Western Forest Products Inc

TSX:WEF

Earnings Call Transcript 2020-Q2

[Operator]

Good morning, ladies and gentlemen. Welcome to the Western Forest Products Second Quarter 2020 Results Conference Call.During this conference call, Western's representatives may make forward-looking statements within the meaning of applicable securities laws. These statements can be identified by words like anticipate, plan, estimate, will and other references to future periods. Although these forward-looking statements reflect management's reasonable beliefs, expectations and assumptions, they are subject to inherent uncertainties and actual results may differ materially.There are many factors that could cause actual outcomes to be different, including those factors described under risks and uncertainties in the company's annual MD&A., which can be accessed on SEDAR and is supplemented by the company's quarterly MD&A. Forward-looking statements are based only on information currently available to Western and speak only as of the date on which they are made. Except as required by law, Western undertakes no obligation to update forward-looking statements. Accordingly, listeners should exercise caution in relying upon forward-looking statements.I would now like to 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, Jacob, and good morning, everyone. I'd like to welcome you to Western Forest Products 2020 Second Quarter Conference Call. Joining me on the call today is Stephen Williams, our Executive Vice President and Chief Financial Officer.We issued our 2020 second quarter results yesterday. 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 with you our outlook and discuss recent developments in our industry. We will then take your questions.Let me start the call by acknowledging our employees and contractors for their commitment to health and safety during this challenging and uncertain time. Their adoption of the strict health and safety protocols that our company implemented at the onset of COVID-19 have not only kept our employees, contractors and communities safe, but their efforts have been instrumental in enabling us to reestablish our business after the lengthy USW strike.Our strategic investments in information technology over the past several years has allowed us to work remotely while ensuring we remain connected, both internally and with our customers around the world. As we navigate through the challenges presented by COVID-19, we will continue to provide all the support necessary to keep our employees, contractors and communities healthy and safe.Moving on to our second quarter results. Despite the uncertain operating environment caused by COVID-19 and operational challenges resulting from the restart of operations after the lengthy USW strike, we generated $29.5 million of adjusted EBITDA. This year's results were much improved from the $15 million generated in the same quarter last year.I'm pleased we were able to successfully deliver solid financial results in the second quarter of 2020 while overcoming the impacts caused by COVID-19 and despite the operational challenges associated with the restart of our BC operations, the consumption of strike-impacted logs and having been unable to participate in the spring buy due to the strike.As we continue to navigate through these uncertain times, we'll remain focused on aligning our production volumes to match market demand while, first and foremost, ensuring the health and safety of our employees.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 2020 by comparison to the second quarter of last year.We reported second quarter adjusted EBITDA of $29.5 million as compared to $15.1 million in the same period of 2019. Results in the quarter benefited from improved lumber and log markets towards the end of the quarter, favorable coastal harvesting conditions, strategically accessing logs that were staged prior to the strike to reduce per unit harvesting costs and accessing the Canadian Emergency Wage program to support employment and communities.These benefits were partially offset by a weaker log sales mix, lower byproduct revenues and higher per unit manufacturing cost due to the restart of operations and production inefficiencies from consuming log inventory that had degraded during the strike.Lumber revenue decreased by 19% compared to the same period last year due to lower shipment volumes. This was partially offset by a higher specialty product mix and the benefits from a weaker Canadian to U.S. dollar.Specialty lumber shipments represented 64% of second quarter shipments compared to 57% in the second quarter of 2019. Log revenue decreased 4% compared to the same period last year. We capitalized on an improved log market late in the second quarter to deliver increased shipments as compared to the same period last year. However, average log price realizations declined due to a weaker sales mix and degraded log quality as a result of the strike.Byproduct revenue decreased 48% due to lower chip sales volumes and lower realized pricing. Freight expense decreased by $6.3 million from the same period last year due to lower shipment volumes. Duty expense decreased by $2.1 million from the same period last year due to reduced U.S.-destined lumber shipment volumes. At the end of the quarter, we had approximately $105 million of duties on deposit.Lumber production decreased 31% compared to the same period last year. We operated fewer shifts, and production efficiency was impacted by log inventory that had degraded during the strike. This also resulted in higher per unit manufacturing cost compared to the same period last year. Log production in the second quarter of 2020 was 2% lower than the same period last year. Log production gradually increased through the second quarter of 2020, overcoming modified operating procedures to mitigate COVID-19 risks and capitalizing on favorable coastal operating conditions.Our BC Coastal per unit harvest cost decreased from the same period last year, as we strategically accessed logs that have been staged prior to the strike. We also reduced higher-cost helicopter logging volumes and limited road expenditures.From a profit and loss perspective, net income was $8.5 million as compared to a net loss of $0.7 million in the second quarter of 2019.Looking at second quarter cash flow and capital management. Cash provided by operating activities before changes in noncash working capital during the second quarter of 2020 was $38.5 million as compared to $4.5 million in the same period last year. The second quarter of 2020 benefited from the receipt of income tax refunds of $11.4 million.In the second quarter of 2020, noncash working capital increased by $46.3 million. Noncash working capital increased as we rebuilt the inventories as we resumed strike-curtailed BC operations and as shipments accelerated through the end of June with improving market demand.Cash used in investing activities was $3.9 million during the second quarter of 2020 as compared to $14.9 million during the same period last year. We reduced our capital spending in order to address uncertainty caused by COVID-19.Last quarter, we announced the suspension of our quarterly dividend to address uncertainty caused by COVID-19. And as a result, we did not make a dividend distribution in the second quarter of 2020.Our liquidity at the end of the second quarter was $95.1 million, and our net debt-to-capitalization ratio was approximately 25%. Liquidity remains a key priority and a near-term focus. Working capital typically reaches a seasonal high at the end of the second quarter. We expect to receive a total of $18 million in the third quarter of 2020 from income tax refunds in the Canadian Emergency Wage program. We will continue to explore opportunities to strengthen our liquidity. We expect sufficient liquidity to be available to meet our ongoing obligations.Don, that concludes my comments.

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

Great. Thanks, Steve. I'd like to start off our outlook section by 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. So far, we've had a productive first month of harvesting, but conditions can change quickly as we head into the late summer.Turning to our markets. At the onset of the COVID-19 pandemic, government actions to limit the spread of the virus created significant demand disruptions. In response, many lumber producers curtailed operations. As governments began to ease restrictions, lumber consumption quickly improved, particularly in North America. Rising demand has outpaced supply. The resulting supply-demand imbalance has led to significant price increases, especially for commodity lumber.Lumber demand in our key export markets has not experienced the same sharp rebound as in North America. As a result, we're directing a component of our lumber production to North American product lines to take advantage of the improved pricing environment. Demand and pricing for our Western Red Cedar products in North America improved through the quarter, led by the Home Centre segment. We expect demand in North America to remain strong in the third quarter, which is traditionally a slower period for Western Red Cedar lumber sales.Demand for niche lumber products targeted to the treating segment in North America remained strong, while demand for timbers consumed in the industrial segment has slowed.In Japan, lumber demand has weakened due to declining housing starts and COVID-19-related challenges. As demand has fallen, market pricing has become more competitive. In response to the weaker demand for our products, we may direct certain Japan-destined volume to the North American market.In the export log market during the second quarter, COVID-19 shutdowns in New Zealand and Europe impacted log supply to China. We expect European and New Zealand log supply to return to pre-shutdown levels, leading to a more competitive price environment as we go forward. The recent strengthening of the Canadian dollar versus the U.S. dollar may impact certain log and lumber realizations in the third quarter.We expect domestic log prices to improve slightly in the third quarter, supported by increased demand from local manufacturers. In contrast, we expect pricing for pulp logs to remain under pressure until demand for pulp and paper improves and the pulp and paper mills return to full production.In the second quarter of 2020, we launched new product branding to increase our presence in the Home Centre and Pro-Dealer sales channels. The new branding will support the strategic marketing and vendor purchase agreements we reached with customers in the first quarter. We expect to see more fulsome benefits of these marketing initiatives as we move forward, supporting us in growing sales volumes in order to capitalize on the growth in the repair and remodeling segment.As we look forward, the potential resurgence of COVID-19 cases around the globe may lead to the reintroduction of restrictions that could impact lumber demand. We plan to utilize our flexible operating platform to adjust to market conditions, and we'll continue to align our production volumes to match our customers' needs.I'd like to provide you an update on a couple of developments now in the industry. In January of this year, the BC government announced changes to the Manufacturing Forest Product Regulation (sic) [ Manufactured Forest Products Regulation ]. The amendments to the regulation require Western Red Cedar and Yellow Cedar lumber to be fully manufactured to be eligible for export.In June, the province announced the deferral of the regulation's implementation to September 30 of this year. The province also updated the regulation to only apply to the BC Coast. We continue to work and engage with the government to ensure that the desired outcome is met without unintended consequences to our global customers or employment in BC.The final policy is yet to be released, but the regulation could have negative implication for global customers of BC cedar products, who through their purchases support thousands of jobs in communities on the coast of BC. It could also have negative implications on the coastal lumber business that is already being disproportionately impacted by the application of duties on our high-priced cedar shipments to the United States.Moving on to the Softwood Lumber dispute. In July, the U.S. Department of Commerce announced an extension for the first administrative duty review. As a result, the determination of final countervailing and antidumping duty rates for 2017 and 2018 are not expected until November 2020. Currently, Western has over USD 78 million on deposit with the U.S. Treasury, which at the current exchange rate is approximately CAD 105 million.Looking to what's next. Our top priority remains the health and safety of employees, contractors and communities. We will continue to adapt our procedures and protocols as necessary to ensure we keep our people safe. We also remain focused on maintaining financial flexibility and a strong balance sheet. We'll continue to review capital allocation on a quarterly basis with our Board, but our near-term focus remains on reducing debt. Despite the near-term uncertainty, we remain focused on growing our lumber production and implementing our strategic initiatives to strengthen our foundation, grow our base and grow our business over the long term.With that, Jacob, I can open up the call for questions.

[Operator]

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

[Sean Steuart, Research Analyst]

A couple of questions. You guys referenced plans to reallocate some of the offshore volume to U.S. markets. Can you give us an order of magnitude in what we can expect for that from a volume perspective in Q3 and maybe even into Q4 and then context on specific grades and end markets you're going to push that product into?

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

Sure. So I think first off, we already do a significant amount of business in North America from our appearance products used in molding and millwork to cedar targeted at the home centers and outdoor living. We do fir appearance timbers, yellow cedar and mélange, glue-lam and lam stock. And we have a pretty strong position in North America, at least in our region in the treating and industrial segments.We also do some products for the construction segment in both dimension in timbers. So it's along with like the products directed to the treating segment and the construction segment is where we expect to grow volume in the next couple of quarters and redirect volume. Most of the volume is going to be redirected from Japan and from China. I think we'd estimate maybe about 10% to 15% additional volume being directed this quarter to North America.And I guess, from our perspective, this ability to redirect volume underscores the benefits of the flexible operating platform we've got and should allow us to participate in the improved pricing environment we're seeing in North America as opposed to some of the export markets.

[Sean Steuart, Research Analyst]

Makes sense. The TFL 19 decision to lower volumes for you guys or the expectation that, that will be the case, I guess, the expected ease you would have to replace that 130,000 cubic meters on the open market, do you expect that this will have any bearing on your sawmill operations at all?

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

Yes. So to be directional, no, we don't think it will have any bearing on the sawmill operations. We've purchased well over 1 million meters in a typical year. And having the volume being reduced in 19 -- TFL 19 shouldn't have an impact on sawmills.I mean maybe just to provide you a little context and for -- TFL 19 is located on the West side of Vancouver Island. But like every one of our tenures, every 10 years, the Chief Forester of the province is required to review the tenures and determine a sustainable annual allowable cut that allows us to harvest in perpetuity. To do this, they do a detailed analysis of growth rates and harvest and then take into account any reductions or deductions from the timber harvesting land base due to government land use decisions and set asides.That's basically what's occurred here. And what they've determined is most of the reduction is due to natural decline, which means there's less volume per hectare than, say, from old forest to new forest. It just so happens the reduction we anticipate will somewhat be in line with the harvest we've had over the past period of time. It is a very high cost area in the West Coast of Vancouver Island. So we -- again, I don't think we see any impact on our business going forward, or it will be minimal.I would like to highlight the use of LiDAR technology, the investment we made a few years ago. It has certainly reduced the expected declines we would have expected to see due to natural decline of AAC over time, because the investment is identifying that forests are growing faster and has improved and enhanced our understanding of the standing timber inventory.So I think it sounds like a bad news story. It's actually not. It should not impact our mill operating platform going forward. And it's actually a good news story from a LiDAR perspective and our investments, because we actually have a much better understanding of our inventories and our growth rates. And that improves our ability to sustainably manage our tenures.

[Operator]

The next question is from Hamir Patel from CIBC Capital Markets.

[Hamir Patel]

Don, we've seen some really good volume growth numbers from quite a few of the wood pressure treaters and composite decking producers. Do you think cedar has lost market share this year?

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

Well, yes, I don't think so. Not for us, Hamir. I mean -- but you have to put everything in perspective when you're thinking of our business. In our business, we got off to what I would call a standing start, which is difficult in the lumber business coming into second quarter. We -- due to the long strike. And so we're pretty pleased with the progress we've made and particularly in the product lines you've identified and particularly in the home centers. We've made investments in our products and branding that has been really well received there. And we're expecting to see a benefit from that going forward.So I don't think cedar is losing any traction. I think we're also very encouraged on the cedar front that as the investments people are making in their homes have increased, especially in the current COVID environment, we're expecting to see cedar demand increase through the traditionally slower third quarter.So maybe to conclude, I would like to think the best products are natural product and those products for us are in appearance cedar and the application of those. I think our treating segment is going very well. An example for us might be that our treating volumes this year, I'd expect to approach what we were doing in 2018. And you have to put that in context our volumes. So I don't think we're losing traction. And I think actually, the work we're doing on marketing is going to benefit us with the increased demand for cedar going forward.

[Hamir Patel]

That's helpful. And then with respect to how your products are priced through the home center channel, is that -- should we think of it as a lag with some of those random lengths benchmarks? And how long would that lag be?

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

Well, yes. So on the actual pricing that the home centers are putting to the final consumer, there may be some lag. We've seen pretty strong pricing in cedar over the last year or 2. And I think if you're comparing it to the immediate run-up in 2x4, you would say it would lag. But I think we're pretty pleased with the pricing momentum we've seen in cedar over the last couple of months here.

[Hamir Patel]

Fair enough. And Don, I just wanted to ask you about the various BC Coastal policy changes this year. If all of them are implemented as conceived, what would be the annual EBITDA impact for Western?

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

I got to say that, that's going to be tough to estimate based on the fact that we don't know what they're going to implement. Maybe try to help answer that question. Like I think I probably, along with most operators in British Columbia, worry about the cumulative effects of these multiple policy changes that have been advanced by the government and the impact it's having on not just Western, not just the Coast, but the industry's ability to support forest sector jobs in our province, especially I think during COVID.I think material to us, probably, Hamir, would be, with respect to the manufacturing lumber rig, maybe just give you a little overview. I mean, the proposed amendments require cedar, Red Cedar and Yellow Cedar to be fully manufactured to be exported. That means that to be fully manufactured, it can't be kiln-dried, planed or re-sawn in a facility outside of BC.Again, just like many of the regulations, the policies still haven't been released and won't become effective till September 30. So we're operating in a bit of a bit of a vacuum here. But I can tell you the regulations that are proposed today could have unintended consequences, as I said, to our customers, but also -- and through their purchases. Those are the guys that support the thousands of jobs and the communities in the BC Coast. So I think we're all surprised by the potentially punitive nature of the proposed regulation on the Coastal businesses.We continue to work with others in the industry to engage government to ensure they can achieve their goal without negatively impacting customers and employment. And I guess, one would have to ask the question, if the government is going to implement something like this, then when is the right time and is it in a COVID-19 environment. But I think they're better positioned to answer that than I am. I think our view is that restricting the volume of products to customers is not a way to grow business in BC, and impacting BC companies is not a way to support investment in BC.I think -- again, for you, I think the question is, well, how would this impact maybe our investment in Arlington? And I can say that as we've always said, Arlington is going to be a key hub for distribution to our customers in the United States and very critical as we invest in marketing and efforts to increase our volume into the home center business.I think also maybe a brief update. We are currently trialing our first trials of Japanese cedar at Arlington, and we're pretty excited about that opportunity. And again, it fits with our marketing efforts and with the targeted segment being home centers. So we're looking forward to how that goes. We also just started trialing U.S.-produced cedar there. So for us, I think we worry about the impacts the policies might have on BC production, BC reputation, BC jobs, but we're not standing still. We're doing things in our business to supply our customers, utilizing the assets we've got.

[Hamir Patel]

Okay, great. And just maybe a question for you or Steve, but can you give us any update on how maybe the M&A pipeline may be looking? We've seen some deals on the distribution side. Curious on some of the categories you're interested in if you're seeing any activity pick up?

[Stephen Williams, Executive VP & CFO]

Yes. So I guess what I'd say is our near-term focus kind of, for us, when we're thinking about prioritizing our capital allocation would be on making sure we've got the liquidity and financial flexibility in our business. And so we're really focused on debt right now. But that said, we continually review our capital allocation, and we continue to review opportunities of acquisitions. Our focus continues to be in the Pacific Northwest in specialty manufacturing. And despite the challenges we've had with the strike and coming out of the strike and now with COVID-19, we continue to see and investigate opportunities. We'll see where that goes. But again, I'd like to reiterate our first priority here from a liquidity and capital allocation perspective is to reduce our debt and create flexibility, given the uncertain environment we're operating in.

[Operator]

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

[Paul C. Quinn]

Just following up on capital allocation. That debt reduction priority, I can understand that. What level of net debt do you feel comfortable with to be able to have the dividend in place?

[Stephen Williams, Executive VP & CFO]

Yes. I mean, I think just with respect to that again, Paul, I think our focus is on liquidity and financial flexibility, given the uncertain impacts of COVID right now. Again, I think just the COVID really clouds the visibility and the outlook. And so again, I think we're just going to focus on debt reduction. We review the capital allocation quarterly with our Board. We'll continue to do so. But I think sort of as Don said, at this point, focus will be on debt reduction.

[Paul C. Quinn]

Okay. And then you guys referenced lower harvesting costs, because you stage logs in the bush. How material was that? Do we see -- will we see a corresponding reversal in Q3?

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

Yes, so as -- I think a great question. So we will see kind of some recovery in Q3. And as I indicated, seasonality-wise, we tend to have supply disruptions and lower harvest levels in typical Q3. Then we tend to increase our helicopter harvesting. So you're absolutely going to expect to see increasing harvest costs just because of that. We did get a benefit of reducing what we call timber developed, which is we've made -- we -- at our company, we expense roads when they occur and then harvest a lot of the harvest later.So I think like a 10% benefit to log harvest costs is what we experienced. We're going to continue to rightsize the business, though, Paul. And I think that's really important. We'll continue to operate on the basis of producing logs in line with our lumber production, and that may mitigate the impacts on costs going forward.

[Paul C. Quinn]

Okay. And then let me just -- maybe you can give us more color on Arlington. When you say -- I understand the distribution aspect. But I guess, are you bringing in Japanese logs -- Japanese cedar logs to cut as well as U.S. logs?

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

No, we're -- so what we've been doing -- so maybe just to backup, Arlington is primarily a distribution center. It's got a rail siding. It's got an ability to load containers. It's got an ability to load a lot of trucks. And we centralized all of our cedar production there, because most cedar customers are looking for mixed -- highly mixed shipments of various products for their inventory. So it's really important that we have a facility that can do that. In addition, it's got to be able to repackage for certain customers. And I think along those lines, the home center business, small packs, bar coding and the like.So that's part of the business there. We also have a planar kilns and the like. And so what we're doing is we're bringing in lumber from Japan and elsewhere in Japanese cedar. There is no ability to manufacture logs at Arlington. It's only lumber and lumber processing, and it's only tied to expanding the product lines that we have for our selected customer base.I guess one thing I could add, Paul, as well, just on the Japanese cedar, I mean this is the early stages. This will be our first shipments coming in of certain product lines and the processing is going to start there at Arlington. I can also tell you that we have processing capacity at Fruit Valley, which is tied to Columbia Vista in Vancouver, Washington. And we'll be utilizing that facility as well to further process some of the Japanese cedar. We haven't seen the results of it yet, but we're pretty excited about the opportunity and the customer base seems quite excited.

[Paul C. Quinn]

Okay. And in terms of the path, you guys flagged increased Japanese cedar imports in the North America. It's confusing the marketplace. How are you going to differentiate those products between West Red Cedar and U.S. or Japanese cedar?

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

Well, I think the marketplace is becoming much more sophisticated and understands the differences of the products and the characteristics. There's definitely a price point here where the Japanese cedar is, in some cases, more competitive than BC cedar. And those are the ways we'll differentiate. We will be calling it Japanese cedar, and we'll market under a different brand.

[Paul C. Quinn]

Okay. And just lastly on the B.C. government changes in regulations. They postponed that until September 30. Has there been renewed dialogue or conversations between the industry and the government on the implementation?

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

Yes. So what's transpired is the government did defer their implementation. They had a consultant go out and deliver a report, engaged components of the industry in that report and creating that report. Those recommendations were made public. We have commented on that, but that is the only actual communications we've had directly with the government, other than expressing our concerns, about the potential impacts and the timing of this, given COVID.

[Operator]

As there are no further questions registered at this time, I'd like to turn the meeting back over to Mr. Demens.

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

Great. Well, thanks, Jacob, and thanks, everybody, for your continued support. I appreciate your interest in our company and your time on the call this morning. Steve and I are both available if you have follow-up questions, and we look forward to sharing with you our third quarter results in November. With that, have a great day. Thank you.

[Operator]

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