July 22, 2021
Forest Products
A Chaotic Era – Do cash lumber prices matter less?
Our view: Lumber stocks have behaved very differently during the pandemic, being far less sensitive to moves in the cash lumber prices. In particular, Interfor, Canfor, and West Fraser are showing far less "beta" to lumber while Resolute Forest Products has become much more sensitive. Until lumber producers re-lever their balance sheets and commodity price volatility falls, we think producers will remain less sensitive to moves in lumber. Longer-term, we think that the equity values will begin to reflect both the cash on the balance sheet and the earnings power of the underlying business.
Why aren't lumber stocks moving with lumber prices? – One of the most common questions we receive is: "why aren't share prices rising as quickly as lumber prices?" Historically, the playbook has been that lumber stocks display an ~1:1 relationship with lumber prices. Between 2015-2019, this worked quite well; however, that relationship has largely broken down since the start of the pandemic. With so many extreme moves in lumber, share prices have been slow to react on both the upside and the downside.
What does this mean for the coming months? – While lumber prices have already fallen >60% from the peak in May, lumber stocks have only fallen by ~12% over the same period. One reason for the reduced sensitivity to changes in lumber prices is the dramatically reduced leverage. For example, Interfor has historically run its business at a net debt to capital ratio in the 20-25% range. Because it has generated so much cash over the past year, Interfor is running net cash. We also sense that investors are taking a longer-term view on the stocks and less focused on day-to-day fluctuations. In our view, this is healthy and will allow producers to make more value-creating capital allocation decisions going forward.
What should we expect over the coming months? – We think lumber producers are significantly undervalued, but directionally are likely to remain under pressure until lumber begins to rise again. On timing, we feel like lumber is likely to catch a bid once builders look to wrap up projects before the fall. In addition, Q2 earnings being reported over the next three weeks should show record results. Thereafter, lumber prices (and stocks) usually bottom seasonally around late-October/early-November.