West Fraser Timber Co. Ltd. (WFG) Q4 2017 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the West Fraser Q4 2017 Results Conference Call. Forward looking statements during this conference call, West Fraser’s representatives will be making certain statements about potential future developments. These forward-looking statements are intended to provide reasonable guidance to investors, but the accuracy of these statements depends on a number of assumptions, and it is subject to various risks and uncertainties. Actual outcomes will depend on a number of factors that could affect the ability of the company to execute its business plans, including those matters described under risks and uncertainties in the company’s annual MD&A, which can be accessed on West Fraser’s website, or through SEDAR, and as supplemented by the company’s quarterly MD&As. Accordingly, listeners should exercise caution in relying upon forward-looking statements. [Operator Instructions] This call is being recorded on Thursday, February 15, 2018. I would now like to turn the conference over to Mr. Ted Seraphim, President and CEO. Please go ahead.

Thank you, and thank you all for joining our call today. I have Chris Virostek, and Rodger Hutchinson with me, as well as a number of our other Vice Presidents on the line. I want to start by recognizing the extraordinary efforts of our employers in 2017 as we continue to realize improvements in production costs and margin despite a number of external challenges. Most notably, the fires in the interior British Columbia last summer truly tested our employees and their families. We still have much work to do to improve our operating results, whether it's improving reliability at a number of mills, to further implementation of our capital plans and, of course, a continued focus on people development. We continue to see tremendous upside potential in our operating performance as we implement and develop capital plans for 2018 and 2019 for our legacy mills, as well as the mills we acquired last year in the Gilman transaction. With respect to lumber markets, we are encouraged by the improving supply demand fundamentals. U.S. Housing starts are approximate $1.2 million are coming into line, with a view we have held for some time, which is at a $1.3 million starts, that demand supply, would be in good balance. With North American lumber demand projected to grow at $2 billion board fee per year and with an expectation of modest increases in overall U.S. lumber production over the next few years, likely in the $750 million to $1 billion board foot range annually, we remain optimistic in our outlook. With that, I will turn it over to Chris.

Thanks, Ted. There are a few developments in the fourth quarter that I'd like to touch on. In early November, revised rates for CVD and ADD were issued. Our company specific CVD rates dropped from 24.12% to 17.99%. Accordingly, we recorded in the quarter a reversal of CVD duties, previously expensed and paid at the 24.12% rate, as well we performed an analysis of the potential ADD rate using actual data for the period. As a result of the trend in lumber prices through the second half of 2017, we estimate our potential ADD rate to be substantially lower than the final rate of 5.57. Accordingly, we recorded a $17 million benefit to earnings in the fourth quarter. To summarize, total duties paid in the year were $85 million, of which $48 million were expensed at expected rate and $37 million was established as a receivable for payments made in excess of the final CVD rate and expected ADD rate. In the fourth quarter, duties paid were $20 million with $17 million recorded as income as the result of previously mentioned adjustment to rates. Our adjusted EBITDA of $341 million for the quarter excludes any impact from duties, positive or negative. The Tax Cuts and Jobs Act passed in the U.S. prior to year-end, reduced the U.S. income tax rate and provided for immediate expensing of capital expenditures. For West Fraser, this will mean a decrease in our go-forward effective tax rate to approximately 24% to 26%, and we estimate the immediate expensing of capital, coupled with other tax attributes will delay us paying any significant taxes in the US for the next few years. Adjusted EBITDA of $341 million or 24.8% of sales was a quarterly record for West Fraser. Strong pricing across all product segments contributed to the results. Lumber adjusted EBITDA margins reached 26%, as shipments grew by nearly 3% from the third quarter, aided by the addition of the Gilman operations, but held back late in the quarter by transportation, resource limitations and bottle mix. Panel margins were in line with the prior year quarter, but off the record pace of Q3. Top margins increased substantially due to better pricing and strong BCTMP performance. Cash flow from operations in the quarter was $254 million, and we ended the year with net debt to capital of 12% and available liquidity of approximately $800 million. For the year, we generated approximately $900 million of cash flow from operations, and reinvested approximately $860 million of that, back into the business through capital expenditure and the purchase of the Gilman companies. In addition, we returned $45 million of cash flow to shareholders through dividends and share buybacks. We announced yesterday our second increase in our dividend in the last 6 months to $0.15 per share for the quarter. Our Gilman integration is on track, all major systems have been converted, and we are starting to process to deploy capital to these mills, as part of our anticipated spending of $300 million to $350 million for 2018. Markets have started the year off strong, particularly in lumber. However, the first month of the year represented a number of weather-related challenges as severe weather in the U.S. South resulted in number of loss production days due to cold temperatures, power curtailments and road conditions. In addition, securing transportation continues to be a challenge in Western Canada. Log inventories remain below targeted levels in a number of areas as a result of the fires in the past summer in DC. With that, I'll turn it back to Ted for some closing remarks, before we open it up for questions.

Thanks, Chris. I would just like to take the opportunity to recognize Rodger Hutchinson, as this is his last quarterly call, before he retires at the end of March. We just celebrated Roger's 23rd anniversary with the company yesterday. We've all benefited from Roger's tremendous financial skills. He also represents West Fraser's core values internally and, of course, externally. And I know we are all proud to have worked with them. I have especially enjoyed my working relationship with Rogers, as well as a great friendship that we've developed over the year. With that, I would like to turn the call back to the operator and remind you all that this is your last opportunity to ask Roger some really hard questions. I think he is ready for you. So we'll turn it over to the operator for questions. Thank you.

Thank you. [Operator Instructions] Your first question comes from Hamir Patel with CIBC Capital Markets. Hamir, please go ahead.

Thanks. Good morning. Ted, you mentioned that potential capacity or production growth in the south of, I think you said $750 to $1 billion board feet a year over the next couple of years. That to me, would seems to be a little less and maybe what creep than what some of the new announcements, at least on a nameplate basis would suggest. So I'm just curious what sort of constraints do you see playing out in the U.S. South to sort of limited production growth?

Yes, I think you know, first of all, last year, I think the production U.S. South grew in that range. And I think as we look forward, I mean, obviously, the U.S. South has got timber, that's not the issue. I think the issue comes down to other than bottlenecking large projects. There's only so many equipment vendors that out there. So I think, you know, getting the equipment, it will be a challenge to get pass that level of production. And I think secondly, people always have to think about where the residuals are going to go, chips and so on. Because the paper market in U.S. South is not really growing. And I think finally and most importantly, and I don't think – I think people underestimate this, labor is a significant issue in the U.S. South. And I'll just give you some examples here. Hourly turnover rates in Canada, at least in our mills are in the single digits. In the U.S., they can range anywhere from 30% to 60% depending on the mill and the company, and we are at the low-end of that range, but we definitely have a lot of work to do. So my point here is, if our turnover is a challenge with a strong economy in the U.S, getting – you know, hiring employees is going to be a real challenge. And I think just to build on that a little bit, that’s one of the reasons we bought Gilman. We have the ability with that acquisition to grow our production, have higher labor productivity, consume the same amount of timber and produce 20% less chips, because the lumber recovery at those mills, even though are they well run, is 20% below the lumber recovery at our legacy U.S. South mill. So we for years have felt that growth in Greenfield capital projects in U.S. South will be rather limited, given those three factors that I just mentioned, which are labor and engineering, as well as harmful [ph] residuals and chips.

Thanks. That’s helpful. And just a question on the plywood side, at least in your outlook anyway, it's sounded - I think you guys were a little bit more cautious there. Just curious how you think about that market? Any interest in building out a presence in the U.S. I wanted to understand your current - more expressively Canada, so how do you think about that?

Well, I think first of all, we tend to be cautious in our outlook for markets, and even today, when you're looking at plywood prices in Canada, they are actually coming back to the levels they were in the second half of last year. I think we're approaching $600. So the Canadian plywood market is probably a bit more stronger than our outlook is stating today. But again, we are going through the winter, which is really hard to predict what the next few months would be like, but it is relatively strong. But coming back to growth for us, we like the plywood business. We would not shy away from an acquisition in plywood in the South that makes sense, but they are rather limited. And I think that's probably the biggest limitation for us. They are rather limited and fundamentally, while we're very interested in that, our real focus right now is to build out our lumber platform in the U.S. South and invest in the 21 sawmills we have down there, but that doesn't mean we wouldn't like the plywood assets.

Fair enough. Thanks, Ted. That’s all I had and Roger, best of luck in retirement.

Thank you, Hamir.

Thank you, Hamir.

Thank you. Your next question is from Sean Stuart from TD Securities. Sean, please go ahead.

Thanks. Good morning, everyone. Congratulations Rodger and thanks for all the help over the years. Few questions for you guys. Just following up, Ted on Hamir's question on the CapEx spend, and I appreciate a lot of the $300 million to $350 million you will be spending this year will go to the South. When you're talking about better lumber recovery factors, can you help us conceptualize how much you envision adding to our U.S. South capacity over the next couple of years?

I think, as we look at our current capacity, I believe it's about $3.1 billion fee. I think over the next 3 or 4 years, we’ll probably see - probably add 10%, 12%, maybe 15% increase on that, but again, that would take time. And frankly, coming back to my comment on capital, if we could get more capital earlier, we do it faster, but capital will be a challenge.

Okay. And Ted, another question on pulp markets. It looks like the BCTMP prices in China are under some pressure. There is reports of lower resale prices for NBSK there as well. How much of that do you attribute to inventory management around Chinese New Year versus maybe more of a sustained correction in the pulp market?

Well, I think, Sean, first of all, I think if anybody said they predicted the pulp market rate for 2017, I think they'd be lying. I think we were all way too conservative. So I think - I just want to make sure when I make my comments about our outlook, it's really a little difficult to understand because what happened last year was significant restriction in imported recycled fiber. Those restrictions have been relaxed a little bit, at least for the next quarter, so we will have to see where that goes. Chinese New Year always plays a role. The one thing I would say, we have very strong order books for NBSK and so, you know, the challenge won't be over the next 3 or 4 months. It will probably be at least sometime in the second quarter if things soften. BCTMP is a little bit different right now, in all honestly, because the board market, they have taken a bit of downturn lately, so the board market appears to be at least today, slightly oversupplied. So we’ve seen some reductions in band for BCTMP. We still have decent order files. But again, that can flip a switch in 60 days. So our outlook is a bit uncertain for pulp markets, I think, the conservative you would be that we should expect softening this year, that may be systemic. We expected that last year, but given the size of the Chinese pulp market, I think a real challenge to predict what will happen this year. And we could be surprised to the upside.

Thanks for that context…

I don't know if that's helpful at all Sean…

It's helpful. I've had trouble calling the cycle as well. One last question on the dividend policy, I guess, for Chris. It was – I’d say relatively modest increases we were necessarily forecasting one. How do you think about the dividend yield relative to your available capital base, which is substantial and your overall capital structure rate right now? Chris, maybe remind us of any targets you have for dividend payout over the mid-to long-term?

Thanks, Sean. So we're - as we think about the capital allocation and how we deploy capital that we generate through the business, I think we try to keep in mind that maintaining a strong balance sheet throughout all the cycles is important and continuing to reinvest in our mills to maintain our cost position are the priorities, and those will continue to be the priorities. I think we find ourselves in a situation now with markets performing as they are and seeing the benefit of the capital expenditure over the last several years that we find ourselves with more options, around how to deploy capital and to return capital to shareholders. We look at their dividends as one element of that, but most importantly, and I think the feedback we've heard loud and clear, is whatever we decide to do on dividends its going to be sustainable throughout all market cycles. And so it's an ongoing evaluation for us. We don't set specific targets around payouts and so forth given the volatility in these markets, and how quickly things can move. But we're trying to make a prudent assessment of the right level over the long-term that can be sustainable in good markets and in bad.

Understood. That’s all I had. Thanks very much, guys.

Thanks, Sean.

Thank you. Your next question is from Paul Quinn from RBC Capital Markets. Paul, please go ahead.

Yes, thanks. Good morning.

Good morning.

A couple of questions. One, just - we've seen the lumber prices take off in the early part of the year, and you mentioned some weather issues and transportation. Is it all around that or where do you – what’s your assessment on lumber inventory in the channels?

Well, I think we believe the lumber inventory were pretty tight in the channel. My new owners and I hesitated there is - I know, it's very important to you guys to kind of get a sense of where the markets are going over the next months and quarters. From our perspective, we don't spend a lot of time thinking about that. What we spend our time thinking about is kind of our longer term view, and our longer-term view it’s really positive. I mean, the year started out much stronger than I think anybody forecasted, and I think Paul, the weather had a big impact on it. But I think the other issue has been with all the volatility last year, with duties on, duties off, I think buyers were very reluctant to take risk and build inventory. So they came into 2017 - sorry 2018 with very low inventories. And so once you have any hiccup in the supply chain, it's having an impact on the market for sure. I don't know if that's helpful.

And we sort of looked at North America and sort of that describes the situation there, offshore markets, maybe you could give us some little color what you see in China, Japan and other Asia?

Well, I tell you what, Chris McIver. is on the line. He was just in parts of Asia recently. So why don't I let him to give you a little bit of color. Chris, are you on the line?

Yes. Good morning, Paul. I would say, if you start with Japan, which is our traditional sort of, high-value market, demand is very strong, from all segment, single-family, apartments, multifamily, and that's good. Quite frankly, anything we can produce within those grades is pretty easy to sell. We just had a few guys over in China. I would say that market is pretty strong. It seems to be taking the new pricing within reason fairly well, and the demand there is again, we're - we limit our position over there. We got a significant position, but we could certainly sell more if you want. And I think that they're pretty optimistic about the market when they come back from Chinese New Year. And we're starting to do a little bit business in some of the other markets, to be in the Middle East or India and so forth. So obviously overall, it's probably strong, it certainly stronger than it was this time last year, and - but it’s behind North America for sure.

Okay, great. And then, I guess, operating performance at Hinton, it's something, you haven’t talked about this quarter, I don’t want to jinx it, but just curious as to whether that mill continues to make gains?

Well, I think everybody online knows how much I enjoy speaking about one specific mill out of 47. But you know, we’re - I was really pleased with how we started the first half of last year, I think we all were, and we had a really tough third quarter and start to the fourth quarter. So the mill is running better. But as I’ve said many times, and thanks for saying you know, you don’t want to jinx it. You know, we need to have a good 12, 18 months behind us before, that doesn't become - I mean, I look at the production everyday for that mill, just so you know. And we talked about it quite frequently. So and that mill runs well, it runs really, really well, and we just got improved the reliability there. And our folks are very committed to it. This year, we don't have any shutdowns. So we don't have any big issues in front of us. So I've got a lot more confident going into 2018 and both reliability, again, how we ended 2017 and the fact that we don't have a large maintenance shutdown in front of us. And so I hope that I can report, and you will see that in our production. I hope I can report as the year goes by that we're making or continuing to make progress. But we're definitely not where we need to be yet.

Okay. And just lastly on the capital allocation, you pointed out, you made almost you know, and generated $900 million in cash flow, and you’ve outlined the CapEx even at 350 on the high-end. Last year, you’ve increased dividends and bought back some shares. So should we be thinking if 2018 similar to '17 that we should see a similar increase in the dividend and a whack load of share bought buyback or?

I think - maybe I'll take a stab at it, and when we look at last year, we basically used all the cash we regenerated. Between the Gilman acquisition and our capital, we basically utilized most of our - the cash we regenerated, I think we paid down some that, of course. But the one thing as Chris said, we really wanted to invest capital in our business, and if we can accelerate our capital spending program, we will do that. Because we've got lots of good projects with us, and again, Gilman provides more in the pipeline. And we also want to grow. And I think about last 12, 13 years of this company, we kind of grew in the lumps. We bought Weldwood in 2005, and all of sudden in 2007, we buy the U.S. Assets of International Paper. And acquisitions come in lump. So I think we definitely still want to grow, and we are going to continue to look for things that fit us and make us better, not just bigger, but they make us better. As Chris said, we think our investors value dividends to certain degree, but they really value steady dividend. And we are going to continue to monitor that and see if it makes sense for us to look at further growing that dividend in time. And then when it comes to share buybacks, we were quite active in that in 2016. Last year, I think there was a lot of uncertainty around the SLA. We were very keen on the Gilman acquisition, and we became aware of that fairly early in the year. So we kind of kept our powder dry when it comes to share buybacks. I expect that we will buyback shares this year to the extent, I can't really say at this time, because we're not afraid of having cash on our balance sheet at this point in the cycle. But we're going to continue to look for opportunities to grow the company Paul. It’s just sometime it comes when you least expect it.

Okay. Thanks, Ted. And Roger thanks for all the help. We wish you the best of luck, but I think it's probably better directed to your wife now, that you’re going to be home 24/7.

Yeah, I was kind of wondering when Sean said best of luck to Rodger, he is retiring.

Paul, I am sure, my wife would agree with you. It is better directed towards her. Thank you.

Thank you. [Operator Instructions] Your next question is from Mark Wilde with BMO Capital Markets. Mark, please go ahead.

Good morning, Ted. Good morning, Chris, Rodger. And Rodger, good luck and good luck to your wife.

Thanks.

We’re spending a lot of time with Rodgers wife to make sure she is ready for him.

Yea, all right. I wanted to start, maybe Chris could help us in just kind of parsing out how big the impact from both kind of weather in these transportation logistics issues were in fourth quarter? And then, what's your best guesses based on what you've seen so far here in the first quarter, because you've called this out in the earnings release?

So I think it was probably less of an impact in the fourth quarter than it was in the first, as we started to see that extreme cold weather in the south. And I don't think we're at a point where we're going to quantify what those impacts were, because we still have the opportunity to potentially make some of that up through the balance of the quarter. I think these things are reasonably typical this time of the year, there may be order of magnitude a little bit more severe this year, particularly in the U.S. South than in prior years. And I think, we called it out on the basis that just to temper and make sure we think about the first quarter that while lumber markets are strong, it's not the only thing to sort of factor into our calculus around the first quarter is that we will have some challenges around those things. On the other hand, the weather could break next week, and we could have a great next couple of months. And so it's really hard to predict. It’s been a bit of a challenge the first few weeks, but we're working hard to try to overcome it.

Maybe I can just add 1 comment there, and I think and not specifically about that, but this indicates to me that when we have a supply disruption, the impact it shows you how the strong lumber market is. We had the fires last summer, and that took out 55 million feet of our production, probably 100 million feet or so in the interior. And we saw the impact that had on the market. And so we're working hard to as Chris said to ship our product, work with our carriers, work with our mills, whatever we can do, but I really do believe that its just an indication of the strength of the market, the impact that you know, a little bit of weather disruption has on the lumber market.

Okay. Ted, is it possible to kind of going to this transportation issue a little more because I know there's the rail issue in Western Canada, a week or two ago, warehousers said, they had a mill in B.C. that they could not get rail cars into for 2 weeks. And then we've got this trucking issue, which is all over North America, and you guys use trucks to bring logs in and then the South you used trucks to take lumber out?

Yes. Well, I think a lot of its seasonal right now, and I think the question is we have a longer term issue. And I know our industry is working on it in Canada with government and with the carriers. And I look at our size, and I'm challenging, you know, Chris McIver is responsible for transportation, I'm challenging Chris and his folks to – and our mills to think about the fact that of the life, we have trouble every wintertime. So I think the challenge for all of us is to figure out, is there another solution? And I don't think we know what the answer to that is, Mark. It's a bit perplexed in, because we don't really have control over it, like we have over our operations. But it really is a challenge and the economy continues to strengthen. I think it's going to be challenge not just for our industry, but for many industries. So I am hopeful that we can use our size to help us overcome, and frankly, better than our competitors.

Yes. And can you guys just talk going over one of the kind of cost issue? With the tight labor, particularly in the U.S. South, are you seeing kind of rates go up for both of your contractors out in the field? And also, what are you paying at sawmills?

Not so much. I think it's fairly modest, but we believe there's going to be a long-term trend in terms of labor cost increasing. And we don't have an issue with that. Obviously, our labor cost in Canada are much higher than they are in the U.S. and our goal is to make sure our employees are paid well, while we improve some productivities. So the capital we're spending, I think it's going to do a couple of things. It's going to help us have higher starting wages because the jobs will be more technical. Secondly, in our industry, we're working really hard improving the working conditions. That's one reason we're spending a lot of capital in our mills. And so I think, we are competing for labor. And it's not just rates, its working conditions, it’s the quality of the mills and it's the way you get people opportunities. So as I said in my opening comments, which we're pretty short, I said we're working on operational improvements, capital. But where we spend a ton of time in this company is on people and people development, and I think it's a big challenge, and we're working really hard to get ahead of it. So markets might be a bit of short-term concerned, but we see it really as more of longer term issue. And if we do it well, hopefully, it will give us a competitive advantage.

Yeah. And hopefully, it drops those turnover rates.

Yeah…

Just another question…

We got turnover rates in Canada in the single digits, why can't we get close to that in the U.S. if we apply ourselves properly?

Yes. My last question is just Ted, if you can maybe give us a little perspective. You really been on kind of 10 or 11 year march to get these Southern U.S. milks up to the West Fraser's standards and can you give help us in understanding where you think you are heading that process right now?

Well, that's a big question. So I’ll try to answer as quickly as I can. I think first, I think it really comes down to operational excellence, peoples, so I just talked about that and capital. So capital is the simplest one to talk about. If you exclude the Gilman mills, I would have said, we were and I think I said last year, I would have said we were probably 50% to 60% through it. Our initial capital is primarily around planers and kilns and you know, we booked a new sawmill basically at Newberry last year. We're going to be starting up, basically a brand-new sawmill in Opelika Alabama in the third quarter. And so we've got some sawmill projects that are - that's where our growth will come from. We've got planer and the kilns capacity, primarily to get us there. And then when it comes to people, it really comes down to leadership and Ray Ferris and Sean McLaren, Ray Ferris is our Chief Operating Officer, and Sean, who runs US South and Chuck Watkins, who runs our manufacturing down there. And there are senior guys who have done a tremendous job building a strong leadership team, and we saw - we do benchmark ourselves against others. And we've seen improvement over the last 3 years, and we've got, I would say, we're halfway there in terms of improving those assets from an operating and maybe more than halfway on the capital side. I look at the Gilman mills that we bought, as we said, when we bought them they have the same EBITDA margins as West Fraser average. Good mills, great management and I said that. What they suffered from was a lack of capital. So I'd say at the Gilman mills it – we’re probably - we've got a lot of great capital projects in front of us. So I think, I am hopeful that we can see within 2 or 3 years, we've got those mills from a capital standpoint at the same spot where all our mills will be in the sales. So I think we still got a 3-year journey in front of us when it comes to capital.

Okay. That’s helpful. I’ll turn it over.

Okay, thanks. Hopefully, that wasn’t too long winded.

Thank you. We have a follow-up question from Sean Stuart. Sean, please go ahead.

Thanks. Just one follow-up, guys. On the duties as we go forward here, maybe you can give us some perspective on the administrative review process? And in 2018, how should we think about how you will expense duties quarter-to-quarter? I guess, I'm thinking specifically on the ADD. Will you expense at your final rate as it stands now? Or will you assess it at what you think the appropriate rate given the moving process?

Well, I was waiting for a really hard question because we threw it to Roger, but I'll take on the first part. So basically, administrative review starts next January. And I think we have until, basically, June I think June or July of 2022 that to have that complete. And then of course, there is always appeals. But I think from our perspective, if we are being conservative, I think we should expect that will be paying these duties through June of 2020. That was how we expense, and I'll leave it to Chris and Roger to answer that.

Yes, I think on ADD front, Sean, given that there's a fairly standard methodology for that that enables us to sort of go and look at what we think the estimated actual rate is going to be. We'll periodically take a look at that each quarter in 2018 and beyond to see if there's anything material change there in terms of it. But given how far we've drawn it down in terms of where we think it's likely to be through 2017, I wouldn't expect major changes to that in 2018.

But just so I understand that, Chris, you'll expense it at what you deem to be the appropriate rate given where pricing is?

Yes, for ADD, yes.

Got it. Okay. That’s all I had .Thanks, guys.

Thanks, Sean.

Thank you. There are no further questions at this time. Please proceed.

Well, again, thanks very much for joining us on the call, and Chris and Rodger are available for any follow-up questions and will talk to you in the quarter. Thanks a lot.