By Stefano Charrey, 6 October 2023
1. Executive Summary
The Timber Finance Carbon & Storage Index was flat (-0.5%) in the first nine months of 2023, correcting -9.2% in Q3 as the European construction sector, and the economy overall, continued to struggle. Macroeconomic numbers for the US continue to be mixed, but the spike in long-term interest rates in Europe, the US and other major economies, increases the headwinds for sectors such as real estate and homebuilding.
2. Macro Overview
The overall macro picture for the construction sector in Western economies continues to be very challenging, as the ECB and the Swedish Riksbank continued to raise, while the Fed, SNB and the BoE decided to take a break as they start to recognise greater downside risks to the growth outlook. European economies are struggling, and this is reflected in most macroeconomic numbers, from construction to industrial production and services. German construction orders picked up recently, but building permits remain weak, down -20% YoY. In Sweden, a key market for timber construction, building activity literally collapsed (see Figure 1), down -72% YoY based on the most recent numbers on dwelling starts, and the outlook remains weak, with residential permits down -28% YoY. Industrial wood production is also in decline, down -10% YoY. France’s residential permits are down -24%YoY and construction activity in the UK has contracted significantly as well. The overall picture remains weak until we see a reversal in monetary policy. Supportive fiscal measures (e.g., incentives) are currently hard to justify as higher interest rates and slowing economies bite into governments’ budgets.
Figure 1: Swedish construction activity. Source: Statistics Sweden
In the US we saw a slowdown in construction activity in the last months, with multi-family starts correcting sharply and single-family stable after a small rebound in the previous quarter. On the positive side, permits remain stable and the single-family inventory for sale remains near the lows of the last over 20 years. Nevertheless, the continued increase in long-term interest rates, while not immediately affecting current homeowners, acts as a significant deterrent against new purchases. As said above, US macro numbers remain mixed and, in some cases, still show remarkable resilience, highlighting a better shape for the US economy than for its European counterparts.
3. Timber Stocks
As mentioned already last quarter, the impact of these macro headwinds on cyclical stocks, including timber stocks, is significant and we see this reflected not only in stock prices but also in the underlying company results. In contrast to 1H23, 3Q23 was characterised by a better average performance of our European companies vs. the North American ones, reverting the previous period’s dynamics: the Timber Finance Carbon & Storage Index was down -9.2% in Q3, driven by the North American portfolio, which contributed -8.9% while the European portfolio contributed negative -0.3%. The worst performers were the stocks with the most exposure to the construction value chain, while the best performers were the Nordic integrated and diversified forest products companies, characterised by large forest assets and product portfolio covering pulp, paper & packaging as well as durable wood products.
Among the worst performers were the Canadian lumber manufacturers, as a group, with strong declines in revenues due to the lower lumber prices. Canfor at the end of July reported 1H revenues down -35% and a net loss for the period, with peers Interfor and West Fraser reporting similar results and highlighting weak pulp & paper market conditions, while their European engineered wood products businesses were the best performing segments, despite weak residential demand. It is worth noting that while the European economy is in worse shape, the European subsidiaries of these North American companies are doing (slightly) better than at home. At the time of writing, Canfor’s stock is down -56% from its peak in 2021; as a comparison, it was down -68% at the bottom in 2009 relative to the pre financial crisis peak in 2007; it is currently trading at ca. 0.6 times tangible book value, in line with 2009 levels. While this numbers alone are no reason for bullishness, they show that the market is already pricing a very significant degree of pessimism.
The best performing stocks in the quarter were the Nordic integrated and diversified forest products companies, namely UPM, Holmen, Stora Enso and Svenska Cellulosa. UPM-Kymmene, the period’s best performer, reported 1H23 revenues in line with the previous year’s period. More importantly, although margins fell, the company provided a relatively optimistic outlook, expecting a normalisation of the recent destocking trends from its customers, and suggesting that the current market conditions may represent a cyclical low, at least in some of the company’s businesses, like pulp. Svenska Cellulosa reported a decline in 1H sales of -14% and a decrease in EBIT of -43%, but still managed to generate a substantial profit. De-stocking trends for kraftliner support the hypothesis of market normalisation, while pulp inventories (despite UPM’s optimism) remain high. Stora Enso disappointed the market in July and its overall outlook for the market was rather pessimistic. The stock collapsed on the day it reported results, but still managed to rise in the following weeks and deliver a solid positive return for the quarter. This is probably a sign of the significant pessimism that was already priced in by the market, after a -50% drawdown from the peak in 2022. Stora Enso later also announced the departure of its CEO, Annica Bresky, replaced by board member Hans Sohlström.
As we are going through the tough part of the economic cycle, companies need to focus on cost controls and managing capacity in an optimal way. The best case in the medium term appears to be a normalisation of building activity at relatively low levels. The pulp and paper business that some companies are exposed to, also still needs to find its equilibrium. On the positive side, this natural, cyclical rebalancing, should prepare the companies for the next growth phase, as the housing inventory ages and the replacement rate, with such depressed construction activity, increases, all-else-equal, the future need for construction and renovation.
4. Disclosures and Conflicts of Interest
Some or all the companies mentioned in this report may be included in the Timber Finance Forest-Based Construction Basket tracker and are part of the Timber Finance Carbon Capture & Storage Index. Timber Finance Management and/or the Timber Finance Initiative may have commercial relationships or be in discussions with some of the companies mentioned in this report. Specifically, Stora Enso is a member of the Timber Finance Initiative association.
Please note that this research is prepared for information purposes and targeted to institutional investors in Switzerland. It does not represent investment advice and does not take into consideration the individual requirements, risk tolerance and goals of an investor. Recipients who are not Swiss institutional investors should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents.
The information presented in this report is obtained from several different public sources that we consider to be reliable. Nevertheless, we cannot guarantee the accuracy of the presented information. The information used may change quickly and we are not committed or obliged to modify the reports base on new information. The opinions and views expressed in this report reflect those of the author at the point in time of its compilation and may vary at any time. Valuation methods like DCF and any other analysis or expert judgement do not provide any guarantee that the target price or fair value will be reached, for example because of unforeseen changes in financial or economic conditions.
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