Western Forest Products Inc

TSX:WEF

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, ladies and gentlemen. Welcome to Western Forest Products' Third 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 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 SEDAR and are supplemented by the company's quarterly MD&A. Accordingly, listeners should exercise caution in relying upon forward-looking statements.I would now like to turn the meeting over I would now like to turn the meeting over to Mr. Don Demens, President and Chief Executive Officer of Western Forest Products. Mr. Demens, please go ahead.

[Donald Eugene Demens, CEO & President]

Well, thank you operator. Good morning, everyone. I'd like to welcome you to Western Forest Products Third Quarter 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. And then we will open the call up for your questions.In the third quarter, we capitalized on strong specialty markets to deliver adjusted EBITDA of $32.3 million. Our Specialty Products focus delivered higher price realizations that offset increased US softwood lumber duty expense, higher stumpage costs and declining commodity market. Wildfires prompted a provincial state of emergency in August and early September, as the worst coastal fire conditions in BC history caused us to curtail our timberlands operations for 5 weeks. As a result log harvest was off 11% compared to the previous year. We overcame these operating conditions by leveraging our well positioned opening log inventory and recent improvements to our supply chain to continue to supplier mills. The combination of increased operating hours at our recapitalize Duke Point sawmill, improved overall mill reliability and a higher mix of commodity lumber production drove lower manufacturing costs. At the end of the quarter, we were forced to curtail our Ladysmith sawmill but I'm pleased to report that we've restarted the mill in late October. This curtailment was caused by reduced domestic supply of small diameter logs due to increased competition from pulp manufacturers and the export market.Average realized lumber pricing increased 16% over the same period last year. The improved pricing limited the impact of reduced specialty lumber sales volumes in the quarter. Sales to Japan, were constrained in the third quarter due to limited Douglas Fir log availability for sawmills on the BC coast. And finally, we continued our balanced approach to capital allocation in the quarter. We made capital investments in our mills and timberlands of $21 million and we returned $19 million to our shareholders through the quarter as we repurchased more than $10 million worth of our common shares and returned approximately $9 million to shareholders through our quarterly dividend. And on a year-to-date basis, we've invested $64 million in our mills and timberlands and returned $42 million to shareholders in the form of dividends and share repurchases.I'll now turn it over to Steve, to review our key financial results.

[Stephen Williams, Executive VP & CFO]

Thanks, Don. My comments are focused on our financial results for the third quarter of 2018 with comparison to the third quarter of last year. As Don mentioned, we delivered third quarter adjusted EBITDA of $32.3 million as compared to $32.6 million in the same period of 2017. Higher specialty lumber price realizations and a weaker Canadian dollar offset an incremental $5 million in lumber export duty expense, an incremental $6 million in third quarter stumpage costs and the impacts of a commodity lumber market uncertainty, which drove a lower quarterly lumber sales volume and drove an incremental $2.6 million inventory provision, as compared to quarter three, 2017. The increase in export duty expense to $11.5 million was due to the CVD having only being applied till August 25, last year, will apply to the full third quarter of 2018. As at September 30, 2018, we had approximately $50 million of duties on deposit.Improved lumber and by product revenue offset reduced log revenue. Higher lumber revenue was driven by a 16% increase in average lumber price realizations, while sales volumes were 4% lower than Q3 2017. Improvements in market log pricing were more than offset by a weaker domestic sales mix and a greater proportion of pulp log sales. Total log shipments decreased 17% quarter-over-quarter. Our export log sales program remains suspended to supplier domestic mills. We delivered another reduction in quarterly manufacturing costs through improved sawmill operating hours and cost influence of a heavier commodity production mix. Log harvest costs rose 12% primarily due to escalating stumpage rates, driven by a recent provincial rate equation update, the influence of total coastal log export volumes and as a result of higher domestic log prices.Freight expense decreased by 18% primarily, due to the suspension of our export log export program. In addition, we shipped lower volumes to Japan. From a profit and loss perspective, net income was $15.1 million as compared to $13.6 million both, resulting in earnings per share of $0.04. Higher revenue was offset by higher operating costs while lower freight expense and reduced restructuring items resulted in higher net income. Looking to cash flow and capital management. Cash provided by operating activities excluding non-cash working capital grew to $25.9 million from $23.1 million in the same period last year, as we improved operating income period-over-period. Third quarter capital expenditures increased to $20.7 million as compared to $15.1 million. Capital investments of $5.9 million were made in Q3 2018 to substantially complete the infrastructure component of upgrades at our Arlington distribution and processing facility.We paid dividends of $8.8 million, an increase from $7.9 million in the same period last year. This reflects a 12.5% increase in our quarterly dividend period-over-period. In addition, we accelerated share repurchases in the third quarter of 2018, spending $10.4 million to repurchase 4.6 million common shares at an average price of $2.27 under our normal course issuer bid. As at September 30, 2018, we had total liquidity of $292 million, including availability under our new 4-year $250 million syndicated credit facility. We continue to explore opportunities to grow and reposition our business and we are committed to continuing our balanced approach to capital allocation.Don, that concludes my comments.

[Donald Eugene Demens, CEO & President]

Great. Steve, thank you. So I like to start of our outlook section by touching on fourth quarter seasonality. In typical fourth quarters lumber consumption declines in North America as construction slows with the onset of winter. In our timberlands harvest volumes decline as we lose delayed operating hours. Winter weather can negatively impact operations and further limit production. The combination of weather-related curtailments and reduced operating hours can impact production volumes and can put upward pressure on log costs.I'd now like to turn our discussion to markets. Despite the recent volatility in commodity lumber, our long-term market outlook remains positive. We expect to see continued growth in U.S. demand for lumber from both the new home construction and the repair and renovation segments, while at the same time, we anticipate Chinese demand for lumber will continue to grow. The strong repair and remodeling sector continues to support demand for Cedar products. That said, we're currently experiencing typical fourth quarter seasonal weakness. And what's different this year is the amount of substitution we're seeing from both foreign and U.S. domestic manufactured products that are mostly available in narrow widths. The narrow-width market is oversupplied and we'd expect to see further price weakness over the near term.Demand for our specialty products is relatively strong, although, we anticipate that over the near-term pricing for our niche products could be impacted by recent declines in the commodity market and falling Pacific Northwest log prices. Falling Pacific Northwest log prices and an influx of European lumber supply is expected to put pressure on the price for our products destined for Japan. As we move into early 2019, we expect buying activity to improve, as customers look to position their inventories for the spring building season. Whether this will positively impact pricing will largely depend upon how much inventory there is in the supply chain. Relatively low commodity lumber prices are expected to influence domestic saw log markets. Meanwhile, we anticipate pulp log pricing to increase slightly as limited log supply will put upward pressure on pricing.With respect to log availability, as mentioned earlier, we temporarily suspended our export log program in 2018, to support additional lumber production at our mills. The export log sales we did make in the quarter were related to Western's management and the short term First Nation timber purchase agreement. The provincial government has expressed concern related to the volume of non-manufactured logs leaving the coast of BC and we're hopeful that ongoing consultations by government with coastal stakeholders will deliver a policy response that may support domestic sawmills. Operationally, we remain focused on delivering on our timberlands manufacturing margin improvement initiatives, to help offset higher stumpage costs and challenging log market availability, which can lead to higher operating costs.Regarding softwood lumber dispute, apart from the retention of the Chapter 19 dispute resolution process, in the new U.S., Mexico, Canada trade agreement, there are no changes to the softwood lumber dispute during the quarter. However, as we discussed last quarter, Western has 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 softwood lumber. Through our challenge, we are seeking ITC recognition that appearance grade Cedar lumber products and structural commodity lumber differ in end-use application. A successful application could result in separate like product classification and require the ITC to rule our Cedar shipments from BC into U.S. producers. We've received rebuttal briefs from the U.S. trade coalition and the ITC in October. Our response to their rebuttal is due in December and we expect a NAFTA panel ruling sometime in 2019. Western Red Cedar especially lumber products sold into the U.S. market have accounted for approximately 86% of our total duty expense since April 2017. In the third quarter alone, we expensed more than $11 million in export duties and have expensed almost $33 million year-to-date.So before we discuss our capital projects, I'd like to provide you a quick update on our sales and marketing strategy. As you know our strategy focuses on the production and sale of targeted high margin products of scale to selected customers. We supplement our key product offerings with purchased lumber to deliver the suite of products our customers require. While we made significant progress with these initiatives, I'm pleased to announce the following additions to our executive management team that are designed to accelerate execution of our plant. Bruce Alexander will join Western next month as a Senior Vice President of Sales, Marketing and Manufacturing. Bruce is an experienced executive and brings over 30 years of sales, manufacturing and management experience in the forest products and manufacturing industries, including on the coastal BC. Bruce will be responsible for positioning Western as the leading global supplier of specialty building materials. Under common leadership, Bruce will increase alignment between our sales , marketing and manufacturing business units and optimize the production of targeted products of scale and grow our selected customer base worldwide. In addition, Don McGregor, joined Western as Vice President of Wholesale Lumber in October. Don is responsible for leading wholesale lumber operations and in building relationships with global suppliers, broadening the scope of our specialty product offerings. Don brings almost 30 years of lumber marketing experience, including more than 20 years as President of Vanport Canada, a leading wholesale lumber company. Don has a proven track record of building highly successful supply and sales agreements in North America and Asia. We expect the combination of our existing industry-leading product portfolio and complementary supply from new supplier relationships will allow us to provide expanded product offerings and deliver greater value to our selected customers.In respect of our capital program, we continue to reinvest in our operating base to position our mills and timberlands as the most cost competitive operations in the coastal BC. In the third quarter of 2018, we advanced the latest phase of the Duke Point planer rebuild and auto-grading edition. Our significant strategic capital investments in the Duke Point sawmill and planer have supported increased sawmill operating hours, which will allow us to internalize more high grade production that otherwise would have gone to high cost external custom cutting programs. At our planer, we're now auto-grading more than 75% of the products we plane at Duke Point. The auto-grader has delivered improved product out terms, lower trim loss and allowed us to operate safely at higher speeds. We believe our auto-grader is the only unit to be operating on the West Coast that can efficiently grade both specialty and commodity lumber products. At -- our capital focus has shifted from infrastructure upgrades to processing equipment installation. We are on track to complete equipment installation in the fourth quarter and anticipate launching secondary processing operations in the first quarter of 2019 . We expect operations in Arlington to assist us in the repositioning of our product lines closer to the final customer.Despite the significant ongoing capital activity, we were able to increase distribution activities at Arlington. In the third quarter we directed almost 25% of our U.S.-bound lumber shipments through the facility. We expect to increase that figure in the fourth quarter and begin to distribute the majority of our U.S.-bound product through this site in 2019 . Looking to what's next. 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 and distribute through Arlington or additional product volumes that we purchase and sell support market share growth in key segments. We believe that the ongoing reinvestment in our coastal operating base, steady improvements in our operating performance and a strong balance sheet, position Western to pursue these external growth opportunities as they become available.With that operator, we can open up the call to questions.

[Operator]

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

[Sean Steuart, Research Analyst]

Couple questions to start with. Your Q3 price realizations, they trended positively on a sequential quarter-over-quarter basis despite weaker commodity lumber markets. It looks like the mix was relatively stable quarter-over-quarter. Can you give us some context on some of the puts and takes in your price realizations for Q3 just aside from the weaker Canadian dollar?

[Stephen Williams, Executive VP & CFO]

Sure Sean. Well, I think you've talked about -- you've nailed the issue perfectly. It's kind of mix but as mix within our mix. What we've seen in our Ceder business is strength in the timber market and we've been able to increase volumes there through our capital projects and seen better pricing which has offset the impacts we have seen in the narrow-width component of the product lines in Ceder. Japan, again we've seen strong pricing there relative to your previous and on our niche business, we've been able to increase the production of timbers which are used for our architectural applications and an appearance applications as well as timbers for home center business. So, I think it's within our different products segments, we've seen growth in the products that make us the most amount of money which has been really encouraging and that's been levered by our capital investments, despite the fact we've been shipping a little bit less specialty lumber.

[Sean Steuart, Research Analyst]

Do you guys have initial thoughts on 2019 CapEx and I guess a broader question, I'm getting at is how much large scale discretionary spending opportunities are there left at your existing operating base going forward?

[Stephen Williams, Executive VP & CFO]

Sure. So I think what we've guided this year Sean is, $80 million to $90 million in CapEx, split kind of evenly, maintenance of business and strategic capital. We have not finalized our 2019 plan. But to give you a sneak kind of look at it. I think you're going to expect to see about the same $80 million to $90 million. To be clear, I don't believe -- and that would be split 50% maintenance of business, 50% strategic. We'll initialize those plans over the next month or so. The focus of our capital kind of remains the same. We're trying to make sure that we've got the best operating base on the coast and in our core business to ensure that they're most competitive. And then to focus the rest of our capital in producing and increasing the production of our specialty product mix. A number of the projects will be focused on low cost, high-return, projects that are simple to implement and I think that's been our focus.Recently, we've got couple of highlights for you to think about on projects we've just recently completed which would be examples of what we'll do next year. We're in the middle of the de-bottlenecking projects at both Cowichan Bay and Saltair, relatively small capital amounts but significant uptime, enhancement is expected. We've just completed our round saw filing consolidation in our new state-of-the-art filing, saw filing shop at Saltair. That's combined all of the round saw filing of 5 sawmills into one. And we have yet to see the real benefits of that, but we're really encouraged of what we see. And we're in the midst of expanding our timber handling capacity at Chemainus, which would complement our Phase 1 program at Chemainus where we installed kind of a one of a kind, auto-grading or enhanced grading process there.So I hope that answers the question.

[Operator]

The next question is from Roshni Luthra of CIBC Capital Markets.

[Roshni Luthra, Analyst]

So Don I have a question for you first. Just a couple of questions. So your largest composite competitor, Trex, they recently upgraded their high-end transcend line and they didn't base the price. I was just wondering, do you see versus your Cedar volumes next year, as they continue to improve their offerings?

[Donald Eugene Demens, CEO & President]

Yeah. So, I think, I had this question a couple times on composites and plastic decking. Our view is that when people make their choices for products for the exterior of their home, they make quality choices and our belief is that there's always going to be a component of that quality related to the, what is the best performing softwood species and outdoor applications at Cedar. It's our personal view that when people look at investing in their home and want the warmth of wood around their property, it's Cedar, the premier choice, we don't see cannibalization from the plastic deck companies.

[Roshni Luthra, Analyst]

And another thing that's recently happened is, there was an announcement last month from San Group about a major sawmill investment in Port Alberni. How do you see that affecting your fiber cost and would they be making any competing product?

[Donald Eugene Demens, CEO & President]

Sure. So for those on the call and Port Alberni, we have -- around Port Alberni, there's an operation at Tree Farm License, TFL 44 as well as, is the Alberni Pacific sawmill that we operate there and the Somass mill which is indefinitely curtailed. There's been an announcement made -- I think for most people who are knowledgeable about the sawmilling industry, many of the large participants in the industry have announced they're going to build sawmills and it's 1 to 2 years out, just to be able to get the equipment, the engineering completed. So we don't believe anything that will -- that has been announced will be an immediate impact to our business. And I think over time it will tell whether or not a sawmill will be built there. Our understanding is the focus is on small logs off the West Coast and our mill there is a large log mill. So again, I don't see any immediate impacts on our operations in the near term.

[Roshni Luthra, Analyst]

And just one last question. What sort of change in log cost rates you're expecting in Q4 compared to Q3 and what type of annual increase in stumpage rates are you expecting on the coast next year?

[Donald Eugene Demens, CEO & President]

Yes. So I think that's a reasonable question, given we are in BC and log costs throughout the province have been rising. I think, we've highlighted in our MD&A on how much our costs have increased this quarter. We anticipate with the changing lumber markets that's given the current formula, which may or may not be adjusted by government. We'd expect to see a leveling off of stumpage cost increases over the near term. Again, it's a market price-base system and the market prices for logs are not going up right now, they're going down.

[Operator]

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

[Paul C. Quinn, Analyst]

Hey, you mentioned the -- your work on trying to get exemption from the softwood lumber duties and the U.S. sites rebuttal to I guess your petition, can you outline maybe just the brief argument as what their position is on the rebuttal?

[Donald Eugene Demens, CEO & President]

Sure, Paul. So maybe a real high level and I covered off just sort of one element of it in my opening comments. But at a high level for us to get a separate like product description or separate like product agreement from the ITC or designation, you need to have achieved 6 different characteristics of separation between commodity lumber. Those would be physical characteristics, interchangeability, channels of distribution, producer and consumer perception, manufacturing facility differences and pricing. And I think you'd go through that list of 6 and I know what your experience you would be able to figure out that -- we have differences between commodity lumber from those 6. So, our real effort -- and so I guess, what happened in the rebuttal is for the first time that I'm aware, there was acknowledgment by the U.S. side that yes, some of the 6 there are differences, but not all of them. So our rebuttal to their rebuttal will have to be that we believe that through these 6 characteristics, we can establish differences between commodity lumber and specialty lumber or Cedar in this case and therefore, we should be treated as a separate like product.

[Paul C. Quinn, Analyst]

I wish you luck on that on. Maybe moving onto -- you pointed out in Q3 that you were eliminated on Doug Fir logs and Cedar logs, is that improved in Q4.

[Donald Eugene Demens, CEO & President]

Yeah, I would expect so. So, again, as you're aware, I mean, the Douglas Fir log market on the coast is heavily skewed from a supply perspective to private landowners, who have just recently gotten together. It's a log that is in high demand in the export markets and high demand locally in the peeling markets for veneer, because veneer is not part of the softwood lumber dispute. Veneer is shipped to the United States duty-free. So the combination of concentration of supply and the fact that there is readily -- ready access to both export markets for logs and a duty-free delivery into United States, has made it really hard for domestic sawmill manufacturers to be able to access fiber. We would anticipate that the challenges around Douglas Fir will continue. Why is that important for Western, because Douglas Fir is a sought after product in our Japanese market and we are looking at all options to expand our production of Douglas Fir to access or to support our customers in Japan.

[Paul C. Quinn, Analyst]

What about on the Cedar log side availability?

[Donald Eugene Demens, CEO & President]

Cedar log availability has been tight. I know over the last, you're getting the HBS reports, I'm sure, recently it's been getting tighter and I think over the last year or so, Cedar harvest on the coast is falling more in line, at least by other participants into a percentage that is similar to how the volume is growing. So I would think Cedar logs are going to be a challenge again, probably next year or challenging, there won't be a whole bunch of supply. I think the big opportunity for us is if we're able to overcome the price challenges we see in the narrow market with our investments in our mills and ensuring we're the most competitive converter of logs to lumber, we'll get access to more logs going forward. But the overall market is, I would think be characterized by type.

[Paul C. Quinn, Analyst]

Okay. And then just your referenced higher stumpage up 6 million year-over-year, how do you break that down in terms of that -- when you pointed out that ongoing influence of coastal log exports, what do you think that issue has done to stumpage on a year-over-year basis?

[Donald Eugene Demens, CEO & President]

Yes. I'm -- the impact of coastal stumpage -- or sorry of coastal exports on the stumpage rate domestic manufacturers are required to pay is an ongoing issue and concern for anyone who's got domestic sawmills. Because the -- and the stumpage calculation -- within the stumpage calculation, there is an export variable. And so the actual percentage, I'm not going to guess, because I haven't looked at the regression analysis recently. But, I think there's definitely -- it's definitely influencing the cost paid for stumpage by domestic sawmills.

[Paul C. Quinn, Analyst]

Okay. And then just lastly, just on Arlington, just trying to figure out sort of the potential uptick for 2019, as you put the majority of U.S.-bound lumber through there, can you help us out trying to figure out how we should look at that?

[Donald Eugene Demens, CEO & President]

Well, I think for Arlington, you've got the 2 components and you've articulated. One is distribution and so you'll see a streamlining of our distribution costs, I think over time, as we increase volume. And then we're going to be in a ramp up. So you've got to give us a couple of quarters to allow us to get the mill running. We still anticipate lower cost in running the facility and lower conversion cost. I think the big opportunity for us though is in the opportunity to direct either lumber that we've acquired offshore or lumber that we're going to acquire in the United States through the facility. And so the real big opportunity for us at Arlington is going to be increasing volumes. And so I think maybe the way to answer this question is simply for you would be, what volume are we targeting from our wholesale business. So, I think wholesale lumber is nothing new for Western and over the last few years, we've consistently provided our customers with that broader product mix through this wholesale activity. I think, for a year, you should target by the end of next year we should be running at up to 100 million feet annually or the next year, year and a half of additional volumes from wholesale. And a portion of that will be going through Arlington in the processing side of Arlington as well as the distribution side. And that's kind of what we're aspirationally targeting.

[Paul C. Quinn, Analyst]

Okay. So basically what we should be seeing at Arlington or the effect, the Arlington effect, if we want to characterize it as that should be lower freight cost and lower cost of goods sold, right?

[Donald Eugene Demens, CEO & President]

Yeah, and additional volumes Paul with their wholesaling, right.

[Paul C. Quinn, Analyst]

Right.

[Donald Eugene Demens, CEO & President]

And I think we'll, we have to go through and how we're going to build a report that going forward. But again, it's early days, Don McGregor just here in October, we got to build our team and then build upon the platform, the smaller platform we've got today and certainly expanding our volumes. And that's what you should expect to see from us.

[Operator]

There are no further questions registered at this time. I would now like to return the meeting back over to Mr. Demens. You may proceed, sir.

[Donald Eugene Demens, CEO & President]

Thanks, operator. So to close, I'd like to thank all of you for your attention and support of Western. We continue to be encouraged by our most recent results and we'll look forward to sharing with you our fourth quarter results in February. Have a great day . Thank you.

[Operator]

Thank you, Mr. Demens. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation.