Canfor CFP.TO
November 26, 2006 - 1:03pm EST by
tickles879
2006 2007
Price: 10.07 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,435 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description



Canfor Corporation (CFP.TO)

Thesis
Canfor is an integrated forest products company located in British Columbia. The company makes lumber, pulp, plywood, and OSB.

Canfor has been a strong supporter of the recent Softwood Lumber Agreement (SLA) that governs the lumber trade from Canada to the U.S.  Under the agreement, Canfor is collecting approximately C$536M (after-tax) of tariff refunds.  Only a small fraction of these refunds were represented on the balance sheet as presented for September 30, 2006.

Adjusting the balance sheet for the tariff refunds, the market price of Canfor’s interest in the partially spun-out Canfor Pulp Income Trust, Canfor trades at P/B = 0.62x.  If the company trades back to its ten-year average P/B of 0.94x this implies a share price of about C$15.22, or about a 50% gain.

Taking account of the pending tariff refund and the cash value of the 50% owned stake in the pulp income trust, Canfor’s adjusted enterprise value for non-pulp businesses is C$826M.  Historic EBITDA from lumber operations was C$499M in 2004 and C$223M in 2005.  If we assumed ‘normal’ lumber revenues were C$2500 and ‘normal’ EBITDA margins were 10-12%, ‘normal’ lumber EBITDA would be C$250-C$300.  Applying a 6x EV/EBITDA multiple yields implied mid-cycle enterprise value of C$1500 – C$1800, implying a stock price range of about C$15 – C$17.

Applying the 2001 – 2005 average ROE of 11% to the adjusted book value presented above implies an earnings power in the neighborhood of C$1.49 per share excluding the spun-out pulp assets.  Applying a 12x multiple and adding back the value of Canfor’s ownership in the pulp trust yields a potential share price of C$20-C$21 once tariff refunds can be productively employed.  Of course the share price leverage would be even better to the extent tariff refunds could be applied to share buybacks at current prices.

The business is capital intensive, but Canfor has recently completed major upgrades at a number of its facilities.  Management stated on the Q2 2006 conference call that maintenance capex in the lumber segment of C$60M annually “at the high end” versus D&A in the segment of nearly C$100M.  

The slowdown of the U.S. housing market and the concurrent implementation of the SLA has depressed lumber prices recently to a level below cash breakeven of many Canadian mills.  In addition the climbing of the Canadian dollar has continued to pressure Canadian forest products companies.  These conditions, creating what may be a timely opportunity to buy a high-quality cyclical company at a bargain-basement price.

Canfor’s cash flows are most sensitive to changes in commodity lumber prices and movements in the Canadian dollar.  Distributions from its pulp business will be affected by NBSK pulp pricing.  To whatever extent you like, you can easily hedge to protect yourself from near-term adverse developments in these markets.  If you are hedging, I believe buying some protection against a stronger Canadian dollar is the best approach.

Business

Canfor’s TTM sales are roughly divided as follows:
    Lumber        68%
    Pulp & paper    22%
    Panels        10%

Canfor’s TTM EBITDA contribution is divided as follows:
    Lumber        47%
    Pulp & paper    50%
    Panels        3%

Lumber

Canfor’s lumber segment benefits from relatively low-cost wood available through the company’s forest tenures primarily in B.C.  

The company has a primary lumber capacity of 5.1B fbm, making it the second largest lumber producer (after Weyerhaeuser) and the largest SPF producer in the world.  The company owns and operates 18 sawmills.  

According to the company its cash conversion costs are around C$110 per mfbm of production, placing it amongst the low-cost producers in North America.  Lumber production costs include cost of sourcing logs (50%), cost of conversion (27%), and cost of bringing the wood to market (23%).  Canfor’s scale and dominance in B.C. gives it economies in each of these categories.

In 2006, the company diversified into Southern Yellow Pine (SYP) production through its acquisition of New South Companies.  New South added about 400mmfbm of lumber capacity to Canfor’s existing 15 Canadian mills.  

The primary market for Canfor’s lumber is house construction and home repairs / renovations in the U.S.  Lumber segment cash flows are highly levered to U.S. SPF lumber prices.

Lumber prices declined to US$278 per MMfbm in Q3 versus US$316 per MMfbm in the prior quarter.  This decline in combination with a drop-off in volume drove Q3 EBITDA to C($44.7M) from C$12.3M in the prior quarter, although C$20M of the decline was from revaluation of lumber in inventory to lower of cost or market.

Lumber pricing below about US$300 per MMfbm creates a challenging operating environment for Canfor.  Fortunately, cash costs at Canfor mills are well below many competitors.  Competitors are shutting capacity.  I believe it is likely the market will soon return to more balanced pricing and Canfor’s mills will again be cash positive as mill shut-downs continue at competitors.  A return of healthy EBITDA margins to the lumber segment could begin as early as next Spring or could take a couple of years depending primarily on your views on housing recovery.  

As the tariff refunds de-lever Canfor’s balance sheet, I hope Canfor might apply a portion of its cash to share repurchases.  I expect the company will apply a good portion towards further diversifying acquisitions in the U.S.

Pulp & Paper

In 2006 Canfor encapsulated the great majority of its pulp and paper operations in an income trust and distributed 20% of its interest in the trust to Canfor shareholders.  The trust also owes Canfor C$125M through an inter-company note.  Canfor shareholders of record as of November 15 will receive an additional distribution of 30% of the pulp income trust, leaving Canfor with 50.1% ownership.

The Partnership is one of the largest producers of northern softwood kraft pulp (NBSK) in Canada and a leading producer of kraft paper.  The Partnership has a pulp capacity of 1.0 million tons and a kraft paper capacity of 135,000 tons.  Canfor contributed its Northwood Pulp Mill, Intercontinental Pulp Mill, and Price George Pulp and Paper Mill to the partnership.  As a side note, Canfor retained whole ownership of small pulp and paper interests in its Howe Sound pulp and newsprint operations and Taylor operations, which may be candidates for disposal at opportune times.

The Pulp Income Trust will regularly payout a majority of its distributable cash.  Canfor has indicated that pro forma for low fiber costs in Canada this year (largely a result of the mountain pine beetle, discussed below), 2005 EBITDA would have been about C$135M.  Maintenance capex for the partnership is C$30M and debt C$125-150M resulting in a proforma 2005 distribution of ~C$95M.  Under this proforma analysis, Canfor would have received approximately C$76M as 80% owner or C$48M cash proforma for its going-forward 50.1% ownership of the partnership.

Capacity closures in Eastern Canada have strengthened NBSK pulp markets recently and demand for pulp has remained strong.  Canfor gained US$20 of pricing in Q3 to US$710 on its Northern European benchmark price and pricing was US$730 going into the fourth quarter.  The company cites an average of 5 independent industry forecasts that suggest Northern European NBSK prices are likely to average US$635 between 2006 and 2009. This compares to US$611 prices obtained in 2005.  According to the company, each US$10 improvement in NBSK pricing results in C$0.06/share impact on after-tax consolidated earnings.

Panels

Canfor has OSB (oriented strand-board) capacity of 1B msf 3/8” basis  (Fort Nelson, BC = 650 mmsf and Peace Valley OSB joint venture adds 820 mmsf of which Canfor’s share is 50%) and plywood capacity of 450M msf 3/8” basis.  Production is primarily at PolarBoard for plywood and Peace Valley for OSB.

Canfor has substantially addressed operating challenges at its plywood plants and ramped up new OSB production during 2006.  In OSB, YTD shipments of 538.4MMsf 3/8” versus 351.3MMsf 3/8” for the first nine months of 2005.  Through the addition of the Peace Valley facility and an increase in production at its existing PolarBoard OSB facility, the company had planned to ramp OSB production from 482 MMsf in 2005 to 1285 MMsf in 2006, a new revenue opportunity of approximately C$213M at YTD prices.

While the plywood market has been reasonably resilient thus far in the face of the housing downturn, OSB markets have been hard-hit by the drop off in demand and new capacity.  OSB pricing has deteriorated to an average US$181 in Q3 versus US$238 last quarter and US$291 a year ago.  According to the company, each US$10 improvement in OSB pricing results in C$0.04/share impact on after-tax consolidated earnings.  

I believe OSB capacity shut-downs will return Canfor to cash-positive panels operations in the near-term.  As with lumber, the long-term outlook depends on how speedily demand for new homes recovers.

Canfor X-Factors

The Softwood Lumber Agreement


On October 12, 2006 the Softwood Lumber Agreement came into affect governing lumber trade between the U.S. and Canada.  The agreement has a number of important effects on Canfor:

1)    The agreement returns US$730M of duties collected by the U.S. in prior financial periods to Canfor, with receipt of the great majority of this amount anticipated in Q4 2006.  Clearly this is highly beneficial to Canfor.
2)    The agreement removes U.S.-imposed counterveiling duty and anti-dumping duty taxes However, in B.C. the tax will be replaced by an export tax the rate of which varies between 0-15% depending on price levels in a Random Lengths lumber composite index.  
3)    The agreement imposes a “surge” tax on all Canadian producers in a given region if the volumetric output of the region exceeds an amount specified in a formula contained in the agreement.  The surge tax is an attempt to keep the regions from deviating too much from historic relative volume contributions to the market.  The agreement will have the effect of reducing incentives to build relatively more new capacity in B.C. even though such capacity would likely be more efficient than capacity in other Canadian regions in the absence of the SLA.  I believe this may help to protect Canfor’s leading position in B.C. while helping to prop up North American lumber prices based on marginal production costs from higher-cost regions.

The Mountain Pine Beetle


The entire B.C. forest products industry has faced unusual circumstances recently with a severe infestation of the mountain pine beetle.  The infestation began in B.C. in the late 1990’s and has continued to move eastward, recently crossing over the Rocky Mountains into Alberta.  

The beetle is native to the area but its population is typically kept in check by cold snaps and/or long periods of relatively cold winter weather.  What is unusual in the current infestation is that weather has not been sufficiently severe to kill the population for a number of years.  

According the government’s action plan for dealing with the pest, the province’s total inventory of merchantable mature lodgepole pine is 1.8 billion cubic meters.  Approximately 411 million cubic meters have now been killed by the epidemic.  At current rates of spread, nearly half of the mature pine in central and Southern B.C. will be dead by 2007 and 80 percent will be dead by 2013.  Pine represents about 50 percent of the total timber volume harvested by Canfor.

In the short-term, harvest plans have been increased in an effort to use dead trees before they have substantially decayed, and to cut swaths through the forest in an effort to slow progress of the epidemic.  Diseased wood can be used by the mills but it is lower quality.  Current estimates are that dead wood remains commercially viable for 5-18 years depending on local conditions, though this estimate is currently subject to study and debate.  

Processing diseased wood also creates greater quantities of wood chips.  This has had the effect of lowering wood chip prices, a benefit to the regional pulp and paper industry.

Recent shifts towards market-based mechanisms for setting log costs should help to mitigate margin compression that sawmills would experience from processing lower quality wood.

In the future (perhaps 10-20 years from now), B.C. harvesting may need to be reduced to a rate that is sustainable given the reduced population of mature pine.

In a worst case scenario, the pine beetle epidemic would continue to decimate B.C. forests for many years, leaving Canfor with stranded sawmill assets.  Even if this doomsday scenario were to play out, I believe it would be a decade at least before the mills ran out of reasonable-quality beetle-killed logs to cut, time enough for Canfor to depreciate most of its equipment in the region and diversify into other regions if necessary.

In a best case scenario, a period of cold weather would stop the beetle in its tracks during the current winter, in which case pine supplies would remain stable for the foreseeable future.

Exchange Rates and Commodity Pricing

The strengthening of the Canadian dollar has made the Canadian forest products industry relatively less competitive than U.S. counterparts.  I believe that in the foreseeable future, Canada is likely to continue to supply about 30% of lumber produced in North America and that US$-denominated lumber prices will be pressured upwards accordingly if the Canadian dollar continues to strengthen.

According to the company, each US$.01 change in the price of the Canadian dollar has a C$0.20 impact on after-tax earnings.  Because Canada supplies about one-third of the lumber used in North American markets, there is some relationship between U.S. lumber prices and the US/CDN exchange rate.  However near-term supply/demand balance has much greater impact on lumber pricing than exchange rates.  The good thing about exchange rate risk is you can hedge it.

While it is hard to see lumber markets substantially weakening, it is possible that pulp markets weaken either on the demand side or if additional supply is brought into the market.  If you’re looking for some insurance against commodity risk, protecting yourself from a collapse of NBSK pulp pricing could be a reasonable idea.

Valuation

Adjusted Book Value

Book value can be adjusted as follows:
(ALL $ ARE CANADIAN)

Consolidated equity (9/30):        $1933

Pulp Adjustments:
Plus minority interest            $122
Less 100% pulp book equity        ($736)
Plus 50% CFX-UN @ market        $379
Plus $125 inter-company note        $125

Tariff Refund Adjustments:
Less net tariff asset on B/S            ($50)
Plus after-tax refund            $536

Adjusted equity:                $2309
Shares outstanding:            142.5
Adjusted BV/Share            $16.20
Market price:                $10.07
Adjusted P/B ratio:            0.63x

Note: Canfor has an underfunded pension plan (~C$200M short) that I did not adjust for in this analysis to make the ratio more comparable to the historic trading multiples of the stock.  

“Normal” ROE

If the 2001-2005 average ROE of 11% could be achieved on a normalized basis (once tariff refunds can be invested productively), this would imply profits of C$212M on the business excluding the income trust, or about C$1.50 EPS.  Applying a 12x P/E multiple to these theoretical earnings and adding in market value of the 50% stake in the income trust yields a potential market valuation of about C$20-C$21.

Currency and Commodity Sensitivities

Clearly exchange rates and commodity prices can dramatically impact results from period to period.  Canfor provides this data on page 54 of their 2005 Annual Report:

                                                                        Impact on annual after-tax earnings (C$M)    Impact on annual EPS (C$)
Canadian dollar – US $.01 change per $CDN                            $28                                                $0.20
Lumber – US $10 change per Mfbm                                           $36                                                $0.25
Duties – 1% change in combined duty rate                                    $9                                                $0.06
Plywood – US $10 change per Msf 3/8”                                        $3                                                $0.02
oSB – US $10 change per Msf 3/8”                                                $5                                                $0.04
Pulp – US $10 change per tonne                                                    $9                                                $0.06
Log costs – Cdn $1 change per cubic meter                                    $12                                            $0.08
Natural gas costs - $1 change per gigajoule                                    $6                                                $0.04
Diesel costs – 10c change per liter                                                $7                                                   $0.05

Risks To Highlight

A strong Canadian dollar accompanied by weak US$ lumber pricing could cause EBITDA to remain significantly depressed for a number of quarters. In the most recent quarter, the company posted just $3.3M EBITDA due to depressed lumber and OSB pricing and a strong Canadian dollar.

A significant near-term risk to the company is if weakness in the U.S. housing market turns out to be deep and prolonged.  However, the degree of undervaluation of the shares relative to ‘normal’ market conditions and the strength of the balance sheet post-tariff refunds gives me confidence that the current entry point is not a bad one.

The mountain pine beetle presents a significant challenge to the company in the near-term as mills, markets, and regulators adjust to higher quantities of beetle-killed wood.  However I believe the company has sufficient liquidity and “runway” of 10-20 years to adjust its business successfully even if the near-term problems should develop into a long-term disaster for the B.C. forest industry.

DISCLAIMERS: My firm has a position in Canfor stock.  We may buy or sell at any time.  This write-up should not be considered a recommendation to buy or sell securities.


Catalyst

*Possible rebound of lumber prices as capacity shuts down in response to the slowdown in housing starts in the U.S.
*Possible weakening of Canadian dollar on lower energy, metals, and commodities prices or other factors
*Possible end to mountain pine beetle epidemic following cold winter weather in affected regions
*Possible pick-up in housing starts in Spring
*Increased Wall Street coverage and attention as Canfor may seek to deploy its tariff refund "war chest" into U.S. forest acquisitions
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