Value Investors Club / AINSWORTH LUMBER CO LTD (ANS)

Description

Recommendation:

I am recommending a long position in Ainsworth Lumber Co. (ANS-T), a low-cost wood panel producer.

(pricing is off by a bit as ANS traded higher in the last couple of trading days, it doesn’t impact thesis however)

Investment Thesis:

ANS is a wood panel commodity producer (specifically, Oriented Strand Board, “OSB”) with fortunes primarily tied to U.S. Housing activity.

Despite a restructuring that transformed ANS into a low cost producer with a manageable balance sheet and strong free cash flow (FCF)

generation, ANS trades at a meaningful discount to intrinsic value and comparables likely due to ANS’s poor history, lack of research

coverage (until recently) and lack of a dividend policy. I believe this idea is especially timely given the recent almost 50% drop in OSB

commodity prices since March that reflects the volatile nature of OSB rather than an end to the US housing recovery.

While an investment in ANS represents good value in its own right, the path to unlocking ANS’s value is filled with near to medium term

catalysts (for those who do not have a perpetual timeframe for investments) due to Brookfield Asset Management’s (BAM) involvement

as a 55% shareholder. Specifically, BAM’s playbook for Canadian forestry companies is quite apparent when reviewing the corporate

actions of Norbord (NBD) and Western Forest Products (WEF). In both cases, BAM (through its subsidiaries) got involved as (or just

before) the US housing bubble burst, increased its ownership, backstopped a rights offering to fix the balance sheet, improved

operations and cut costs, initiated a dividend and announced buybacks. With improved ANS operations, a late 2012 rights offering

and recent sell-side coverage, a betting person would reasonably conclude a dividend initiation and buyback are in the cards.

Further, with BAM’s recent public comments regarding wanting to exit their forestry investments and their ownership in NBD

(another OSB producer), I believe an M&A transaction to exploit overhead and cost synergies between NBD and ANS is to be

expected in the medium term (18-24 months?).

In terms of valuation, I see sustainable FCF generation in the $0.45-$0.50 per share range and come up with a DCF target of $4.20

Although the theoretical downside for most equity investments is zero, realistically I see ANS downside protection in the $2.50 per

share range ($0.20 to $0.25 FCF). This assumes a long-term OSB price of US$200/msf where major competitors in the space would

generate no EBITDA (which is probably draconian and unsustainable). Finally, given ANS trades at a discount to peers despite lower

production costs and low cost embedded growth, I also expect ANS to re-rate to trade in-line (if not at a premium) to peers.

Valuation Summary:

Draconian Downside: $2.50

Current share price: $3.20

DCF value: $4.20 (annual FCF in $0.40 to $0.50 range)

Multiple re-rate relative to comps: $3.59-$5

There is also a ~$360 mln US non-capital tax loss carry forward that expires starting 2026. If realized that would add ~ $0.15

to all the valuation scenarios (ANS has no US operations at this point)

Industry Overview:

What is OSB?

OSB stands for Oriented Strand Board and is a wood panel product used in home construction (~45%) (think wall sheathing,

roof, floor board, doors, etc), repair & reno (~25%) and other industrial uses (~30%). In simple terms, OSB is produced by

cutting hardwood trees into shreds, placing these shreds with waterproof glue on a matt and applying a thermal press to

put it together (please read regulatory filings and consultant reports for a more technically accurate description). This commodity

is priced on a thousand square foot basis, generally at a thickness of 3/8 of an inch. The benchmark price is typically the

North Central price.

Supply/Demand Dynamics?

Clearly OSB demand is driven by US housing starts and housing activity (renovations).

Investors who are at least not negative on US housing should find OSB an interesting place to be.

OSB demand peaked in 2005 at approximately 27 billion square feet, before troughing at ~ 14 billion square feet.

As of 2012, demand has only recovered to ~16 billion square feet and appears to be lagging the rebound

seen in U.S. housing starts.

On the supply side, we can look at OSB capacity (what productive capacity is out there) and OSB “effective” capacity

(what productive capacity is out there and not shutdown). Total North American OSB capacity is ~ 27 bln msf and this

number hasn’t really changed since 2007 (i.e. there has been over capacity due to housing bubble but nobody built much

net new greenfield capacity in recent years). Due to mill shutdowns, the industry’s effective capacity, however, has come

down from ~ 27 bln msf during the boom years, down to ~21 bln msf currently. The risk to the industry, clearly, is the

possibility of a 20% increase in effective capacity in the next 2 years, without an offsetting increase in underlying

demand over the same period.

Who are the OSB players?

Thanks to the bursting of the US housing bubble, the North American OSB industry has consolidated in recent years.

The top 5 OSB producers account for ~77% of production including: Louisiana Pacific (LPX) 20%, Georgia Pacific 17%,

Norbord 16%, Weyerhaeuser 14% and Ainsworth 10%. Bottom line is the producers probably won’t risk colluding on

prices/supply (http://gotaclassaction.com/in-re-osb-antitrust-litigation-court-approves-five-separate-settlements-worth-95925000/)

but logic would dictate they will not ramp up mill restarts so aggressively as to kill their profitability.

Anything special about OSB?

Yes, as an engineered wood product, it has essentially the same structural properties as plywood panels but it is a lot

cheaper to manufacture (~20 to 30% cheaper). The cost advantage exist because with OSB, the input cost is cheaper

as lower cost and lower quality hardwood can be used – one is just shredding these low quality cheap trees and gluing

them together into a panel. On the other hand, plywood panels are typically made from softwood which is more expensive

input. Further, plywood production requires higher quality softwood. Essentially, you need bigger logs where you are

“peeling” layers out of the log (think sharpening your pencil) to assemble a panel. Given the cost advantage, OSB has

been consistently taking market share from plywood. OSB’s % market share of the overall panel market went from ~55%

in the late 1990’s to 60% currently. Consultants expect OSB market share to increase to 65% by 2014/2015. The key

point here is whether you are forecasting a normal housing start number or a peak future housing start number, OSB

demand for a given level of housing starts will be higher in the future given anticipated market share gains

(and there is no cogent argument for market share losses I’ve heard, versus plywood).

If I think US Housing Would Rebound, Why Not Lumber?

Especially from a Canadian perspective, OSB represents less risk because its fibre input is mostly hardwood, not softwood.

There is something called the Mountain Pine Beetle infestation in BC Canada. A shortage of pine trees may drive lumber

producers’ costs a lot higher despite a rebound in housing and robust lumber prices. Further, OSB is considered a value-added

product and not subject to duties when sent to the US. Lumber however, is subject to duties based on the softwood lumber

agreement (beyond scope of this report). Further, changes/renegotiation of the softwood lumber agreement could materially

affect the profitability of lumber producers, not so for OSB producers.

Commentary on OSB Prices:

OSB prices have historically been volatile. During the US housing boom, OSB prices peaked in 2004 at US$371/msf,

before troughing at US$161/msf in 2007. In 2012, the annual average was US$269/msf. Going as far back as 1995,

the 17 year average nominal OSB price is ~ US$235/msf.

Year to date, OSB prices peaked in March/April at ~US$425/msf. Since then, OSB prices tumbled down to US$240/msf.

History of Ainsworth (please read the filings for the nitty gritty):

It is very interesting “Ainsworth Lumber” is neither run by/controlled by the Ainsworth family anymore, nor do they produce

any lumber (its OSB!). Formed in 1952 by David and Tom Ainsworth, Ainsworth Lumber initially operated sawmills and produced

lumber. In the 1990s, ANS decided to enter the OSB business and IPO’ed in 1992. Over the next 15+ years, the Ainsworth family

expanded OSB capacity aggressively by making acquisitions at any price while racking up a significant amount of debt

(reaching ~ $1 bln). Making matters worse (for minority shareholders), the family occupied every single senior management

position at ANS with the exception of the CFO (who coincidentally got paid the least) and paid themselves quite handsomely.

Rumour was the Ainsworth family had the use of a private aircraft at the expense of the company without disclosing it on the proxy.

This seems to be confirmed by ANS selling their “aircraft” for US$5.75 mln in 2011 (Note 6 of 2012 Annual Report).

At any rate, the bursting of the US housing bubble forced ANS to recapitalize in 2008 in order to bring its $1 billion in debt

closer to $450 mln. As a consequence of the recap, the Ainsworth family was ousted and all of the ANS U.S. mills they acquired

were shut and completely written off (they paid $650 mln for them at the peak of the market!). In 2010, HBK Investments

(debt holders who now have shares and warrants) sold its ANS equity stake to BAM’s subsidiary Brookfield Special Situation Partners.

Converting their warrants, BAM then had a 55% ownership in ANS. Since BAM “took the keys” to ANS, BAM took a number of

aggressive steps in optimizing the company and unlocking value:

1) Help cut G&A almost in half when compared to 2007 levels

2) With mill closures and disciplined capex spend, OSB production costs are now in the $175/msf range vs $235/msf pre-recap

3) Installed a competent CEO with 23 years’ experience at LPX (who else can help get ANS trading at a LPX multiple?)

4) Installed a former BAM Senior Vice President as CFO

5) Put 3 BAM guys on the board

6) Further delever balance sheet via a rights offering (net debt now ~$220 mln, all the way from $1 bln pre-recap) and senior note refinancing

7) Arranged for the acquisition of 50% interest in High Level mill from its bankrupt JV partner Grant Forest Products for $20 mln (or $47/msf).

Granted it is an idle mill but it does give ANS an option for 50% brownfield production growth. Most importantly, you will see in page 9 of ANS’s

2012 annual report that ANS’s “shrewd” acquisition was so favourable that even accounting rules dedicated ANS take a “bargain purchase gain”

of $49.7 mln (I don’t think I have ever seen this happen in the forestry industry). This also resulted in an asset writeup of ANS’s original 50%

stake in High Level of +$22.8 mln. I think this is a great example of BAM’s capital allocation skills, especially when compared to ANS’s recap

acquisitions that resulted in complete writedowns.

M&A Transactions
Buyer	Seller	Location	TX Value	Capacity (mmsf)	C$/msf
Norbord	International Paper	US South	250	1155	$ 216
Ainsworth	Boise/Voyageur	Ontario CAN	193	440	$ 439
Ainsworth	Potlatch	Minnesota	458	1350	$ 339
Tolko	Weyerhaeuser	BC CAN	38	240	$ 158
Norbord	Meadwestvaco	Minnesota	36	220	$ 164
Tembec	Jolina	Quebec	85	250	$ 340
Georgia Pacific	Grant Forest Products	Various	430	2250	$ 191
Ainsworth	Grant Forest Products	50% High Level	20	430	$ 47
Arbec	Weyerhaeuser	New Brunswick CAN	48	430	$ 110
				AVG	$ 223

Completing its transformation into a low-cost producer, with a right-sized balance sheet and an option to grow production by 50%,

I expect the market to eventually recognize the intrinsic value of the business easily north of $4 per share. I believe I’m sufficiently

conservative in the assumptions used in my DCF, including: 1) a 12% discount rate (just because), 2) no terminal growth,

3) a US$235/msf 2014 and long-term OSB price deck (in line with 20+ year average despite an improving housing picture).

If I assume OSB prices of US$270/msf (the 2012 average), ANS is a double from here.

	2006	2007	2008-stubs	2009	2010	2011	2012	2013	2014	2015	2016
Sales		460.9	359.3	285.9	329.5	293.3	409.1	459.8	544.2	581.3	581.3
Costs and Expenses
Cost of products sold		460.5	341.1	263.1	259.6	264.6	287.2	280.0	385.0	411.3	411.3
Selling and administration		30.8	29.2	19.7	18.6	17.4	16.4	16.7	16.9	17.2	17.4
Amortization		47.0	35.8	36.3	29.3	24.0	25.6	30.0	32.0	35.0	37.0
Costs of curtailed operations/Other		66.1	- 2.0	2.5	2.1	3.3	3.7	2.0
		604.4	404.2	321.6	309.6	309.4	333.0	328.7	433.9	463.4	465.7
Income from Ops		- 143.5	- 44.9	- 35.7	19.9	- 16.1	76.1	131.1	110.3	117.9	115.6

Finance expense		- 77.1	- 87.7	- 53.1	- 49.5	- 49.8	- 50.8	27.2	27.2	27.2	27.2
Loss on early repayment of LT Debt						-	- 22.9
FX Gain (Loss)		151.9	- 107.1	80.6	29.0	- 11.1	9.4
Gain (Loss) on derivatives			- 9.9		6.2	- 6.2	24.0
Gain on acquisition of High Level						72.5	-
Other items		6.0	2.8	3.8	5.3	1.6	- 1.2
EBT		- 62.7	- 246.8	- 4.4	10.9	- 9.1	34.7	158.3	137.5	145.1	142.8
Taxes		30.7	13.3	20.3	- 0.6	16.7	- 5.9	- 47.5	- 41.2	- 43.5	- 42.8
Income from Continuing Ops		- 32.0	- 233.5	15.9	10.3	7.6	28.8	110.8	96.2	101.6	100.0
Net Income from Discon't Ops		- 184.4	- 88.3	- 37.5	- 0.9	0.7	- 0.4
Net Income		- 216.5	- 321.8	- 21.6	9.4	8.3	28.4	110.8	96.2	101.6	100.0
EPS		-$ 14.78		-$ 0.22	$ 0.09	$ 0.09	$ 0.28	$ 1.28	$ 2.28	$ 3.28	$ 4.28
Shares Outstanding		14.6		100.0	100.7	100.9	102.6	241.6	241.6	241.6	241.6

EBITDA				- 21.21	- 9.30	- 34.90	9.51	215.50	196.67	207.27	207.02

Actuarial Losses						- 4.9	- 4.6
BVPS				$ 2.08	$ 2.17	$ 1.88	$ 3.76	$ 1.74
Net Debt				- 407.6	- 396.6	- 455.7	- 249.1	- 222.7
Net Debt per share				-$ 4.08	-$ 3.94	-$ 4.52	-$ 2.43	-$ 0.92

Cash from Ops		- 127.3	- 55.6	- 35.3	6.8	- 27.0	68.1	140.8	128.2	136.6	137.0
Capex		- 70.1	- 8.6	- 6.8	- 10.2	- 7.8	- 6.0	- 30.0	- 25.0	- 20.0	- 12.0
FCF		- 197.4	- 64.2	- 42.1	- 3.4	- 34.9	62.1	110.8	103.2	116.6	125.0
FCF per share		-$ 13.48		-$ 0.42	-$ 0.03	-$ 0.35	$ 0.61	$ 0.46	$ 0.43	$ 0.48	$ 0.52

	Base Case	2 $325 OSB yrs	4 $300 OSB yrs	2 $162 OSB yrs	$200 OSB forever
ANS DCF Value per share	$ 4.15	$ 5.08	$ 5.86	$ 3.38	$ 2.50
Theoretical dividend @ 30% FCF	$ 0.14
Theoretical current div yield	4%

Discount Rate	12%
Growth Rate	0%

As a side note, you will see most of ANS’s wood fibre supply is accounted for with long-term contracts which limits the risk of

significant cost inflation going forward.

Commentary on Brookfield Asset Management:

While it is exciting to have a business trading at a material discount to my intrinsic value estimate, it is even more exciting

when I see many catalysts that should unlock this value (and even perhaps push valuation even higher). I believe the

involvement of BAM could provide catalysts in the near-term.

While you may not like BAM’s investment style (especially if you’re Bill Ackman,

http://www.businessinsider.com/ackmans-value-investing-congress-presentation-2012-10?op=1), it is pretty

indisputable they are great capital allocators with BAM’s share price increasing 20% CAGR over the last 20 years

(and having the courage to buyback stock during the crisis).

BAM’s Involvement in Paper and Forest Products Industry

BAM through its various subsidiaries have been fairly active in acquiring stakes in building materials (i.e. lumber and panels)

and timberland companies several years ago (just around the financial crisis). My sense is their investment thesis is:

1) Unlike commodities facing structural declines (like paper products), building materials demand is cyclical and BAM is fairly

confident U.S. housing will rebound at some point

2) Some forestry companies are run by entrenched founding families that are not particularly good at capital allocation or

keeping a prudent balance sheet

3) BAM employs some fairly senior forestry industry people and former sell-side analysts (i.e. http://ca.linkedin.com/pub/reid-carter/11/b48/4b0)

– presumably they are ready to install them as management or reach out to industry veterans

BAM now wants to sell

In recent conference calls, BAM has made it pretty clear they are interested in divesting their forestry related investments given:

1) their capital has been deployed for ~5 years and they see other redeployment opportunities, 2) US housing is recovering

3) the heavy lifting is pretty much complete in terms of management, operation and financial overhaul.

Clearly, BAM isn’t just talking about this and they are taking action in realizing value. Not only that, they seem to do everything

in their power to get top dollar for their assets. For instance, see their recent Longview sale:

http://www.brookfield.com/content/2013_press_releases/brookfield_sells_longview_timber_and_longview_fibr-37384.html

How BAM Extracts Value:

Unlike the outright Longview sale, BAM’s approach to Canadian building material companies have been a little different.

For those with access to Bloomberg, I encourage you to do a quick “CACS” on NBD and WEF and you will get a sense of what I mean.

Its impractical for me to write a full report of NBD and WEF here but I will give a brief narrative on both.

Norbord (OSB producer)

- Heading into the financial crisis, NBD had too much debt on its balance sheet and began burning cash

- At the end of 2008/early 2009, NBD did a rights offering fully backstopped by BAM to delever its balance sheet

- Irrational fear drove NBD’s share price below the rights’ exercise price and BAM backstopped the offering

and raised its equity stake to ~ 75%

- With help from a recovering US housing market, NBD also improved its operations under BAM’s guidance

- Over the past ~2 years, NBD (I’m sure with BAM’s input) had a couple of share buyback programs. BAM also used this

opportunity to throw in secondary offerings to reduce their stake (BAM now just under 65%)

- Most recently, NBD announced in April 2013 a variable dividend based on FCF starting in June 2013.

http://www.norbord.com/news/norbord-reports-improved-q1-2013-results-declares-dividend.php

Western Forest Products (Lumber producer):

- Formerly known as Doman Industries, a forestry company founded by the Doman family

- Similar to Ainsworth, Doman had a levered balance sheet, a questionable capital allocation strategy

and mediocre operating assets

- BAM got involved as housing downturn began

- WEF also did a rights offering in Dec 2008 to help improve balance sheet. BAM (through Tricap its restructuring arm)

owned just under 50% of WEF

- New management team installed, operations improved, costs cut

- Requests sell-side coverage (see recent initiation reports)

- Just this week announced initiating a dividend and a $100 mln dutch auction (share buyback) which BAM will participate

http://www.marketwire.com/press-release/western-forest-products-announces-100-million-substantial-issuer-bid-initiates-regular-tsx-wef-1807976.htm

Unlocking ANS Value Imminent

Given the pattern of how BAM operates, I think BAM is highly likely to follow the same playbook for ANS. In fact, with the

rights offering complete and some debt refinanced, I see a dividend and/or share buyback announcement quite imminent

(in recent conference calls ANS hinted at being open to returning capital to shareholders but mentioned the upcoming capex spend).

Interestingly, several sell-side analysts have also initiated coverage of ANS (with “Buys” of course).

I am very confident that BAM is keenly aware and irritated that ANS trades at a discount to both NBD and LPX

(on consensus EV/EBITDA multiples) despite being the lowest cost producer with the best assets amongst the three.

Not only that, ANS has installed capacity that can be restarted fairly quickly to grow production by 50%. Given the

history of ANS, I would assume BAM is working hard to get sell-side to cover ANS and tell its newly improved story,

and initiate a dividend comparable to NBD in the hopes of an ANS multiple re-rate. Here is what the 3 OSB producers

are trading at on 2013 and 2014 EV/EBITDA multiples, the implication here is ANS can easily re-rate and trade anywhere

from $3.59 to $5 per share (in fact one could argue for a premium given its low cost advantage and growth potential):

Comparable Analysis	ANS	NBD	LPX
Stock Price	$ 3.13	$ 29.65	$ 15.13
Market Cap	$ 756	1592	2101
Net Debt	222.7	276	319.6
EV	$ 979	$ 1,868	$ 2,421
2013E EV/EBITDA	4.5	5.0	6.5
2014E EV/EBITDA	3.7	5.2	5.4
2013E consensus EBITDA	217.83	373.44	$ 371.9
2014E consensus EBITDA	263.33	360.67	$ 445.2
Dividend Yield		2%
	2013	2014
If ANS trades at NBD multiple	$ 3.59	$ 4.72
Upside	15%	51%
If ANS trades at LPX multiple	$ 4.95	$ 5.01
Upside	58%	60%

Unlocking Value Via M&A:

BAM Happens to own 65% of Norbord (16% OSB market share) AND 55% Ainsworth (10% OSB market share).

It is definitely not a stretch for BAM to orchestrate a merger between NBD and ANS as there should definitely be some overhead

and operational cost synergies. I concede it is too difficult to quantify what the upside to ANS may be as I have no idea how the

deal would be structured, which side would pay the premium, etc. However, presumably with much improved trading liquidity,

an industry leading proforma market share (26% vs LPX at 20%), a management team with good capital allocation skills and

likely reasonable dividend yield (LPX does not pay a dividend currently), it is not difficult to envision the NBD/ANS entity trading

at a premium multiple to LPX down the road.

Why does this opportunity exist:

- Horrible shareholder experience with ANS before restructuring

- Virtually no sell-side coverage until recently

- Multiple discount due to lack of dividend

- Financial restructuring via rights offering and debt refinancing not well understood

(I noticed ANS rights were occasionally trading below intrinsic value (difference between market price and exercise price))

- Volatility in underlying OSB commodity (-50% from March 2013 peak) driving fear

Risks:

- Weaker US housing markets and OSB oversupply

- Lack of industry supply discipline

- Strengthening C$

- BAM rips off minority shareholders (i.e. via egregious management contracts, incentive fees, etc.)

Disclaimer: The write-up is only intended for VIC members and not for dissemination.

Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Dividend and/or share buyback announcement and multiple re-rate

- Growth in productive capacity via High Level mill restart

- Merger with Norbord, realizing synergies and multiple re-rate (to LPX)

- Outright sale

- Continued deleveraging of balance sheet

show sort by

			2013	2014
Price:	3.32	EPS	$0.00	$0.00
Shares Out. (in M):	242	P/E	0.0x	0.0x
Market Cap (in $M):	802	P/FCF	0.0x	0.0x
Net Debt (in $M):	223	EBIT	0	0
TEV (in $M):	1,025	TEV/EBIT	0.0x	0.0x