West Fraser Faces a Challenging Year Ahead as Lumber Prices and Demand Remain Muted

Equity Analyst

Spencer Liberman

West Fraser is one of the largest softwood lumber and oriented strand board, or OSB, producers in the world, with significant production capacity in Canada, southeastern United States, and Europe. New construction and remodeling are the main uses of softwood lumber and OSB products in North America. West Fraser is closely tied to the North American market as it accounts for roughly 85% of sales (70% in U.S. and 15% in Canada). As price-takers, West Fraser and its peers see dramatic profit variations depending on the health of housing markets and overall economic conditions. 

West Fraser’s lumber segment accounts for roughly 45% of revenue and sells a variety of construction and specialty grade dimension lumber. West Fraser mainly sells Western Spruce, Pine, Fern, or SPF, and Southern Yellow Pine, or SYP, lumber. The firm sells almost all its SYP in the U.S. while exporting a portion of its SPF. In recent years, West Fraser has purchased lumber capacity in the southeastern U.S., amplifying its exposure to U.S. housing and diminishing its reliance on western Canadian mills, which have struggled with timber availability as a result of a reduction in the Allowable Annual Cut, or AAC, in British Columbia. Availability of Canadian timber has also been affected by the mountain pine beetle and severe wildfires. 

West Fraser’s acquisition of Norbord Inc in 2021 significantly expanded its portfolio of engineered wood products (plywood, particleboard, medium-density fiberboard, and laminated veneer lumber) and made the firm the largest producer of oriented strand board. Engineered wood products in North America and Europe account for roughly 40% of West Fraser’s revenue with orientated strand board representing a majority of EWP sales. The firm’s pulp and paper segment mainly sells pulp that is used to manufacture tissue and kraft paper while also producing newsprint paper. West Fraser produces pulp at mills in Canada but exports a majority of its production. This has led to volatile earnings for the segment due to rising transportation costs and supply chain congestion in recent years.

Business Strategy & Outlook

We do not think West Fraser benefits from an economic moat, despite being one of the largest producers of wood products in North America. While the firm’s commodity businesses, lumber and pulp, can be immensely profitable when demand is strong, margins crumble during times of weak demand as West Fraser’s operations possess no structural competitive advantages. Fundamentally, lumber is a commodity. Building a moat in a commodity business typically necessitates a low-cost production position or a transportation cost advantage—something West Fraser, along with its North American peers, fundamentally lacks. Unlike some of its competitors, West Fraser does not own its timberland. Instead, the firm leases timberland from local governments and private landowners with predefined agreements to harvest a certain number of trees each year. While these contracts are long-term in nature, we do not think it warrants an economic moat as the firm is not able to exert pricing power from these contracts. 

West Fraser’s lumber segment, which accounted for roughly 45% of 2023 consolidated revenue, produces dimensional lumber products in the United States, Canada, and Europe. With fairly homogeneous capital assets used to produce lumber and unconstrained access to good timber, the lumber business does not lend itself to any form of competitive advantage. During times of strong economic conditions and housing booms, producers face stretched operating capacities and are awash in cash as higher lumber prices drive margin expansion. Soon after, producers begin to add kilns and planers to existing mills to meet heightened demand. This capacity expansion can typically be operational in three to nine months, which then gives way to lower operating rates and substantial losses when lumber prices recede. It is also common practice in the lumber industry to idle mills during an economic trough and then restart the mill during times of stronger demand. When demand is strong, industry capacity is quickly increased, and intense competition constrains returns. West Fraser’s lack of competitive advantages limits its ability to earn returns above its cost of capital over a prolonged period of time. 

While some producers of commoditized products can benefit from a cost advantage that supports an economic moat, we don’t think that West Fraser and its North American competitors experience similar advantages. West Fraser operates 34 lumber mills that are spread out across Canada, southeastern United States, and Europe. Lumber companies tend to operate with a handful of sawmills because mills need to be close to where the timber is harvested. Timber is mainly transported to the mills via trucks, which can only transport the lumber roughly 200 miles before it becomes unprofitable. Since its production is spread across over 30 mills that each have their own fixed cost structures, West Fraser is prevented from capitalizing on any operating leverage advantage. Some commodity producers derive an economic moat due to the low value/weight ratio of their product. It can be unprofitable to transport those products over long distances, so local players have a strong competitive advantage over distant competitors. Once the timber is cut into standard size lumber, its value/weight ratio is much higher than raw timber and it can be compactly loaded for transportation. This allows the lumber to be transported via truck or rail depending on the distance to its destination. This negates a transportation cost advantage the company might be able to generate from the locations of its timberlands because competitors have access to low-cost shipping to customers via railroads. 

It's important to note that timber is a renewable resource that is replanted after harvesting to ensure a consistent supply. Growing time depends on a variety of factors including species, growing conditions, water availability, and so on. Southern Yellow Pine can grow for 20-40 years before its ready to harvest while Spruce, Pine, Fir can take up to 70 years. While this may seem like a significant amount of time, the trees are grown and harvested on lots that are on a stringent schedule in order to produce a consistent supply of timber. West Fraser and its competitors all have access to a somewhat endless commodity at similar costs that are harvested in the same locations. This forces West Fraser and its peers to act mainly as price-takers since they all produce identical wood products using comparable processes with no structural advantages. There is also very little room for differentiation in the lumber industry, as most wood products are cut into industry standard shapes and sizes (that is, 2x4 and 4x4). 

Following its acquisition of Norbord in 2021, West Fraser expanded its wood products portfolio and is now the largest producer of oriented strand board. West Fraser mainly produces OSB, plywood, MDF, LVL, and particleboard in North America but operates a few mills in Europe as well. Engineered wood products, specifically OSB, are mainly used in new construction and repair and remodel projects. In traditional single and multi-family housing, OSB is used as wall sheathing and roof cover. OSB sheathing typically covers the frame of the structure and provides significant strength. Since OSB is unfinished, it typically is covered by roof shingles and exterior siding. OSB is manufactured by dicing low-quality softwood timber into thin strands, adding resin and stacking them 8-10 inches high, and then adding heated pressure to create a strong wood composite. 

West Fraser’s engineered wood products are manufactured using standard processes that usually involve applying adhesives to uniform feedstock under pressure and heat. While these products are less commoditized than 2x4s and other dimensional lumber products, engineered wood products are not proprietary to West Fraser. Many competitors produce a variety of engineered wood products using similar processes. This is because the processes are relativity simple, and competitors have ample access identical feedstock. Like the firm’s lumber business, engineered wood products can be immensely profitable during times of strong market demand and tight industry supply. The excess cash generated during these times quickly leads to brownfield or greenfield expansion, which increases supply and lowers prices. Lower prices tighten margins and inhibit West Fraser’s ability to earn returns above its cost of capital for a prolonged period. 

West Fraser’s pulp and paper segment mainly manufactures northern bleached softwood kraft pulp, or NBSK, bleached chemi-thermo mechanical pulp, or BCTMP, and newsprint paper. NBSK is typically used in tissue paper and kraft paper while BCTMP is a main input in a variety of paper products. Pulp products typically use feedstock that is a byproduct of lumber production, so forest product companies often operate a pulp business. Pulp shipments have remained steady over the years while prices have been volatile due to oversupply and logistics challenges. This business operates with low barriers to entry and intense competition from other forest product companies. Since forest product companies have significant access to wood fiber, most participate in the pulp and paper markets as the barrier to entry is very low. Wood fiber can easily be broken down using a standard mechanical or chemical process. The low barriers to entry and intense competition from other forest product companies prevents this business from substantially out earning its cost of capital. 

Unlike the firm's mostly profitable lumber and EWP segments, the pulp and paper business has posted an operating loss in each of the last five years. While rising materials costs have pressured profitability, increased freight costs and vessel delays have had the most significant impact. West Fraser produces its pulp in Canada but exports a majority of its products. This distribution model makes it difficult for the segment to consistently out earn its cost of capital, especially in an environment with rapidly rising freight costs. We expect the segment will return to profitability in a few years, but do not think it will earn similar returns to the firm’s lumber business once freight costs normalize. That said, the pulp and paper business is not large enough to represent a material impact on our opinion of West Fraser.

None

Economic Moat

West Fraser Timber Co. Ltd.

West Fraser Timber Co. Ltd. is a diversified wood products company, which engages in producing lumber, engineered wood products (oriented strand board, laminated veneer lumber, medium density fiberboard, plywood, and particleboard), pulp, newsprint, wood chips, other residuals and renewable energy. Its products are used in home construction, repair and remodeling, industrial applications, papers, tissue, and box materials. The firm operates through the following segments: Lumber, North America Engineered Wood Products, Pulp & Paper, Europe Engineered Wood Products, and Corporate. The company was founded by Henry Holman Ketcham Jr, Samuel Kendall Ketcham, and William Peters Ketcham on January 28, 1955 and is headquartered in Vancouver, Canada.

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West Fraser Timber Co. Ltd. engages in the production of lumber and engineered wood products. It operates through the following business segments: Lumber, North America Engineered Wood Products (NA EWP), Pulp and Paper, Europe Engineered Wood Products (Europe EWP), and Corporate and Other. The Lumber segment refers to the manufacturing, selling, marketing, and distributing lumber. The NA EWP segment includes North American OSB, plywood, MDF, and LVL operations. The Pulp and Paper segment is involved in the production of pulp and paper mill. The Europe EWP segment operates the U.K. and Belgium OSB, MDF, and particleboard. The Corporate and Other segment relates to other wood products and related activities. The company was founded by Henry Holman Jr Ketcham, Samuel Kendall Ketcham, and William Peters Ketcham on January 28, 1955 and is headquartered in Vancouver, Canada.

The average of price targets set by Wall Street analysts indicates a potential upside of 25.1% in West Fraser Timber Co. (WFG). While the effectiveness of this highly sought-after metric is questionable, the positive trend in earnings estimate revisions might translate into an upside in the stock.

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VANCOUVER, BC , Feb. 27, 2024 /PRNewswire/ - West Fraser Timber Co. Ltd. ("West Fraser" or the "Company") (TSX and NYSE: WFG) announced today that the Toronto Stock Exchange ("TSX") has accepted West Fraser's notice to renew its normal course issuer bid ("NCIB").

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West Fraser Timber Co. Ltd. (WFG) Q4 2023 Earnings Call Transcript

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VANCOUVER, BC , Jan. 22, 2024 /PRNewswire/ - West Fraser Timber Co. Ltd. ("West Fraser" or the "Company") (TSX and NYSE: WFG) announced today that it will permanently close its sawmill in Fraser Lake, British Columbia, following an orderly wind-down.

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West Fraser Timber Co. Ltd. (NYSE:WFG ) Q3 2023 Earnings Conference Call October 26, 2023 11:30 AM ET Company Participants Ray Ferris – President and Chief Executive Officer Sean McLaren – Chief Operating Officer Chris Virostek – Chief Financial Officer Conference Call Participants Hamir Patel – CIBC Sean Steuart – TD Securities Paul Quinn – RBC Capital Markets Ketan Mamtora – BMO Capital Markets Operator Good afternoon, ladies and gentlemen, and welcome to West Fraser's Q3 2023 Results Conference Call.

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