14
Jul

Sector Fundamentals – Primary Timber Products

HP BEITRAG Sektor Grundlagen - Primäre Holzprodukte

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1. Introduction to Primary Timber Products

We define primary products as wood products at the initial stage of the timber value chain. This includes logs, round wood, woodchips and lumber.

Timber REITs own timberland and sell standing timber, logs, as well as primary products such as lumber – in any case we consider them as a separate category due to their special tax status (as REITs) combined with their large timberland asset base.

In Europe and North America there are, ten companies that can be classified as primary producers. Of these, five are investable (market cap > USD 100m), have a relevant operating track record [1], and generate a significant share of revenues (> 50%) from primary products:

  • West Fraser Timber, leading in terms of production volumes, producing both primary and secondary (engineered wood) products. Founded in 1955 in Canada, has a significant presence in Europe as well as on the secondary products side.
  • Canfor, founded in 1938 in Canada, is one of the leading producers of primary products with a focus on lumber production.
  • Interfor, founded in 1963, another leading Canadian producer of primary products focused on lumber production.
  • Acadian Timber, based in Canada and focused on the initial stages of the value chain, selling logs and standing timber at auctions, and also offering timberland management services, with a business model very close to that of a Timberland REIT. It was indeed structured as a fund, established in 2006 by Brookfield Asset Management, and converted to a corporation in 2010. We classify Acadian as a Primary Producer because from a formal and legal point of view it is not a Timber REIT, but it must be clear that its nature is quite different from that of other primary producers.
  • Koskisen, a Finnish company producing lumber as well as secondary wood products, especially plywood and chipboard. The company recently held an IPO in 2022 but has a long history dating back to 1909.

The four North American players are all Canadian, while the European player is Finnish and, despite a majority of revenues from primary products, also has a very significant share of sales from secondary products. A breakdown of each company’s product mix is provided in Figure 1.

 

     

 Figure 1: Segment breakdown for the five primary products companies considered. Source: companies’ reports, Timber Finance.

Europe has other listed players in this domain such as the French Rougier SA and the Swiss Precious Woods, focused on the production of primary products in developing countries; or the Polish company Klon; their limited size (market cap below USD 100m) and liquidity (on average far below USD 100k per day) make them less suited for institutional investors looking for larger and more liquid positions/holdings.

[1] The Canadian company GreenFirst Forest Products is a primary products manufacturer, has a market capitalization of ca. USD 150m at the time of writing, but has a short operating track record and environmental metrics, used for the analysis in this report, are not publicly available. Hence, it is not included.

2. Profitability Profile

As evident from the average margins and returns on capital employed at different stages of the economic cycle, Primary Products companies are very cyclical, with the exception of Acadian Timber, characterized by a different business model based on owning and managing forests. In exchange for lower volatility in its results, Acadian generates a low return on capital employed, consistent with a REIT business model.

Figure 2: Operating Margin and Return on Capital Employed in different economic phases. Sources: Bloomberg, companies’ reports, Timber Finance.

In line with the characterization above, the cumulative earnings generated by the companies over a full cycle (from 2006 to 2022) depicted in Figure 3 show a rather stable profit generation by Acadian (except for the large loss in 2007 that was a non-cash charge reversed in 2008). Interfor, Canfor and West Fraser incurred large losses during the great financial (and real estate) crisis of 2007-2009, as demand for building materials including lumber collapsed. While West Fraser was back to (annual) profitability as early as 2010, it took Interfor until 2012 with a capital increase in 2011 aimed at reducing debt. The period 2020-2022 lead to an extraordinary acceleration in the earnings thanks to the dramatic rise in lumber prices, a rather exceptional situation historically.

Figure 3: Cumulative profit evolution based on EPS, normalised to 1.00 as of 2006.

3. Business Models

The typical business model of primary product producers like Interfor, Canfor or West Fraser consists in sourcing logs reliably and cost-efficiently, processing them in their mills and facilities, and selling the end-products (lumber). The Canadian companies source the majority of their logs for their Canadian operations from long-term tenures on Crown timberlands, while their US operations purchase logs predominantly on the open market. What complicates the life of Canadian sawmills is the way logs are priced in different provinces, as Canadian timberlands are state-owned (hence “Crown”). Pricing approaches range from fixed pricing in the New Brunswick province, which has been far below market prices, to market-linked pricing in the Alberta province that more closely follows market price volatility. These differences in the approaches can lead to lags in the price adjustment of a company’s input costs that do not reflect actual market prices. Sourcing from low-stumpage tenures can provide a competitive advantage to primary (as well as secondary) producers. As reported by the companies, Interfor has cutting rights in the provinces of British Columbia (B.C.), Ontario, Quebec and New Brunswick; West Fraser and Canfor have tenure exposure predominantly in B.C. and Alberta.

These regional pricing approaches (in certain cases interpreted as subsidies to the industry) are part of the cause for the US-Canada lumber trade dispute. Very cheap stumpage pricing systems could be adjusted in the future, which poses a risk to the margins, if companies cannot fully pass on those price increases to customers – a likely scenario in a commodity market, unless there is a move further in the value chain, increasing the share of secondary products.

4. Sustainability and Environmental Impact

Primary Products manufacturers process wood in their sawmills and generate carbon emissions through the operation of their manufacturing facilities and the logistics (downstream and upstream). They consume energy and produce carbon emissions in order for the logs and lumber to be processed further in the value chain until, at a later stage, they will be used for construction and can substitute other, more carbon-intensive, raw materials like steel and cement. The residues and by-products from their manufacturing processes, like wood chips, can be used either as a source of energy (releasing carbon back into the atmosphere) or as raw material for other wood products, the latter use being preferred from an environmental point of view – see details below.

4.1 Sustainability and Environmental Impact

Primary Products companies are confronted with the challenge of minimizing emissions while being cost-competitive in a market characterized by limited value added compared to subsequent stages in the value chain, for instance manufacturers of engineered wood products like cross-laminated-timber (CLT).

Figure 4: Emissions profile and carbon intensity of revenues. Carbon intensity includes Scope 1, 2 and biogenic emissions (reported resp. estimated). Sources: companies’ reports, Timber Finance.

 

Primary Products companies obtain significant amounts of energy from wood waste. In the chart we see how dominant biogenic emissions are with respect to the total emission mix from Scope 1 and 2. All four companies analysed have similar proportions of biogenic emissions despite varying product mixes. Canfor highlights that their biogenic emissions come from wood-waste energy as well as from the chemical reactions of their pulp business; Interfor and Koskisen, who do not produce pulp, have comparable proportions of biogenic emissions, nevertheless. It should be noted that not all companies report biogenic emissions (the numbers for Koskisen are estimates based on discontinued reporting resp. modelled from biofuel consumption; Acadian does not provide any estimate of GHG emissions and has a different business model) and are by default not included in the GHG footprint numbers. The reason for this is that biogenic emissions – in this case emissions generated from burning of biomass – are formally considered carbon neutral, since they originate from carbon that has been previously absorbed (sequestrated) by trees and is expected to be sequestrated again by newly planted, growing trees. Despite their biogenic nature, it is important to have a clear picture of total emissions, as even biogenic emissions are real emissions. It is important to note that not all biogenic emissions have the same environmental impact: biogenic emissions associated with the combustion of by-products for which there is no alternative industrial or environmental use can be considered more environmentally friendly than biogenic emissions generated from by-products which could have been used as durable stores of carbon (such as particleboard). From an environmental point of view, by-products should whenever possible be used in wood products and only subsequently as an energy source – companies should aim to decarbonize their energy consumption from other renewable energy sources.

  • Koskisen provides details of its bioenergy sourcing, noting that certain plants use 100% biomass obtained from by-products from its own production processes, while other bioenergy plants are still in the process of classifying and quantifying the sources of biomass.
  • Interfor provides details on the use of its process residuals, uses both biomass and pellets as biofuels, but information on where the biomass is sourced from is not published.
  • Canfor provides some interesting statistics: 15% of their residuals from the Wood Products division and 94% of the residuals from the Pulp division are used as bioenergy. Residues are also used internally to manufacture other products and are sold externally for a variety of purposes, from the production of pellets to fiberboards, providing some degree of circularity, at least internally and towards external customers (rather than on the external sourcing side).
  • West Fraser estimates that 7% of its raw material (logs) are transformed into biomass for energy generation. As they estimate 47% becomes lumber and veneer, ca. 13% of their process residues becomes bioenergy. Based on the aggregate numbers reported by West Fraser with respect to the redirection of waste for energy use, and using standard conversion factors, waste covers the majority of the company’s biomass energy consumption.

4.2 Carbon Balance

Another important metric to consider is the ratio between carbon emissions (including biogenic emissions) and carbon stored in the products manufactured. Let us take the numbers provided by West Fraser as a reference: the company estimates 15.8 Mt of CO2-equivalent stored in their harvested wood products. This compares to 8.8 Mt of CO2 emitted in Scopes 1 and 2 (including biogenic emissions) and 13 Mt including also Scope 3.

Figure 5: CO2 balance of West Fraser for the harvested wood products it manufactures. Sources: company reports.

There is significant variation in the balances across companies and it should be noted that there is no systematic and 100%-comparable reporting for these metrics. Nonetheless, the numbers above provide us with a reasonable intuition of the estimated carbon balance, with more CO2 stored in the products than emitted along the value chain from the sourcing of raw materials to the delivery of the products to the company’s customers [2].

[2] Additional emissions will be generated by customers who will further process primary products

5. Conclusions

Primary Products companies make it possible for carbon to be stored in durable wood products such as sawtimber that will be further processed and used in construction. Different companies have different product mixes, with some extending into the value chain and manufacturing engineered wood products, and some involved in the pulp business, which tends to have shorter lifecycles when it comes to carbon storage. Primary Products businesses (with the exception of Acadian Timber) are cyclical as they serve cyclical markets (such as the construction industry). Hence, their profitability has been and will continue to be driven by the cyclical expansion and contraction of global and regional economic cycles. The extraordinary imbalances experienced by timber markets in 2021 and 2022, which led to exceptional price swings for lumber, were reflected in exceptional profitability in the last two fiscal years, and going forward we are expecting the normalisation of profitability to historical averages. The volatility of profits and stock returns will continue to be linked with the macroeconomic cycle, influenced, among other factors, by monetary policy (interest rates). The increased interest in timber construction as a carbon-removal activity [3] and the focus, also from a regulatory [4] point of view, on the reduction of buildings’ carbon footprint, should provide additional support to the demand for primary products to be used further in the value chain. From an environmental and sustainability point of view, it is crucial for companies to minimise wood waste which is combusted for energy purposes. By-products should wherever possible be used in composite wood products and the share of renewable (non-biogenic) energy in their industrial processes should be increased.

[3] See UNFCC Concept note https://unfccc.int/sites/default/files/resource/a64-sb001-aa-a05.pdf

[4] https://www.gresb.com/nl-en/embodied-carbon-what-it-is-and-how-to-tackle-it/#

6. 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.

Please note that this research is prepared for informational purposes and targeted to institutional investors in Switzerland. They do not represent investment advice and do 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.

For more details and questions, please do not hesitate to get in touch with us at info@timberfinance.ch or:

Timber Finance

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General disclaimer © 2023 Timber Finance Management AG (“Timber Finance”). All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of Timber Finance. Timber Finance Management AG makes no representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and Timber Finance Management AG and its third-party licensors shall have no liability for any errors, omissions, or interruptions of any index or the data included therein. All data and information is provided by Timber Finance “as is”. Past performance is not an indication or guarantee of future results. This document does not constitute an offer of any services. It is not possible to invest directly in an index. Exposure to an asset class represented by an index may be available through investable instruments offered by third parties that are based on that index.

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