TLDR; West Fraser Timber is slightly overvalued with a negative margin of safety. They are very attractive in the moment, but it is because of a spike in lumber prices, and over the long term, these results are not expected.
West Fraser Timber (WFG) is a Canadian lumber company that produces different wood/wood related products. They have lumber mills in North America and Europe. They have the largest market cap, the most revenue, and the most earning in the industry. They also produce the largest volume of sawn wood in the world, making them the largest lumber company in the North America, if not, the world.
One of the major owners of WFG is the Canadian billionaire, Jim Pattison. In response to speculation that Pattison intends to merge WFG with Canfor (another lumber company), WFG has adopted a shareholder rights plan. WFG has recently experienced significant volatilities relating to its principal product, lumber, which may be tainting some ratios and figure to appear much more attractive than what is to be expected long term.
Founded in 1955 by three brothers, the company has had a history of calculated growth and acquisitions. By 1960 they had $550,000 in sales, and in 1963 they made their first acquisition. By 1970 sales were $24.2 million, and by 1975 they are $48 million, driven by acquisitions. They went public in 1986. In 1994, they made the decision to preserve the largest intact costal rainforest in the world (which was 7 times the size of Redwood National Park), an early decision towards promoting environmental stewardship. By 1995, sales were $1.5 billion, and in 2007 they became the largest lumber producer in North America. The current CEO was appointed in 2019.
In the three years after his appointment, revenues have averaged twice the revenues of the preceding decade, a fact that will have to be examined more thoroughly as it correlates to commodity prices. In lieu of having contacts with company analysts, insiders, and historians, we can correlate financial trends with management commentary to gauge performance, results attained, and rationality.
We can see a clear drop in 2009 on the income statement, which is obviously attributable to the financial crisis. It would be interesting to hear the company narrative on this event. On page 4 of the 2008 annual report, the CEO gets straight to the point, but emphasizes that the underlying business is strong, as seen on the balance sheet. Before we get into what the CEO had to say in defence of WFC, we should take a look at the company values and see if they align with his strategy. They are:
• cost control in all aspects of the business
• efficient, modern mills
• responsibility and leadership in environmental performance
• the active involvement of employees in the business
• a relentless pursuit of excellence in everything we do
His response to naysayers in the crisis:
“Over the years West Fraser has followed a business strategy which, we believe, allows us to prosper in the good times while always being prepared for the bad times. This strategy can be summarized as follows. First, we continually invest in our plants and equipment to ensure a low-cost operating structure. Second, we operate with a lean, flat and flexible management structure. Third, we have an incredibly talented and dedicated team of employees who live, breathe, and promote our frugal cost control environment in good times and bad. And fourth, we try to maintain a solid and conservative balance sheet.”
It does seem that the company lived up to its values in extreme crisis. He goes on about the business strategy moving forward, and about the negative impacts of the crisis. He assures readers of commitments the company has made to employees, the environment, and shareholders. The company rebounded within the next year, living up to what he told shareholders, including the companies first priority, cost control as evident in the decreased number of employees following a 2007 peak.
The current financial position of the company is attributable to a temporary increase in lumber prices. The CEO does not recognize this in his 2021 letter to shareholders, attributing the financial performance to their employees in a year where lumber prices were temporarily spectacular. Without performing technical analysis on lumber prices, it is clear that there is an average price for the good that is much lower than the prices experienced in 2021. Consumers will only pay so much for a product in a highly competitive industry. This also coincides with a hot housing market.
The long-term prospects of the company are not reflected by its short-term history. We will factor that into any valuations we do. There is a high variance for many of their long-term financial ratios, so let’s look at averages since 1995, and compare them to the current values:
| Field | 2022 Value | 28 year average |
|---|---|---|
| Return on Equity | 25.01% | 11.64% |
| Return on Invested Capital | 23.46% | 9.21% |
| Return on Assets | 19.33% | 5.03% |
| Inventory Turnover | 4.61 | 4.38 |
| Net Profit Margin | 20.36% | 6.55% |
| Debt to Equity | 0.10 | 0.40 |
| Price to Book | 0.78 | 1.34 |
| Price to Free Cash Flow | 2.93 | 59.79 |
Wouldn’t it be nice if things were the other way around? The company is solid in the long term, but you would not expect Phillip Fischer to recommend it to you. Maybe 20 years ago, but it is so large now that it dominates a competitive industry, achieved through aggressive acquisitions. The current results are not indicative of what has historically been achieved and are not a result of exceptional employees or managerial decisions, but they do provide a unique opportunity to strengthen the company position. There are opportunities for growth equal to the growth of demand for lumber, but also pegged to the price of lumber. Because of frequent acquisitions, the average sales growth of the company is not indicative of long-term growth expectations for a mature commodities company. Long term growth of such a company could eventually end up being the rate of new housing starts plus some price index rate, such as inflation or average increase in lumber prices.
In the following section, a DCF is calculated. But there is a major assumption made: that the financial results after 2020 are not indicative of future growth. Because of the extremely favorable current financial position, a positive adjustment for the next two years is made, but after that, the average growth rate is assumed.
If we assume that the growth in Canadian housing starts in indicative of the growth in demand for lumber, we arrive at 2.264% each year. We should then look at the price of softwood lumber, apart from 2020 and onwards. Over a 30-year period, I found that the average annual price appreciation of lumber is 0.381%. If the company did nothing but cut down trees and sell them at market prices, it would grow at an estimated 2.645%. However, we know that WFC has a propensity to acquire businesses, so to credit their own ability to expand, we can look at their net income growth over the past 25 years, excluding the price spike following 2020. We arrive at 4.184% CAGR. Management has not announced any big plans to grow the company more than they already do, so this is a reasonable value to use to project long term growth. The premium the company brings would be found by subtracting our base growth for the lumber industry, which is 4.184%-2.264% = 1.92%.
For the DCF take a starting free cash flow of $590 million (arrived at by looking at the average OCF/interest expense from 2017-2020), a premium growth rate in the next two years of 8%, and then a continuing growth rate of 1.92%, discounted with an estimated RFR of 4.17% and we arrive at the following intrinsic value (10 yr DCF) of $5.850 billion. The margin of safety is negative. A last ditch measure to see if there is any value is to look at the value of its land assets.
PP&E in 2021 is $4.1 billion, up over 100% from 2020. The fair value assessed for their land is $2.088 billion. Most of the land they operate on is actual granted crown land, but WFC would have control over about $34 billion in timber if all trees on all of its managed crown land were fully grown. But the land is not owned by them, so it is not considered an asset, and less than 5% of their managed crown land is ready to be cut down, so there are not hidden assets so to speak of.
Based on the research above, the conclusion is that West Fraser Timber is not a value play.
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