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Morningstar | West Fraser's Earnings Wane as Wood Product Prices Fall Back to Earth; Lowering FVE to CAD 57

Following a fairly rapid decline in lumber and panel prices from their summer peaks, West Fraser's diluted earnings per share declined by 34% from the second quarter, to CAD 2.99. However, this was largely expected, given that second-quarter product prices were at record highs. We've slightly reduced our near-term estimates for production in 2018, as it's taking slightly longer than we expected to offload existing finished goods inventory. The company also deployed CAD 300 million in share repurchases during the quarter at an average price of nearly CAD 86, which we view as value-dilutive. Having updated our model to reflect these changes, we've trimmed West Fraser's fair value estimate to CAD 57 from CAD 59. Our no-moat rating is unchanged.

West Fraser's third quarter remained solid operationally. In its lumber segment, adjusted EBITDA margins declined to 28%, from 34% during the second quarter, but above the 22% margin generated a year ago. The sequential decline was driven by a 15% decrease in dimensional lumber prices. The company's rebuilt Opelika sawmill was brought on line in August and should lift production capacity by 100 million board-feet over the coming years. This represents the company's ongoing pivot to the U.S. South, as Canadian timber availability continues to decline. We think this is the right strategic move, given the abundance of timber in the South. West Fraser also benefits from avoiding the risk of tariffs on exports into the U.S. from Canada. However, we've lowered our dimensional lumber composite price forecast to $470/thousand board-feet from $500/mbf to reflect the faster-than-expected plunge in prices after the second quarter.

We were somewhat disappointed to see West Fraser pile in on share repurchases during such frothy conditions. Shares were trading at nearly double the levels seen as recently as 2016, on some of the highest lumber, panel, and pulp prices in more than a decade. While we acknowledge that timing is challenging, the size (CAD 300 million) of the repurchase in this especially cyclical industry strikes us as hard to justify.

In its panel business, top-line sales dropped roughly 15% versus the second quarter, driven by lower selling prices across the industry. Given that those higher prices were supporting especially strong profitability, segment adjusted EBITDA margins declined to 20% from 28%. We've slightly trimmed our outlook for the remainder of 2018. Over the long run, we expect middling prices as supply remains unconstrained even as demand gradually improves with increased U.S. homebuilding.

Pricing remains exceptionally strong in pulp, which has been spurred by restrictive Chinese policy on old corrugated container imports. Over the long run, we think supply will increase in response to today's attractive profit margins. In addition, Chinese manufacturers are starting to show an interest in increasing containerboard production in the U.S., likely before exporting the finished product to China to skirt fiber controls.