Louisiana-Pacific Harvesting A Windfall In OSB, While Reinvesting In Siding

Summary

• With strong housing demand and exceptional discipline among suppliers, OSB prices have moved to once-unthinkable highs, driving exceptional profits and free cash for LPX.
• Management is reopening its Peace Valley mill, but won't be committing any resources to new capacity; with West Fraser reopening Chambord, supply is increasing about 5%.
• LPX's priority is the siding business, and the company is converting two plants to siding production and looking to leverage higher-margin new products like ExpertFinish to continue growing share.
• OSB prices may start easing later in 2021, but LPX can generate exceptional profits and cash flow from the housing cycle in the meantime.

Reports of the demise of the oriented strand board (or OSB) boom were certainly premature when I last wrote about Louisiana-Pacific (NYSE:LPX), as the combination of strong housing demand, some lingering COVID-19 disruptions, and unprecedented industry discipline has led to prices rising from around $800/msf when I last wrote about the company to almost $1,200 at the end of last week (as per Random Lengths) – staying far above past spikes to around $450/msf and a prior long-term average of around $280/msf.

How long the boom can last is a great question and I’ve given up trying to answer it. The plant restarts from West Fraser (WFG) and LPX will expand industry capacity by more than 5%, but prices are likely to stay high into the winter as inventories very slowly rebuild. In the meantime, LPX continues to run the OSB business with a profit/cash flow maximization strategy while prioritizing reinvestments into SmartSide, a plan that certainly won’t harm OSB prices.

I don’t have particularly good answers on valuation at this point. I don’t think OSB prices can stick at these levels, but it seems as though producers have learned from the past cycles, and the siding business continues to offer upside. I can argue for a near-term fair value of $60 or more, but the reality is that the shares are likely to trade pretty closely to OSB prices and price expectations in the near term.

Oligopoly, Or Common Sense?

The level of discipline exercised by OSB producers over the last few years is exceptional and unusual. The OSB market has historically been pretty volatile, with the swings in demand from housing exacerbated by overreactions on the supply side – adding too much capacity in the good times and shuttering too much capacity in the bad times.

That hasn’t been the case this time around. Not only has there been consolidation in the space with the top four players operating around three-quarters of the installed capacity, there have been actual plant closures or conversions to other products. Companies have been slow to reactivate what idled capacity there has been, and with LPX and West Fraser reopening their last idled plants, there isn’t much left - I haven’t seen word on whether Georgia-Pacific is considering reopening the Allendale plant, the only major idled facility left.

The restarts from West Fraser and LPX will probably be enough to allow for a slow rebuild in channel inventories, but prices are likely to stay high through year-end (LPX management agrees). With that added capacity, it’s an open question whether anyone else is going to be tempted to spend the $300M and three years it would take to bring a new plant online – at today’s prices it’s tempting, but none of the majors are talking about adding capacity.

There have already been calls for government intervention, but I’m not sure what that will accomplish. The assets in place are what they are and the government cannot order a company to build a new plant. While collusion is certainly possible, it’s also possible that the companies have learned some hard lessons from years of volatile and generally low returns on investment, to say nothing of the market tending to punish companies that allocated capital into new capacity over capital returns.

I’m not making the case for today’s prices becoming a new normal, but I can see an argument for them not returning to prior norms unless and until somebody decides to build new capacity. LPX, West Fraser, Weyerhaeuser (WY), and GP have learned they can generate a lot of profits and cash flow from the assets they have, so I don’t see new OSB capacity as a top-of-list priority.

From OSB To Siding

LPX management has been consistent that they do not intend to add OSB capacity and that they are running the business with the aim of cash maximization. With siding, though, it’s a different story. Smart Side continues to take share from vinyl siding, and the company’s relatively new pre-finished ExpertFinish product should drive even more share growth and higher margins – buyers like the convenience of a finished product that doesn’t need to be painted, and with the finishing process largely automated, a lot of the 100% higher price flows right through to margins.

LPX is pulling out the stops to maximize the opportunity with SmartSide. The company is converting its laminated strand lumber mill in Maine (Houlton) to siding, with start-up expected in 2022, and will then be converting its Sagola, MI mill from OSB to siding, with a 2H’23 intended startup. These moves will add about 30% to LPX’s siding capacity, and that should be enough to get the company through to mid-teens market share. I would expect, though, that sometime around late 2023 or early 2024, the company will need to make a go/no-go decision on a new greenfield plant for further siding capacity.

The Outlook

In conjunction with the conversion of Houlton, LPX has announced that they are “exploring alternatives” for the remaining Engineered Wood Products business. For whatever reason, LPX just couldn’t get traction with this business (it hasn’t been an awesome business for Weyerhaeuser either), and it’s better for shareholders that they’re getting out now.

With strong residential construction activity, helped by a housing shortage and still-attractive rates, there’s no reason to expect any near-term weakness in OSB prices. I do wonder at what point these prices will create actual demand destruction (or force construction projects to stop/pause for lack of materials), but I don’t see much that will hurt pricing in the near term – even if someone decides to add capacity, it will take years to reach fruition (apart from GP restarting Allendale).

Pricing could fall by a quarter or more in 2022, but that would still be more than enough to generate attractive profits, so I expect at least two more years of above-trend EBITDA from LPX. I also expect healthy ongoing growth in SmartSide, and while the siding business will never generate the same peak margins as OSB, it should be a more consistent, more profitable, higher-return business over a full cycle, with share gains still likely for at least the next five years.

I’ve raised my full-cycle EBITDA estimate for LPX from $550M to $635M and also raised the target EBITDA multiple from 7.25x to 8x – I believe a higher multiple is justified by the demonstrated improvement in industry discipline, as well as the ongoing growth of the higher-margin, higher-potential siding business.

The Bottom Line

I believe it’s appropriate to use a blended approach, using a weighted average of the next year’s EBITDA estimate and the full-cycle EBITDA estimate. A 20% weighting of my 2021 estimate supports a $61 fair value now, but obviously there could be more leverage to even higher OSB prices in the near term, and a 50/50 split would drive a $75 fair value.

I continue to believe that an LPX investment today is playing a game of musical chairs. I like the decisions that LPX management has been making, and I think this is a well-run company today, but I don’t think you’re going to want to be owning the shares when OSB prices finally head lower … whenever that may be.

Analyst’s 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.