Western Forest Products Inc

TSX:WEF

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to Western Forest Products Second Quarter 2018 Results Conference Call. During this conference call, Western'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 are 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 risks and uncertainties in the company's annual MD&A, which can be accessed on SEDAR and are supplemented by the company's quarterly MD&A. Accordingly, listeners should exercise caution in relying upon forward-looking statements. I now turn the meeting over to Mr. Don Demens, President and CEO of Western Forest Products. Mr. Demens, please go ahead.

[Donald Eugene Demens, CEO, President & Non Independent Director]

Thank you, operator. Good morning, everyone. I'd like to welcome you to Western Forest Products Q2 2018 conference call. Joining me on the call today is Steve Williams, our Executive Vice President and Chief Financial Officer. I'll provide you with some introductory comments, and then ask Steve to take you through a summary of our financial results. I'll then share our near-term outlook and provide an update on our capital initiatives. We can then open it up to you for questions. In the second quarter, we successfully capitalized in strong markets to deliver adjusted EBITDA of $50.2 million. Increased volumes and improved product pricing allowed us to overcome a weaker sales mix, the impact of lumber export duties and rising BC log costs. In our timberlands, we leveraged improved operating conditions to deliver another quarter of strong log production. Higher harvest levels, combined with increased log purchases have allowed us to more than double our mill log inventory compared to this time last year. In our manufacturing operations, we capitalized on improved log inventories to increase operating hours. A combination of the increased hours, improved reliability delivered from our margin improvement initiatives and a higher mix of commodity lumber production drove the lower conversion costs. Price improvements in each of our product segments offset lower specialty lumber sales volumes, allowing us to deliver similar pricing to last year. Also in the quarter, we commenced lumber distribution from our newly-acquired facility in Arlington, Washington. And finally, we continued our balanced approach to capital allocation. In the quarter, we made capital investments of $19 million, we increased our dividend by 12.5% and we repurchased more than $4 million worth of shares through our NCIB which, we announced this morning, has been extended to August 2019. On a year-to-date basis, we returned approximately $23 million to our shareholders in the form of dividends and share repurchases while investing $32 million in our business. I'll now turn it over to Steve to review our key financial results.

[Stephen Williams, Executive VP & CFO]

Thanks, Don. My comments will focus primarily on our financial results for the second quarter of 2018 with comparison to the second quarter of last year. As Don discussed, we achieved second quarter adjusted EBITDA of $50.2 million as compared to $47.1 million in the same period of 2017. Improved lumber realizations and lower operating costs more than offset higher lumber export duty expense and rising BC log costs. Export duty expense of $11.7 million is compared to $9.2 million in the second quarter of last year. As of June 30, 2018, we had approximately $40 million of duties on deposit. Improved lumber and byproduct revenue offset reduced log revenue. Higher lumber revenue was driven by a 21% increase in shipments versus Q2 '17. Average lumber price realizations were consistent with the same period last year despite a heavier mix of commodity shipments in Q2 2018. Average realized log pricing decreased by 15% on a lower value sales mix, owing to the temporary suspension of our export log sales program to supply our domestic mills. We reduced our manufacturing costs through improved sawmill operating hours, a heavier commodity production mix, and as a result of our margin improvement initiatives. Log harvest costs rose 10% due to escalating stumpage rates and higher contracted rates. Second quarter harvest costs included an incremental $12.6 million of stumpage expenses compared to the second quarter of 2017. Higher contractor rates were the result of a different regional mix of timberlands operations period-over-period. Freight expense decreased by 13% due to a temporary curtailing for export log sales and, as a result, the geographic mix of our lumber shipments and a stronger Canadian dollar. From a profit and loss perspective, net income was $27.1 million or $0.07 per share as compared to $25.6 million or $0.06 per share in Q2 '17. Increased net income was due to improved operating income, partly offset by higher income tax expense. In the second quarter, we utilized our remaining noncapital tax loss carryforwards. Looking to cash flow and capital management. Cash provided by operating activities excluding noncash working capital was $48.6 million as compared to $40.4 million in the same period of 2017 as we improved operating income period-over-period. Capital expenditures increased to $18.7 million as compared to $8.2 million in Q2 '17. Progress with ongoing infrastructure upgrades at our Arlington operation contributed $2.2 million to increased capital expenditures in 2018. We paid dividends of $8.9 million versus $7.9 million in the same period last year, and in the second quarter of 2018, we spent $4.1 million to repurchase 1.6 million common shares under our normal course issuer bid. As at June 30, 2018, we had total liquidity of $276 million compared to $269 million at the end of 2017. We continue to explore opportunities to grow our business and we are committed to continuing our balanced approach to these capital allocations. Don, that concludes my comments.

[Donald Eugene Demens, CEO, President & Non Independent Director]

Great, Steve. Thank you. I'd like to start off our outlook section by just touching on third quarter seasonality. Typical third quarters can be challenging operationally as hot, dry weather can restrict logging activity, reducing harvest volumes and impacting costs. As our coastal forests dry out, we shift to less productive early morning operating hours to reduce fire risk. We've had a productive first month in this quarter, but the recent hot weather has led to harvest curtailment in most of our operations. We're optimistic that a cooling trend could get us back to work in the near term. Our market outlook remains positive despite the recent declines in North American commodity lumber prices. Demand for our specialty products in our key markets remain strong despite increased competition from substitutes. Pricing in our Cedar segment had become uneven as anticipated production from U.S. sawmills has created short-term market imbalance. Over the mid- to long-term, we expect global log and lumber consumption to continue to rise, supported by increased U.S. new home construction, a strong North American repair and renovation segment and steady market in China. Pricing in the domestic log market's expected to moderate over the second half of the year as higher coastal log harvest has increased sawlog supply. Pulp log pricing is expected to increase slightly as coastal pulp mills build inventories ahead of the winter. As mentioned earlier, we temporarily suspended export log sales in the first half of 2018 to support additional lumber production from our mills. Export log shipments recognized in the period were related to Western's management of a short-term First Nations timber purchase agreement. The provincial government's expressed concern relating to the volume of non-manufactured logs leaving the coast of BC, and we anticipate the government will deliver a policy response that will support domestic manufacturers. In the meantime, we remain focused on delivering on our timberlands' margin improvement initiatives, which include a significant focus on cost containment to offset rising stumpage costs. We expect our manufacturing operations will benefit from improved mill log inventories, which should support higher lumber production and sales as we move into the operationally-challenging third quarter. In May, we filed a NAFTA challenge to contest the U.S. International Trade Commission's finding that cedar lumber products were not a separate like product group from structural softwood lumber. Through our challenge, we're seeking ITC recognition, that appearance grade cedar and structural commodity lumber differ in end-use application. A successful challenge could result in separate [ like ] product classifications and require the ITC to rule that cedar shipments from BC injure U.S. producers. We anticipate receiving rebuttal briefs from the U.S. Lumber Trade Coalition and the ITC in the fourth quarter, and a NAFTA panel ruling sometime in 2019. Duty on our U.S.-bound Western Red Cedar products have accounted for approximately 85% of our total duty expense since April 2017. In respect of our capital program, we continue to reinvest in and consolidate our operating base to position our mills in timberlands as the most cost-competitive operations on the coast of BC. Through the second quarter of 2018, we continued making investments in our people through targeted safety and financial training, and in our management information systems to lay the foundation for improved operations and create a platform for future growth. Second quarter capital achievements were highlighted by a significant progress in ramping up the autograder at the Duke Point planer and completing the startup of the Chemainus timber deck upgrade project. Through the first half of 2018, we've implemented $2.7 million in small, high-return debottlenecking projects, including centralizing our east side roundsaw saw filings. At Arlington, in the second quarter, we invested $2.2 million in capital infrastructure upgrades, enabling us to begin distribution activity from the site. We expect to complete site infrastructure upgrades and commence processing equipment installation in the third quarter of 2018, and we remain focused on a late fourth quarter startup of our secondary processing business. We expect operations in Arlington to assist us in repositioning our product lines closer to the final customer. Looking to what's next. In the second half of 2018, we plan to invest an additional $20 million on small high-return strategic capital projects in our manufacturing operations, including the modernization of mobile equipment at our sawmills. We expect these debottlenecking consolidation and modernization initiatives will achieve our hurdle rates of return. Including capital projects planned for Arlington this year, we are reiterating our expectation to invest $80 million to $90 million in our business in 2018. As Steve indicated, we continue to evaluate external growth opportunities that will support our specialty product focus. Growth may come from the acquisition of production assets, the acquisition of lumber that we will process through Arlington, or additional product volumes that we would market, supporting market share growth in key segments. We believe that our ongoing reinvestment in and consolidate -- consolidation of our coastal operating base, steady improvements in our operating performance and a strong balance sheet have positioned Western to pursue external growth opportunities as they become available. With that, operator, I can now open it up for questions.

[Operator]

[Operator Instructions] Our first question is from Sean Steuart from TD Securities.

[Sean Steuart, Research Analyst]

A few questions. Don, with respect to Western Red Cedar lumber markets, you mentioned, I guess, uneven markets creeping in and you touched on some substitution and unexpected production from the U.S. Can you give us a little more context around that? And we've seen Cedar shipments as a percentage of total come under some pressure. Any visibility on what those percentages on a volume base might look like through the second half of the year?

[Donald Eugene Demens, CEO, President & Non Independent Director]

Sure. Let me try to [ add ], Sean. So what's happened in the U.S. market is, and as you know, pricing for cedar products has risen, partially propelled by the application of duties on our products, but also, just to give, demand has been good and we've taken a pricing leadership position. The higher pricing has drawn in substitutes, and now we're seeing some volume of lumber from offshore trying to substitute for cedar. That's hard to do, given the natural attributes of cedar, but we're seeing Japanese sugi, milled in China, come into the market, especially into the fence picket market, where most of the consumption of U.S. cedar was directed. As that volume's entered the market, we've seen some of the logs that were destined for the fence picket market end up in local U.S. sawmills, and that has found its way on to the market. So why is this a problem? All of this volume is incremental and on the margin, but it's a problem because most of the distribution channel will contract their cedar purchases well in advance. So any blips of production, and that's what I would call this, an unexpected increase in volume, can have an impact on the margin. So what are we talking about? What kind of volume are we talking about? Well, most of the -- and what kind of products? Most of the production is narrow width and thin; thicknesses of 1-inch and less than 2-inch, 4-inch wide. And that product line is under pressure, and that product line represents about 15% of the volume we handle. So in general, we're seeing just a -- what you would expect to see, increased volume availability by lesser and lower performing substitutes coming into the market and a -- an effect on production going forward. We believe all of this will be absorbed. But in the near term, things are a bit choppy on about 15% of the products that we handle. On the other products we produce, pricing's actually improving. So I hope that covers off that part on the market. And again, I don't think it's anything that wasn't really expected over the longer-term. On your question about what percentage of our business will be specialty and how much cedar we'll do, I think you can expect our volumes to be about similar as we get through the back half of the year. As you're aware, as you end up in the back half of the year, cedar demand in United States goes down just as the weather gets worse, and prior to the spring build where the distribution channel wants to have cedar on their shelves ahead of the springtime building season.

[Sean Steuart, Research Analyst]

Okay. On Arlington, can you remind us what the secondary processing capacity will look like once that starts up in the fourth quarter? And any context you can give on the M&A environment in the Pacific Northwest, in general, right now, as you look to potentially grow in that region?

[Donald Eugene Demens, CEO, President & Non Independent Director]

Sure. So let me start just on production volumes at Arlington. So as you know, just to remind everybody, Arlington, we purchased that at the beginning of the year. The site's 18 acres, 170,000 square feet of covered space, 7-car rail siding and has secondary -- it has secondary processing capability. What we're doing at Arlington is we're going to use it as a distribution hub into the -- one of the best cedar markets there is, and that's the Pacific Northwest. And so we've just commenced that part. On the processing side, we'd anticipate having our planer line and kilns operational in the fourth quarter, with a capacity of up to 100 million feet of processing on a yearly basis. That number is a target number. It really depends on what product lines that we end up producing there. We've got a pretty clear idea what we want to do, that would be on our current structure and our view of processing in the near term. Over the longer-term, we expect to have additional equipment, making increased volumes of finished products, targeted closer to the end user. When we think about M&A activity in the Pacific Northwest, as we've talked in the past, those opportunities, we believe, are -- will becoming available, because -- especially in the specialty side of the business. Most of that capacity is controlled by single-owner operators, and it's just a matter of when the time is right for them to determine what their succession plan is and how they would -- and if they would like to exit the business or pass the business on to Western. As we've discussed, as the largest specialty softwood lumber producer, we are the likely candidate for at least to be included in the discussion.

[Operator]

Next question is from Hamir Patel from CIBC Capital Markets.

[Hamir Patel]

Don, you mentioned that competition being caused by the imported product. One of your composite competitors keeps pointing to sort of continued market share gains from wood. Are you seeing Western grade cedar lose share or are they displacing something else?

[Donald Eugene Demens, CEO, President & Non Independent Director]

Thanks, Hamir. We're not seeing a significant impact directly in our business for people that want to have plastic decks over wood decks, which is a primary end use for those products and where we see the competition. As we say, we're making products. And cedar -- we're fulfilling people's opportunity to make a great outdoor living experience for -- in their home. I think they may be continuing to champion their market share growth, but in actual fact, I think, the market itself is -- it continues to grow and they're going to continue to increase volume for that segment of the market. So -- we haven't really seen a loss share directly or lost sales as a result of composite substitutes. I think where we're seeing increased competition, as I tried to outline is, is this knock-on effect, as Japanese sugi milled in China, mostly in the fence pickets, it's finding its way into the market, and that's freeing up logs that were once consumed in the fencing business in United States into the sawmills there.

[Hamir Patel]

Okay. Fair enough, Don. And then, just given your strong balance sheet and limited acquisition opportunities in the Pacific Northwest. Did you ever think it could make sense to actually own a composite manufacturer because, to your point, there's different segments of the market, and for the section that maybe doesn't directly compete with you it -- I imagine that there could be some channel synergies. Just curious what you think about that.

[Donald Eugene Demens, CEO, President & Non Independent Director]

Well, yes. So pretty loaded question. But, I think, we're always looking for product lines that will support our market share in our targeted segments. And so could we, one day, look at that? I guess. I think we're going to stay more focused on looking to grow the product lines that we currently make or taking them up the value chain. And I think that's where our focus is going to be in the near term.

[Operator]

[Operator Instructions] The following question is from Paul Quinn from RBC Capital Markets.

[Paul C. Quinn, Analyst]

Just a question on BC government, and I don't want you to get ahead of them. But what kind of things do you think they're going to do on the log export side, and how beneficial will it be to you as domestic manufacturer?

[Donald Eugene Demens, CEO, President & Non Independent Director]

Paul, well, yes. I think it's hard for us, as you've just indicated, to prejudge what their -- moves they'll make if any policy moves. They've engaged the industry in discussions. I think they'd like to see industry come up with an outcome. But we certainly anticipate some sort -- some form of policy adjustment to ensure more volume of unmanufactured logs are actually manufactured in BC. I would expect that in the near term as well, Paul. I mean, I think it's part of their platform, and they have committed to making changes to direct more volume into the local market.

[Paul C. Quinn, Analyst]

Okay. And then just in capital allocation. How are you guys looking at the -- your ability to buy back shares versus the dividend? Is the dividend at the appropriate level now that you've raised it?

[Donald Eugene Demens, CEO, President & Non Independent Director]

Yes. So -- good question. I mean, I think, we've continued to use a balanced approach in our capital allocation, and we review it every quarter. As you know -- I mean, on the dividend side, we just increased our dividend. We feel pretty good about where it is now, and we will, certainly at these levels, with the recent sell up in stock price, start looking more at the NCIB, which we reinstated again, through to August 2019. We'll start looking at being probably more aggressive in our NCIB.

[Paul C. Quinn, Analyst]

All right. What do you see in Niche markets? Any change at all in that marketplace?

[Donald Eugene Demens, CEO, President & Non Independent Director]

So, yes. The Niche markets, those will be product lines for appearance products that would end up in the door window molding business, it would be appearance timbers. It would be industrial timbers, like the cross-arms to the top of telephones poles and things like that, and we've seen really good demand in that market. We're growing volumes. We've got -- and we're working hard at increasing our production, especially on the timber side. And why we like the timber business is, I note it would be both internally in our mills and through our custom-cutting operations, because we've invested in our timber decks and there's not very many competitors who can provide the breadth of product lines in timbers that we can. So long and short -- or the long and short of it is, demand's been good. We're looking at growing our volumes there, and we like the pricing traction that we're getting in the market as we grow in that segment.

[Operator]

And there are no further questions registered. I'll turn the meeting back over to Mr. Demens. Please go ahead.

[Donald Eugene Demens, CEO, President & Non Independent Director]

Great. Thank you, operator. So to close, just want to thank you all for your attention and support of Western. We continue to be encouraged by our most recent results and look forward to sharing our third quarter results with you in November. With that, wish you a good day.

[Operator]

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.