The housing recovery trade seems to have hit a bit of a snag recently, as even hot trades like Home Depot (NYSE:HD) and Mohawk (NYSE:MHK) have cooled a bit recently. With mortgage rates heading higher and new construction activity still not that strong relatively to long-term averages, timber, lumber, and wood products companies have gotten dinged. While I had already been planning to write on Louisiana-Pacific (NYSE:LPX) and point out that it seemed as though the market was pricing in too much skepticism about the OSB, siding, and engineered wood markets, the company did a deal that only makes the story more interesting.
In buying Canada's Ainsworth Lumber (OTCPK:ANSBF), Louisiana-Pacific is not only adding capacity ahead of increased demand, but it is also improving its sales/margin mix, adding an Asian export business, and perhaps helping to quell fears that the industry will act irresponsibly with respect to capacity restarts/additions. While I'm actually surprised at how undervalued Louisiana-Pacific appears to be, it looks like there could be room here for 20% to 40% appreciation even after the strong positive reaction to the Ainsworth deal.
Consolidating The Space, And Improving Mix/Margin
On Thursday morning (September 5), Louisiana-Pacific announced a friendly merger with Canada's Ainsworth Lumber, the #5 player in the North American oriented strand board (NYSE:OSB) market. OSB is a type of engineered wood product that is used in structural sheathing for walls, floors, roof decking and so on. Since its wide introduction in the 1990s, OSB has grown its share to around 60% of its addressable market, supplanting plywood in many applications.
Turning back to the deal, LPX is buying Ainsworth in a $1.1 billion deal that offered a 30% premium to Wednesday's close for Ainsworth shareholders. LPX is looking to fund the deal through a mix of cash and stock (52% cash/48% stock) and is offering three different options to shareholders - all stock (0.235 shares of LPX for each Ainsworth share), C$3.76/share in cash, or a mix (C$1.94 cash, 0.114 LPX shares), subject to collars. LPX has already secured the support of Brookfield Asset Management (NYSE:BAM), the owner of 54% of Ainsworth, so the deal is likely going to go through.
At 5.7 times trailing EBITDA, LPX is paying a premium relative to fellow Canadian Norbord (NBRXF.PK), but less than most analysts assign as fair value to the manufacturing operations of others in the space like Weyerhaeuser (NYSE:WY) and Boise Cascade (NYSE:BCC).
What's more, this should be an accretive deal for LPX. Ainsworth operates a relatively small number (four) of larger plants and generates a higher percentage of its sales from higher-margin, value-added products, which has translated into significantly better margins. Per the pro forma information offered by LPX, Ainsworth's adjusted EBITDA margin was 25% in 2012 and 37% over the past twelve months, versus about 12% and 19% for LPX. While Ainsworth's free cash flow generation over the past decade doesn't look quite as strong, a lot of that can be tied to heavy spending on capex during the peak of the U.S. housing boom.
This deal will also bring some meaningful consolidation to the OSB space. Louisiana-Pacific controls about 20% to 22% of North American installed capacity in the OSB market, with Georgia Pacific close behind in the high teens (and in the process of adding about 20% more capacity), Norbord is close behind in the mid-teens, with Weyerhaeuser at around 10%. Ainsworth was the #5 producer, with about 2.5 billion square feet of active capacity and the potential to increase that up to 3.1 billion relatively quickly. All told, and including announced capacity additions, LPX should emerge with something in the neighborhood of 30% of industry capacity, though likely closer to 25% including added/restarted capacity projects underway.
As I mentioned before, Ainsworth has an attractive product mix, including specialty flooring, oriented strand lumber, insulated structural panels, and products designed for the Japanese construction market (12% of Ainsworth's sales), where it has about 70% to 75% market share in a market where OSB has only about 10% share relative to plywood. All told, about 50% of Ainsworth's product mix could be considered higher-value.
Ainsworth is also a low-cost producer - very likely the low-cost producer in North America. This position is due to both large, efficient, and relatively new mills, as well as access to lower-cost fiber. Ainsworth has also been disciplined with its capacity additions, and running its mills at around 90% capacity since 2009 certainly helps (roughly 40% of industry capacity was idle last year, and about 30% so far this year).
Louisiana-Pacific Has Its Own Qualities To Offer As Well
Although the acquisition of Ainsworth is most definitely one of those "catalysts" that institutional investors lust after, LPX had some solid positives working in its favor even before this move.
While LPX doesn't boast quite the same level of high-value products in its revenue mix, the company has nevertheless been making an effort to increase those contributions in recent years. What's more, the company enjoys a strong share in the OSB market, with around 20% to 25% market share and 15% total share of structural panels. Said differently, when houses get built in North America, a lot of them get built with LPX products.
Continuing that theme, LPX is also a large player in wood siding (about one-third of its revenue) with its engineered SmartSide product (which carries a 50-year warranty). There are numerous competitors in the siding space, including vinyl siding producers like Ply Gem (NYSE:PGEM) and Axiall (NYSE:AXLL) and niche producers like Headwaters (NYSE:HW), and engineered wood siding is only about 5% of the market ($400 million), but LPX has 75% share and engineered wood does appear to be displacing vinyl, traditional wood, and fiber cement. Of the whole $8 billion market, 10% share for LPX seems achievable just on supplanting traditional wood, and it's well worth remembering that the "normalized" annual market for siding is closer to $11 billion a year.
Louisiana-Pacific also continues to build its engineered wood products business. Now, OSB and LPX's siding are both types of engineered wood, but Louisiana-Pacific uses Engineered Wood Products (NYSEARCA:EWP) to refer to products like laminated veneer lumber, I-joists, and so on. LPX has a relatively small share here (in the mid teens) and is number three behind Weyerhaeuser and Boise Cascade, but it is a business with growth potential.
Last and not least, LPX has meaningful OSB operations in South America where, to the best of my knowledge, it is the only OSB producer (or at least the only one with real scale). LPX has plants in Chile and Brazil and while OSB is a pretty new material to these markets, the possibility of combining market share penetration against traditional lumber and plywood with above-average homebuilding growth in markets like Brazil is appealing for the long term.
Beware Of Competitors And Irrational Exuberance
This isn't a perfect, or risk-free, story. Foremost among my concerns are the ongoing capacity restarts and additions in the industry. Not unlike other cyclical building materials sectors, the engineered wood sector has the nasty habit of over-expanding in response to rising demand and undermining pricing.
To that end, OSB pricing has spent most of 2013 declining, with prices down about one-third quarter-to-date. Investors may remember that LPX was a very strong stock in 2012 - and that's when OSB prices were steadily rising - but with OSB prices crossing over the 2012 levels back in July, investors are right to worry about whether the market has gotten a little ahead of itself with its enthusiasm for a housing recovery. All told, about 7 billion to 10 billion square feet of capacity could eventually come back (though it takes time and money to restart a mothballed facility), and there simply isn't the housing activity in the U.S. to absorb that right now.
Will LPX's competitors be more rational? We can hope so, but the history here is not good. Still, with an improving margin and value-added product mix, LPX should be able to better differentiate itself from the commodity OSB market and maintain some pricing and margin advantages.
Trying To Dial In The Growth Potential
Clearly there is quite a bit of estimation and guesswork that goes into a long-term model for a company like Louisiana-Pacific. Higher rates and iffy job growth could stifle the housing recovery, and competition may make it hard to improve revenue and margins in the coming years.
That said, I see the combined companies growing sales at a long-term rate of 8%, with much of that growth in the next five to six years. I also believe that Louisiana-Pacific can return to the good days of double-digit free cash flow margins, such that free cash flow grows by 15%. As it so happens, I'm building my model on the assumption that Ainsworth's superior margins to come down closer to the industry average, so there could be room for outperformance there. Even so, a free cash flow-based fair value of $23 (including the share dilution and cash spent for Ainsworth) is quite appealing in its own right.
The Bottom Line
My long-term free cash flow model suggests a fair value of $23, while my EV/EBITDA model (including Ainsworth) says $20 on the basis of a 6.5x forward multiple (and building materials stocks can trade at multiples as low as 4x or 5x in times of pessimism and up to 8x or 9x when the Street is thinking recovery). Both numbers, then, suggest meaningful share price appreciation even on the basis of what I think are pretty conservative estimates and multiples.
Certainly there is a risk that the housing market stalls, progresses at a slower rate, or reverses altogether. Likewise, there is a risk that LPX's rivals act irresponsibly. These are both risks that just go with the territory. That said, I believe investors are being well-compensated for those risks, I believe Louisiana-Pacific is an appealing stock even after today's favorable post-deal run.
Disclosure: I 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.