This write-up was inspired by cmn3d's detailed write-up on the housing industry since there were some comments asking for more details on specific stock recommendations. Thus, if you do not want to make an investment based on the thesis that the US housing market is going to recover, you can stop reading now.

 

cmn3d's made a detailed argument for investing in the housing industry and since he's more eloquent and thorough than I, please read his post. I want to add just one more thought to his work. Look at a long-term chart of housing starts (NHSPSTOT Index on Bloomberg). Looking at this monthly going back to 1960, prior troughs in starts happened at the 700-900k level and then bounced quickly. The current downturn in starts is unprecedented in both magnitude (500-600k) and duration (its been at these levels for almost 3 years now). When I look at this chart, I come away with a few conclusions: 1) overbuilding is followed by a period of under building; 2) normalizing for the peaks and valleys, the average during the last 50 years looks like its around 1.5m; 3) it looks like the period of overbuilding in the 2000s has now been offset by the period of under building in the last 3 years. Thus, this simple chart also supports the argument that we are closer to a recovery in housing starts than people think.

 

With that industry background behind us, I want to present LPX as an attractive investment based on a cyclical housing recovery. I won't go too much into the business description as you can read that yourself in the 10K. LPX is primarily a maker of Oriented Strand Board (OSB). It also makes other building products like siding and engineered wood products, but OSB is by far its largest product and thus the focus of my work. OSB has similar uses to plywood in housing construction, but its cheaper so it has been taking share from plywood. OSB volumes are highly correlated to housing starts, so if housing starts recover LPX will too.

 

The key ingredients for an attractive cyclical recovery play are 1) valuation substantially below "normal" so there is substantial upside when the recovery comes (impossible to time exactly) and 2) a balance sheet that's strong enough so you can afford to wait a while if you are wrong. I believe LPX fits both of these criteria.

 

 

 

I estimate at a "normalized" level of 1.4m housing starts, LPX can do EBITDA of $300-400m. The current TEV is $714m. I'll be the first to admit that estimating "normalized" earnings for a cyclical company like this is more art than science. Thus, rather than go into the detailed calculations of how I get to the $300-400m, a look at the historical financials serves as a sanity check for this assumption. EBITDA was over $600m in both 2003 and 2005 and over $900m in 2004. EBITDA went negative in 2007-2009 (neg $170m at trough year). However, LPX has cut costs as the downturn persisted and thus they did $77m in EBITDA in 2010 and are projected to do $11m in 2011. Using 5x EBITDA on $300-400m of EBITDA gets you to a stock price of $12-16, or 100-160% upside.

 

A second way to look at valuation is replacement cost. The two most recently built OSB mills were built in 2007 and 2008 by Grant Mills (private) and LPX. These plants cost an estimated $366/sq ft of capacity. LPX has 7.4m of total capacity (including 1.3m of siding capacity with is very similar). When you add the other non-OSB and siding products (at estimated replacement value of ~$250m) and $98m of net cash, LPX's assets are worth $23/share. If I take a 30-50% haircut to the replacement cost, I get to $11.50-16.00/share, or ~90-160% upside.

 

A third way to look at valuation is to see what knowledgeable strategic buyers have paid for similar assets. There were two comparable transactions in the OSB space in 2010. The first one was in May 2010, Georgia Pacific bought 2 mills out of bankruptcy from Grant Mills (the same mills mentioned in previous paragraph). The second one was in March 2010 when Brookfield took control of Ainsworth (ANS CN). In both cases, both buyers have reputations being shrewd buyers of cyclical businesses - Georgia Pacific is controlled by the Koch Industries and Brookfield (BAM) are well-known investors in "hard assets." On a price/ft of capacity basis, these deals were estimated to be $270-280/sq ft. If you apply this $270-280/ft metric to LPX, it's worth $18/share or ~200% upside.

 

 

 

LPX has $98m of net cash on its balance sheet.

 

Even at these depressed level of housing starts, LPX is not burning cash. During the trailing 24 months, LPX is almost exactly cash flow neutral.

 

Thus, even if the housing market stays depressed for a while LPX does not have solvency risk.

 

In a market panic, who knows where anything can trade so I am not going to throw out an arbitrary downside price. However, based on the current valuation and financial position, I believe there is unlikely to be permanent impairment of value from this level.

 

 

 

Balance sheet is better than it looks. If you look at the reported balance sheet, LPX shows up as having $724m of debt and $334m of cash. I have been referring to LPX as having $98m of net cash. The difference is that there are $488m of this debt is collateralized by $534m of notes receivables, effectively making this debt non-recourse to LPX. Worse case scenario is that LPX would be on the hook for $56m out of this $488m. Thus, when people "screen" for LPX, it shows as having more debt that it actually does and having a TEV of $1.2bn, not $714m.

 

The OSB industry has consolidated during the downturn, so industry structure is better and pricing could be more disciplined. As noted above, there have been two recent acquisitions in the OSB space. Thus, 4 players now control 74% of North American capacity. In addition to Ainsworth, Brookfield also controls a company called Norbord, so I am counting Brookfield as 1 of the 4.

 

 

The primary catalyst is recovery in the housing market, specifically housing starts. It's impossible to time exactly when this will happen, but based on my research I believe this will happen within the next 2-4 years. Using 150% upside (rough mid-point between 90-200% upside described above) and assuming this happens in 2-4 years, this gets you to annualized return potential of 26-58%

 

Downside is also protected by how cheap these assets are relative to replacement cost and prior strategic transactions. Since there has been active consolidation in this industry, if LPX stock stays at depressed levels it could attract strategic interest. As one can never predict M&A, this isn't a core part of my thesis, but something that helps me sleep better at night while I wait for the cyclical recovery.