AVTG/iStock via Getty Images
AVTG/iStock via Getty Images
I have previously covered homebuilders extensively and one of the largest building material suppliers, which led me to move higher in the housing supply chain and research more for the sawmills and lumber products producers.
In this article, I explore the prospects of West Fraser Timber Co. Ltd. ( NYSE:WFG ), a Canadian forestry producer and a key beneficiary of the housing boom. Indeed, the company operates in a cyclical industry with many speculators trying to time the market and cash out at the peak. However, the strong housing market is driven by several macros and demographic shifts that provide a solid bullish outlook for WFG and reaffirm the buy rating.
The company's fundamentals continue to impress with record-high liquidity levels. Specifically, the company ended Q3 with an outstanding cash and short-term investments balance of $2.11 billion, and on top of that, has access to an operating bank line of $1.03 billion, which sums up to massively available liquidity of $3.13 billion. To that effect, WFG has plenty of financial flexibility to retire early any debt as they have done in the previous quarters, proceed with share repurchases, and boost its growth through strategic acquisitions.
WFG maintains a conservative capital structure of just 7.08% in total debt to equity, one of the lowest in the industry, and has excellent room for leverage if needed to ramp up production fast to meet excess demand. The company maintains $519 million in long-term debt, and in anticipation of the higher interest rate environment from 2022 onwards, the management has recently entered into an interest rate swap contract. The contract expires in August 2024, and the company will make fixed payments with a weighted average interest rate of 1.14% and receive a 3-month LIBOR rate on a $200 million principal, which is a wise move to partially hedge interest rate volatility.
Despite the housing boom since 2020, which favorably expanded profitability and returns, the company records RoE figures more than doubled the industry's averages. Suppose the upward trend extends to a supercycle, the company can easily deploy more capital to generate more M&A activity and growth through more leverage.
The management maintains a balanced capital allocation strategy, reinvesting its excess returns for future growth and rewarding shareholders through the share repurchase program.
On February 1st, 2021, the company acquired Norbord, the world's largest producer of oriented strand board (OSB), and it's currently on track to produce $61 million annual synergies for WFG by the end of 2022. WFG has become the leading OSB producer through the acquisition of Norbord, which has significantly improved its competitive positioning. To that effect, the specialty OSB products now account for 30% of the total product mix, which provides more profit margin stability and less exposure to commodity price volatility.
Source: WFG Q3 2021 Earnings Presentation.
Last but not least, WFG's lumber mill portfolio further expanded in Q3 by acquiring Angelina Forest Products and GP OSB Mill for approximately $300 million and $280 million, respectively. As a result, the company will expand its production capacity meaningfully and realize operational synergies through these two low-cost fiber producers mills, with strategic locations in Texas and South Carolina.
The management over the past decade has managed to deliver on average ROIC figures above its WACC, with major pullbacks occurring due to the industry's cyclicality. The extraordinary ROIC results since 2020 will persist in the foreseeable future not only due to the expected elevated lumber prices but also due to the increased production and operational efficiency synergies.
Source: Chart created by the author with data from Guru Focus Premium.
The company has completed massive share repurchases in the last twelve months, surpassing the $1 billion mark, which has rewarded shareholders richly. Moreover, the share repurchases were performed during a period of rising earnings while valuations remained relatively low. This also reaffirms that management aims for the best use of cash by adopting shareholding friendly policies that will reward shareholders in the long run.
WFG operates in a highly fragmented and cyclical commodity environment, and the recent disruptions in the supply chain and labor shortages have put back lumber prices in the rising trajectory. In addition, the extreme weather conditions in Western Canada and intense floods in British Columbia forced the company to cut production due to transportation disruption, leading to a 25%-30% drop in shipments. To that effect, WFG cannot provide a reasonable estimate of when entire operations will resume, and this phenomenon is expected to negatively affect production output and continue putting upward pressure on lumber prices in the short term.
On the positive side, the strong homeownership demand and rising prices incentivize mill producers to expand their production capacity and meet the elevated demand. However, until production capacity reaches the desired level to meet demand, lumber prices will remain high before entering their normalization phase into 2022.
The overall market outlook for WFG remains solid in the near term, and the bullish thesis is mainly supported by the following:
Favorable Demographics: The first-time home buying activity will remain elevated in the following years, supported by the millennials demographic, which have entered the first-time homebuyer age, and along with the work-related behavioral shifts, the trend will persist in its positive direction.
Source: ACT's Earnings Summary Presentation 3Q-2021.
Positive Sentiment: US Building permits rose to 1.71 million in November, an increase of 3.6% from last month, addressing any affordability concerns for housing and proving the resilience of the homeownership demand once again. In addition, the recent NAHB survey conducted showed that homebuilder confidence rose for the fourth consecutive month despite the supply chain constraints and labor shortages.
Justifiably early investors in the cycle may be tempted to book their profits. However, the cycle is not over yet, and there is still a long way to go with more upside potential for WFG supported by the housing undersupply in residential construction, the favorable millennial demographics, and strong homeownership demand in the following years.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.