West Fraser Timber Co. Ltd. (WFG) Q1 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the West Fraser Q1 2018 Results Conference Call and Webcast. At this time, all lines are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. [Operator Instructions]. 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 depend on a number of assumptions and is subject to various risk 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 the risk and uncertainties in the company's annual MD&A, which can be assessed on West Fraser's website or through SEDAR as a supplemented by the company's quarterly MD&A. Accordingly, listeners should exercise caution in relying upon forward-looking statements. This call is being recorded on Thursday, April 26, 2018. I would now like to the conference over to Ted Seraphim, President and CEO. Please go ahead.

Good morning, everyone. Joining me on today's call are Chris Virostek, our Chief Financial Officer; Ray Ferris, our President; and a number of our Vice Presidents. It was a challenging quarter for the company, primarily from a transportation standpoint. As you can see from our results, transportation issues had a meaningful impact on our financial results. We deferred approximately $40 million of potential earnings into finished inventory. We need to bring more flexibility into our logistics management in order to reduce the impacts of weather on our customer service and transportation performance. We are working closely with all our logistics providers to ensure that we reduce in inventory build as soon as possible and we don't experience similar results next winter. We are enjoying strong markets for all our products and we continue to be very optimistic with our outlook for lumber and panel markets. $1.3 million housing starts, combined with demand in North America likely to grow at double the rate of capacity growth over the next few years, continues to support our view. Pulp markets continue to surprise us by their strength and resiliency. We are delighted with the results of the Gilman acquisition and the integration was essentially completed in a few months after we close the transaction. This acquisition provides further capital improvement opportunities to build on the strong operating performance of a great management team. Before I pass this along to Chris, I want make certain that our investors know that strong financial performance doesn't in any way color our view of what's really important. We continue to try and strengthen this company and the challenges we face in the first quarter will push us to become even stronger operators. We need to be prepared for all challenges. Thanks. And with that, I will pass it to Chris.

Thanks, Ted. Transportation was a significant headwind for us in the first quarter. Inventories increased by approximately $228 million since year-end. At March, we estimate we had approximately $75 million of finished lumber in excess of target inventory in our Canadian mills. Seasonal buildup of log inventories in advance of breakup was an additional $130 million. The balances increases in inventory split between pulp and panels, both of which were also affected by transportation challenges. There is a significant amount of lumber backed up at our mills and we'll take some time to get it all moved off, even when transportation services resume more normal operations. The late spring has helped rebuild log inventories at a number of our mills, following the fires last summer in BC, although some pockets of tight log inventory still exist. Capital spending in the first quarter was $104 million, an increase from the pace in the fourth quarter of last year, as we made significant progress on our high priority Alberta sawmill rebuild, which is now in startup, and construction of our new sawmill at Opelika, Alabama, which will start up later this year. Those two projects accounted for nearly $40 million of the $104 million spent in the quarter. We repurchased $46 million of common shares in the first quarter at an average price of $86.22. We ended the quarter with total liquidity of $584 million, comprised of cash on hand of $125 million and revolver availability of $459 million. Net debt to capitalization increased slightly from 12% at year end to a still healthy 17% largely as a result of the inventory swings. In summary, our first quarter financial results represent a continued strong trend buoyed by attractive pricing levels in all our commodities. Our consolidated adjusted EBITDA margin increased by 300 basis points from 24.8% in the fourth quarter to 27.8% in the first quarter. We increased our lumber adjusted EBITDA margin from 26% in the fourth quarter to 29% in the first quarter. Our panels and pulp segments also saw increases in margins quarter-over-quarter. That being said, we acknowledge the challenges ahead of us in the balance of the year to reduce our inventories that have grown as a result of transportation challenges and to recapture lost production from Q1. With that, I'll turn it back over to Ted.

Thanks, Chris. I would also like to share with you the announcement we made last week at our AGM in Quesnel. As you know, we focus a tremendous amount of effort on recruitment, development and succession and I'm always sharing the pride I have to work with such an outstanding employee group. Over the past few years, we've faced a number of retirements at the executive and senior management level. We've promoted four of our senior leaders to vice presidents in early 2016 and have recruited our Vice President of corporate and government relations in 2015 as well as having Chris Virostek joined us last year. Within our 100 most senior managers, approximately 75% have taken on new roles in the last three years. It's been an exciting time of change for many of us. Ray Ferris has played a pivotal role in the development of this great team. And I was delighted to announce last week that Ray was promoted to President and will succeed me as CEO when I retire in June of 2019. Ray and I have much work to do together for the next 14 months and I look forward to his move to Vancouver from Quesnel in 2019. And with that, we'll open it up for questions, operator.

Thank you. [Operator Instructions]. Your first question is from Sean Steuart from TD Securities.

Couple questions, Ted, to start. Do you have any visibility on freight availability, improving and context on the timing to unwind your finished product inventory through the remainder of the year? How quickly can we expect that unwinding to happen?

Well, this is going to be a challenge for us, there's no question. And if I was going to make a prediction, I would say it's more of a target than a prediction. Our target is to make sure we have our inventory at target levels, end of the third quarter, early the fourth quarter. And we've had a lot of dialogue with CN; CN handles 75% of our Canadian production. And we've had a number of discussions with them. The CEO of CN and some of its management team are coming out to meet with our GM of transportation, Chris McIver, our Vice President of Sales, Ray Ferris, and myself in a few weeks. And I've had some discussions with their CEO. And my message to him was we're going to work with CN to find a solution but we're also spending time now looking for longer-term other alternatives and we're going to have to look at making other, longer-term commitments depending on our comfort level with CN. I think you guys all know the issues with CN and I think, they are talking about -- they have hired people, they're investing capital and so on. The question in our mind is how quick will that happen. And I can tell you, we're already taking advantage of other alternatives. Our inventories plateaued out late in the quarter. We've seen a slight improvement from CN but we're having to take advantage of, as I said, of other alternatives. So I wish I could give you a prediction, but we think it's -- if we get it done by the end of the third quarter, I'll be pretty happy, to be perfectly honestly with you.

I know it's not in the West Fraser DNA but in the near term, would you guys consider taking downtime just to keep inventories in check?

No, I mean -- well, we were forced to take some operational downtime at our QRP mill because we had nowhere else to store the pulp in and it's very difficult with BCTMP. But in terms of our lumber operations, you've seen our margins, we have very strong margins. We have a very strong outlook towards the balance of the year. And we will find the solution here. I think we could have done a better job, there is no question. Would the impact have been material? I think, given our dependence on CN, I mean, we don't have any direct real access with CP. But given our dependence, as I said, I think we could've done better. We're going to be focusing on finding other alternatives and they may cost us a bit of money. But no, we plan to continue to run our mills, ship our production and then ship our inventory. But it's going to be a bit of a challenge for us, for sure.

Okay. One last quick one, Ted, and I'll get back in the queue.

You bet.

We saw some fiber cost inflation in Western Canada in Q1. I guess, the auction, bidding, drilled things up, higher lumber prices as well. Any visibility on ongoing inflation from here in Western Canada through the remainder of the year on that front?

Well, I think, first of all, in July 1, stumpage formula will be updated; that's based on the bid prices. And given what we've experienced, we probably will see probably a couple of dollars a cubic meter at least on our quota within the -- in Q3. We don't really buy much volume obviously in the second quarter, given breakup. And we've seen, in certain parts of British Columbia, you see more cost inflation than others in terms of the purchase market and that's moving, frankly, at much more than 2% on a year -- sorry, by much more than $2 a cubic meter on a year-by-year basis. So we expect to see continued inflation, particularly in these good lumber markets and with a declining timber supply in British Columbia. And that's probably the reason why above 70% -- almost 70% of our production today is outside of British Columbia.

Okay, that's really good detail. Thanks, Ted.

Thanks, Sean.

Your next question is from Hamir Patel from CIBC Capital Markets. Hamir, please go ahead.

Ted, you mentioned you guys are looking at using some other alternatives to help mitigate some of the CN challenges. Just curious, maybe if you could maybe put a range on what level of SPF shipments you might expect in Q2?

Well, today is April 26, and we've basically been pretty close to shipping our production. We're hopeful to do better than that. I mean, we need to do better than that. We are -- I don't want share too much because it's a bit of a competitive issue. And so -- but we are looking at other alternatives. And I can tell you this; I think I brought this up in the February call, around Q4 results. We really challenged our group and this is the entire organization at the mill level, at our transportation and our sales level, to give it a good long term solution to this.

That's helpful and --

At the end of the day, Hamir, results will speak for themselves as far as that's concerned. And -- but this has got a high degree of focus for us.

And then, I hate to bring up Hinton but yourselves called it out this quarter. So just curious, what -- where you are in that journey of getting that mill where you want it to be? And maybe what sort of production are you targeting there this year? And what's the long-term goal?

Well, I think, I'll comment on that. Before I talk about Hinton, I think, I just want share we're pretty delighted with the performance of our Cariboo pulp mill. Our BCTMP mills and our -- so Cariboo's really made great progress. Our two BCTMP mills and ANC continue to be tremendous operators. Hinton -- we made very good progress right through kind of the first half of last year. We've struggled in all honesty, Hamir. We have a good asset there. It's really about improving reliability and we have -- we took a whole bunch of steps forward. We have taken a step backwards and so to give you visibility, I think, all I can say is our expectation is to have better results in the first quarter in our overall NBSK production, which means Hinton has areas that needs to improve. And again, I'd rather stop talking about what we're going to do and focus on what the results are going to be. But I mean, until we do better than the first quarter, that's the visibility I would give you.

Fair enough. And just a final question for Chris. Can you maybe outline what are some of the major capital projects that are embedded in the guidance for this year?

So you know we have a suite of projects across the Canadian lumber platform panels, pulp and the U.S. lumber platform. So the two more notable ones are high-priority and Opelika that we mentioned. But we continue on the path that we've been on for the past several years with CDKs, sawmill upgrades, planer upgrades, all things geared at not only increasing capacity but improving grade, improving recovery, modernizing our mills, steps to reduce turnover in the mills through automation and increasing reliability across the platform. So I wouldn't characterize anything that we're going to do over this year within that guidance as materially different than what we've been doing for the last two or three years.

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

Just to dwell into this transportation issue, I guess, we heard from everybody it's going to be a problem and then we saw one of your competitors really do a remarkable job despite everybody's issue with transportation on the quarter. What's the major difference between your performance on the transportation side and theirs? And what do you hope to address going forward?

Well frankly, I don't think you've ever heard us talk about a competitor on one of these calls. And I'm not going to start that today. But I think I tried to elaborate on it a little bit. And we -- our dependence on CN, I think, it's pretty critical. And we have a big machine here at West Fraser and our ability to turn on a dime when CN let us down so dramatically was pretty difficult. And I think, part of it is location of our mills and we probably had less apparent options than potentially other large companies have. I guess, this is as far as I will go. But we're going to develop those options. And they may be a bit more costly but there is areas where we can make commitments. And I think, the other issue that we faced and I can't speak for others but the same time we had weather issues, the trucking industry, a lot of the truckers weren't available in the first quarter in the wintertime. And so we got to find a way to address that next winter as a company. So I would say -- so I think we're going to look at other trucking options and frankly, some of them are as competitive as Rio but we have to make sure that they're available to us. And let's be frank, we've never been let down to this degree by CN. And CN knows that and they've reached out to us.

Yes, to be fair, I mean, you did outperform on production in the quarter if you had more of a problem to deal with so maybe if I can understand that, if you're 75% dependent on CN, is the 25%, is that truck?

Well we have -- we do some transloading and then, we do some direct trucks primarily to Vancouver, but we do transloading. For example one of our mills, Sundre in Alberta, does not have real access so we do transloading out of that along with some trucking. So yes, it -- we are very dependent on them. And they're telling us they want to win our business back. And we do have to think long-term around here as a company. We're not going to make radical changes that don't make sense long-term. And the other thing I do want to say is I really applaud JJ Roue for reaching out to me within a day of becoming their CEO. I had a tremendous relationship with Claude Mongeau. Claude did tremendous work in the relationship with West Fraser. So we built a really great relationship. And obviously, we all know the issues they faced. I'm not going to -- it's not my job to beat them up. But I think they realize what their issues are. And we're going to sit down with them, as I said, in next 10 days and really get an understanding what they can do for us longer-term. But also, how much can we rely on them between now and next winter. So we've got lots of options on the table. And we recognize that they're always going to be our most important transportation company in terms of moving our product. But we need to have a different arrangement going forward and if we can't rely on that, I mean, we have to find other solutions. Paul, I wish I had a more direct answer for you but I think that's about all what I can say for now.

Yes, I know, that's fair. Maybe just talk about -- pricing in the quarter was very strong. The cynic in me would say, a lot of that has to do with the transportation issues experienced by the industry but also recognize that there is strong underlying demand. How do you think that shakes out in terms of the drivers in the run-up in price in both Western and SPF which we can talk about the transportation. But also in Southern Yellow Pine?

Okay, I was going to make a joke about you being a cynic but I will stop. We can do that offline. But -- and I'll have Chris comment on the markets. But to me the interesting thing is, and I'm a broken record, as you know, but we kept saying at $1.3 million housing starts we expected the stars to align. And we saw the impact of the forest fires last year, which was not significant. And it seems like any time we have an interruption in production or service, the market has difficulty in reacting. And I also believe that -- I think our customers are starting to recognize that we are moving into a strong market and they've got think a little differently. But with that, maybe I think, Chris could give a bit more -- Chris McIver can give a bit more color on maybe pricing in the quarter and where you see things going?

Yes, it's pretty interesting. We had a time in Q1 where we pretty much pulled off the market on the lumber side because of transportation issues, we were -- we were struggling to get our product out. At that time, you saw the market back off some, not that related to us particularly, but very quickly, the buyers were back, they're back today, they're buying very strongly right now. They are not holding a lot of inventory in the U.S. That's our experience. And the products moving through the whole network very quickly. So we see a pretty robust overall market. And certainly housing is good. R&R, we think, is actually really, really good. And offshore, we had a hard time getting to market for a little while. And I think, overall, it's very positive. Including panels and our pulp group as well. We've seen a rebound in the pulp side as well over the last month or so. Yes, and SYP, it continues to be strong. And they don't have the transportation issues. So we have -- we've seen a really strong pricing. So certainly part of this is transportation but a lot is just the underlying demand, so.

That's great. That's why Q2 getting the inventory.

Thanks. Thanks, Paul. We're going to need it.

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

I wonder if we can just start off by talking about capital allocation. Here, you're throwing off a lot of free cash, you've repurchased about $45 million for the shares in the first quarter. I wondered if you could just kind of talk with us about how you're thinking about capital allocation in light of these very strong cash flows and the good balance sheet right now.

Well, I'll tell you what, I'll let Chris answer the question because I didn't know what the word meant until Chris showed up here. I'm joking. But I think, we have a history of investing capital first. And we're going to continue to do that, and Chris mentioned that. But I think I will have Chris give you a little broader view on how we're thinking there.

Sure. Thanks, Ted, and thanks, Mark, for the question. As we think about the hierarchy, right, and we recognize that we're in a cyclical industry here. And as great as pricing is now, there's likely going to be a time when it's not so great. And so we spend a lot of time looking at where are we today, where -- when could we see another downturn? How much stickiness do we think are in this pricing? Where do we see log inflation going? Looking at those long term forecasts, and then using that as a means to kind of think about how do we deploy our capital. So first and foremost, it's making sure that we're operating within a comfort level that will serve us well in a good markets and in bad. So that we don't find ourselves in a position to make a -- have to make a decision in a weak market that we don't want to make, we don't want to be constrained in anyway. We look at that as sort of the guard rails. And then first and foremost, its investing in our mills, which we've been doing for a number of years. We have a long backlog of projects that stretches out a couple of years in front of us in terms of what we want to invest in our mills. We are looking for opportunities in light of these markets for ways that maybe we can bring some of that forward and realize the benefits of that sooner. We've increased our dividend twice in the last 6 months, and we've been active on share buybacks through the last six months. And so we also keep an active pipeline of acquisition opportunities in front of us. But if we're going to grow the business through acquisition, we want do it in a way that makes us better. And so that's why we probably have been a little bit more selective. We don't want to buy any fixer-uppers. And we're really kind of looking at opportunities very carefully as they come to us. So we'll continue to return capital to our shareholders in a prudent, sustainable way. And make sure we have the right balance sheet going forward.

Yes, that's fair, that's a good answer. I wondered, just on the sort of capital spending and acquisition front, if you can just sort of talk about where you see valuations now on the acquisition side? And then with regard to kind of capital spending, maybe update us on what you're doing at Gilman? And whether you might be looking at prospectively any new sawmill projects? It seems like over the last six months, we have seen a pretty dramatic ramp up in new sawmill projects announced in the southern U.S.

Well, maybe I'll try and comment on that. You probably won't applaud me as well as you applauded to Chris, but I'll give it a shot. I think, in terms of valuations, I'm not -- it's really not much I want say on that, other than I don't feel like defending our Gilman acquisition. We didn't look at that as a cost -- on a cost per thousand board foot acquisition; we looked that based on our view of markets but more importantly, we looked at timber base and quality to people. And I can tell you, it's going to -- I mean, we're pretty confident based on this year's results that it's going to be a tremendous, tremendous return for us, much better than even we anticipated. So we're very delighted, we're able to buy it last year rather than having to buy this year. It brings capital to us and opportunities, as we said in the last call. I mean, they've done a great job with the equipment they have. But again, a perfect example here is our log -- our lumber recovery out of the log, there was about 20% worse than our other U.S. mills on average. And not all those mills are fully modernized, either. So tremendous opportunity. So we just think about the opportunity of potential using the same volume of logs producing 20% less chips and 20% more lumber. That's pretty exciting to us. And we do have the opportunity in some of our regions, some of our mills to even grow that footprint from a log supply standpoint. So we're looking at projects and I think we've outlined that we're probably looking at $200 million to $250 million of CapEx that we want to spend over the next couple of years; that hasn't changed. In terms of visibility on sawmill projects, again, you're not going to like this answer, Mark, but we don't really like talking about it until we break ground. And so all I can say is, we're starting up the Greenfield sawmill in Opelika this summer and we're not afraid of Greenfield. But it's got to fit into our capital -- our overall capital plan and it's got to make us better. So we are pretty comfortable with large cap spending. I mean, at the AGM last week, I shared with everybody that we had 61 major projects from 2012, I believe and until the end of last year. That's 10 or 12 major projects a year, whether it's CDKs, planer upgrades, front end of sawmills, energy systems and I don't see that changing for the next three or four years, for us. When it comes to future valuations, I think it really comes down to your view on the market. You've got to have a strong view on lumber markets. And there's got to be good synergies. But I want to echo Chris's words. We have a strong balance sheet but we're not going to use it improperly. We're a large company. We're more interested -- we want be a great company. So -- and acquisition's got to make us better. I hope I answered part of your question.

I think that was a good answer. And just the last one I had, I'm picking up some kind of signals from the team Os and some of the others that we might be starting to see a little bit of upward pressure on kind of southern log cost. They've been quite low by historic standards really since we came out of the recession. What are you guys seeing?

Well, we're not seeing that. And at the end of the day here, I think it'll come down to where the sawmill capacity has grown by reaching. I don't think this is broadly across the South of the U.S. and given the huge inventory overhang of timber, we sure don't see that happening in the next couple of years in any meaningful way. And I think that's experience we have had for a number of years. And we don't really see that changing. We are not chasing logs, I can tell you that much.

[Operator Instructions]. There are no more questions at this time. Please proceed.

Well, thanks very much for joining us on the call. And we'll be talking to you in the summertime. Thanks a lot. Bye.