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Morningstar | Strong Pulp Prices Should Help Ease the Pain of Low Lumber Prices for West Fraser in 2019

Lumber supply constraints and increases in U.S. homebuilding facilitated an exceptionally strong year for West Fraser in 2018. Adjusted EBITDA leaped by 33% to CAD 1.5 billion, due to robust wood product prices early in the year and the recent purchase of Gilman Forest Products. However, high prices have encouraged the introduction of additional capacity in the U.S. South. Also, U.S. homebuilding growth slowed in the fourth quarter, leading to a decline in lumber and panel prices. Although high pulp prices have offset some of the weakness, we expect meaningful margin contraction heading into 2019. Accordingly, we've reduced our fair value estimate to CAD 55 per share, down from CAD 57. Our no-moat rating is unchanged.

The fourth quarter proved challenging for West Fraser's lumber operations. More than half of its capacity is in western Canada, which faced significant cost headwinds. Not only does U.S.-bound lumber face a 24% tariff, but log prices have risen rapidly amid limited log supply. Management reported a 6% reduction in regional capacity based on these factors. Excluding tariffs, profitability fell, with adjusted EBITDA margins down to 8% from roughly 30% in early 2018. In 2019, margins should expand from fourth-quarter levels, as lumber prices gradually recover and West Fraser curtails higher-cost capacity.

In contrast, pulp and paper performance was solid through the fourth quarter. Throughout the year, NBSK pulp prices rose, reaching a high of $1,428 in the final quarter. This supported a strong 22% adjusted EBITDA margin for the year. Pricing should remain a tailwind in the near term, with Chinese demand for pulp remaining high. This is due to strict old corrugated container regulations, as OCC is a substitute for pulp. In the long run, we think lower pulp prices will lead margins lower as restrictions ease due to China's dire need for imported wood fiber.