Transcript, RBC's ↑, strategy woes, capacity-addition horror I do find new ways to be disappointed it seems, but perhaps hoping that in a US $700 lumber environment that net of duties they'd be pushing into $200/mfbm US margins was too optimistic. I'd also hoped that they'd have found a way to run at closer to capacity, so produce ~60 million feet. I expected the power issue would be modest given it happened in the final two weeks of the quarter, and expected that its EBITDA contribution to go to zero. The power thinking was pretty conservative given Q4-2019 it hit $5M in EBITDA.
Anyway, only hitting 42 million feet wasn't great. Assuming the $700/mfbm US lumber was $560 US after-duty, this means they did a $126/mfbm US margin and had conversion costs of US $433/mfbm. So, higher cost, lower production, and lacking ~$1.7M in byproduct revenue are the drivers here. No by-product revenue this quarter too is very odd. I'm neutral at best on these earnings, but on the brighter side they didn't lose any money on futures this quarter.
It's not all bad as 2021 could average (easily) $700 US lumber all year. Assuming the mill is just stuck at a lower long-run bound of ~220 MMFBM, and adding back in by-product revenue (pulp mills are doing great and will bend over backward for chips), this less-productive quarter gives an expectation a minimum $202/mfbm CAD margin. This excludes the duty change. With the new rate from 20% to 9%, that's an extra $77/mfbm US or $99/mfbm CAD too. So, 2021 at $700 lumber would be a daily safe bet to earn $66M CAD on the low end. That’s not bad at all.
Q&A was limited with the single guy there from RBC, and not Paul. They bumped this up to $3.00 as well. 6.5x is the same as CFP and IFP, and better than RFP's 5.5x. It should be a blended rate between the power value of 12x and a bad lumber mill at 5x, but that's another story.
| Valuation (3/3/2021): Our $3.00 price target is based on a blended ~6.5x EV/EBITDA multiple on our trend EBITDA (weighted 85%) of $25MM and our 2021 EBITDA estimate (15% weighting) of $44MM. We believe the company should trade near the middle-range of the typical range for Canadian Forest Product companies (range 5.0x to 7.0x), reflecting the company’s smaller size, limited operating footprint, and higher relative exposure to British Columbia, however offset by extremely strong lumber markets. Our price target supports our Outperform rating. |
If you adjusted these RBC assumptions to $66M 2021 and say $30M trend, while knocking off another $10M in debt (net debt from $49M to $39M), you’d have an implicit price target of $4.15/share. I could see that in 3 months if we have the back half of the year futures pricing hold at $600 or $650 at the lowest. The back end of the futures market today only his September, and this is $713 and rising. The analsyts will have to call it by around then, as the current estimate likely assumes long-run lumber prices of $500 and 2021 prices at $600.
About 1/3 of the year is in the bag at $1000 lumber, so it’ll take a pretty horrific back 8 months to average out to $600. Going in 4-month increments from $1000 to $750 to $550 about the least optimistic take I can imagine knowing the fundamentals driving demand and very real barriers to adding capacity in the next few years, and that averages out to $770 lumber for 2021, meaning Confiex can do $96M CAD or so... 20% more than the current market cap. You’d have to get up pretty early in the morning to not dramatically increase the share price in that environment. Moreover, the net debt doing way is worth a bit over $1/share, and 2021 should be able to achieve that. My worry is that there could be scenarios where the large relative valuation gap with peers not just persists, but widens – peers race up while CFF suffers the overhang of a bad (or absent) strategy, poorly executed, I suppose that's my broader theme here.
Excuses are always a big part of these calls. Sometimes they are small, like the ESG thing. Ken says: “So we didn't quite get our ESG credentials developed and well documented, but most of the what's been done, and we are pleased that we'll be in a position to share them with you when we have our call reported on our Q1 results in April.” If you don’t know what this likely entails a more in-depth version is here for West Fraser: https://www.westfraser.com/responsibility/responsibility-report.
Nevertheless, ESG?? I am not sure that it’s of any consequence yet. This is nice to have, and no protestors are banging on the door. You can’t get added to any green indices or anything being an irrationally volatile penny stock, so there’s no upside for impressing people with how sustainable you are. Rather, the first priority should be removing those other barriers – don’t be a penny stock, and start by having a clear mission and vision. Provide a direction as to the corporate strategy – which to me is absolutely essential to have should there be any discussion of Mackenzie CapEx.
An example of gaps in the corporate strategy is the incongruence of how they even talk about the buy-back (NCIB). Ken says:
“Our analysis indicates that we can continue to afford to fund an NCIB and concurrently maintain our strong lumber business balance sheet and fund projects that are necessary to remain compliant with enhanced safety and environmental regulations as well as quick payback projects and improve our operating reliability”
I might be reading it too much to this and maybe it’s intended to be reassuring, but context matters. Contextualize that it takes a relatively modest dollars share of the steady cash (thanks to the brutally low share price) yet has a large impact, and provide a guiding framework to show it’s a least a priority. I fail to understand how there could be any doubt that a $5M annual bill might be too much to bear?? Come on, man. Your NCIB is approved for $5M a year or 3M shares annually. We all know you can hit that on 1/3 of power earnings.
The message on this sort of thing should be more like: this is mission-critical and a top priority to use given the massive upside of repurchasing undervalued shares. He needs to prioritize the return of capital, not make it sound like it’s this big albatross – it’s doubly offensive in a $900+ lumber environment. They need to see this through. It was this mgmt team and Board that diluted the @*#! out of the share count (26M to 46M) – I can’t complain though as I agreed at the time (granted, this was predicated on things like their rosy view of El Dorado… that was not at all accurate, meaning the risk profile was higher than it seemed at the time of the huge debt addition.) Regardless, it’s over and done and water under the bridge, – but at least own up like you want to correct this mess you made via a robust NCIB.
Anyway, it’s the same song and dance, and more efforts to explain away the fact that the strategy is not aligned with market expectations. The log diet argument is partially valid, but in high pricing instances like H2-2020 and H1-2021 can make a great return on even low grade. In very lean markets, prime grades for Japan or Home Depot made a small profit, it can be only break-even on structural grades (#2), and then you’d get obliterated on low grades (#3 or Econ). I get the rough logs don't flow as well, but not to the tune of running at ~85% still.
At some juncture, these guys have to show results.
If you are well-prepared, come in with a good strategy, and still fail – that’s one thing. But the twitchiness and obstinance about strategy that hurts this company the most is less forgivable. Occam’s Razor, man – you are a power utility that – by the grace of refusing to return capital as a dividend as part of a balanced approach to re-invest and deleverage – means you trade at abnormally low and undefendable valuation levels. In the 80's you'd be long gone to a Raider, but the Poison Pill keeps Ken flying high with his (2017) $450k base + $442k share-based (which he's selling in droves it seems, thanks for the solidarity) + $400K incentive. So I doubt we have aligned incentives here.
The vision should reflect that this is a power-driven cash cow, integrated with an aging mid-tier (at best) lumber mill which still carries much upside. Yet, it’s important to acknowledge that the mill is likely dogged by fundamental problems (workforce, management, core competency, geography), and this means the lumber tail cannot wag the power dog. Run the mil as best you can, but don't have the audacity to pin your hopes on it (and its highly capital-intensive future possibilities) – unless the bigger issues of firm core competence are addressed. Modernizing this mill is a job for a different company.
The CC had the usual comment, highlighted below, which speaks to the valuation gap to peers. This is an issue of course. Framing by book value underplays the issue dramatically. The book value is very low based on the initial Mackenzie purchase for $21M in 2009 in the depths and despair of the Global Recession (so of course they got it cheap). The discount to any market measures today is far more than this 30% to book. It’s likely 20%+ for the power plant, and at least 75% on value for the sawmill, even a modest 2019 comparable BC/AB transaction (Dunkley) back when lumber prices were $350 not $1000. Here's the comment from yesterday's CC. We can’t just blame logs. I would hope that there is some deeper pondering as to why the market places such an extreme discount on this equity.
"As we reported back then, we launched our NCIB because we believe that our shares trade at a material discount to fundamental value. One reason we believe this is that we trade at a 30% discount to book value, while the other BC-based SPF producers trade at premiums. We appreciate the fact that returns on shareholder investment in the interior BC lumber sector have been lower than they have been in competing supply regions. And we also recognize that, if investors expect lower returns, shareholder investment, they will, of course -- those stocks will have lower trading price relative to book value. However, we remain confident that our return on shareholder investment is poised to increase as we move forward because we'll be moving to a greener log diet because we expect further supply reductions to take place in the interior of BC."
Given Ken is trying to explain away this horrific valuation gap, it’s worth revisiting. Deloitte's 2017 "Overview of business valuation parameters in the energy industry" has power renewables mean valuation at 9.8x. The power business is a good one, so that is safe. Range: 8.1x to 13.0x. https://www2.deloitte.com/content/dam/Deloitte/it/Documents/energy-resources/Business%20valuation%20parameters_Energy%20industry.PDF
I'd therefore accept that the power business at $14M/year valued at 9.8x is $137.2M. The problem is that takes up the entire EV. So, it may be the sole driver of the firm enterprise value today. But calling the lumber mill and tenue $0 is hard because I never learned how to divide by zero. So let's say the power arm is valued at the lowest possible global power valuation bound, which is 8.1x. That is $113M, leaving $21M in residual value for the mill (and tenue). I'll ignore tenue and assume it's a needed input for the power plant and therefore can’t double count it. (I actually doubt that, and we know tenue changes hands for $80 to $150 per M3 so it’s worth likely $60M+).
The implications of this thinking is that:
- The market value for the mill is as low as $20M CAD. For 240 million feet, that is a capacity value of $87/mfbm CAD, or $66/mfbm USD.
- The implication is this trades at a discount of 90% to the mill capacity replacement cost.
- I assume $650 USD per mfbm here.
- Per Paul Quinn on Interfor's latest addition: "At $472/mfbm, we view the valuation as favorable for Interfor given that it is below new build costs of ~$650/mfbm and that the company will likely benefit from the current record pricing environment."
- BC is a discount to the US South. Roughly half, but the gap may close as BC normalizes.
- Not a lot of transactions obviously. Just closures as part of the rationalization that removes about 20M M3 of annual cut. Still, Dunkley bought two older mills (likely needing capital) for $100M totally 280 mfmbm in 2019. That's ballpark - $357/mfbm. https://forestsfields.com/breakingnews/in-case-you-missed-it-dunkley-lumber-purchases-two-sawmills
- Therefore, it appears that Ken may have managed to cruise to a staggering 75% discount to that more modest Dunkley benchmark.
This frames the expansion argument:
- Ken may wish to spend ~$650/mfbm to expand capacity, but the market tells us it does not value Conifex lumber capacity with Ken at the helm. He cannot produce reliable or even explainable financial or operational results.
- I’m not saying it’s easy – this is a hard task in a tough place. It would be an uphill battle even for a pure operational type.
- The main issue is the incoherent corporate strategy does not support lumber platform growth.
- An undertaking like this seems like it has an outsized risk of being egregious destruction of shareholder value. You don’t spend $800/mfbm Canadian to uplift your value by $80/mfbm. There are better things to do with that capital.
- I would presume this type of thing is an exit strategy to lure a buyer on better terms, and I suppose perhaps the cost is less, but that's irrelevant if the market values your current capacity at 10% of the replacement cost.
I am not fussed that the US South expansion failed. It could have been huge, and yet failed big. Go big or go home, at least it was a fair thing to bet on. The issue I have with this is it is no longer in the rearview mirror if Ken wants to spend money to add capacity.
- I take a dim view of this, and see it as a high-risk gamble. History matters. I recall the value proposition for the El Dorado purchase was it was cheaper net capacity than a greenfield.
- They paid $21M for the site
- They planned (and I believe spent) ~$78M to bring it up to working order at 180 MMFBM capacity.
- Page 4 of the link below.
- https://www.conifex.com/main/wp-content/uploads/2015/08/Annual-Information-Form.2016-Final-1.pdf
- That math would be $550/mfbm US – cheaper than new, sure. But also 8x more than the current market treatment of Mackenzie.
- The main issue is that El Dorado didn’t work. Resolute had to reinvest some significant amount and it only got up and running nearly a year after the deal. This is not the sort of stuff that inspires any confidence in their ability to add incremental capacity.
- These are difficult undertakings. When a single-shingle mill finally gets up to bat, they get the C Team as the vendors have their best working around the clock for WY, GP, WFT, CFP and IFP. This oversubscription is good for the industry (it's hard to grow and puts a limit on how much capacity can increase by) but it's bad for Conifex as they are poorly positioned in the queue.
The driver of this valuation gap goes beyond being a small player. I wager that it’s mostly because the strategy sucks and the Board seems largely absent of oversight/accountability in not making a leadership change or setting direction and vision. They allow more of the same to continue. Well maybe the strategy is fine… who knows. The point is we don’t know the upside, but I think we know the downside (today’s prices). I think the market assumes the worst here, and no benefit of the doubt is being given. So we have all the downside of the opacity and ambiguity, but none of the upside. While the share price lately has risen, the gap relative to peers grows – but any stock in this space would rise in this unprecedently good environment, so modest appreciation isn’t any notable validation.
Operational execution seems risky too. I’m sure this Andrew is a very capable guy and the right new VP, but I had thought he had another purview like fibre? That’s also an important focus. I wonder if sticking him with the day-to-day operations as well (all of it) might be short-sighted. I'd be a lot more comfortable if they literally brought it a Canfor or West Fraser guy (just a mechanically focused been-there-done-that type) to drive the bus and work with their senior team. Maybe Andrew has good people or contractors under him – I hope so. CFF has turned over a lot of execs in the past.
What’s not risky to me is the Mackenzie fiber supply review. This is from the 2012 update: “Mackenzie is the location of two operating sawmills and one Kraft pulp mill. There were four sawmills and two pulp mills operating in the community before the 2008 economic downturn” It has lots of spruce, and moreover only just over half of the pine died. With just Conifex left they get the first dibbs. The current Annual Allowable Cut of 4.5M M3 could be cut in half (unlikely) it’s totally fine for CFF to pull out the million or so M3 they need annually. Even if there was competition they would be well-positioned with the green power and what appears to be reasonable efforts to collaborate with the First Nations. The guys are risk are those trucking their share elsewhere. Canfor might be doing this with their mill down and big fibre demands in PG.
https://www2.gov.bc.ca/assets/gov/farming-natural-resources-and-industry/forestry/forest-health/mountain-pine-beetle/mackenzie_tsa_backgrounder.pdf
Anyway , here's the transcript: https://finance.yahoo.com/news/edited-transcript-cff-earnings-conference-220000024.html