Description

Introduction

We have followed and invested in LPX off and on for the last several years. We think LPX equity is modestly interesting outright long at current levels and a very interesting pair trade versus competitor Norbord. We detail the thesis below, but the basics are simple. LPX and Norbord are OSB manufacturers trading at similar valuations, yet LPX is unlevered and a third of LPX’s 2018 EBITDA comes from their rapidly growing Siding division. We believe Siding is a higher quality business which if spun out would trade at a 200-300% premium to LPX and Norbord current valuations. As the Siding segment approaches half of EBITDA in 2020, we believe either the market will reweight LPX’s shares or management will be forced to spin the division.

Thesis – LPX Standalone

Historically, LPX’s major business has been the production of oriented strand board (OSB), a commodity primarily used in the construction of single family homes. OSB is effectively a single-play on US residential construction, where we remain long-term bulls. While OSB is a commodity, the market is consolidated, and no significant new-build capacity has been added since the Great Recession. As housing starts approach 1.3MM, the market is operating at greater than 95% utilization and OSB prices are currently at “peak” levels. While we typically avoid owning commodity producers in “peak” environments, we believe OSB prices will remain strong over the next three years, given minimal recent capacity additions and a one-to-two year lead for new capacity. Further, Street estimates remain too low and the market is valuing LPX (and Norbord) at 5-5.5x EV/EBITDA, implying limited near-term downside. Given the year-to-date rally in OSB prices, we believe LPX (and Norbord) shares could modestly rally into the spring if prices continue to move higher. However, we believe the market will remain cautious towards “peak” multiples and we do not expect multiple expansion for the OSB segment.

What makes LPX an attractive investment even in a “peak” pricing period is its rapidly growing Siding segment, which we believe is a classic “hidden asset” masked by the OSB segment’s volatility. LPX manufactures a branded siding product which has grown revenues at a mid-teens CAGR over the last five years, EBITDA is beginning to expand faster than topline, and the product has significant share gain potential. For comparison, the Siding segment’s closest peer is James Hardie (JHX AU), which trades at 24x EPS and 15x EBITDA. Siding contributed ~$200MM in 2017 EBITDA and we believe could approach $300MM by 2020. This compares to current “peak” OSB segment EBITDA estimates of $500MM and $175MM if OSB prices normalize. Assuming 12x 2018 EBITDA for the Siding segment and 5x “peak” OSB EBITDA yields a $37 price on 2018 estimates which increases to $50 on 2020 estimates.

We believe the market has been slow to adjust to LPX’s significant Siding growth and is still valuing LPX as a commodity player despite the Siding segment representing most of future value. Some bears counter that without a spin, the market will not reweight LPX towards high-growth peers. However, we argue bears are underestimating the power of compounding and the odds of a split. Siding will be the majority of LPX’s “normalized” revenues and EBITDA by 2020. We think there is a good chance LPX’s shares are awarded a greater than 0.5x turn premium versus commodity peers as the Siding segment becomes the dominant earnings source. Further, if shares do not reweight, we believe management will effectively be forced to split the company, either voluntarily or by an activist. We do not think management and the board can retain shareholder support with >60% of EBITDA trading at a 10-turn discount versus peers.

Thesis – Pair Trade

Applying a 5x multiple to Norbord and assuming “peak” OSB prices of $350 PSF yields a $46 price, up 25-30%, modestly below our 2018 LPX expected return. However, we believe the pair is particularly attractive on a risk-adjusted basis. If OSB prices fall towards a normalized $260 PSF (as they inevitably will) and the market reweighted OSB businesses to a “normalized” 8x EBITDA, Norbord would fall to $18, down 50%, as North American OSB is >90% of Norbord’s EBITDA. However, LPX’s Siding business is independent of OSB pricing. Applying the same 8x EBITDA valuation (conservatively ignoring a SOTP approach) and “normalizing” OSB EBITDA yields $24, down on 15% from current levels. Further, the risk/reward improves as Siding continues its rapid growth. By 2020, we believe Siding can contribute $300MM in EBITDA, and an 8x valuation on whole-co “normalized” OSB would yield $30, with Siding contributing 60% of profits. In this scenario, we apply an 8x multiple to all segments for conservatism and to show the relative risk/reward versus Norbord. If OSB prices normalize in the next two years AND LPX reweights, we would profit on both sides of the pair trade.

We want to highlight that we are not recommending a stand-alone Norbord short. We consider it a well-run business that, while at peak, should generate significant FCF over the next few years. We simply recommend using Norbord as a hedge versus a long investment in LPX, which we believe creates a strongly skewed risk/reward. As we believe there is potential absolute upside to both LPX and Norbord, we recommend a long-skewed position.

Risks

• Fall in OSB Prices – OSB is a notoriously volatile commodity, largely a product of high-fixed manufacturing costs (an OSB plant costs $200MM to build, only requires five or six employees per shift, and runs 24/7) and a volatile end market (residential construction). While new capacity increases seem digestible, there is always risk of a housing slowdown, which would quickly pressure the OSB market.

• Siding Sales Growth and Margins – Siding is a rapidly growing segment. While we believe higher margins and sales are likely over time, the higher growth comes with a less predictable long-term outlook. If Siding were to materially slowdown, our view of the stock would change.

• Competitive Engineered Wood Siding Products – While LPX is by far the market leader, other OSB manufacturers could announce siding products, which could weigh on LPX shares

o However, we believe LPX’s substantial lead in technology, brand awareness, and distribution are significant competitive advantages

o We note Norbord actively considered entering the siding market in 2015, yet ultimately sold its best “siding-capable” mill to LPX in 2016

Catalysts

• OSB Price Rally – OSB prices have rallied YTD and are significantly above Q1 2017 levels, while shares of LPX are only marginally higher. While simplistic, we believe LPX shares could “catch up” with the OSB rally if pricing continues higher into Q2.

• Continued Growth in Siding – As Siding’s growth continues, we believe “Mr. Market” is likely to reward LPX with a higher multiple

• Spin of Siding – If shares remain at a 5x EV/EBITDA multiple while Siding becomes the majority of revenue and EBITDA, we strongly believe management will be forced to spin the segment

Siding Market

LP has ~85% market share of engineered wood siding, which is currently 8% of the overall siding market and growing ~10-15% annually both from overall market growth of 5-10% and share gains from wood and vinyl siding. The overall US siding market was ~$9.6B in 2017, with normalized levels closer $11-$12B, of which LPX targets $6-$7B as their addressable market. The market is ~45% repair and remodel (R&R), 35% new residential construction, and ~20% non-residential construction. It’s worth noting siding is more levered to new construction than most building products, providing both greater cyclical risk and higher cycle opportunity, as we believe housing starts remain below normalized levels. The market is expected to grow at 7-8% annually through 2020, as R&R increases ~5% and new residential increases 10-15%.

Over the past 10 years, engineered wood (EW) and fiber cement (FC) have gained significant share from vinyl and wood siding. Wood has been falling in share for decades, as vinyl, EW, and FC all offer similar appearance product with lower cost, easier installation, and easier upkeep. Vinyl took share from wood in the 1980s and 1990s, peaking out at ~39% share in 2003, yet has lost share and stands around ~20% today. While vinyl remains the lowest cost solution, EW and FC offer a much better value proposition. Both are only 5-15% more expensive with a superior appearance and easier upkeep. JHX is LP’s main FC competitor, and the two have been “duking it out” to see who can win the most in a rapidly growing market.

LPX has guided to 12-14% topline growth for the next few years. Longer-term, we believe LPX could eventually reach $3B in total siding sales, implying a ~25% market share of the normalized US siding market and half their addressable market. Regarding medium-term estimates, reaching just half that goal in five years implies an ~13% growth, in-line with LPX’s guidance.

Our Siding Estimates

When analyzing the Siding segment, we backout the OSB sales/profits still being recorded in the segment. We estimate Siding EBITDA ex-OSB by applying the OSB segments margins to the OSB sales in the Siding segment. However, there are shared costs so our trailing numbers are imperfect estimates.

Ex-OSB, the Siding segment had ~$820MM/~$195MM in sales/EBITDA for 2017, which is ~15% sales growth, ~34% EBITDA growth, and an ~23.7% margin. Looking forward, we model 13% sales growth and 30-33% incremental margins. It’s worth noting incremental margins in the last three years have significant outperformed our forecast.

LPX has unconsolidated corporate level expense of $110MM per year, of which we allocate $55MM when considering a possible spin. However, that number is likely to increase over time as certain sales and marketing expenses are reported in corporate expense. We also model Siding’s ex-growth capex at ~3% of sales. The Siding segment’s current GAAP D&A expense is ~3.5-4.0% of sales.

OSB Supply and Demand

The OSB market is relatively simple. Given OSB’s low value compared to weight/volume, North American OSB is a nearly-zero import market. Supply is relatively consolidated in the hands of a few manufacturers and various industry research groups provide accurate supply forecasts. While the remaining ~10% of industry capacity still-idled (and small new builds) is scheduled to come online in the next two years, continued single family start growth should absorb this supply. Roughly speaking, 100k single family starts equals 1MM MSF of demand or 4% of total North American capacity. We forecast ~75k-100k additional single family starts per year for the next three years with GDP-rate growth for the rest of OSB, yielding >90% utilization and strong OSB pricing.

However, OSB is a commodity and will inevitably crash back to normalized (and if history is a guide, cash-breakeven) levels. Further, OSB is a notoriously volatile commodity with huge seasonal swings, making OSB profits difficult to predict. For this reason, we recommend hedging at least part of the position with Norbord equity.

OSB Prices

LPX Other Businesses

LPX has two other businesses, North American Engineered Wood Product and South America, which combined are less than 10% of EBITDA. For conservatism, we value both at 5x EBITDA, in-line with Norbord.

LPX Replacement Cost

Given the volatility in OSB earnings, we also value LPX’s OSB business on replacement cost. In theory, if the market requires additional capacity, the existing capacity should be worth at least as much as the cost of new builds. LPX has ~4.5B MSF of siding capacity, with typical new capacity costs of $325 per SF, yielding a replacement value of ~$1.5B. Combined with $587MM in net cash and valuing LPX’s other businesses at $350MM (5x 2018 EBITDA), we reach a Siding valuation of ~$1.7B. This implies LPX siding business is trading at roughly 10x EBITDA – corporate expense. We believe 10x EBITDA for a 15-20% EBITDA growth business, replacement cost for a cyclical commodity manufacturer, and net cash value are reasonably safe entry points for an investment.

For comparison, replacement cost valuation for Norbord implies $25 per share, down ~30%.

Norbord

Norbord has two business segments: North America and Europe. North America is a pure-play OSB manufacturer that is directly comparable to LPX’s siding business, with similar cost structure, margins, and end markets. The segment earned $638MM in 2017 EBITDA. We project $780MM in “peak” EBITDA versus Street estimates at ~$620MM, and apply a 5x valuation. Europe is a growing OSB market, but at $41MM in 2017 EBITDA it is a minor segment. We project $55MM in 2018 and value it at 8x EBITDA. Norbord has ~$300MM in net debt, versus LPX’s ~$600MM net cash position.

SOTP Models

Siding Model

Catalyst

·       OSB Price Rally – OSB prices have rallied YTD and are significantly above Q1 2017 levels, while shares of LPX are only marginally higher. While simplistic, we believe LPX shares could “catch up” with the OSB rally if pricing continues higher into Q2.

·       Continued Growth in Siding – As Siding’s growth continues, we believe “Mr. Market” is likely to reward LPX with a higher multiple

·       Spin of Siding – If shares remain at a 5x EV/EBITDA multiple while Siding becomes the majority of revenue and EBITDA, we strongly believe management will be forced to spin the segment