Tembec - A Not So Obvious Way To Benefit From Rising Lumber Prices

| About: Tembec Inc. (TMBCF)
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Lumber prices should move significantly higher in both the near-term and longer term, and owning the stock of Tembec (OTCPK:TMBCF) is a good way to benefit from this. Most investors gravitate towards the stocks of the large lumber producers like West Fraser (OTCPK:WFTBF), Canfor (OTCPK:CFPZF), and Weyerhaeuser (NYSE:WY) to get exposure to lumber prices or to the smaller producers like Interfor, Western Forest Products, or Conifex that are focused primarily on lumber. However, any given change in lumber prices causes a much larger change in EPS relative to the stock price for Tembec than for most of these other lumber producers. This effect is so strong that rising lumber prices and the positive effect it has on Tembec's EPS can be a catalyst for the stock price to move significantly higher.

Tembec is a Canadian forest products company that produces a number of different products. Almost all of its manufacturing operations are located in Quebec and Ontario with the main exception being a dissolving pulp mill in France. Most recent 12 months sales were $1,625 million, and approximate sales mix by product is as follows: dissolving pulp (mostly high value specialty grades) 29%, hardwood pulp 27%, lumber 23%, coated bleached board 12%, and newsprint 9%. All dollar amounts in this article are Canadian dollars unless otherwise indicated.

Tembec is around the eleventh largest lumber producer in North America, and in the near term rising lumber prices is the variable that will likely affect earnings at the company more than any other factor. To illustrate the sensitivity of earnings to lumber prices, an increase in the average price of lumber of $50 per MBF in U.S. dollars for a year should increase annual EPS by about $.37, which is a very large increase for a stock that is trading around $2.59 per share.

The following table shows my estimate of lumber sales as a percentage of total sales, annual lumber shipments, and the change in annual EPS resulting from a $50 per MBF increase in the average price of lumber for a year as a percentage of the company's stock price for the largest publicly traded lumber producers in North America. Stock prices are as of October 25, 2013.

 

 

Company - Symbol

Lumber Sales /
Total Sales

Stock
Price

Lumber Shipments
(OTCPK:MMBF)

Change
in EPS

Change in EPS /
Stock Price

West Fraser - WFT.TO (WFTBF on Pink Sheets)

59%

C$89.59

5,300

C$4.76

5.3%

Canfor - CFP.TO (CFPZF on Pink Sheets)

63%

C$21.78

4,700

C$1.29

5.9%

Weyerhaeuser - WY

19%

US$31.39

4,200

US$.23

0.7%

Interfor - IFP-A.TO

87%

C$11.59

1,800

C$1.68

14.5%

Resolute - RFP

11%

US$14.80

1,600

US$.82

5.6%

Western - WEF.TO

73%

C$1.44

1,000

C$.11

7.6%

Tembec - TMB.TO (TMBCF on Pink Sheets)

23%

C$2.59

700

C$.37

14.1%

Potlatch - PCH

50%

US$42.58

600

US$.48

1.1%

Conifex - CFF.V

100%

C$7.95

500

C$1.26

15.9%

A $50 per MBF increase in the average price of lumber for a year or an even bigger increase is quite probable in the near term based on supply / demand fundamentals. The main driver for higher lumber prices over the next several years will be increasing housing starts in the U.S., high levels of exports to China, and production that may have a hard time keeping up with rising demand.

U.S. housing starts are forecasted to be about 900 thousand units and 1.2 million units in 2013 and 2014 respectively. Beyond this, starts should continue to rise for a number of years to 1.5 million units, which are considered to be a normal level of new home construction to support population growth, household formation, and demolitions. Furthermore, within five years annual housing starts should increase to well over 1.5 million units in order to compensate for many years of under-building.

At the same time that housing starts are rising and creating demand for lumber, exports of lumber to China should continue to be a major source of demand. Currently the annual amount of lumber that is being exported from North America to China is equivalent to almost 300 thousand U.S. housing starts. Also, it is notable that this is a relatively new form of meaningful demand for lumber. It was only as recently as 2009 that exports of lumber to China from North America started to increase to significantly high levels.

On the supply side one particularly notable constraint on lumber production is a sizable decline in the availability of logs in British Columbia stemming from beetles killing a large amount of standing timber. The magnitude of this problem is very large, and there are estimates that harvest levels in the interior of British Columbia could be reduced by more than 30% from current levels. From the time the problem started about 10 years ago till it runs its course, more than half of the commercial forests in British Columbia, the largest lumber producing province in Canada, will be lost to the beetle infestation.

The main question related to this disaster is one of timing. Notable is the fact that on October 24, 2013 West Fraser and Canfor each announced plans to permanently close one sawmill in the interior of British Columbia in the first half of 2014 due to lack of an adequate log supply stemming from the beetle problem. There will likely be many more announcements like this over the next few years.

Also, in Eastern Canada harvest levels are being reduced by 20% to achieve a more sustainable rate of timber growth. This affects Tembec's lumber production. However, my modeling reflects a reduced level of production, and the company's earnings and sensitivity to lumber prices reflect this lower production.

While rising lumber prices should be enough to drive Tembec's earnings and stock price higher, there are other reasons to want to own the stock. Specifically, Tembec's dissolving pulp business, which is focused on high value specialty grades, should generate good and improving financial returns in the coming years. Also, the company has the potential to divest non-core assets in a way that is value enhancing to shareholders.

In dissolving pulp Tembec focuses most of its production on high value specialty grades. This kind of dissolving pulp is referred to as specialty cellulose, and it is used to impart higher strength, truer color, better clarity, higher viscosity, fewer defects, and consistency in a variety of products. Different kinds of specialty cellulose that the company makes are used in many products including pharmaceuticals, food, personal care, cosmetics, and paint. In addition to specialty cellulose Tembec also produces a small amount of viscose grade dissolving pulp, which is primarily used to make rayon.

Specialty cellulose is a relatively small global market, and Tembec is one of the three largest producers in the world. The other two largest producers are Rayonier (NYSE:RYN), which has the highest production of the three, and Buckeye Technologies, which was recently acquired by Georgia-Pacific.

Along with lumber, making specialty cellulose is a core business at Tembec, and it is a major earnings contributor to the company. Whereas earnings from lumber are cyclical, earnings from specialty cellulose is much more stable.

There is a little concern that an upward trend in specialty cellulose prices might suffer from a near term setback. In fact Rayonier management has expressed this concern in their most recent quarterly earnings conference call. However, this may not be much of a problem for Tembec, because of the specific customers it serves, and the earnings outlook for specialty cellulose is positive particularly in the longer term.

In support of its specialty cellulose business Tembec is pursuing an aggressive capital spending program that will lower its cost of production and ultimately increase production capacity. This capital spending also includes projects to generate electricity using a waste product from the manufacturing process.

Tembec also produces a small amount of viscose grade dissolving pulp, where the main use is in making rayon. The market price for this type of dissolving pulp is much more volatile than for specialty cellulose, and the price of the viscose grade tends to follow the price of cotton to a certain extent.

Cotton prices are currently not abnormally high or low by recent historical standards, but they are very much lower than highs reached in connection with a dramatic spike in prices that peaked in the first half of 2011. Not surprisingly the market price for viscose grade dissolving pulp soared and fell along with the price of cotton. Also, high prices resulted in a significant increase in production capacity for viscose grade dissolving pulp, which put further pressure on prices. However, the longer term earnings outlook for viscose grade dissolving pulp is positive based on increasing use of rayon in textile markets, and Tembec will benefit from this.

The other major products that Tembec makes might be thought of as non-core. These products are hardwood pulp, coated bleached board, and newsprint. Also, the company is a very small producer of hardwood lumber, which is distinctly different from the softwood framing grades of lumber that is a core product, so hardwood lumber is also non-core.

Tembec has been active in recent years in selling non-core assets, and the assets associated with most of these remaining non-core products are possible future divestitures. In fact the company has specifically indicated that it would like to monetize non-core / non-strategic assets at an accretive value. However, the company's coated bleached board mill and one of its three hardwood pulp mills are located at the same site as one of its dissolving pulp mills, so it might make sense for these two non-core mills to be retained.

My estimate is that Tembec might be able to sell two hardwood pulp mills, a newsprint mill, a hardwood sawmill, and three relatively inconsequential fingerjoint lumber plants for total proceeds of around $107 million. Also, Tembec recently announced a sale initiative associated with land the company owns in British Columbia. The initial sale of land, which will close around November 1, 2013, will generate proceeds of $4.2 million, and by the end of 2014 the company hopes to realize up to $75 million from land sales including the initial sale just noted.

All of these divestitures have the potential to be value enhancing for Tembec shareholders. Firstly, the company has sizable tax loss carryforwards to protect gains on the sale of assets from taxation; and secondly, the assets to be divested generate relatively small amounts of earnings or in the case of the land, possibly no earnings.

Tembec has a September fiscal year end, and the most recent financial statements are as of and through June 2013. Latest 12 month sales, EPS, and EBITDA through June 2013 were $1,625 million, $(.03), and $96 million respectively. EPS and EBITDA reflect management's adjustments to exclude unusual items.

Based on the current stock price of $2.59 per share, market capitalization is $259 million, and with net debt of $344 million enterprise value is $603 million. Latest 12 month EBITDA of $96 million includes an estimated $19 million in EBITDA associated with a softwood pulp mill that Tembec sold in May 2013. Therefore, since cash proceeds of $97 million from this sale are already reflected in net debt, EBITDA should be reduced by $19 million before calculating an enterprise value to EBITDA valuation multiple. Reflecting this adjustment, enterprise value is 7.8 times EBITDA.

Based on this measure of valuation, Tembec may not seem to be particularly undervalued. However, if the company is successful in selling the non-core production facilities that were previously described for $107 million, and they sold the British Columbia land for $69 million, and there is no income tax to be paid on any gains, then this would generate $176 million of cash that would reduce the enterprise value of the company.

My estimate is that the 12 month EBITDA from all of these assets that could be sold might be $9 million. Therefore, if enterprise value is reduced to reflect the cash proceeds from the sale of these non-core assets, and EBITDA is reduced by an estimate of what the assets earn, then enterprise value would be $427 million, EBITDA would be $68 million, and the enterprise value to EBITDA multiple would be 6.3. This lower valuation multiple does make Tembec look more undervalued, and when this is coupled with the likelihood of increased earnings, the stock looks compelling as an investment.

A proforma value for the stock based on latest 12 month EBITDA reflecting the sale of the mill that recently took place and also reflecting the potential sale of the other remaining non-core assets is $3.65 per share. This is assuming an enterprise value to EBITDA multiple of 7.8.

The stock may go much higher than $3.50 per share depending on future earnings, which are likely to be significantly higher than recent earnings. Also, a richer valuation multiple may be applied to these higher earnings. It is worth noting that the stock traded at an all-time high of $6.40 per share in late March and early April of 2011.

Within the next two years it's not unrealistic to think that lumber prices could be at an average level that is $100 per MBF higher than recent lumber prices. With these kind of higher lumber prices and with not much change in Tembec's non-lumber businesses, the company could be generating 12 month EPS of around $.70. This level of earnings might justify a stock price of $6.00 per share, which would be close to the prior all-time high.

Ownership of Tembec stock is fairly concentrated. Of the 100 million shares outstanding about 64% is owned by four institutional investors. Wayzata Investment Partners, Trilogy Capital, Steelhead Partners, and Restructuring Capital Associates own 20%, 18%, 13%, and 13% respectively. This leaves only about 36 million shares held by all other investors.

The primary market for Tembec's stock is the Toronto Stock Exchange. However, the stock also trades in the U.S. on the Pink Sheets.

Average trading volume on the Pink Sheets is very low, but market makers keep the bid/offer spread reasonably tight and in line with trade on the Toronto Stock Exchange taking into consideration the conversion from Canadian dollars to U.S. dollars. Also, the market makers make it possible to easily trade amounts of stock that are much larger than the average daily trading volume at reasonable prices.

There are very compelling reasons to believe that lumber prices are on the verge of rising to a significantly higher level. Most investors would not necessarily think of owning Tembec in order to benefit from this. However, it is one of the best ways, and as rising lumber prices boost Tembec's earnings, this can be the catalyst for the stock to move higher.

Disclosure: I am long OTCPK:TMBCF. 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.

Additional disclosure: I am long lumber futures.