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Morningstar | Canfor Shifts to a Buy-Versus-Build Strategy; Maintaining FVE Despite Modest Overpayment

Over the past week, Canfor announced a capacity curtailment, the purchase of Elliott Sawmilling in South Carolina, and the major purchase of Vida Group in Sweden. Although we believe these decisions are slightly value-destructive, the impact is modest and our fair value estimate is unchanged at CAD 23.50 per share. Our no-moat rating also remains intact.

In our view, Canfor's purchases of both Elliott Sawmilling and Vida are marginally value-destructive for current shareholders. Elliott was purchased for $110 million and will expand production capacity in the U.S. South by 210 million board feet. Canfor plans to purchase 49% of the business when the deal closes in the first half of 2019, and the remaining 51% one year later. Based on our existing expectations for regional profitability, we believe the deal destroys roughly CAD 43 million in value. The Vida deal similarly seems value-dilutive by about CAD 42 million, on a purchase price of CAD 580 million for 70% of the business. We assume synergies will be immaterial, and we primarily see the purchase of Vida as an effort to reduce earnings and cash flow volatility for Canfor.

This is certainly a pivot for Canfor, given its prior intentions to pursue a greenfield strategy in the U.S. South. We've reduced our confidence in a greenfield project coming on line in the next few years, given the higher debt levels associated with these purchases. This will likely consume incremental cash in the near term. We are skeptical about this course of action, given that building out its own capacity wouldn't have exposed Canfor to purchase premiums.

Our valuation for the Elliott acquisition depends on our estimate of roughly $25.6 million in trailing 12-month EBITDA, and Canfor's weighted average cost of capital of 9.5%. We assume changes in profitability year to year will mimic our expectations for Canfor's mill network over the coming decade. We apply the same 6.5 times enterprise value/EBITDA multiple to estimate the terminal value of the assets in 2027. With lumber prices coming off record highs over the past 12 months, we think the stated 4.3 times EV/TTM EBITDA purchase price is deceivingly cheap. In aggregate, we think the assets are worth CAD 43 million less than the price paid, based on our assumptions above.

The purchase of Vida comes with a significantly higher degree of uncertainty, but still strikes us as slightly expensive versus the underlying cash flows we forecast. Canfor is purchasing 70% of the business for CAD 580 million by the end of the first quarter of 2019, with the option to purchase the remainder in 2029. Business operations will remain under the control of the prior owners for the foreseeable future. The business is composed of roughly 1.1 billion board feet of lumber capacity in Sweden, mixed with additional revenue streams in the form of manufactured housing and energy generation, among others. The purchase price is 5.7 times EV/EBITDA based on estimated 2018 EBITDA of CAD 145 million.

The challenge in estimating the value of the Vida purchase is low visibility into regional lumber prices and, accordingly, whether today's margins are historically high or low. Management did not disclose much in the way of long-term historical financials for the business, but articulated that pricing is more stable than in North America. We estimate EBITDA growth of just under 2% annually, with one mild recession and recovery over the next 10 years. We apply the same purchase price multiple of 5.7 times EV/EBITDA to estimate the terminal value of the business, with few regional comparisons to draw to this purchase. When all is said and done, we believe the underlying value of Vida's cash flows falls about CAD 42 million short of the purchase price.

One qualitative benefit of the deal is that a roughly 15% revenue exposure to Europe will likely smooth earnings and cash flow volatility to some extent. Wood product demand is highly regional in nature, despite some global shipping volumes. This has long paired Canfor's fate to that of the U.S. housing market. A potential benefit to having a more diverse business mix, is that you have more flexibility to deploy resources when valuations may be especially attractive, during a downturn for example.