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Morningstar | Peaking Lumber, Panel Prices Double West Fraser's EBITDA to CAD 532 Million in 2Q

West Fraser Timber posted extremely strong second-quarter results, as wood product prices continued a nearly yearlong rise across North America. Lumber prices have increased more than 40% over the past 12 months, and oriented strand board prices are up 35% over the same period. Despite an uptick in Canadian input costs, a large share of the price increase has padded West Fraser's bottom line. Transportation bottlenecks have kept pricing elevated for longer than we originally expected, so we've raised our fair value estimate to CAD 79 per share from CAD 77 to account for higher near-term profitability. Our no-moat rating is unchanged.

However, there are signs that the supply constraints that occurred over the trailing nine months are beginning to ease, as West Fraser has recently seen shipments return to normal levels. By our estimates, North America has enough wood product capacity available for production. As transportation bottlenecks ease, pricing should fall in the near term. We've already begun to see signs of this, as weekly lumber prices have started to soften. Going into 2019, we expect a nearly 10% decline in lumber and panel prices, despite increasing product demand.

As we transition to 2020, we see room for a return to lumber prices of $500 per thousand board feet and above. We expect this level to stay in place for a number of years as U.S. demographics support increased homebuilding activity, which makes up the bulk of lumber demand. Even the recent spate of new mill construction in the U.S. South won't be enough to keep demand from exhausting available capacity. As we approach 2025, we expect today's economic profits to subside, given a fairly flat production cost curve at midcycle levels of demand.

Pricing benefits aside, West Fraser operated well in its lumber and panel businesses during the second quarter. Lumber segment adjusted EBITDA margins rose to a record 34% during the quarter. Margins were boosted by a combination of efficiency at the company's newly acquired Gilman mills and increased exposure to U.S. South log costs, which were flat to down. We've nudged estimated operating rates higher for 2018, as SPF production appears to be back in full swing earlier than we had anticipated. We've also lifted our dimensional lumber price forecast to $500/mbf for the year, with peak prices having reached higher-than-expected levels this summer. Additionally, panel segment adjusted EBITDA doubled from the year prior, as operations remained solid and costs rose more slowly than price.

West Fraser's pulp segment benefited from higher pulp prices versus the prior year, driving adjusted segment EBITDA to $68 million, up from $42 million. The firm did run into operational issues at its Hinton northern bleached softwood kraft mill, which affected production and led to a slight margin contraction versus the first quarter. Management guided to a negative outlook for the segment, suggesting that increased pulp supply will probably keep a lid on prices. This lines up with our outlook, as we see both prices and margins coming under pressure in the coming years.

For more on our U.S. housing thesis and its impact on lumber companies, see our December 2017 Observer, "Lumber Companies Poised to Profit as Millennials Form Households."