Why the timber business is surprisingly strong right now

Pine beetles and U.S. housing have made forest products a bright spot among commodities

 
Worker checking on stacks of two-by-fours

(West Fraser Timber)

Looking for a ray of hope in Canada’s beaten-down commodity industries? Take a gander at forest company stocks. This sector has been almost counter-cyclical to the much larger energy and mining sectors for more than a decade. Over most of that period, producers alternated losses with profits, their capital allocation was suspect and share prices barely budged. But thanks to low expectations, a tree-killing infestation and a growing U.S. housing market, this sector is finally rewarding shareholders.

Since Oct. 7, 2011—the sector’s lowest point in 13 years—the S&P/TSX Paper and Forest Products Index has jumped 218%. Some of the industry’s biggest names, such as West Fraser Timber (TSX: WFT), are up 15% to 20% over the past 12 months. Michael Underhill, chief investment officer at Capital Innovations and manager of the Sprott Timber Fund, says he thinks they’re just getting started.

One reason is the increasing demand from the U.S. housing rebound. There was a huge inventory of vacant homes following the 2008 crash, which slowed the recovery. However, housing starts crossed the million mark in 2014, and they still have a way to go to reach their pre-recession level of 1.5 million. With U.S. fixed mortgage rates about a percentage point below where they were a year ago, Underhill thinks the market will pick up further. “Everything’s looking better, from single-family starts to multi-family starts. Household formation is the highest it’s been in the last five years,” he says.

It’s not just about the U.S. anymore, either. During the crash years, forest companies turned to China, where wood-frame construction is beginning to catch on. Today, exports to China add the equivalent of 300,000 housing starts a year to demand in North America, says Stephen Atkinson, an analyst with Dundee Capital Markets.

While demand is growing, supply is constrained. The mountain pine beetle has destroyed more than half the commercially viable pine in the interior of B.C., the top producing province; while the worst is over, a generation of trees has been lost. The blight also affected Washington, Oregon, Idaho and Colorado.

All of this bodes well for earnings. In contrast to oil’s oversupply, the timber shortage should help support lumber prices for years to come. Today’s price of about US$300 per thousand board feet is actually lower than it was a year ago, but Underhill thinks it could hit US$600.

Since the recession, companies have also improved their balance sheets. Many are generating free cash flow and making smarter capital allocation decisions, says Benoit Gervais, a portfolio manager on the Mackenzie Resource Team. It’s still a volatile business, so you want to buy stocks of companies that have modest debt loads and use their capital wisely. Firms weighted to B.C., for example, have bought mills and timberlands in the southern U.S. and eastern Canada in order to keep their volumes from shrinking. The South has the lowest harvesting costs on the continent, adds Atkinson.

Even though the U.S. rebound is in full swing, investors haven’t priced in the full recovery yet, says Underhill. Many aren’t thinking about the longer-term demand drivers. Buy now, be patient through the inevitable price swings, and you should be rewarded, he says.

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