2 best forest products stocks to buy

Research analyst Daryl Swetlishoff argues that recent weakness in lumber demand was due to seasonal rather than structural problems. He says West Fraser Timber and Interfor Corp. are his ‘best buy’ picks among forest products companies. Cash flow should beef up at large-caps such as the former first, but smaller companies like the latter offer more upside.

Best_Forest_Product_StocksVancouver-based analyst Daryl Swetlishoff of Raymond James Financial is calling for a reality check on the outlook for forest products, making the case that prices will head upward in the coming quarters. Recalling the early summer rally in lumber prices, Mr. Swetlishoff says: “In retrospect, the early summer rally was overdone, setting the stage for the dramatic equal-but-opposite sell-off over the summer, which we view as similarly overdone.”

The analyst concedes that the industry has been revising its earnings guidance downward. He says, however, that: “History shows building materials companies’ shares exhibit a much tighter correlation to spot commodity pricing. We contend investors willing to pick amongst the wreckage for bargains will be rewarded over the next six-to-12 months.”

Rising interest rates, higher real estate prices (and lower affordability accordingly), and slowing existing home sales in the US housing market are among the top factors feeding into concerns about lumber demand. By way of rebuttal, Mr. Swetlishoff highlights a recent report by fellow Raymond James analyst Buck Horne examining the top 25 US housing markets. Mr. Horne found that although housing affordability was down compared to summer levels, it remains in the normal range for a healthy housing market. A year-over-year increase in US median household income levels (up 5.6 per cent in July 2018) helped to drive the trend.

Mr. Swetlishoff adds: “Compared to the national average of 4.3 months of inventory, the top 25 markets are much tighter with only three months of supply. While we tend to agree that some data points, especially in West Coast markets, warrant close monitoring, the larger mosaic still indicates a strong fundamental backdrop for modest single-family housing start growth roughly in the five per cent year-over-year range.”

Problems were seasonal—not structural

The analyst argues that recent weakness in lumber demand was due to seasonal rather than structural problems. “Obviously hurricanes Florence and Michael had a major negative impact on US home building during September and October 2018. Also, September proved to be a very wet month in the key market of Texas, which we expect contributed to the drop in US South housing activity, down 13.7 per cent month-over-month.”

Nevertheless, US single-family home construction starts only made up about a fifth of North American lumber demand last year, Mr. Swetlishoff stresses. “The retail market is reportedly robust and, at about 30 per cent of demand, is a material factor. With strong economic activity, industrial markets, roughly 20 per cent of North American demand, are also reportedly firm. On balance, we continue to see about 2 billion board feet of incremental North American growth in lumber demand, or four per cent, in line with the annual consumption increases since the Great Recession.”

Finally, the seasonal trends suggest that lumber prices typically peak in March and hit their lowest point in October, so investors may still have time to dig in during November. “Note, while prices are trading at higher average levels, the 2018 March-to-October pattern mimics the prior 10-year average although pricing is down 34 per cent this year versus the 10-year average of 13 per cent,” says the analyst.

2 best forest products stocks to buy

He names West Fraser Timber Co. Ltd. (TSX—WFT) and Interfor Corp. (TSX—IFP) as his ‘best buy’ picks among forest products companies. Cash flow should beef up at large-cap names such as the former first, but smaller companies like the latter offer more upside, the analyst says.

West Fraser Timber has actually ranked among Mr. Swetlishoff’s favourites since the end of April. The analyst explains: “The stock traded down following 2018 first-quarter results.

“West Fraser is now trading near the same level as July 2017, despite adding 200 million board-feet per month of high-margin US South capacity, buying back $600 million of outstanding shares, and raising the dividend twice.” Based on Raymond James’ “conservative” estimate of US$465 per thousand board feet benchmark SPF lumber pricing for 2018, Mr. Swetlishoff calculates WFT is trading at less than five times 2018 EV/EBITDA (enterprise value-to-earnings before interest, taxes, depreciation and amortization).

“We note that Canadian SPF (spruces, pines and firs) lumber pricing has averaged about US$520 per thousand board feet year-to-date and would have to average US$450 for the balance of the year, US$100 lower than the current spot price, to hit our forecast. We urge investors to add to positions,” he says.

The analyst added Interfor to his favourites based on his bullish view of the lumber market generally, which supports strong earnings and free cash flow growth.

“With no change in our long-term outlook, this (stock’s recent pullback) represents an opportunity for investors to take advantage of an attractive entry point.”

This is an edited version of an article that was originally published for subscribers in the November 23, 2018, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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