West Fraser Timber Co. Ltd. (WFG, Financial) is a major producer of wood products and other forest-based materials. Over the last decade, the company experienced solid growth in revenue and profitability, driven by strong demand for lumber and wood products, especially in the construction and housing sectors. The company also benefited from its operational efficiency, cost management and strategic acquisitions that expanded its product portfolio and geographical reach - actions that should continue to pay off in the long term.
A history of financial growth
It currently generates more than $880,000 in sales per employee, which translated into $9.7 billion in total revenue last year, up from $4.4 billion in 2018 and $3.2 billion in 2013. On the bottom line, West Fraser has done even better, growing net income from $328 million in 2013 to over $1.9 billion in 2022. More importantly, total equity has climbed from $1.8 billion to over $7.6 billion with every dollar of retained earnings producing around 75 cents in market value. Not ideal, but that is where the opportunity for investors lies right now. At its peak in February 2022, the rate was closer to $2 for every $1 retained.
Lumber is lucrative
West Fraser has displayed a robust profit margin of 20.36%, showing the company's ability to generate strong earnings while controlling costs. Additionally, the operating margin stands at 26.93%, reflecting the resiliency of the company's core operations. The high operating margin suggests that West Fraser is effectively managing its operating expenses and generating healthy profits. The return on assets of 16.01% signifies that West Fraser's management is effectively utilizing the company's assets to generate approximately $16 in earnings for every $100 of assets. The sector median is around 5%. Also, the company's return on equity sits above 25%, highlighting its ability to provide significant returns to its shareholders.
The company has a healthy balance sheet, with total cash (most recent quarter) of $1.16 billion and total cash per share at $13.91. The company's total debt sits at a manageable $536 million, especially if West Fraser can continue to produce nearly $2 billion a year in net profit. However, with quarterly revenue declining 20.70% year over year, the fluctuations in lumber prices, global economic conditions and investment costs will likely push the margins down as well.
Challenging 2023, recovery 2024
West Fraser Timber faces a challenging outlook as operating conditions deteriorate. Lumber shipments in 2023 are anticipated to decline from the previous year's levels, with easing transportation issues likely to counterbalance the relatively weak demand for home construction materials. These seem like short-term worries only.
Shipments from Canadian properties are expected to range from 2.6 billion to 2.8 billion board feet, while volumes from holdings in the U.S. South will likely be between 2.9 billion and 3.1 billion board feet. The total North American Engineered Wood Products units are likely to see volumes of 5.9 billion to 6.2 billion square feet. Elevated costs are likely to further impact margins. The entire industry faces challenges such as labor and raw material shortages - including resins and chemicals, intense competition for logs and high stumpage fees.
This period of difficulty for West Fraser coincides with expected increased spending. The company has allocated north of $600 million for its capital budget. These factors indicate that the earnings per share decline will be significant this year, rebound sharply in the near future and grow long term. The price of lumber is just a short-term benefit (or hinderance) to growth as 92% of homes built are wood-framed. That is not changing anytime soon.
Macro environment
In 2022, U.S. home sales had a significant slowdown due to increasing mortgage rates. By summer 2022, the average 30-year fixed mortgage rate had risen by approximately 300 basis points compared to the previous year, reaching over 6%. This surge, according to the National Association of Home Builders, led to more than 16 million households being priced out of the market. Higher rates and uncertainty deterred plenty of qualified potential buyers.
Roll the ball forward a little bit and, as a result, both new and existing home sales witnessed a sharp decline, with year-over-year decreases of 17% and 18%. As the current spring selling season moves on, homebuyer optimism, as indicated by Fannie Mae's Home Purchase Sentiment Index, remains near the lowest point since the index's inception in 2010. In fact, purchase mortgage application volume is now 30% lower than 2019 levels. Morningstar predicts a 22% year-over-year decline in housing starts with a total of 1.22 million units versus 1.275 million units previously expected.
Not great for the short term, but maybe they are wrong. What's likely to happen is that homeowners will use this time to update and renovate their homes. Long term, we will need more homes built across North America. That puts West Fraser in a great position to capitalize on increasing demand. The company is closely tied to the North American market, which accounts for roughly 85% of sales - 70% in U.S. and 15% in Canada.
Conclusion
The company owns or manages over 20 million acres of timberlands and sells for $2,000 an acre on the low end. Lumber accounts for over 45% of West Fraser’s revenue. In the long term, it will likely navigate through these short-term challenging conditions, focusing on cost management and strategic planning as it has in the past.
Additionally, it is not an easy business to get into. West Fraser was founded in 1955 and has seen a lot of transformation during the last 68 years. Today, the company is known for its commitment to sustainable forestry practices and responsible stewardship of its resources. This commitment was reflected in its operations, which included reforestation efforts, conservation of wildlife habitats and support for the certification of sustainably managed forests. While doing this, it is also able to produce reasonably high profitability. With the stock down 27% since last summer, the bad news may be already priced in.
