October 27, 2023
Forest Products
Thinking through lumber producer valuations
Our view: Although lumber stocks could struggle to gain momentum until a pathway to stronger demand becomes more clear, we think valuations that are at cyclical lows make this a good time to start getting up to speed on the sector. Lumber producer balance sheets are also generally in good shape, which in our view reduces potential downside risk if market conditions remain challenging into the 2024 building season. Meaningful near-term potential catalysts for the lumber group include: 1) interest rate cuts, particularly if employment remains relatively healthy; 2) permanent capacity reductions, which in our view are most likely to occur in high-cost British Columbia (with current prices likely translating to below break-even economics for many producers); 3) temporary supply disruptions (e.g., transportation issues or similar) that could result in tighter supply-demand conditions; and 4) better visibility to an agreement that would return some or all of softwood lumber duties to producers.
Weakness in lumber stocks: the story so far. Lumber producers have had an uninspiring 2023, with share prices trending lower YTD and setting up for a second down year in a row. A surge of European imports in late 2022/early 2023 was tough to digest against a backdrop of a market that was otherwise well- supplied, and as a result, lumber markets have failed to achieve meaningful tension for much of the year. Higher interest rates have weighed on housing demand (although this has been offset to some degree by new residential construction tailwinds, as existing home sales have slowed), and while we held optimism earlier in the year that rate cuts could be on the table for late 2023, we think the stocks have increasingly reflected the anticipated effects of elevated interest rates on the 2024 homebuilding season. R&R spending (typically ~40% of softwood lumber demand) also looks ready to ease after a string of several strong years. Despite near-term headwinds, we remain bullish on the medium-term outlook for lumber demand given a large millennial cohort in its prime home-buying years, underbuilding following the global financial crisis, and aging housing stock.
EV/Trend EBITDA valuations are below long-term averages. The valuations of each of Canfor, Interfor, West Fraser and Western Forest Products on an EV/Trend EBITDA basis show significant discounts to long-term averages (please see Exhibits 4-7). Our Trend EBITDA estimates represent our view of "mid- cycle" economics for producers, and while our 2024 and 2025 EBITDA forecasts for each of those four companies are below our Trend EBITDA estimates, the lumber market has repeatedly shown that conditions can change rapidly, and that pricing and margins can swing materially higher on a market imbalance.
Capacity-based valuations imply significant discounts to replacement cost. Greenfield costs for a new lumber mill have risen to the >US$800/mfbm range (e.g., Canfor's new mill in Alabama, which has expected capital costs in the ~US$840/mfbm range). Looking at Interfor as an example, as it is essentially a pure-play lumber producer, we estimate the market is pricing in ~US$175/mfbm for the company's lumber capacity. While older mills are generally somewhat less competitive than newer mills, we think the magnitude of the discount implied is notable.
Our EV/EBITDA and capacity-based valuation metrics exclude any credit for duties on deposit, which are substantial and provide another pillar of support for the stocks. On a pre-tax basis, duties on deposit per share represent anywhere from 15-91% of the current share prices of the lumber producer group (please see Exhibits 1-3). Interfor and Western Forest Products stand out in particular, at 83% and 91%, respectively. While softwood lumber duties have been more topical over the last couple of quarters, there is no visibility to a return of duties at present (as noted by West Fraser with its Q323 results); however, we highlight that ~80% of duties were returned to producers in 2006 (please click here and see page 23 for more information).