Summary
- Stock is undervalued to peers due to a slow last half in 2014, and less exposure to the US.
- However the companies wide product offering and ongoing efforts to increase margins reduce risk.
- In time as strength in US demand for lumber softens, the company will be well positioned to profit from other markets, making it a potential takeover target.
THE PITCH
Western Forest Products(OTCPK:WFSTF) is undervalued. In spite of having a great product mix, clients over the globe and a clean balance sheet, the company still trades to a discount to peers, as well as to my estimation of intrinsic value. Their diverse geographical segments will play in their favor in years to come. In this report I will explain why I believe the security has 40% upside. I will also discuss why I believe it might be a takeover target down the line, which could offer as much as an 80-100% return.
NB: I own the security traded on the TSX (WEF.TO, which is more liquid), and share prices refer to the Canadian stock in Canadian dollars unless it is stated otherwise.
COMPANY OVERVIEW
Western Forest Products is a wood products company which sources wood on coastal British Columbia from 5 tree species: Western Red Cedar, Hem-Fir, Douglas-Fer, Yellow Cedar, and Sitka Spruce. A wide range of products are produced in their 9 manufacturing facilities in British Columbia. They derive 40% of their revenue from Canada, 20% from the US, and 15% each from China and Japan. The rest comes from other less significant markets. The company has a pragmatic approach. Since demand for lumber is cyclical and highly dependent on home construction & repairs, and since supply is widely impacted by seasonality, the company focuses on what it can control: making the company's sawmills more efficient through strategic Cap-ex, and proposing niche appearance products as well as structural wood.
INDUSTRY OUTLOOK
The outlook for lumber products defers from one of the companies geographic segments to the next. Currently, in North America, lumber is mostly demand driven. This can be derived by two factors: the recovering home market in the US which increases demand, and the pine beetle infection which has reduced supply in many of British Columbia's forests. Since Western Forest Products is a coastal firm, they weren't at all affected by the bug.
(click to enlarge)
Source: Census
The consequence of such a dynamic is that the firm has been getting better prices for their lumber, and that they keep all gains from a stronger US dollar and a weaker Canadian dollar.
(click to enlarge)
Source: Author's Data from Interim reports.
This isn't the case in China. Throughout the first quarter demand for export lumber was weak, given inventory levels in China have attained high levels. However when inventory comes down one should expect Canadian exports to go up again. In Japan, management believes they are in a better competitive position since many of their competitors are selling their products to the US to service the higher domestic demand. These export markets are mostly supply driven and the low Canadian dollar gets passed on to them.
"In this case what is happening is the buyers are getting the benefit of that dollar weakening on a positive" -Donald Demens, CEO
Overall though the Canadian sawmills exports have been showing strength in the first quarter, up 15.3% from last year in April, which obviously goes hand in hand with the April's high housing starts in the US.
(click to enlarge)
Source: Madison's Report
This trend should continue throughout the rest of the year. Historically the second quarter has been the strongest for the company, due to the seasonal aspect of the business. This year, the second quarter should be even better, when you take into account increased shipping to China towards the end of the quarter as inventory comes down, and marginal increase in demand coming from stabilization in Japan's housing market.
OPERATING METRICS
It goes without saying that Western Forest Products was hit hard in the aftermath of the housing bubble.
(click to enlarge)
Source: Author's Data
It might have been a blessing in disguise, it is only since 2010 that the company has been profitable. The return on equity has been swell since then as well. The numbers for 2015 are my estimates from the model I constructed. (More on that below)
(click to enlarge)
Source: Author's Data
I mentioned the company's endeavor in niche products as well as structural products. These specialty products reduce EBITDA volatility considerably, which has probably contributed to the firm's ongoing profitability.
Source: May Investor Presentation
VALUATION
I love the saying that says there are no bad assets just bad prices. Being able to determine a fair price for a security is both difficult and essential. In attempting to do so, I have constructed a DCF model with a base and bear case, looked at peers, and how the company has been priced relatively to its earnings over the last five years.
Peer Multiples.
In comparing Western Forest Products to its peers it became apparent that the company was trading to a discount to most on nearly all counts. The most important ones to consider are Interfor(OTC:IFSPF), West Fraser(OTCPK:WFTBF), and Canfor(OTCPK:CFPZF), the company's main competitors.
(click to enlarge)
Source: Author's Data.
I then calculated the implied price for Western Forest Products stock based on the median multiples. I also added a "reasonable" column, which reflects ratios more in line with the company's top competitors.
(click to enlarge)
Source: Author's Data
Given its return for equity in 2014 (17%) triumphs Western Fraser (13%), Interfor (7%), and Canfor (10%). At a 6% net margin, the company is well in line with its competition. The truth is in all industries some companies will always trade at a premium to the average, and others at a discount to the average.
One apparent reason for the discount is the discrepancy in the 4 companies geographical exposure. As I mentioned above Western Forest Products only generates 20% of their revenue from the US. On the other hand Canfor generated 58% of their revenue from the US, West Fraser 46%, and Interfor 59%. Given the current strength in the US economy, Western Forest Products will be less exposed to the increase in US demand than its competitors.
This also explains the discrepancy in relative performance between 2013 and 2014. In terms of revenue growth, both West Fraser (11% growth) and Interfor (30% growth) triumphed Western Forest's 6%.
And at a first look it would look like Western Forest had a worst year, EBITDA was down 15% year over year whereas the competitors increased theirs. This comes mainly from a contraction in the company's gross margin from 24% to 21%. This came from two areas: forced to buy expensive logs in the open market to compensate for weak production in the third quarter & weaker export prices. I excluded Interfor from the chart below. Since the stock has soared to over 100x TTM earnings,
These are some elements which explain why the valuation gap increased between the company and its competition. In the catalysts section, I address why I believe the discount is too steep, and why the gap could narrow soon.
DCF
I constructed a DCF Model with the following assumptions: For the base case, I suggest a 5% growth in revenue for the next 5 years, with COGS margins in line with historical norms. Here is a quick screenshot.
Source: Author's Data
I arrived at a WACC of 10.8% which I used to discount the cash flows and here are the outputs:
(click to enlarge)
Source: Author's Data
The current assumptions confirm the hypothesis developed in the peer multiple analysis. Picking the numbers in the middle of the range gives us a target of $2.70-$3.00. For these projections to play out, the company just needs to keep operating the way it has in previous years, without any major hiccups on the macro level.
However since the demand for lumber is highly correlated to the construction market, if demand was to be constrained once again within one of the companies markets, this growth might not be achievable. I also put together a bear case, within which the company's revenue would only grow at 1.5% per year, and the cogs margin would be 2% worse. Here are the outputs.
(click to enlarge)
Source: Author's Data
Using the DCF method it would seem that in a not so good case, the downside would be of 11%.
Given the potential upside, I think the risk return ratio is asymmetrical given the stock's current price.
PE Lines
I like to draw up Price-earning lines at different levels for a company for two reasons: the first is to see how the company is being priced compared to the historical trend line, and also to see if the multiples I believe the company should trade at have ever been achieved. And as you can see until the first half of 2013, the company traded way above the low 12x TTM earnings it fetches today. Even just earlier this year the company traded at around 2.80$. This is a positive, because investors have already priced the company at such levels.
(click to enlarge)
I believe right now is an opportunity.
CATALYSTS
I mentioned above that the company's price has been mediocre this year, and outright bad in comparison to its competitors. It also came apparent that the company's EBITDA margins were less dramatic. I believe Western Forest Products has been underappreciated by the markets recently because:
- Modest growth in comparison with the competition
- Dramatic decrease in EPS
- Less exposure to the US.
On the other hand I believe the valuation gap could quickly close for these reasons in the short run:
- The company will catch up the production they missed out on in the second half of last year during the second quarter.
- Shipments to Asia should start to increase again with the stabilization of the Japanese housing market.
- The company's strategic Capex should start to have a positive impact on margins.
- The strong seasonal aspect in North America.
RISKS
As with every investment there are a few risks. With Western Forest Products, one of the main short term drivers of risk is the volatility of demand. As such, even though the company has diversified its product offering with specialty products whose prices are less volatile; housing starts, renovation and construction still drive an important amount of the business.
The next non negligible risk is the price they can get for their wood. They have very little control over the price of structural wood which trades as a commodity. In the short run, isolated events (such as the pine beetle in BC) can have a strong impact on price.
From an investor's point of view, there is also the possibility that the revenues won't match my projections. However the company's specialty products decrease the volatility of the company's earnings. As such if industry headwinds were to occur, it would be less hit than its competitors, somewhat limiting the downside.
It also struck me that Western Forest Products might just be a potential takeover target. Obviously being undervalued isn't enough.
Both Canfor and Western Fraser could be potential candidates. Their enterprise value is 4 times and 7 times that of Western Forest Products respectively.
The first point is companies could diversify their operations through buying Western Forest Products. Their niche and specialty products provide a great hedge to decreases in demand for lumber products.
Also the company has access to great quality and rarer woods, such as Yellow Cedar, which could increase a competitor's product offering.
Furthermore the company's has a different geographical concentration of clients than their competitors. While Western Fraser Canfor are heavily exposed to the US, Western Forest Products has more exposure to Canada and Asia, without mentioning over areas like Europe. This could substantially decrease the business risk of one of its major competitors.
The strategic Capex the company has deployed and is deploying to increase the productivity of its mills gives them attractive, up to date assets.
If you add that the company has a clean balance sheet and capital structure at only 0.2 debt to equity, you have a potential takeover target. Companies might be attracted by Western Forest Products when the strength in US demand for lumber soften, since they will seek to gain exposure to other markets.
Obviously you don't invest in a company on the basis that it might be of interest to a potential acquirer, however it is interesting to know this might be a possibility.
WRAPPING IT UP
To wrap up everything, I recommend a strong buy on Western Forest at these prices, the security seems mispriced and could quickly appreciated 30-40%. Upside could be tremendous if it is acquired. If things don't go to well, downside seems limited by less volatile margins than the competition.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Source: https://seekingalpha.com/article/3285725-western-forest-products-the-valuation-gap-could-narrow-quickly