Some may view the U.S. economy as in the midst of a "Rodney Dangerfield" recovery but perhaps the more fitting metaphor is the Energizer Bunny, given how things just keep on going and going. Throw in the U.S. dollar's 20-per-cent climb against the loonie over the past two years and we might want to own shares in Canadian companies that sell to U.S. markets. One of the better ideas, in my opinion, is B.C.-based forest-products firm West Fraser Timber Co. Ltd.
In 2014, the company collected revenues of $3.9-billion in the United States (46 per cent), Canada (29 per cent) and Asia (25 per cent). It is North America's largest and lowest-cost producer of softwood lumber (it also provides panels, newsprint and pulp). Free cash flow in 2014 was a strong $425-million and net debt was a modest 20 per cent of capitalization.
The stock has gained about 300 per cent in five years but valuation is still reasonable for an industry leader. Total enterprise value to earnings before interest and taxes and depreciation and amortization (TEV/EBITDA ratio) is only slightly above the industry average.
As the company's 2014 annual report notes, West Fraser's earnings "are sensitive to changes in world economic conditions … particularly to the U.S. housing market." That's good to see, because the latter sector is in an upswing that is expected to gather momentum over the next two years.
"The basic supply of shelter in the United States is tightening," Scotiabank economist Patricia Mohr observes. "Apartment vacancy rates at a mere 4.2 per cent in March are propelling multiple-unit building permits to an annualized 592,000 in May, the highest level since January, 1990."
Permits for single-family houses are also rising, reaching an annualized 683,000 in May. Yet, this level is only half the annual average of 1.35 million permits over the eight years to 2007, suggesting considerable room for the home-building industry to expand.
Other data are supportive, such as a 14-year low in the inventory of existing U.S. houses for sale, and the three million U.S. jobs created over the past 12 months. There is also pent-up demand in the historically high percentage of young adults living with parents – if it reverts to norm, an estimated four million new households will be created, Home Depot Inc. chief financial officer Carol Tomé says.
Prices for lumber are still not much above the lower boundary of their cycle, with Western two-by-fours cut from spruce, pine and fir selling for under $300 (U.S.) per thousand board feet. The long-term average is near $375 and the upper boundary is near $450.
A one-cent gain in the U.S. dollar against the loonie boosts West Fraser's earnings by $24-million, the company's annual report states. Since the Bank of Canada is not expected to follow the Federal Reserve's first round of rate hikes, the loonie may fall further in the future. West Fraser has $300-million in U.S.-dollar debt that nicks earnings but its U.S. assets moderate the impact.
An aggressive program of capital expenditures over the past four years plowed $1.4-billion into upgrading operations. This "will bolster West Fraser's industry-leading sawmill margins," TD Securities Inc. notes.
What are the risks? A big one for some investors is the expiry in October of the U.S.-Canada softwood lumber agreement (which recently imposed a 10-per-cent export tax on Western Canadian firms in response to low lumber prices).
It appears U.S. lumber companies want to replace the current agreement with a more restrictive one. However, West Fraser now has a hedge in place: Due to management's acquisition of a large number of U.S. sawmills in recent years, nearly 40 per cent of its lumber capacity is currently in the United States.
Moreover, when the current agreement expires, there is a one-year standstill period that rules out export taxes and other unilateral actions. As U.S. housing recovers and lumber prices improve over this interval, U.S. producers may have a harder time proving they are in distress.
Another risk is market downturns. Indeed, Canadian house construction may be close to peaking. An offset, though, is the improvement in West Fraser's share of the domestic lumber and panel market due to the strong U.S. dollar (which causes the products of its U.S. rivals to be priced higher in Canada).
Weakness in Chinese and Japanese markets is a concern, as well. Except monetary policies are now aimed at pumping up their economies with low interest rates, which tend to be supportive for housing markets.
In sum, West Fraser's shares appear to be a good way to play the U.S. housing recovery and strong U.S. dollar. But the lumber industry is cyclical, so investors should be prepared to say goodbye. My guess is in about two years.