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Morningstar | Canfor Faces Significant Log Price Headwinds; Reducing FVE To CAD 18.50 On Structurally Higher Costs. See Updated Analyst Note from 02 May 2019

Although wood product conditions improved sequentially in the first quarter, pricing and input costs were a significant challenge for Canfor. Concurrently, stronger lumber margins offset weaker pulp segment results. Consolidated EBITDA margins rose versus the fourth quarter to roughly 5%. We expect them to improve gradually over the course of the year as seasonal issues pass and benchmark prices rise. Following the sustained surge in British Columbia log prices, we've reduced our EBITDA margin assumptions for Canfor's lumber segment to reflect higher input costs over the long term. Accordingly, our fair value estimate falls to CAD 18.50 per share from CAD 20. Our no-moat rating is unchanged.

Lumber segment adjusted EBITDA margins ticked higher to just over 7% in the first quarter, due to both the acquisition of Vida and slightly higher North American lumber prices versus the fourth quarter. Although Vida has only been on the books for one month, the business appears to be running near capacity, which should help bolster results while British Columbia remains a drag due to significant log cost inflation. In light of that log cost inflation, we've reduced our margin assumptions for Canfor's capacity in Western Canada, given that the log shortages are being caused by a long-term reduction in harvestable timber.

However, we still expect margins to rise over the next five years, driven by rising demand as opposed to supply shortfalls. As younger adults in the U.S. continue to form new households, we expect that additional construction will be required, generating a meaningful increase in lumber demand. This should spur prices and margins higher.

We have mixed feelings about the purchase of Vida. One positive aspect of the deal is that housing demand is mostly driven by local circumstances. Exposure to Northern Europe should reduce the severe volatility associated with cash flows for this business. However, the acquisition also exposes Canfor investors to additional currency risk, even if underlying trends are stable.

We expect Vida's operating rates to remain between 90% and 95% of its nameplate 1.1 billion board feet capacity. Looking back to the 1960s, Swedish timber prices appear to have been fairly stable through time after adjusting for inflation in local currency. With current prices not far from long-term norms, we leave them fairly flat in our forecast. We do not assume any significant currency movements between the Swedish krona and Canadian dollar.