Western Forest Products Inc

TSX:WEF

Earnings Call Transcript 2018-Q4

[Operator]

Good morning, ladies and gentlemen, and welcome to the Western Forest Products' Fourth Quarter and Fiscal 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 introduce and turn the meeting over to Mr. Don Demens, President and CEO of Western Forest Products. Please go ahead Mr. Demens.

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

Great, thank you, Louise, and good morning, everyone. I'd like to welcome you to Western Forest Products' Fourth Quarter 2018 Conference Call. Joining me on the call today is, Steve Williams, our Executive Vice President and Chief Financial Officer. We issued our 2018 fourth quarter and full year results yesterday. I'll provide you with a summary of the year and then ask Steve to take you through the summary of the fourth quarter. I'll then share our near term outlook and provide an update on developments occurring in the industry. We'll then open the call up to your questions. In many ways, 2018 was a remarkable year. We experienced record market volatility and the business had to respond to a full year of softwood lumber duties and rising log costs in British Columbia. Despite these challenges, I'm pleased our business was able to respond. We capitalized on our specialty product focus in a volatile price environment to generate adjusted EBITDA of approximately $144 million in 2018, compared to about $153 million in 2017. This was despite a $31 million incremental increase in stumpage expense and a $27 million incremental increase in softwood lumber duties. As you're aware the imposition of duties on specialty producers has a disproportionately greater impact than it does on commodity producers. Despite the operational headwinds, I'm pleased to report we made significant progress implementing our strategic initiatives in 2018, which included strengthening our foundation, growing our base and exploring growth opportunities. Some of the highlights from 2018 include our acquisition of a processing and distribution center in Arlington, Washington, which will enable us to more effectively service our selected U.S. customers, while partially mitigating the damaging effects of duties on our products destined for the U.S. market. We also announced the acquisition of Columbia Vista in Vancouver, Washington, which will expand our Douglas fir specialty product production. This will make us more meaningful to our selected customers, particularly in Japan, and I'm pleased that we successfully completed the acquisition in February. We advanced our strategic partnership with the Huu-ay-aht First Nations by agreeing to sell an interest in our Port Alberni Forest Operations, further showing our commitment to building mutually beneficial relationships with First Nations. We enhanced our senior executive leadership team with Bruce Alexander joining as Senior Vice President, Sales, Marketing and Manufacturing. Common leadership of our sales, marketing and manufacturing business units will drive alignment between these functions and facilitate the production of targeted products to scale to selected customers worldwide. We further strengthened our sales and marketing team with the addition of Don McGregor as Vice President, Wholesale Lumber. The addition of targeted wholesale lumber products will allow our mills to concentrate production and improve efficiencies, while we deliver an enhanced product offering to our selected customers. We completed a new 4-year $250 million credit facility, which will ensure we are positioned to take advantage of future growth opportunities. And finally, we implemented a number of foundational systems improvements and are poised to migrate to a new financial system in the first part of 2019, helping us advance our platform for growth. And importantly, we increased our quarterly dividend through the year by 12.5%, and we continue with our balanced approach to capital allocation, which included returning $60 million to shareholders via dividends and share repurchases throughout the year. With that, let me turn it over to Steve to review our key financial results.

[Stephen Williams, Executive VP & CFO]

Thanks, Don. My comments are focused primarily on our financial results for the fourth quarter of 2018 with comparison to the fourth quarter of last year. We delivered fourth quarter adjusted EBITDA of $18 million as compared to $38.9 million in the same period of 2017. Results were impacted by an incremental $10 million in lumber export duties, and incremental $6 million in stumpage costs, a weaker commodity lumber environment, which drove an incremental $4.4 million inventory provision, weaker log sales mix and volume and an unrealized mark-to-market loss of $2.2 million on outstanding foreign currency contracts that's compared to $0.7 million unrealized gain in the fourth quarter of 2017. As at February 1, 2019, we had approximately $65 million of duties on deposit. Improved lumber revenue was offset by reduced log and byproduct revenue. Higher lumber revenue was driven by a 9% increase in shipment volumes. Improved specialty product pricing was offset by weaker sales mix and a declining commodity lumber pricing. Lumber revenue was also enhanced by the increase in direct in-market sales to China. Freight expense was relatively flat quarter-over-quarter as increased in-market sales to China were offset by a temporary suspension of our export log program. For the first time in 3 years, Western Red Cedar lumber demand and purchasing behavior returned to fourth quarter seasonal norms. In the prior 2 years, customers purchased their first quarter requirements in the fourth quarter to avoid the impact of pending export duties. In the fourth quarter of 2018, Western Red Cedar sales were 11% lower than last year as customers deferred purchases closer to the spring building season. Despite this, lumber price realizations for Cedar were supported by an increase in high value Cedar timber sales. Improvements in market log pricing was more than offset by a weaker log sales mix. Total log shipments decreased 25% quarter-over-quarter. Our export log sales program remains suspended in the fourth quarter in favor of supplying our domestic Mills. We improved lumber production 9% over the fourth quarter of 2017, driven by additional operating hours, despite the impact of storm-related power outages and capital projects, which interrupted production in late December. We significantly increased year-over-year production at our Duke Point sawmill through improved operating efficiencies and higher operating hours and grew finished lumber production from the upgraded planer. Recent investments in our Chemainus timber deck drove a 14% increase in high-value Western Red Cedar timber production over the same period last year. The market continues to demand high value cedar timbers and we are well positioned to capitalize on the increased demand as seasonal buying patterns return to normal. Fourth quarter manufacturing costs were 3% higher than the same period last year, due to mix of operations, higher natural gas pricing and storm and capital-related downtime. Log production in the fourth quarter of 2018 was 3% higher than the same period last year as we took advantage of improved harvest conditions to make up ground from fire-related curtailments in the previous quarter. Excluding stumpage expense, our harvest costs were consistent quarter-over-quarter. Stumpage expense increased by 75% over the same period last year as a result of provincial stumpage rate equation updates, the ongoing influence of coastal log exports and higher market log pricing. Our timberlands margin improvement initiatives, partially offset higher contracting costs. From a profit and loss perspective, net income for the fourth quarter of 2018 was $5.3 million, resulting in earnings per share of $0.02, as compared to $19 million and $0.05 per share for the same period in 2017. Operating margins and net income were reduced primarily by higher export duties and stumpage expenses. Looking to cash flow and capital management. Cash provided by operating activities, excluding changes in noncash working capital was $18.1 million, down from $31.9 million in the same period last year, driven primarily by incremental export duties and stumpage expenses. Fourth quarter capital expenditures increased to $31 million as compared to $22.5 million in the same period last year. In the fourth quarter of 2018, we invested $4.5 million in Arlington infrastructure and equipment upgrades. We expect to commission secondary processing late in the first quarter of 2019 and continue to increase the portion of U.S-bound shipments distributed through Arlington. We expect operations in Arlington to assist us in repositioning our product lines closer to the final customer. We returned $17.8 million to shareholders via dividends and share repurchases in the fourth quarter. And 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 & Non Independent Director]

Great. Thanks, Steve. So I'd like to start off our outlook section by touching on first quarter seasonality. In typical first quarters, our harvest can be periodically impacted by winter weather, which can restrict our ability to harvest timber. And harvest volumes are often skewed to the end of the quarter when the weather and light conditions support greater activity. Similarly, when we look at market -- the market perspective, sales typically accelerate through the quarter and tend to be back-end loaded. I'd like to turn to a discussion of our markets. Despite the recent market volatility in commodity lumber pricing, our long-term view of market fundamentals remains unchanged. In North America, rising lumber consumption will continue to be driven by increase in new home construction and a robust repair and renovation sector. We expect lumber demand in China to continue to grow, due to a government commitment to housing. While in Japan, lumber consumption is expected to remain relatively stable over the next couple of quarters. In the first half of 2019, we expect Western Red Cedar lumber pricing to vary by product. We anticipate prices to remain stable for Western Red Cedar timbers and wide-width products; and in contrasts, we expect the narrow-width Western Red Cedar lumber markets to remain challenged due to product substitution from low-priced imported lumber and an abundant supply of narrow-width U.S. cedar lumber production. Also we anticipate pricing in high-value Western Red Cedar export markets to weaken. To mitigate the impact of lower Western Red Cedar pricing, we will endeavor to manage our product mix. Our Japan product mix is expected to improve with the inclusion of Douglas fir production from our recently acquired Columbia Vista division. We expect demand for our fir products to be supported by the recent closure of a Japanese fir cutting mill, however, any price gains in fir lumber will be limited as the cost of imported Pacific Northwest logs continues to fall. The improved competitiveness of Douglas fir in Japan will challenge both pricing and demand for BC Hemlock products. We expect sales volumes in our fir niche products decline due to increased production from Duke Point and with the addition of Columbia Vista. Pricing will be competitive, however, as U.S. producers benefit from a declining U.S. Pacific Northwest log costs. And we anticipate North American demand of pricing for commodity lumber to improve as we enter the spring building season. Lumber pricing in China is now reset and is expected to remain flat through the first quarter of 2019. In response to the weaker markets, limited market log availability and high stumpage costs, we are curtailing operating hours at our Cowichan Bay sawmill from 100 hours to 80 hours per week effective February 11. So let me now address a couple of developments in the industry. The BC government has recently announced its coastal revitalization plan. Very few specifics have been provided to date, so it's too soon to determine the potential impacts these changes will have on our business. So we share many of the same goals with the BC government, including a strong forest resector on the coast, sustainable employment for communities, increased First Nations participation and a strengthened domestic manufacturing sector. We've cautioned government that coastal BC lumber producers are already faced with the highest duty costs on lumber shipments into the U.S. of any region in Canada, and we're faced with increased competition in key markets as a result of the duties. We also must compete for logs with jurisdictions like Japan that offer subsidies to their forest products industries, allowing them to pay more for the BC logs they import. To be clear, these challenges are not new and our business is successfully managing through them. In closing, we remain committed to working with the government to support our industry, in creating business hosting conditions and an operating environment that will keep business on the coast globally competitive, while avoiding policies that add cost or restrict supply to our global lumber customers. Moving on to the Softwood Lumber dispute. As discussed last quarter, 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 commodity Softwood Lumber. Through our challenge we're seeking ITC recognition that appearance-grade Cedar lumber and structural commodity lumber differ in end use application. A successful challenge could result in separate like product classification and require the ITC to rule if Cedar shipments from BC injure U.S. producers. In December, we filed our response to the rebuttal briefs received from the U.S. Lumber Coalition and the ITC. We anticipated a hearing would take place in April of 2019, but due to the recent U.S. government shutdown, we anticipate that panel hearing will be delayed until May or later. And any ruling will not be issued until late 2019 or early 2020. Western Red Cedar specialty lumber products sold into the U.S. market have accounted for approximately 85% of our total duty expense since April 2017. In the fourth quarter alone, we expensed more than $10 million in export duties and in 2018, we expensed $43 million. Looking to what's next, we remain focused on implementing our strategic initiatives to strengthen our foundation, grow our base and grow our business. In 2019, we will continue our prudent and balanced approach to capital allocation. Given the market and operating uncertainty, and assuring we are maximizing the benefits from the capital we've already invested, we're scaling back capital investment to approximately $65 million in 2019 from about $95 million in 2018. I'm pleased to inform you that we've launched another margin improvement initiative this year and are targeting another $25 million in margin improvement from our timberlands, manufacturing and sales groups through improved operating efficiencies and process optimization. And finally, we'll continue to implement our growth strategy. We expect growth to come from operational improvements, the inclusion of our recent acquisitions and additional product volumes from our wholesale lumber business. We will continue to seek additional capacity through acquisitions that are aligned with our strategy of increasing the production of targeted products in targeted speciality products and moving up the value chain. With that, operator, we can open up the call for questions.

[Operator]

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

[Sean Steuart, Research Analyst]

Lot to digest there. So few questions. You guys referenced the lower weighting of Cedar in the mix for Q4, both year-over-year, and sequentially. Based on how you expect things to shape up in 2019, can you give us an idea of what you're expecting for a production profile split by end markets this year?

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

Yes. We certainly saw a decrease in the volume of Cedar in the fourth quarter. As Steve indicated, that was a move back to seasonal norms as you recall. Our distributors -- distribution customers were stocking their inventories ahead of the imposition of duties in the first quarter, both 2018 and 2017. I think overall, we're looking at growing our Cedar volumes. Most of that will come through wholesale volumes. So we did around $200 million or so last year in Cedar and we'd like to see that increase with the wholesale activity. Certainly, the other thing to think about is the reduction in hours at Cowichan Bay, it's a commodity mill for the most part, we won't be reducing the Cedar volumes that we consume there, going from 100 hours to 80 hours will reduce the amount of commodity lumber we're producing. And that, of course, will also enhance our specialty product mix.

[Sean Steuart, Research Analyst]

Good. The lower CapEx guidance for 2019. I just want to make sure, I'm thinking about that the right way. You guys still have a very strong balance sheet even adjusted for the acquisition you just made. Should I read that as you're being cautious on CapEx in light of, I guess, less transparent markets? Or should I read it, as you guys have spent a lot of the discretionary capital you need to at your current asset base and this is a return to more normal spending?

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

Yes. I think you've got a combination of those. You've hit on both points. We have invested significantly in the existing mills that we have, and we're going to target more of the CapEx that we have currently at some modernization -- fleet modernization that's going to improve productivity, reduce fuel consumption, things like that as well as continuing to move ahead with smaller technology influence investments, including an auto-grading system inside the sawmill at Duke Point, which allows to separate grade better, for example. So on the capital front, yes, we have invested significantly over the last couple of years and so we're going to automatically be slowing down a little bit. Also, you're also right, the uncertainty in the marketplace and regulatory environment had us take a step back and ensure that we are investing capital where we're going to get a return.

[Sean Steuart, Research Analyst]

Got it. And a quick one for Steve. Can you just walk us through the inventory NRV write-downs, the math for this quarter relative to the write-downs you would have taken in Q3?

[Stephen Williams, Executive VP & CFO]

Yes. So -- and my comment was referencing year-over-year. But I think as you know, we average cost our inventory and we go on a line-by-line basis each quarter a lower cost or a market. So with the falling commodity markets as we go line-by-line, our provision on our inventory rose where last year we had a gain from quarter 3 to quarter 4 in a rising environment. So that's where you get that $4 million differential year-over-year. So...

[Operator]

Our next question is from Paul Quinn from RBC Capital Markets.

[Paul C. Quinn, Analyst]

Might have been asleep, but I thought I heard you say stumpage costs were up 75% year-over-year. Maybe you could give me some context for that in dollars per cubic meter, dollars per thousand or percentage of your costs?

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

Yes. So I think if you were to look year-over-year on a dollar basis, is approximately -- sorry, in the fourth quarter about $5 per cube (sic) [ cubic meter ].

[Stephen Williams, Executive VP & CFO]

Higher.

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

Higher, sorry, Paul.

[Paul C. Quinn, Analyst]

And then how sensitive is that coastal system to some changing in -- changes in lumber prices? It sounds like on the specialty side, you think it's going to be flat, but we have seen some drops on the commodity side, is stumpage going to come down a little bit for that and how sensitive?

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

Yes. Well the current stumpage system is, as you know, is complicated and driven by a data set of auctions that occur from BCTS, which are mostly driven by export. And then, by log pricing, not lumber, and so for a lumber -- domestic lumber producer or manufacturer, it makes it difficult when it's driven by log pricing. And as you're aware, there is not a significant amount of excess log volume in the markets. So there's a lot of marginal bidding behavior for people to continue to access logs in the open markets. So try to be clear, it's not very responsive to lumber. It's responsive to log pricing and data setting updates by the government.

[Paul C. Quinn, Analyst]

Okay. That's helpful. And then, in terms of Arlington, I thought my understanding is that you're going to commission that or finish the work in Q4. It sounds like the commissioning is now going to be late in Q1 '19. Is there been a setback of that facility?

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

Yes. So I think we've struggled like others with -- ensuring we can get the contracting and we've had a couple permitting challenges and engineering -- getting engineering done. Nothing major. It's just a matter of ensuring that the facility is meeting the standards of the local jurisdiction and ensuring that we do it right. So, yes, we're a couple of months behind, but in general, we expect to be commissioning in the first quarter and you'll start seeing some -- we'll start seeing the benefits of that late in the second quarter and through the year.

[Paul C. Quinn, Analyst]

And then reducing Cowichan down to 80 hours, what does it do on an annual basis in terms of your commodity lumber production?

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

Yes, Cowichan Bay at where it was operating at about 200 million feet a year -- 185 million feet a year to 200 million feet a year, you're looking at 30 million feet to 40 million feet less production.

[Paul C. Quinn, Analyst]

30 million feet to 40 million feet.

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

Yes. And Paul, if I can add to that, sorry, part of that, of course, depends on the mix of species we push through Cowichan Bay. So we do a combination there of Hemlock and Cedar and that would be assuming we kind of maintain the same mix as last year, but 30 million to 40 million is a pretty good number.

[Paul C. Quinn, Analyst]

Okay. And then, just lastly, Columbia Vista, the contribution in '19 I mean, you took it on February 1, but can you give us some parameters as to what do you anticipate that business delivering into this year?

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

Sure. So currently, operating currently and the way we've been operating on a 60-hour basis down there, the guys would produce about 60 million feet to 65 million feet a year. Importantly, we'll be putting about 35 million feet into Japan. So we'll look at opportunities to grow production at Columbia Vista as long as the log market would support it. So we won't be out bidding marginal logs. And -- but I think materially, you can look at about 20% to 25% increase in our Japan product mix, and that's important because it's Douglas fir that the customers are seeking and it allows us to leverage the rest of our product mix. So long history, you can take a 65 million feet approximately of additional production and a bit of -- and certainly an increase in our Japan business.

[Paul C. Quinn, Analyst]

And then how that relates back to dollars to the bottom line?

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

Well, we haven't guided on EBITDA by operation, but it certainly will be, because of the specialty product mix, it's going to be similar to what we've been generating from our specialty mills.

[Stephen Williams, Executive VP & CFO]

Paul, it's Steve. I'll just point you to our 8-Q and the MD&A. You can actually see we've added disclosure on line items for stumpage in there. So...

[Operator]

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

[Hamir Patel]

Can you talk more about the wholesale business you're building out. How much revenue would you expect from that in 2019? And how should we think about the effect on your EBITDA margins?

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

Sure. So wholesale has always been a part of our business. We've been doing, somewhere 16 million feet a year to 20 million feet a year in general over the last -- in average over the last number of years. And what would I have said in the past and try to guide is we're looking at growing this business to 100 million feet and you can assume $1,000 sales average, you can do the math, real easy. So over a period of time, couple of years, this isn't typical wholesale business where you buy, sell, trade. There's a component of that, but we're looking at establishing long-term supply arrangements with specific producers of specialty products. And we will let the market know when we get material contracts established, that will take some time. So to give you an actual firm number for 2019 is a little difficult, but I think you can factor in over the next couple of years, reaching 100 million feet by say some time the end of 2020, when we run at -- as a run rate.

[Hamir Patel]

Okay. And then, the effect on your margins I mean, is that kind of low single-digit?

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

Yes. That's a good point. So absolutely, the margins will be different than our current process -- manufacturing business. But we'll also -- they will be even more stable. And so, again, our view is that it's all part of, especially product profile, meeting our customers' needs, while allowing us to specialize in our mills and drive efficiencies. So the volumes that we will generate and the dollar revenue we'll generate and the EBITDA we'll generate from wholesale will be low single digits.

[Operator]

So Mr. Demens, that's all we have. We have no further questions. So I'll return the meeting back over to you.

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

Great. Thanks, Louise, and thanks, everybody, for your continued support. We're excited about the progress we've made through 2018 and advancing the company from a strategic position. And we certainly appreciate your interest and your time on the call this morning. Steve and I are available if you have any follow-up questions. And we'll look forward to sharing with you our first quarter results in May. Have a great day.

[Operator]

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