When Japan’s Miyagi Prefecture was looking to replace masts from a 400-year-old tall ship damaged in last year’s tsunami, the local government turned to coastal B.C.’s Western Forest Products (TSX:WEF).
The company’s donation of coastal logs to repair the Japanese tourist attraction was not only an example of corporate goodwill but also underlined WFP’s focus on specialty wood products and Asian alliances to move from the shadow of creditor protection to the light of positive cash flow.
Under tough global market conditions, including the freefall of the U.S. housing market, the company has posted 10 straight quarters of positive pre-tax earnings. For the recently reported first quarter, the company reported pre-tax earnings of $9.3 million and a net income of $1.9 million on sales of $223.4 million, including $157.2 million in lumber revenue – the highest quarterly tally since 2007.
“We have a real tight relationship with our customers in Japan,” said Brian Cairo, WFP’s chief financial officer, of the company’s support of one of its key trade partners. “It was a unique opportunity for us to give back to the people of Japan.”
In 2004, Doman Industries was the charity case as it was forced into bankruptcy protection. In turn, Brookfield Special Situations Management, a subsidiary of Brookfield Asset Management (TSX:BAM-A), acquired the assets of Doman to form WFP.
WFP then embarked on an important consolidation of coastal lumber interests to set the foundation for a turnaround.
In May 2006, WFP closed its $202 million acquisition of Cascadia Forest Products, transferring ownership of the largest Crown tenure holding in coastal B.C. The same year, Western acquired additional tenure through its purchase of the Englewood Logging Division (Tree Farm Licence 37) from Canfor (TSX:CFP) for $45 million.
“What they’ve amalgamated into the current Western Forest Products is the best assets of the coast. They’ve got the best tenure on the coast and the best tree harvesting rights,” said Paul Quinn, paper and forest products analyst with RBC Capital Markets.
WFP’s specialty wood segment includes high-value western red cedar, used in sidings, decks and trim; Japan specialty structural products using Douglas fir and hemlock; and niche products like doors, windows, railings, moulding and trim.
Together this specialty segment accounts for 81% of the company’s revenues.
WFP’s commodity segment – which covers traditional lower -grade, dimensional lumber – accounts for 19% and is currently focused on more attractive margins in China after the U.S. housing market deflated.
They’re not a “commodity, pump out the two-by-four company like West Fraser or Canfor,” said Quinn.
“Our tagline is we have the ability to generate strong cash flows through all market conditions, including today,” said Cairo. “Even though the commodity markets are down right now, we’re still able to generate pretty decent cash flows because we have these specialty segments.”
The company’s vertical of higher-grade products is its defining trait, according to David Elstone, an analyst with ERA Forest Products Research.
“One thing that is a positive for Western Forest Products is they’ve become well-known and established as the western red cedar lumber producer,” said Elstone.
“That species marches to a distinctly different tune than what many of the lumber products do. Even when prices were declining in 2007 and 2008 for (Interior spruce, pine, fir), western red cedar was actually doing very well.”
WFP has an annual available harvest of approximately 7.1 million cubic metres and a lumber capacity of 1.1 billion board feet from eight sawmills and two remanufacturing plants.
However, the company is well positioned to capitalize on recovering wood products markets. The company is operating well under the ceiling of capacity with last year’s actual cut below the maximum at 5.7 million cubic metres and sawmills running at 83% of capacity with shipments of 811 million board feet.
Margins and cost-cutting have also been the Kool-Aid for WFP’s management team. Over the last three years, operating costs have been reduced by 25% from an average of $160 million cubic metres in 2008 to $120 million cubic metres year-to-date.
During the same period, the company has invested $40 million into maintenance, infrastructure and some operational improvements.
However, the company has dedicated $125 million, funded from company cash flow, to be spent over the next three years with a strict focus on strengthening operations and margins. Cairo said the company is projecting a minimum $25 million in annual margin improvements from its capital spending.
The company kicked off the capital campaign in February with the announcement of a $16 million upgrade to its Saltair mill in Ladysmith. The project includes upgrades to the mill’s edgers, stackers and sorters. The upgrades are expected to increase production by approximately 15% and lower unit costs.
“The Saltair investment is the first in new capital investment directed at repositioning our business. It allows us to make more finished products in the sawmill rather than taking the products out and having them remanufactured,” said Don Demens, WFP’s chief operating officer. “It improves our efficiencies and drives down our costs.”
Another revenue driver is price hikes owing to tightening timber availability in the Interior and the rest of Canada. A significant WFP competitive advantage is the one tree species the company is not exposed to in its jurisdiction: pine. Although it’s akin to whistling past the graveyard, the company knows it can benefit from the mountain pine beetle infestation when the U.S. housing market claws out from its hole.
“There’s no getting around it: the mountain pine beetle will impact fibre supply. Sixty-five per cent of the pine forest will be dead by 2020 – that’s about 15 to 20 sawmills,” said Cairo. “You couple that with markets coming back in the U.S., albeit gradually, and increased demand in China, and you’ve got a real dislocation in supply demand. Our thesis and what a lot of people hold is that the price will inevitably increase.”
Brookfield currently owns 49% of common shares and 100% of non-voting shares for an aggregate 86% equity interest in the company – 66 million shares are freely traded. WFP is housed in Brookfield’s restructuring fund – where companies with unrealized value are put back on their feet and later sold at a premium. Brookfield says WFP remains an unfinished investment.
“With the hard work now behind us, we are well positioned to benefit from improving markets for our lumber and we don’t have any immediate plans to sell our investment in the company,” said Dominic Gammiero, who doubles as managing partner of Brookfield’s Special Situations Fund and WFP chairman & CEO. •
