Industry Overview
Our Sector Outlook
The forest products sector is benefiting from synchronized strength across bellwether forest product commodities. In our view, key commodity prices in this sector are poised to stay well above trend over our two-year forecast horizon, even as lumber and oriented strand board supply additions accumulate. There are several emerging H1/21 headwinds that are expected to mitigate much-improved commodity prices: 1) rising fibre costs (most notably in Canada); 2) other input cost inflation (e.g., resins and chemicals); 3) higher freight costs/shipping bottlenecks; and 4) the weaker U.S. dollar.
The average share price correction for our coverage universe between mid-February and late-March was 15%, led by lumber-weighted equities. We attribute recent weakness to profit-taking after an unprecedented run over the preceding 11 months, as investors digest rising interest rates, choppy housing data, and the sustainability of exceptional wood product commodity markets. Context is important – the average trough-to-peak gain for our coverage universe from March 2020 lows to February 2021 peaks was 297% (353% for lumber/panel producers). This compares with gains of 64% for the S&P/TSX Composite over the same period.
Key points on commodity markets:
Softwood Lumber — North American lumber markets have reached an apparent peak, but the supply response continues to lag exceptional demand. The Random Lengths Framing Lumber Composite (RLFLC) price of US$1,026/Mfbm has pulled back US$18/Mfbm (-2%) over the past three weeks, after recording all- time nominal highs for the preceding five weeks. The current RLFLC price is still up 87% since mid-November 2020. Prices for benchmark Western SPF 2x4 #2 & better improved 2% over the past week after plateauing over the preceding month. Slight cracks have emerged for Southern Yellow Pine – the regional composite price has moderated 5% over the past four weeks. We attribute the market slowdown to recent inconsistent U.S. housing data and affordability concerns (i.e., rising interest rates from a low base and materials cost inflation for homebuilders/renovation projects). Tracked lumber capacity expansion initiatives over the next two years total 2.7 billion board feet (1.9% CAGR), many of which we expect may come online over an extended timeframe. Companies in our coverage universe with heavy exposure to lumber: CFP; IFP; RFP; WEF; WFG.
Oriented Strand Board (OSB) — Exceptionally tight fundamentals continue to drive OSB prices higher. Following a brief 19% pullback during November, North American OSB prices have surged to new records since the end of 2020. The current OSB composite price of US$1,050/Msf is an all-time high, up 77% since the end of November 2020, and represents almost four times our estimate of trend levels. Prices have recorded new peaks since late-December, driven by robust underlying demand and a dearth of supply. Supply shortages have been exacerbated by a MDI resin shortfall (substitute alternative phenolic resins have resulted in lower OSB line speeds). Anecdotal reports indicate that producer order files stretch out as far as eight weeks (well above normal). Net OSB capacity additions over the next two- and-a-half years total only 680 million square feet (1.3% CAGR). Companies in our coverage universe with exposure to OSB: WFG; LPX.
Market Pulp — The significant pulp market recovery since H2/20 shows signs of waning, even as producers forge ahead with proposed April price hikes. Global pulp mill inventories moderated during H2/20 and, in tandem with planned/ unplanned/Q2 deferred industry downtime and resurgent demand, precipitated one of the fastest pulp price recoveries on record. The current transaction price for northern bleached softwood kraft (NBSK) pulp in China is ~US$980/tonne, up 80% from the July 2020 trough. NBSK pulp list prices in North America and Europe have increased 27-37% from recent early-2020 trough levels. Proposed April hikes of US$100-$155/tonne would take list prices to records in North America, and within 1% of the October 2018 record in Europe. While pulp market fundamentals have improved, we are skeptical that there is enough support for accelerating gains from current levels. Market reports indicate eroding tissue and Chinese paper mill margins. Companies in our coverage universe with exposure to market pulp: CFX; CFP; UFS; RFP; MERC; WFG.
Printing & Writing (P&W) Paper — Graphic paper prices are moving higher as industry supply closures have balanced markets. January/February US$40/ tonne newsprint price hikes lifted reference prices from four-and-a-half year lows. Proposed US$45-$50/ton April/May increases would lift newsprint prices in the East to the highest level since December 2019. Demand for North American newsprint declined 26.2% in 2020 (26.9% YTD through February) and industry operating rates averaged 71% (88% YTD). Producers have announced price increases for uncoated groundwood grades for April (US$40/ton) and May (US$30/ton). Proposed US$60/ ton price hikes on uncoated freesheet were partially implemented beginning in late- March, and the current price for office copy paper of US$1,060/ton represents a ten- month high. Price hikes are supply/cost-driven. North American P&W paper demand declined 20.8% in 2020 (19.5% YTD through February) and industry operating rates averaged 80% (86% YTD). Companies in our coverage universe with exposure to P&W markets: RFP; UFS.
Containerboard — North American packaging market fundamentals remain firm, even as box demand growth in early-2021 has moderated from exceptional rates in Q4/20. The March US$60-$70/ton containerboard hikes were partially implemented. The current price for benchmark 42-lb kraft linerboard is an all-time nominal record, up US$60/ton (8%) from October 2020 three-year lows. Recent supply disruptions (i.e., malware attacks at three producers and severe weather) have added tension. Anecdotal reports indicate that higher costs were also the impetus behind the proposed March price hikes (raw material, energy, and transportation cost inflation). Relative to record Q4/20 levels when U.S. box shipments grew 6.7% y/y, U.S. corrugated box demand in Q1 has moderated but producers' order files are relatively strong during a period when the industry is typically rebuilding inventory. Expected net North American containerboard capacity growth between 2020 and 2023 totals 3.9 million tons. Growth from Q4/20 onward translates to a three-year capacity CAGR of 3.8%. Companies in our coverage universe with exposure to paper packaging markets: CAS.
Our Sector Stance: Overweight
We remain positive on mid-term share price prospects for most lumber and OSB producers, as we believe that investors underestimate the free cash flow potential through 2022. Current outsized earnings are not considered sustainable, but this cyclical wood products peak is exceptional as measured by magnitude and longevity. Adjusted for expected free cash flow yields of 13% in 2021 and 9% in 2022, we estimate that our coverage universe trades at an adjusted trend EV/EBITDA multiple of 4.8x versus the long-term average of 6.2x. Given the recent correction, and with more Buy than Hold ratings for our coverage universe, we are comfortable with our sector overweight stance. Our top picks in the sector are West Fraser and Interfor.