West Fraser Sandwiched Between Healthy Markets And Trade Policy Uncertainties

| About: West Fraser (WFTBF)
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West Fraser is not only the largest North American lumber company, but it is also consistently the most efficiently run, with management relentlessly focused on cost improvements and capital reinvestment.

A trade dispute between the U.S. and Canada creates a great deal of uncertainty for Canadian lumber, but West Fraser produces about 40% of its lumber within the U.S.

West Fraser looks around 5% to 10% undervalued today assuming ongoing growth in the U.S. housing market, but news around the lumber trade issue could drive meaningful short-term swings.

After a tough decade, things have at last turned up for lumber company West Fraser (OTCPK:WFTBF) (WFT.TO) and its peers. Operating rates in North American have been in the vicinity of 90% and housing starts have been slowly grinding higher. What's more, the company's own constant focus on costs and self-improvement has positioned it to make the most of the upturn in demand.

The "but" is the uncertainty regarding trade policy between the U.S. and Canada. West Fraser is a Canadian company, and while it produces about 40% of its lumber in the U.S., that leaves another 60% vulnerable to potential tariffs. My base case is that the outcome of this trade dispute is not crippling to West Fraser, Canfor (OTC:CFPUF) (CFP.TO), or Interfor (OTC:IFSPF) (IFP.TO) (nor unfair to Weyerhaeuser (NYSE:WY)), and that West Fraser's shares are currently priced at a bit of a discount on the assumption that there's a continuing build toward 1.6M to 2.0M housing starts in 2019/2020.

While West Fraser's ADRs do have the dreaded "F," they do offer some liquidity. The Canadian shares are far more liquid, though, and most brokers facilitate trading on Canadian exchanges without too much difficulty.

The Biggest And Maybe The Best

With well over 6 billion fbm of capacity, West Fraser is the largest lumber producer in North America, and lumber operations generate around two-thirds to 70% of the company's revenue and EBITDA. West Fraser operates over 30 mills across Canada and the U.S., with close to 40% of its production in British Columbia (mostly SPF, or spruce, pine, and fir), another 20%-plus in Alberta (also SPF), and the remainder in the southern U.S. (which is mostly SYP, or southern yellow pine). Expanding into the U.S. has been a long-term priority for the company, and was assisted by a few M&A transactions in years past.

With close to 10% share of the North American market, West Fraser has ample scale. It also has a relentless attention to detail, as continuous cost improvement has been a major focus of management for a long time. West Fraser also puts its money where its mouth is in this respect, with the company consistently reinvesting in its sawmills to keep them modern and cost efficient. As a large percentage of the lumber market in North America is made up of small operators with just one or two mills, I believe this scale and capacity to reinvest is a significant competitive advantage for the company.

North American lumber is heavily influenced by Canadian operators, as West Fraser is the largest and Canfor is the second-largest player, with Weyerhaeuser as the #3 player. Other Canadian players of note include Interfor, Resolute (NYSE:RFP), and Tembec (OTCPK:TMBCF) (TMB.TO), though the latter two do not have lumber facilities in the United States. Given the potential impact of trade policy (more on this in a bit), that's not a trivial detail.

West Fraser also operates seven mills in its Panels business, a business that generates close to 20% of its EBITDA from plywood, fiberboard, and laminated veneer lumber. West Fraser isn't much of a rival to Boise Cascade (NYSE:BCC) or Weyerhaeuser in the U.S. plywood industry, as most of what it produces is sold within Canada.

Last and not least, West Fraser has a pulp and paper business that generates close to 20% of its revenue. West Fraser is the third-largest pulp company in Canada, operating two NBSK and two BCTMP mills, as well as a newsprint mill. While pulp and paper is a volatile business, management has tried to improve results through careful cost control, including managing energy costs by prioritizing self-sufficiency and altering production schedules around electricity prices (idling capacity when electricity prices are higher).

The U.S. Market Drives The Story

Although West Fraser generates around 50% of its revenue outside the U.S., the U.S. is nevertheless the largest market for the company and the dominating factor in its fortunes. The U.S. housing market accounts for about 70% of the demand for lumber in North America (split between new construction and renovation/remodel/repair), and housing starts go a long way toward driving demand volume and pricing. Operators try to balance capacity with full-cycle demand, and market pricing tends to get "interesting" when capacity utilization exceeds 85%. Unlike with manufactured lumber products, there's not a lot of idled capacity that can be restarted relatively quickly.

Outside of lumber, the U.S. is also seeing growing demand for manufactured wood products like oriented strand board (or OSB), an important driver for Louisiana-Pacific (NYSE:LPX) and Weyerhaeuser, but not West Fraser. Likewise, West Fraser doesn't have Weyerhaeuser and Boise Cascade's exposure to products like I-joists, though it does compete in laminated veneer lumber (with Weyerhaeuser, Boise Cascade, and Louisiana-Pacific).

The elephant in the room with respect to the U.S. market is the future of trade policy concerning lumber. The U.S. Lumber Coalition argues that the Canadian government effectively subsidizes its lumber industry by under-charging for logging on public lands and the end result of years of wrangling (and attempted unilateral action by the U.S.) was the Softwood Lumber Agreement (or SLA) which has since expired. With no replacement agreement in place, the U.S. Lumber Coalition is pushing the U.S. Department of Commerce to act, and the department should announce its position in April and June of this year regarding its position on subsidies and dumping actions. Barring a negotiated agreement, the U.S. could once again attempt to implement duties on Canadian lumber (I have seen rumors of a 30% figure).

Although West Fraser has meaningful U.S.-based assets that would not be subject to that duty, it would nevertheless have an impact on the business. China and Japan have become meaningful customers for West Fraser over the years (accounting for close to a quarter of revenue), but neither of those markets is looking great right now and China's demand has been weighted more heavily toward lower grades (less valuable to West Fraser).

There's also no simple solution. While the U.S. Lumber Coalition may believe that Canadian producers get an unfair advantage, the reality is that U.S.-based production cannot fully supply the market (over time more capacity could be added, but it's not in place today). Higher duties on Canadian imports and/or import quotas would certainly boost prices for U.S. lumber producers, but it would also carry the risk of slowing/damaging the U.S. home construction market (which in turn has implications for jobs, growth in other industries, and so on), so I believe this a more nuanced decision for the U.S. government than it may first appear.

The Outlook

I expect the initial U.S. position on the trade issue to be harsh, if not draconian, but I expect that it will be the "opening bid" to a negotiating process that ultimately leads to an operating environment relatively similar to the last decade. If there are meaningful changes, I would expect them to be tiered in a way that reduces the impact during the good times (so that the U.S. government doesn't kneecap its own housing market), but makes the operating environment more difficult in periods of lower demand.

On the margin side, I expect ongoing demand for lumber and healthy pricing, combined with the company's strong cost focus, to drive strong margins for a few years. West Fraser is typically the most profitable of the lumber companies (not necessarily in every single quarter, but more quarters than not, and certainly over a full cycle), and the fact that industry operating rates are already strong at less than 1.5M housing starts is encouraging.

I expect housing to remain cyclical, and so I'm only looking for long-term revenue growth in the neighborhood of 4%, with FCF margins ebbing and flowing from the low single digits to the low double digits. Management has been consistent about reinvesting in its own asset base, but will look for deals at the right price (and nothing has looked right for a while now) and has been buying back shares (almost $200 million spent last year).

On a DCF basis, the shares look slightly undervalued while the more near-term oriented EV/EBITDA approach supports a fair value about 10% above today's price. At this point, I believe the market is expecting ongoing growth in new housing (but not a major acceleration) and an initially adverse U.S. position on the trade dispute, so either strong growth or a more conciliatory position (or an actual negotiated deal) from the U.S. could be good for sentiment.

The Bottom Line

There's certainly a risk that the market isn't fully discounting the worst-case scenario in this lumber trade dispute, and that's the biggest risk I see with the stock. That said, I believe West Fraser is the best operator in the space and is well-placed to benefit from ongoing growth in the U.S. housing market. As I don't believe the U.S. government will risk tripping up the housing market just to support lumber prices, I think there's enough potential reward here to at least merit further due diligence.

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