Conifex Timber Inc

TSX:CFF

Earnings Call Transcript

[Operator]

Good morning, ladies and gentlemen. Welcome to the Q1 2018 Conifex Timber Results Conference Call. I would now like to turn the meeting over to Mr. Ken Shields, CEO. Please go ahead, Mr. Shields.

[Kenneth A. Shields, Chairman, CEO & President]

Well, thank you, Atlanta, and good morning, everyone. And welcome to our call. We plan to do 3 things this morning: quickly recap our Q1 results; number two, review the key terms of the sawmill purchase transaction we have under way; and number three, outline why we believe the transaction strengthens Conifex and makes us more attractive to investors. You will have already noted that the 2 main features of the sawmill purchase transaction are number one, we triple our dimension lumber manufacturing capacity in the high-margin U.S. South supply region; and number two, Blue Wolf becomes an important shareholder in our company. CFO, Yuri Lewis, is here with me in Vancouver; Executive VP, Hans Thur, is on the line from Arkansas; while Charlie Miller, the Blue Wolf partner responsible for the mills we will acquire, is also on the line with us. Following my prepared remarks, we will be all available to answer questions. We will be making forward-looking statements and references to non-IFRS measures and, therefore, call your attention to the disclaimer on Slide 3. Yesterday afternoon, we reported Q1 net income of $2.5 million or $0.10 per share. Although this represents a significant decline from earnings of $0.30 in Q4, it also represents a significant improvement from the $0.06 per share loss we reported in Q1 of last year. These results bring our trailing 12-month earnings to $0.79 per share and EBITDA to just under $50 million. Turning to our lumber segment. Q1 EBITDA of $7.3 million was down about 50% from the previous quarter but up 40% from the year-earlier quarter. In common with all other producers in the interior region of BC, our Q1 results were unfavorably impacted by 4 factors. Number one, severe weather conditions. It meant that our lumber production of 124 million board feet was 6% below the level we had targeted, and it also meant that unit cash conversion costs were higher than we had anticipated. Number two, shortages in railcar availability, which meant that we only shipped 91% of the lower lumber production we achieved. Number three, increased log costs. And these, of course, reflect the heightened bidding competition for purchased wood in the interior of BC and higher market rate stumpage on our tenured wood. And number four, of course, higher export duties. We expensed $6.3 million in duties in Q1 versus $1.9 million in Q4 of last year and 0 duties in Q1 of '17.We also incurred hedging losses of $2.3 million in the quarter. At our assumed tax rate of 27%, this after-tax loss was equivalent to $1.6 million or $0.06 per Conifex share. We purposefully locked in prices on a portion of our planned 2018 SPF 2x4 production. We wanted to establish a healthy base level of cash flow generation even if SPF lumber prices softened. These hedging initiatives provide us additional certainty that we will cover increased debt service obligations on the new credit facilities we plan to draw down to fund the purchase of the 2 mills. Beginning April 1, our results from El Dorado will be included in our income statement. Southern Yellow Pine shipments from El Dorado were at an approximate 70 million board feet annual run rate in March, which is equivalent to roughly 40% of the 2-shift lumber capacity at that site of 180 million board feet annually. In April, hourly production showed further improvement, and we also added to the number of operating hours scheduled at the site. In Q2, we expect shipments from El Dorado to be established at a run rate equivalent to approximately 60% of capacity utilization. Our analysis indicates that El Dorado is EBITDA positive at an approximate 50% to 55% operating rate while it is net income positive at an approximate 65% operating rate. Turning to our power business. Q1 EBITDA of $3.6 million represented a 20% sequential decline from the record results we've reported last quarter, but it was a 28% improvement over Q1 of last year. The higher year-over-year results reflect the progress we've made operating this plant under extreme winter weather conditions. The lower sequential results reflects the impact of 2 short, unplanned maintenance outages that we experienced following 150 days of continuous operation at the plant. We expect, and have for some time and continue to expect, that our bioenergy segment EBITDA will be higher in 2018 than in 2017. One other area that I'd like to discuss about our BC mills is that based on our review of our recent production rates, we determined that it was necessary to increase our stated production capacity from 525 million board feet annually to 540 million board feet. This increase reflects productivity gains from capital projects we completed over the past 12 months at our Mackenzie facility, partly offset by some more conservative expectations about future production that we've adopted for our Fort St. James location. We also need to caution you against annualizing our Q1 results to serve as a guide for our full year results. Our analysis indicates that the pattern of quarterly results we compiled last year, where only 13% of the full year EBITDA was achieved in Q1 that, that pattern will likely be repeated this year. At our BC mills, EBITDA is highly sensitive to production and shipment volumes. For 2018 as a whole, we expect that our lumber production and shipments will exceed 2017 volumes by about 15 million board feet. We also expect a growing cash flow contribution from El Dorado as we continue our ramp-up through the remaining 3 quarters of the year. We have no quarrel whatsoever with consensus estimates calling for Conifex as presently constituted to achieve approximately $70 million in EBITDA in 2018. Our analysis indicates that we should be able to meet this consensus EBITDA estimate so long as the U.S. dollar trades at something like a 25% or 26% premium to the Canadian dollar, and so long as benchmark SPF lumber prices average $460 per thousand board feet for the year. I think we're all aware that current cash prices are -- for the benchmark are $630, which is roughly $170 per thousand board feet higher than the consensus estimate. And I think that the last time I looked at the lumber futures contracts that are maturing in the mid-July 2018 to May 2019 period, the average contract price was $550, which is $90 higher than the consensus of $460 price. But in any event, that summarizes our comments on Canada. And I want to now turn to the announcement of the acquisition of the Suwannee and Caddo River Mills from the Blue Wolf group that we announced yesterday. First of all, though, it's very important for me to mention how much every person at Conifex respects Charlie Miller and the entire Blue Wolf team for their accomplishments since they entered the U.S. South lumber business in 2013. It's been a complete success story. The mills' employees, suppliers and customers have benefited. Two forests dependent U.S. South communities have been revitalized, and Blue Wolf's investors have compiled excellent returns. Those of us at Conifex who have been able to spend time with Charlie and the Blue Wolf team over the past few months have immense regard for them, both as individuals and as business people. Blue Wolf will be granted rights to nominate 2 individuals to Conifex's Board of Directors. One nominee will be Mr. Charles Miller, the principal of Blue Wolf, who oversaw the purchase, modernization, ramp-up and subsequent EBITDA growth under way at the 2 sawmill complexes. And the other nominee will be an individual who's currently on the board of Suwannee Lumber, a Mr. George Judd, and he has served as the CEO of PrimeSource Building Products and BlueLinx Corporation, which is a very large North American distributor of building products. All of us look forward to welcoming the Glenwood, Arkansas and Cross City, Florida employees to Conifex and providing them opportunities to sustain and advance their careers. Having access to their experience and local expertise was an important factor behind our decision to add the mills to our portfolio. We look forward to all of us working together to help make Conifex an even more successful company. Slide 2 of the presentation outlines what we hope to cover in the next 15 minutes or less. And Slides 4 and 5 summarizes the key features of the transaction. As a result of the transaction, our Southern Yellow Pine 2-shift dimension lumber capacity increases 200% from 180 million board feet to 550 million board feet annually. Our total lumber production increases roughly 50% from 720 million board feet to just under 1.1 billion board feet annually. But what's important to us as well is that 50% of our lumber capacity will now be located in the high-margin U.S. South supply region. To the best of our knowledge, Conifex will be the only public lumber company with a majority of its capacity in the attractive supply region. Those of you who have listened to our recent calls already know that we are convinced that the U.S. South supply region will continue to be a more profitable lumber supply region then the interior region of BC. Slide 6, which sets out the location and capacity of our expanded portfolio of mills, illustrates that a majority of our production is now sourced from the U.S. South. Compared to the interior of BC, benchmark lumber selling prices are typically higher in the U.S. South, log costs are lower, and accordingly, EBITDA margins are wider. This is why we believe our return on shareholder investment should increase as the number of mills we operate in the U.S. South increase. Slide 7 sets out key information about the mills and product mix. The Suwannee Mill located in Cross City Florida and the Caddo Mill in Glenwood, Arkansas are each capable of producing approximately 185 million board feet of dimension Southern Yellow Pine lumber on an annual basis assuming 2-shift operations. We believe the mills have every essential ingredient that's necessary for superior cash flow generation. First of all, the saw timber requirements at both mills are available at affordable prices from fiber baskets we know; two, the converting equipment of both sawmills has recently been modernized and upgraded, which means that cash conversion costs and lumber recovery factors are both competitive; three, each mill has the equipment and the operating experience necessary to produce significant proportions of narrow-width lumber products, and we expect the narrow-width products will continue to enjoy a premium mill net selling price realization; four, both mills have contracts in place to deliver sawmill residuals to a cross section of local customers at full market price; and last, both mills are ideally located to serve growing markets. As the most southerly located mill in Florida, Suwannee Lumber has natural transportation advantages serving South Florida. Caddo River has the benefit of a 1-day truck delivery cycle time to 3 cities in Texas, namely, Houston, Dallas and Austin. And those 3 cities, in the aggregate, account for about 10% of all the single-family housing permits issued in the U.S. About 60% of the output from the Suwannee Mill is comprised of decking products, which are sold under contract at premium prices to lumber traders with whom the mill has deep, long-standing relationships, many enduring for a 30-plus year period. The balance of the Suwannee output is kiln-dried Southern Yellow Pine dimension lumber. The product mix at Caddo is approximately 80% Southern Yellow Pine dimension and 20% decking. We were impressed with the potential for Suwannee Lumber when a group of us at Conifex first visited the site in 2009. We weren't able to purchase a complex back then because our finances and other resources were fully committed to completing the purchase of the Mackenzie sawmill complex, which was under way at that time. We were also impressed with the potential for the Caddo River Mill when we first visited the site in the spring of 2016. And of course, back then, we were unable to pursue it because we were already committed to the modernization and restart of El Dorado. But my key point that I wish to share with you this morning is that Conifex was well aware of the potential for strong EBITDA generation from these 2 mills a long time before we entered into discussions with Blue Wolf last fall. And now that we've completed our comprehensive due diligence investigations of both mills, we're completely satisfied that the capital upgrades at both sites were well designed and efficiently executed. Slide 7 summarizes the recent capital projects and supports our opinion that the complexes resemble new mills in many respects. Over the past 12 months, both mills completed significant upgrades that utilize proven technology capable of delivering fully competitive lumber recovery product mix and conversion cost performance. These recently modernized and upgraded mills have modest future requirements for maintenance of business, capital expenditures; and consequently, the cash flow the mills generate is available for debt repayment or for reinvestment to further our growth objectives. Slide 9 sets out the purchase price and our financing plans. As you can see there, the consideration that's being paid for the acquisition consists of $150 million plus net working capital and cash, USD 50 million through the issuance of approximately 9 million in Conifex shares to Blue Wolf at an issue price of CAD 6.50 and 3.5 million warrants to Blue Wolf that will be exercisable for 5 years at a spread price of $8.78. In effect, we are acquiring the mills on a debt-free, cash-free basis for USD 200 million and the issue of 3.5 million warrants. Net working capital and transaction costs will be funded out of existing Conifex liquidity. The incremental debt we require will be supplied from credit facilities provided by a U.S. bank with existing lending relationships with the Blue Wolf mills. The bank has committed to fully underwrite a senior secured credit facility in an aggregate amount of up to USD 220 million. This provides us the funding we require to retire our existing lumber and corporate segment debt, to fund the acquisition of the Blue Wolf mills and to support our working capital requirements. The term loan matures in 5 years and, under present market conditions, the interest rate of -- on the loan is approximately 6%. We're also considering some supplemental financing to raise approximately USD 50 million through various potential alternatives, including equity, debt, convertible instruments, et cetera. I'm sure some of you on this call this morning view issuing new shares at a price below our estimate of fundamental value as being dilutive to existing Conifex shareholders. Let me tell you that the issue of shares to Blue Wolf was used to expand and strengthen our business. And as a result, and based on our expectations and targets, we believe that the transaction will be immediately accretive on an earnings per share basis. Looking at the targets for the acquired mills, our targets are to achieve production and shipments from Suwannee at a 90% capacity utilization rate in 2019; to add an additional shift at Caddo River at mid-year 2018, immediately following the installation and commencement of operation of the second dry kiln; and to achieve production and shipments from Caddo at a 90% capacity utilization rate in 2019. Of all the slides in the package we distributed, Slide 10 is perhaps the most important because it illustrates what the base level of EBITDA generation at the acquired mills was in 2017. And it sets out how we see EBITDA being shaped over the next 2 years. So starting with the 2017 base. This essentially represents the contribution from Suwannee in 2017. Caddo River commenced this testing and start-up phase in Q3 of 2017, and it turned cash positive in the final quarter of 2017. But if you look at the base, you have to bear in mind that Suwannee completed a major rebuild of its large log line in 2017, and that rebuild was under way right when Hurricane Irma hit. So it took a bit longer. So looking at the Slide 10, we've included an estimate of something like $7 million as a benefit from the Suwannee upgrade. This is our estimate as to what the benefits are from the improvements to the large log line and the avoidance of the downtime that was taken in 2017. And you'll also see that we've added something like $5 million of potential EBITDA, and this is simply if we use Q1 of 2018 price realizations rather than 2017 price realizations that it will impact Suwannee's results favorably by about $5 million a year. Then the other 2 contributors to a stronger EBITDA are the commencement of 1-shift operation at Caddo River. So what we've shown under 1 shift is the Q1 2018 annualized EBITDA from a 1-shift operation. And what we're showing for the 2-shift operation is that in 2019, if it operates on 2 shifts, that we should have an incremental $13 million or so of EBITDA. So that -- thanks for bearing with us as we go through that Slide 10. As a check of the reasonableness of the future earnings power illustrated on this slide, the most recent available information indicates that the 2 mills achieved EBITDA of approximately USD 110 per thousand board feet in Q1 of 2018. The target we've set out on Slide 10 indicates that at 90% capacity utilization, the mills would be producing approximately $130 per thousand board feet in 2019 based on 90% operating rates. The benefits from a second shift operation at Caddo River are significant and would logically support an expansion in EBITDA margins. So in summary, we believe that this illustration accurately depicts the future earning power of the acquired mills based on current Q1 pricing and all the information at our disposal. Extending that, it means that the USD 200 million cash purchase price translates into a multiple of less than 5x the 2019 EBITDA that we've targeted of approximately $45 million. Earlier on this call, we mentioned that we've got no quarrel with analyst estimates calling for us to achieve around $70 million in EBITDA this year from our existing business. And as just mentioned, we're currently targeting additional EBITDA approaching USD 45 million from the acquired mills. And on a combined basis, this would permit a rapid reduction in net debt at Conifex. There's really 4 factors that give us confidence in our ability to forecast a rapid debt paydown. The first and most important factor is that we're purchasing Caddo and Suwannee at what we believe are very affordable multiples of EBITDA. The second important factor is that we're going to finance the acquisition with an appropriate mix of debt and equity, and we'll be completely satisfied that any new debt we can take on will be comfortably serviced from the cash flow from the acquired mills and our existing mills. Third, we have modest near-term requirements to fund maintenance-type capital expenditures to sustain operational reliability. And lastly, our cash flow is not significantly impacted by the need to fund cash income tax payments. We've got significant tax shield as a result of the heavy expenditures we incurred on U.S. mill modernizations and upgrades over the past 2 years. And simply put, our analysis indicates that we will be retiring the acquisition debt at a pretax, not after tax, cash flow. Against this background, we believe that we will achieve very conservative financial leverage ratios about 18 months from the closing of the acquisition. Slide 12 summarizes the strategic benefits of the transaction and the expectations that we have for value creation in our company. Simply put, the acquisition creates a company with much more scope and scale and just over 1 billion board feet of production capability. It creates a public company with the majority of its production and EBITDA sourced from the most attractive softwood lumber supply region in the world. It also, in our view, is a preferred alternative to the other option, which is to pursue greenfield construction. We greatly prefer an acquisition over greenfield construction at this time. We observed that the heightened competition under way to develop new sawmill sites in the U.S. South is such that there's considerable uncertainty as to when new facilities could come onstream. There's a lot of uncertainty about what construction and start-up costs will be incurred, and there's also considerable uncertainty over the level of the EBITDA generated from a new facility. We don't know what lumber market conditions will be like when these mills eventually come onstream. So simply put, we think that acquiring mills, with their certainty of near-term and immediate cash flow, is a better alternative for us to grow our business. We like the product and market diversification the mills provide us. We like the leverage it provides us to build on our lumber marketing and logistics services. We believe the purchase price is entirely affordable. It's going to be immediately accretive to earnings per share, and it will create a company with greater visibility, a higher stock market capitalization and the potential for improved trading liquidity. So in summary, those are the reasons the Conifex board concluded that the combination of the Conifex and Blue Wolf businesses results in greater and more certain long-term shareholder value creation than any other alternative that was available to us. Summing up, we view this combination with the Suwannee and Caddo River Mills as a unique growth opportunity, both in terms of its size and diversification and one that extends logically from our entry into the U.S. South in 2015. Through the modernization and restart of our El Dorado, Arkansas mill, we've gained first-hand knowledge of the significant potential that exists there. The Suwannee and Caddo Mills are a great fit with El Dorado, and we believe they will help propel our development into a high-performing U.S. South lumber producer. Thank you all for your attention. We're pleased to respond to any questions you may have. So we'll turn the meeting back over to the operator.

[Operator]

[Operator Instructions] The first question is from Hamir Patel with CIBC Capital Markets.

[Hamir Patel]

Ken, could you maybe give us some color as to how the transaction came together? Were there other bidders involved? And any comments you might have on where you think these mills are positioned on the cost curve in the U.S. South?

[Kenneth A. Shields, Chairman, CEO & President]

Well, the transaction came about, evolved from a relationship that developed between myself and Charlie Miller as we were doing a home and home series, namely, he and his colleagues were invited to come and tour our facility at El Dorado. And that afternoon, I went and toured his facility. So Charlie, why don't we turn it over to you to explain the background of the transaction.

[Charles P. Miller, Partner]

Sure, Ken. So it really developed out of the mutual respect between Conifex and what they had set out to build and what we at Blue Wolf set out to build. We had very similar philosophies about how to treat people and how to run the business, and it really just came from that. And after the meeting, after seeing El Dorado and then hosting Ken and George, their lead director for -- at Caddo, we sat down in a room and I said, "Look, I think that it makes a lot of sense to put these together." The one negative about private equity is that we're a limited duration vehicle. And we always wanted to find a solution that provided a long-term owner for the business that had -- that shared our culture and philosophy. And so it really just came out of that. And we're thrilled to be part of this, and we're -- we look forward to being a contributor to Conifex going forward.

[Hamir Patel]

Charlie, that's helpful. So Ken, I get the theory of -- maybe place these this asset relative to a typical sawmill in the south? Where do you think these assets stack up? They've had some capital projects recently. What else do you have planned in terms of investments at both mills over the next 2 years? And what should we think about incremental CapEx in 2018 and 2019?

[Kenneth A. Shields, Chairman, CEO & President]

Okay. Well, Hamir, first of all, the transaction does not close until July 1. And secondly, there's something like -- there's always a budget for the routine maintenance of business, the capital and buying mobile equipment as it comes off-lease and so on. But we think that the Suwannee complex, the log decks, the log processing, the primary breakdown, the secondary breakdown, the trim sort and stack line, the kilns and the planer with automated grading are all very good. We have a crane system in El Dorado that may make sense for Suwannee down the road. But there's no urgency to do anything there. At Caddo River, we like the log handling and debarking works very well. Breakdown units are well known to us. There's one brand-new continuous kiln that's operational at full capacity today and another one that's about to start up. Down the road, we could spend a bit of money to put in a new planer complex. And of course, with the ramped-up production, we're going to need more covered storage for finished lumber and the rough dry lumber before it goes into the planer. But we will be liaising with the leadership team at Caddo and probably reflect on the merits of spending money on a new planer complex as we settle our 2019 budget and business plan.

[Operator]

[Operator Instructions] The next question is from Paul Quinn with RBC Capital Markets.

[Paul C. Quinn, Analyst]

I guess I'll start with the log supply. Maybe you can discuss the log supply for the acquired mills, who the main suppliers are and what those wood baskets look like?

[Kenneth A. Shields, Chairman, CEO & President]

Okay. I will start on that. First of all, we have commissioned an independent study of the fiber supply availability in South Arkansas and Northern Louisiana. And Paul, we looked at an area of 20 million acres, which is exactly the same size as the Prince George timber supply area here in BC. And you'll probably recall that in the Prince George timber supply area, that the harvest level has been set at 8.3 million cubic meters for 5 years, which is roughly 10 million short green tons a year, and then it's going down to 7.3 million cubic meters, which is probably 8.5 million tons a year. In South Arkansas and North Louisiana, in the footprint equal to Prince George, there is a saw timber undercut of 6.5 million tons per year. So there's tons of very affordable fiber that's available. Both Caddo River and El Dorado have plenty of gatewood purchase opportunities. Now that the logging stands are dryer, and there's instances where we have to put our independent suppliers on quota and to limit ourselves from being swamped. We've not experienced any price inflation in log costs. The fiber basket in the Suwannee River area, it's generally a sandier soil conditions. It's got a product mix that's heavier towards flash time, which has a different notch structure than the conventional -- than most of the dimension lumber pine in the southern U.S., and that is what gives us the premium rate outturn, and that is what accounts for our ability to have 60% decking production. So when you're looking at that North Florida region, and we are generally to the south and west of the Gilman mills purchased by West Fraser, you will note that the log costs are a bit higher than they are in South Arkansas. But the quality is also higher and, in many respects, the EBITDA margins from the more expensive log in that region of Florida -- the EBITDA margins in that part of Florida are often higher than they are in many parts of the U.S. that have a cheaper log than is processed in Florida. The suppliers are -- the list of timber REITs that you publish us on regularly, it's the Who's Who down there, Weyerhaeuser and PotlatchDeltic, are big suppliers. The [ T ] mills are big suppliers. We have a very large number of log suppliers. And we've got tremendous visibility as to the future availability of an affordable log supply.

[Paul C. Quinn, Analyst]

Okay. And then, I guess, taking a look at your Slide 10 here, doing that bridge to 2019, what's the CapEx required to make the bridge?

[Kenneth A. Shields, Chairman, CEO & President]

We haven't put in anything. Yuri, could you refresh me? I think that the Blue Wolf mills CapEx this year was in the range of USD 12.5 million?

[Yuri Lewis, CFO & Corporate Secretary]

Both of them together.

[Kenneth A. Shields, Chairman, CEO & President]

Yes, together. And at June 30, $8.5 million will have been spent. So what these projections assume is that the $4 million is spent in the back half of 2018, Paul. And there's no material capital other than just bare minimum sustaining capital in our model for 2019, and that's the basis of the EBITDA components set out on Slide 10.

[Paul C. Quinn, Analyst]

Okay. And then just -- maybe just over to the operational performance of your El Dorado Mill. Sorry, I got on late. Just wondering where we're at with the second shift?

[Kenneth A. Shields, Chairman, CEO & President]

The second shift has been operational since April. And I mentioned, Paul, that we expect to have shipments equal to roughly 60% of capacity in Q2. So it's 180 million board foot mill, and we're running at 120 million board foot annual rate at present.

[Operator]

There are no further questions registered at this time. I would like to turn the meeting back over to Mr. Shields.

[Kenneth A. Shields, Chairman, CEO & President]

Okay. Well, thank you for bearing with us as we provided a fairly comprehensive review of the mills that we are acquiring. We're delighted to have the Blue Wolf people as an important shareholder in our company. We're delighted to have achieved this broadening and expansion and diversification of our business. Thank you all for your interest in Conifex, and enjoy the rest of the day.

[Operator]

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.