Lumber prices have soared on production cuts at a few sawmills and increased demand from homebuilders.
This is likely to significantly boost Resolute Forest Products’ Q3 and Q4 EBITDA, giving the company cash to reduce liabilities.
Despite recent performance, Resolute remains extremely cheap on a forward “EV/EBITDA” and book-value basis.
The forest products market may be in a lasting shortage due to a decline/stagnation in production activity over the past decade.
This year has no doubt seen many strange occurrences that do not always fit into historically normal patterns. In many instances, assets that many believe would go down in a poor economic environment have skyrocketed in value. One notable event has been a growing and seemingly speculative bubble in North American lumber prices.
In general, lumber prices are very sensitive to economic conditions. A poor economy causes lumber to decline in value as construction demand slows. However, this time, lumber mills were concerned lumber prices would fall and slashed production. Even more, low mortgage rates and workers leaving cities have caused a boom in home sales and construction demand, causing demand for lumber to skyrocket. The net effect has been an extreme shortage of lumber and all-time-high prices. See below:
As you can see, lumber prices have declined quite a bit back toward historically normal levels as construction demand declines in the cool season. Still, this has allowed many mills to clear out inventory and lock in high contract prices.
For beaten down mills like Resolute Forest Products (NYSE:RFP), the ‘lumber bubble’ is a saving grace. As you can see below, the stock has risen by a staggering 230% since April due to the lumber price spike:
Clearly, 2020 has been an extremely volatile year for RFP. The company remains extremely cheap and is likely to see a much-needed spike in earnings this quarter. Its forward “EV/EBITDA” is only 3.6X, and the company has over $500M in working capital, while only trading at a market capitalization of $375M. With the outlook for its wood products business growing, it could be a solid turnaround bet. Then, again, a reversal in demand could jeopardize the company due to its relatively large pension liabilities.
A Renewed Look at RFP’s Prospects
I covered RFP last year in “Resolute Forest Products: Solid Deep-Value Turnaround Play“. The stock is up a bit since then but has been on a wild ride due to the COVID-19 pandemic and subsequent rise in lumber prices. Resolute operates in four major wood product categories, wood products, tissue, paper, and pulp. As you can see below, all four of these products offer a positive EBITDA per unit, but margins have declined for numerous products:
RFP’s wood products category is likely to see an extreme spike in Q3 and Q4 since prices have risen from nearly RFP’s AISC of $300-400/MBF to $600-900. This means its unit EBITDA for wood products is likely to rise to above $200+ this quarter. With normal quarterly shipments being around 400-500K MBF (presentation pg. 8), this could mean an $80-100M in EBITDA, far higher than its usual $10-30M in EBITDA from the product.
Of course, this is offset by a decline in demand and sales prices at RFP’s other businesses. Pulp prices have been stagnant, while paper prices have declined slightly. Still, we are seeing an overall positive environment for the forest products industry. This is an industry that has been struggling with poor demand for years and record-low margins which have caused numerous bankruptcies and plant closures. However, the net result has been a lack of suppliers which has led to price spikes as we’ve recently seen with lumber.
No doubt lumber prices will likely decline back toward the $400-600 range, but if they can stay at such levels, then it is great news for RFP. The company is in a slightly difficult spot, financially speaking, but it will only take a small but lasting increase in prices to save it. If it can be stabilized, significant returns are likely to come to investors.
A Look at RFP’s Financial Position
RFP’s most significant liability is its unfunded pension liabilities which currently total around $1.4B. The company also has $620M in long-term debt which was reduced in recent quarters. The company has a book value of $1.25B, which is far higher than its market capitalization of $375M.
Quite frankly, unless there is a significant deflationary event, I do not believe its pension liability is a major issue. RFP has very volatile income and cash flow due to its thin margins and the volatility of its sales prices, but, on average, the company generates about $100M in positive cash flow per year. See below:
Even in poor conditions, the company has had positive cash flow. Its earnings are often negative due to depreciation, but this has allowed the company to build a huge $830M deferred tax asset. Even if product prices reverse lower, the company has a very strong working capital buffer and relatively low financial debt that should allow it to persist. Still, I believe it is more likely that product prices are high due to a lack of supply.
The Bottom Line
Overall, I believe RFP remains a strong long-term deep-value opportunity. COVID-19 has created extreme volatility for the company, but the increase in demand for new homes is likely to persist as people leave major cities. Housing starts are very high, which is likely to keep lumber demand strong.
There are a few other companies one can consider in this industry. This includes BMC Stock (NASDAQ:BMCH), Louisiana-Pacific Corporation (LPX), and Universal Forest Products (UFPI). Of these, RFP is quite a bit cheaper based on most valuation metrics, but these companies are a bit more stable.
Even more stable are the vertically integrated wood products companies like Weyerhaeuser (WY), Enviva (EVA), and Rayonier (RYN). These companies are much more stable since they own timberland and pay high dividends. These are better companies for investors looking for income and less volatility.
RFP is my favorite overall since it has the most to gain from a turnaround. It is a pure-play deep-value stock in an industry that seems to be reaching stability. Of course, if the increase in home demand reverses and declines to 2008-type levels, then Resolute could be in trouble. Additionally, its paper and pulp business may remain in secular decline due to a lack of demand for newsprint and office paper. Still, the worst seems to be behind the company. If so, its stock could certainly rise 2-3X toward a more reasonable forward “EV/EBITDA” level of 7-10X.
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Disclosure: I am/we are long RFP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.