Published on the Value Lab 25/8/22

West Fraser Timber (NYSE:WFG ) is one of our preferred commodity picks in the current environment. We had a theory starting in March that WFG and its close cousin Interfor (OTCPK:IFSPF) could see surprising resilience due to releasing bottlenecks despite their pretty volatile product selling prices. WFG has been seeing that resilience now, and supply dynamics that we spoke about, mainly beetle infestations in British Columbia, are becoming increasingly durable supply constraints for the lumber market to the benefit of our incumbents. This defends against macro risks on the demand side, including in housing. While we like this stock a lot, we think the market corrections are in an overture right now; things could get worse. Feeling that there isn't a major cost in waiting out our concerns, we'll do so for now with WFG.

British Columbian forests have beetle infestations and this has naturally meant declines in output from those forests already of 25%. The lumber companies are now closing the sawmills in those areas, calling it quits. In WFG's case this is 2.5% of their North American lumber production, for Interfor it would be a little more given they have no OSB business and they're a lumber mill pureplay. This is a longstanding natural issue that supports the supply side of the price system.

Besides the update on BC, there are bigger developments that confirm elements of our thesis. When we last discussed Interfor, we mentioned that lumber was stacking at mills because flatbeds were unavailable, and therefore logistics has been their bottleneck. This was important because it dispelled the idea that sawmills were the limiting factor, which at some point they were. It also meant that if logistics became available, pent-up demand would flow through. We started to see support to this idea this quarter.

For the $460 million declines due to depreciation of lumber prices, we saw about a quarter of that come back through improved volume due to slowing down pressure on logistics and availability of flatbeds. Moreover, input cost inflation is still hurting the company, and that might not last. Higher fiber costs are likely to reverse in lag of the lumber and OSB price declines, and other things like resins, which are chemical products, should see some decline as commodities and the goods boom pull back.

QoQ Volume Growth (Q2 2022 Pres)

While a release of bottlenecks is nice, the company still depends on lumber and OSB prices. Those are likely to see further downside on the housing situation. US housing is still very bubbly, and with rising rates pricing people out of the buyer's market, housing construction should slow too, and rather work through finishing and selling the bulge in incomplete inventories for now. Moreover, we think unemployment could take a sudden hit in the next numbers, further making issues for housing where mortgages are very levered to employment data.

Overall, the macro picture is worrisome. So while a 4x PE LTM shows a late cycle multiple, one that is probably a little too pessimistic and reflects a fear of commodities in the downcycle, we think that there will be incremental deterioration. We'll wait on the sidelines here.

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