled $33 million. We completed the balance of our Green Transformation Program expenditures in the previous quarter and received reimbursement of $24 million in the current quarter. This leaves, as Hank mentioned, $10 million still to be received. Our balance sheet remains strong with a net debt-to-capital ratio of 13%.

Hank, that concludes my comments.

Henry H. Ketcham

Thank you, Larry. So, operator, we'll -- we're finished, and we'll turn it over to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from Paul Quinn from RBC Capital Markets.

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

A couple of questions here. Just maintenance on the pulp side for the balance of 2012?

Edward R. Seraphim

Paul, it's Ted. We have no maintenance plans for the remainder of the year.

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

Okay. And, Ted, while I got you, the idling of Tembec's Chetwynd BCTMP mill, does that materially affect your Slave Lake operation?

Edward R. Seraphim

I think it's really hard to tell, Paul. I mean, China is a big buyer of BCTMP. So I think it depends more on their buying patterns than Chetwynd running or not.

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

Great. And then just on the -- if you could give us Chinese lumber shipments to date, and what they've changed sort of year-over-year.

Henry H. Ketcham

They're roughly the same year-over-year, Paul. They kind of slowed down late in the fourth quarter, but they've picked up, and we're running about the same rate as we were last year.

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

Okay. You mentioned operational improvements on the CapEx spend that you've done in the U.S. Can you sort of ballpark that delta for us, what we expect in the balance of the year in 2013?

Henry H. Ketcham

In terms of what, production costs? What?

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

EBITDA would be perfect, but costs are fine.

Henry H. Ketcham

No, I really can't, Paul. I mean, these things -- we've got an ongoing program down there, as you know. So we're going to have some plants slow down as we do capital projects down there this year and next year. So this is going to be kind of an evolving process. I really can't talk about specifics down there.

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

Okay. And just a clarification. I think at our RBC conference, I made a comment in a note that you guys would consider selling your Kraft pulp mills. I just wanted to get a clarification. Those are core to you, and the only way you'd consider selling them is if you had somebody that offer you an outrageous price, and we're going to make sure that they ran them for the future going forward, right?

Henry H. Ketcham

Well, it's nice of you to bring that up, Paul, because I do think that somehow we're slightly misquoted. No -- Kraft -- I mean, we're an integrated company. Kraft pulp was core to our business. Obviously, what I said at the conference is when we acquired Weldwood, it was the lumber assets we were really after. But we've integrated the pulp assets into our company. They're running well. They're key to our success, and we think that -- we think what the Green Transformation Programs and other capital we've done there that we've driven the cost structure into a very good position. So we're very happy with our pulp business.

Operator

The next question is from David Quezada from Raymond James.

David Quezada - Raymond James Ltd., Research Division

My question is just on the Japan market. I understand inventories, over the last couple of months, have been a little elevated. Could you tell us what you're seeing in that market? And when you expect to see volumes start to come up a little bit from the rebuild, if at all?

Henry H. Ketcham

David, I'm going to let Chris McIver, who runs our sales, answer that.

Christopher D. McIver

Hi, David, it's Chris. Yes, we've seen very little pickup due to the rebuild, and it appears to us it's going to be a while before they make any real firm decisions on how much rebuilding they'll do. Our inventories over there haven't really risen. We remain pretty steady and at very similar levels to last year. So I don't think we're going to see any material increase this year and probably at least a year away or so.

Operator

Your next question is from Sean Steuart from TD Securities.

Sean Steuart - TD Securities Equity Research

Question for Ted or Hank. Just trying to gauge, I guess, the extent of the pulp price correction here that we're in the midst of I guess from your comments, you're expecting weak markets for the foreseeable future. It feels like this is going to be a relatively hard landing. Can you speak to maybe what you expect to see in your price realizations for the third quarter, as it sounds like spot markets have come under a lot of pressure, and then maybe differentiate a little bit between NBSK and BCTMP markets?

Edward R. Seraphim

Well, I think -- it's Ted here. In terms of NBSK, I'll answer that part, first. When you look at the list price in the U.S., I believe it's 870, 880 today. But when you look at net prices in China, which I think is probably a better indicator where the market is, those prices are 650, 630. And I think there could be some -- so if you compare that to the second quarter, that's a price decrease of $30 or $40, and that might give you some good indication what the rest of the year looks like. I think they're getting to price levels which are starting to impact some of the high-cost producers. So where it goes from there, I don't know. But if we look at past history, we would think that we're looking at challenging, challenging period over the next 6 to 12 months, but we're not too sure if it will go much further than where it is today. In terms of BCTMP, really, BCTMP prices fell dramatically in 2011, and they've been fairly flat, plus or minus, over the last 12 months. So we don't anticipate significant downside there. So on balance for the company, we'll probably take less of a hit going forward than a peer NBSK producer would, as we look to the second half of the year.

Sean Steuart - TD Securities Equity Research

Hank, on the discretionary CapEx program for the sawmills, can you just go through how much of the $230 million is left? And then following on Paul's question, just trying to understand how the benefits roll out, how much of the expected cost savings is really related to getting the operating rates up and running these mills closer to full capacity?

Henry H. Ketcham

So the $230 million you're referring to is the -- is what?

Sean Steuart - TD Securities Equity Research

The $230 million total program, I guess, when you initially announced it.

Henry H. Ketcham

Okay, right. So it's kind of a rolling program. So I'd say that -- let me put it this way, Sean. We would expect to be spending -- as long as our cash flow allows us, we'd expect to be spending between $150 million and to maybe somewhat over $200 million per year on our CapEx. Our maintenance CapEx is significantly lower. But -- so we're going to continue doing this year in, year out, at least for the foreseeable future. And it's going to hit our U.S. divisions, our Alberta divisions and our B.C. divisions at different times. So we're a long ways through our $230 million, but we've got significant capital plans in the next 2 or 3 years as well. So I think you just think in terms of maybe $150 million to $200 million per year for the next 2 or 3 years.

Sean Steuart - TD Securities Equity Research

Got it. And then, Hank, just one clarification in your initial remarks there. Did you say you expect Western Canadian log prices to be up $3 a cubic meter in the third quarter, is that the number?

Henry H. Ketcham

We expect the average in the B.C. Interior, the average in the B.C. Interior to roughly be around $3 a meter. It's going to be some higher, some lower.

Operator

Your next question is from Bill Hoffman from RBC Capital Markets.

Bill Hoffman - RBC Capital Markets, LLC, Research Division

Just a question, and I apologize if I missed a part of your comments before, but when you talk about the BCTMP markets right now, can you just talk about what you're seeing as far as demand levels there? And with the Chetwynd closure, is that business that -- is interesting or worthwhile for you all to look after?

Edward R. Seraphim

Well, I'll answer the first part. I think in Hank's comment on that, we have very good order files in our -- overall in our pulp business. In BCTMP, we have very strong order files. So as I said earlier, Chetwynd hasn't shut down yet. We've got strong order files. Where it goes from here is primarily dependent, as I said earlier, on Chinese demand. And I wasn't too sure about the second part of your comment around you asking -- do you want the BCTMP business? I wasn't sure what you're referring to there.

Bill Hoffman - RBC Capital Markets, LLC, Research Division

Just given all the hardwood capacity is coming on globally, just wondering whether you think the BCTMP market can just decouple a bit or whether it's just going to follow the same pricing pressures. And then the other thing is, my understanding was that Chetwynd sales were mostly into Korea as opposed to China. That's why I was sort of curious whether there was -- whether you guys were in that market or whether you're interested in being in that market.

Edward R. Seraphim

Well, we're a large BCTMP producer. I guess with Chetwynd down, we will be the largest in the world. So we're obviously in all the markets, including Korea. When they pull out, there will be some rebalancing. In terms of price, relative pricing with hardwood and other grades, BCTMP tends to follow hardwood but not always. It's a bit of its own unique market, and it really comes down to the supply and demand for that product. We've seen times where BCTMP is sold at a discount. We've seen it when it's sold at a premium. So our job at West Fraser is to manage our costs, but also to manage our efforts in the marketplace, so we continue to increase market share for BCTMP. If we do that well, then we'll be able to combat some of the impact of the new hardwood kraft supply, and I think our folks have done a pretty good job over the last 5 years doing that. So I think we're pretty confident going forward in that business.

Bill Hoffman - RBC Capital Markets, LLC, Research Division

That's helpful. And then just a quick question on the lumber side. I guess, Hank, you mentioned a minute ago that you didn't want to give any details on the China sales -- basically, flat year-over-year. Can you just give us some sort of sense of what percentage of sales that might be in your business right now? Is that sort of 10% of the sales or...

Henry H. Ketcham

I mean, Asia for our Lumber business would be roughly 30%, maybe a little bit more.

Bill Hoffman - RBC Capital Markets, LLC, Research Division

And where is that versus 5 years ago?

Henry H. Ketcham

Sorry?

Bill Hoffman - RBC Capital Markets, LLC, Research Division

Where is that versus where it was 5 years ago?

Henry H. Ketcham

Well -- and this is all SPF by the way. Versus 5 years ago, 2007, I mean this really started in say 2005 and when the B.C. government helped open us -- markets for us over there. So I would say it's starting from, in our company's case, almost 0. I'm sorry, I should amend that. We've been a steady shipper to Japan for 30 years. So the Japanese portion has been roughly the same over the last 4 or 5 years. So it's China -- the difference in our shipments to Asia has all been China and a little bit elsewhere, but mostly China.

Bill Hoffman - RBC Capital Markets, LLC, Research Division

How much was the Japan piece then?

Henry H. Ketcham

Japan would be roughly 8% to 10%.

Operator

The next question is from Alex Ovshey from Goldman Sachs.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

On the lumber side, that business is starting to make money. It appears that U.S. housing market is finally showing some signs of life. So as we think of more normalized environment in lumber, I'm curious if you have thoughts on how to think about the profitability per unit for your businesses, and whether or not you expect to see a meaningful diversion between the profitability on the Canadian side and the U.S. South assets.

Henry H. Ketcham

That's -- well, to start with, we do see -- I think we are anticipating a slow -- maybe uneven, but a slow and steady improvement in housing. It could be very slow and it could be very unsteady, but I think, definitely -- in our view, anyway, we've seen the worst of it. So what's going to happen in B.C. is there's a -- we're going to see a decline in wood supply, and we're going to see, we think, an increasing demand from North America for the products. So in general, we're going to see -- we should see margins improve over time in lumber. I can't really -- I don't really want to talk about the difference between the U.S. and Canada at this point.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Okay, that's fine. Broadly speaking, I'm curious, what are your thoughts on the price route that we've seen in lumber year-to-date? Do you think it's more demand- or supply-driven?

Henry H. Ketcham

Well, I would assume supply is relatively constant. So I think it's probably that -- we've generally had seasonal rallies in lumber in the spring when the building season really gets going. I suspect it's primarily that.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. Lastly, just on pulp, I think there's a lot of paper-based packaging capacity that's coming online in China, specifically on the boxboard grades. And do you have a sense for how that ultimately will get fibered? And would there be any potential impact on the demand for BCTMP from that new capacity?

Edward R. Seraphim

It's Ted here. I'll try and answer that. I think first of all, there's always new capacity in paper coming on in China, but you also have to be cognizant that they're also shutting down a lot of old capacity. So at the end of the day, when it comes down to China, what we need to focus on is, will the demand be growing for that packaging? And if it does, then it won't be supplied by fiber within China because there is -- appears to be -- I don't want to say a fiber shortage in China, but fiber's very tight. So it will be -- it'll largely -- any growth in demand will be largely based on imported wood pulp. And BCTMP plays a big role in packaging. And that's where we have a fair amount of optimism.

Operator

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

Mark Kennedy - CIBC World Markets Inc., Research Division

Just a couple of questions. First of all, Hank, you had a chart there were you showed that with respect to lumber grades, we've seen that Southern Yellow Pine premium get to about $40 over SPF. And likewise, you've seen the economy grades come to within about $40 of #2. I just like your views going forward, do you sort of see both of those spreads sort of being maintained in that range? Or do you see any change in the next few quarters?

Henry H. Ketcham

Mark, I think Chris McIver might want to answer that question.

Christopher D. McIver

Hi, Mark. Yes, I think you have to look at a couple of things. One, we did show that those are 2 and [ph] better -- 2x4 pricing. So in the South, we've seen significant decreases in spread between the wide and the narrows. And that's still a bit of an anomaly. And we think as housing comes back, those spreads will again come back. But today, you're seeing a spread in 2x4, but you've actually got a discount in the wides, and that obviously affects us. So going forward, we expect to get more normalized, where the wides will also help us on that. So -- and then the low grade, I think that's a relative spread that's more traditional.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay. And just a follow-up, Chris, like with the euro now at an all-time low, I think it's EUR 1.22 here today against the U.S. dollar, are you seeing or do you expect to see any more competition, either from Scandinavian lumber coming into the Eastern U.S. or China as well?

Christopher D. McIver

Mark, yes. We're not seeing any -- I shouldn't say any, but we're seeing very little European wood come into the U.S., which tells me that current pricing is not competitive. So we certainly don't know exactly where they are competitive, but it isn't going to be at these levels. We're hearing numbers substantially higher before they come back. But when the market normalizes, we expect the Europeans will come back, at least partially. And they are in China. It's not a significant market for them. They have a freight disadvantage. They're bigger in the Middle East and so forth.

Mark Kennedy - CIBC World Markets Inc., Research Division

Okay. And then one last question, Hank. I think you mentioned that on Hinton -- or maybe Ted wants to take this, but you said that you're running at a relatively full capacity there now. So that bit of hiccup you had there in Q2 on production, like did you think that's behind you? And do you sort of see Hinton more or less maintaining its current pace then?

Henry H. Ketcham

Well, I think Ted and I would both agree that it was a very, very long hiccup, kind of a 2-quarter hiccup. So I would say that we need a 2-quarter interlude between hiccups to tell you for sure that we've got it behind us. But feel -- we do feel very comfortable that the fundamental issues, they were identified and worked on during the first half of the year. We feel they have predominantly been corrected. And I hope in the third quarter, we're going to be able to confirm that.

Operator

There are no further questions registered at this time. I'd like to turn the meeting back to Mr. Ketcham.

Henry H. Ketcham

Okay, well, I think we appreciate everybody joining us, and I think that's the end of the call. Thank you very much. Bye.

Operator

Thank you. The conference call has now concluded. Please disconnect your lines at this time, and we thank you for your participation.

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