Interfor Corporation

Thanks very much, operator and good morning everyone. Thanks for joining us.

I'm here as usual with Marty Juravsky, our CFO and Bart Bender, Senior Vice President, Sales and Marketing, to go over Interfor's second quarter's results and our outlook for the balance of the year. I am going to keep my remarks brief and will turn the session over to you for questions as soon as I can.

To the extent that you have already seen the results of most of others in our sector, there won't be any surprises with our results, which were well below levels we consider acceptable. And the result primarily of product pricing that continues to languish at levels we haven't seen for a few years.

Much of the blame for poor price levels can be placed on lower-than-expected takeaway levels associated with adverse weather conditions for much of North America and a number of other factors that have impacted the pace of new housing starts, as well as the slower than ideal supply response, which taken together, has created an overhang on the market as slowing the pace of lumber exports in North America has compounded the situation. Viewed on a quarter-over-quarter basis, prices remain commodity benchmark throughout between six 6% and 10% in the second quarter with the Western Species showing both the largest drop and the highest level of volatility.

After taking account of order file lags in the [lake], our sales average per quarter on a pre-duty basis was $603 per thousand board feet in the second quarter, down $10 or 2% from the first quarter. Total duties' expense in the quarter amounted to $7.8 million or CAD10.8 million, bringing the total to-date to $76.5 million.

During the second quarter, we also dealt with the ongoing impact of high log costs in B.C. Interior that have come about as a result of timber shortages and a disconnect between lumber prices and the formula for determining stumpage rates in the region.

In fairness, log costs in the interior were lower in the second quarter than they were in the first quarter, but they remained very high relative to log costs in competing regions, and disproportionately higher relative to lumber sales values. There are a couple of other significant items that had an impact on our results in the second quarter that are worthy of note.

First, there was $10.3 million inventory write down in the second quarter, triggered by the drop in market prices during the quarter. Significantly almost 90% of the write downs were incurred by our B.C.

Operations. This expense reported in the second quarter compared for the recovery of $4.1 million in the first quarter of the year.

And I think as most of you know, inventory adjustments of that nature were reported in production costs. We also received compensation during the quarter of $7.7 million in the B.C.

government as a settlement for the cancellation of two timber licenses on the B.C. coast in 2017.

Of this amount, $6.6 million is reported in pretax income, but it is not reported in our adjusted EBITDA. Taken together, Interfor reported a net loss of $11.2 million in the second quarter of 2019 compared to a loss of $15.3 million in the first quarter of the year.

EBITDA in the quarter was $12.6 million versus $16.3 million in the first quarter. Production in the quarter was $647 million board feet effectively the same as the prior quarter with our U.S.

operations accounting for 71% of our total volume, made up of the Northwest at 22% and the South at 49%. Capacity utilization was flat quarter-over-quarter at 83%, made up of 45% on the B.C.

coast, which continues to be impacted by log supply issues, 81% in the B.C. Interior, which reflects a combination of market curtailments and some other factors, 87% in the Pacific Northwest and 91% in the US.

South, which reflects a series of projects related curtailments ahead of our Phase 1 projects. Shipments during the quarter amounted to 674 million board feet, up almost 9% versus the prior quarter.

During the second quarter, Interfor generated $9.9 million of cash from operations before changes in working capital and $32.2 million after changes in working capital considered. Capital investments totaled $65 million in the second quarter, including just a little under $52 million on the Phase 1 and 2 discretionary projects the U.S.

South. Net debt closed the quarter at $198.2 million, the equivalent of 18% of invested capital, leaving the company with a very strong balance sheet and available liquidity at just over $390 million.

In terms of our strategic capital initiatives, I'm please to say that our Phase 1 projects at Meldrim and Monticello in the South were both completed during the quarter, and are in the ramp-up phase and showing very encouraging signs. I should also point out that both mills were negative contributors from a P&L and EBITDA standpoint during the second quarter, as the vast majority of startup costs were expensed rather than capitalized, which we expect will reverse in the current quarter.

We're now turning our attention to the Phase 2 projects at Georgetown, Eatonton and Thomaston, which we'll complete in phases over the next two to three years. And finally, before I turn the session over to Bart for his comments on the lumber market, we just want to touch base briefly on the transaction that we entered into in early June with Canfor to acquire cutting rights in the Adams Lake area of the B.C.

following their decision to permanently close the mill at Vavenby, which is located approximately 100 kilometers from Adams Lake. The timber supply situation in the B.C.

Interior, as I mentioned earlier, is particularly challenging. After dealing with the impacts of the mountain pine beetle infestation, there's simply too much milling capacity chasing too few trees, and that equation needs to be rebalanced as the industry is going to remain competitive on a global scale, going forward.

The good news is that process is well underway. The bad news is it has serious negative consequences for workers, communities and other stakeholders who were affected by the closures.

Acquiring those licenses will strengthen Adams Lake long-term timber supply position, and support the continuation of this two shift operating program in the face of declining allowable cuts in the region. I'd also note that since our transaction was announced, there're a number of other permanent closures have been announced in the region, which will also help take pressure off of log markets.

The transaction is subject to various consents, including that of the B. C.

government, and we're working through that currently. Bart, I think, what I would like to do is turn over to you for some comments on what's happening in lumber market, our look for the balance of year.

And then we'll come back and we'll take questions from guests. Thank you.

Okay. Thanks, Duncan.

So difficult weather late in Q1 and into Q2 caused in market inventories throughout North America to increase through the quarter as builders delayed construction. Due to this inventory build of at the distribution level, the North American spring building season did not result in any significant sustained tension with direct-mill purchases as our customers put a greater emphasis on reducing their inventories.

Today, our customers report in-market inventories to be average or slightly below. On the positive side, our customers report activity so far in Q3 to be improving, and expect the latter half of 2019 to be stronger than the first half.

The recent interest rates reduction from the U.S. Fed reserve is expected to help.

That said, from a lumber market point of view, July continued to be a very challenging with downward price pressure from June, particularly in the last. So far in August, we had mix results with price volatility seen in both in the Southeast and in the West.

For Interfor, on export side of the business, markets were active in Q2 with quarter-over-quarter volume growth seen in Japan, China and other Asian countries. This demand is expected to remain consistent in Q3, however, the U.S.

China trade dispute and the ensuing uncertainty is an area of caution. Our specialty business demand for, both cedar and reserve plane boards, continues to be steady and we expect similar results through the balance of the year.

From a supply side's point of view, extensive curtailments have been announced so far this year, most significantly from British Colombia. The majority of these are permanent and we are just now starting to see the impacts as log inventories, work in progress and lumber inventories are processed and checked.

We expect shipments from Canada into the U.S. to reflect these permanent closures throughout the quarter, which will put pressure on inventories and ultimately bring tension back to the mill sales.

Short term, as demand and supply shift, price volatility will continue. Long term, we feel our markets -- the market fundamentals are favorable and we expect lumber demand to continue to grow.

I think I'll stop there, Duncan.

Great, Bart. Thanks very much.

Operator, I think at this point it makes the most sense to turn this session over to our guests so we can respond to their questions.

Thank you. Good morning, Duncan, Marty, Bart.

First question, we have seen, as you talked about in your prepared remarks. We have seen some permanent capacity curtailment announcements, better results that improved more recently, yet lumber pricing remains quite weak and volatile.

What in your view are the key issues? Is it really a demand off take still, or is it inventories in the channel?

Or is it simply that we need to see more supply come out of the market?

Well, Ketan, I think it's a combination of all those things. Demand clearly has been weaker through the first half of this year than we have otherwise expected.

And we attributed in part at least to worse weather conditions, but there's also a bunch of other factors that are work there. And to the extent the weather piece of that, it's a bit of an excuse.

So I think there's an element of that that is real. So demand has been weaker than anybody would have expected.

The supply response has been slower than ideal, which was, what I said in my remarks. And we've seen a number of curtailments both market related curtailments and permanent curtailments.

But I think if you look at the piece of shipments, when mills close it just means that, if anything, they've got too much inventory. And they -- but when the mills curtail, they continue to ship.

So there's a fairly significant lag that takes place between an announcement of a curtailment one form or another, and when the actual impact on shipments tends to occur. And so as we monitor volumes over the last number of months, shipment levels haven't declined to the extent that production has come off.

But I think that's -- as these mills run their inventories down, there's just less product available for shipment to the market. And that's when you're going to start to see the rebalancing of that overall demand supply equation.

And as Bart indicated, we would expect to see more tension between available supply demand and better pricing resulting from that.

And Duncan, just on that, is it fair to say that it takes about three to four months, typically, to work through inventories at the mill and in the channel? Is that a difficult average?

I don't know if that's typical or not. I'd suggest it might be a little longer than I would otherwise expect.

It depends what kind of log inventories are in front of the mill when the announcements made. A mill would normally have a month plus of inventory and a normal operating configuration, and it depends what kind of log inventory and then the decision on whether they're going to actually process those logs, run those log decks out, or whether they're going to ship those logs elsewhere.

So it depends on particular circumstance. But if anything, I would suggest that maybe your number is a bit long.

And then while on the topic of demand, can you also touch upon what you guys are seeing in the R&R market?

Well, all the figures that we're seeing now tells us that there's some slowing happening in the R&R market. And quite frankly, we're having some difficulties we're wrapping our minds around that, because the customers that we have that are more actively involved in the R&R market are telling us that their volumes are good.

The recent Harvard study that came out indicated that some of their indicators are suggesting a slowing in the R&R market. And something that we're watching really carefully to see if that really translates through and begins to impact overall demand levels.

Up to now, I think Ketan, it's fair to say that the biggest difference has been in the new home construction market where -- whether it's labor availability, or land availability, or financing availability or just weather, as we talked about earlier, has slowed the pace of activity there as opposed to any particular weakness in the in the R&R side of things. But it's something that we're an eye on.

And just last question from my side. When you think about capital allocation, Duncan, at this time in the cycle.

How do you think about the different tools that you have? More recently, you've been focused on internal investments.

But as you look at the stock price today, the tool of share repurchases versus M&A, perhaps seller expectations have come down given what has happened. How do you think about capital allocation?

What we'd like to tell you, we think about it a lot, Ketan. We haven't seen any evidence that seller expectations have fallen back more in line with what we would consider reasonable price levels from an M&A standpoint.

So where we are not wildly motivated to step-up and do anything from that standpoint yet, though, I think continued weakness in the market tends to bring a bit more realistic view to some folks. We continue to look at the other alternatives for us.

Right now, we're focusing significantly on both our CapEx strategy in the South, and on our transaction with Canfor. And so we've backed away somewhat from our NCIB and we think that's the best approach for us to take from a longer term strategic positioning standpoint.

We're also, I think, very cognizant of managing our balance sheet in a volatile business. There is a fair degree of uncertainty from a broader economic standpoint.

There is uncertainty from a housing market standpoint. And so we're being very careful as we manage any spending, or allocation of capital to ensure that as all done within the constraint of a prudent balance sheet and debt structure.

Duncan, I wanted to ask you about B.C. log costs.

We have seen purchase log costs move higher, I think it's up about 10% through May. I know the stumpage equitation is pretty complicated.

But does that bidding behavior which seems irrational mean that we probably shouldn't expect much stumpage release at the next July 1st revision?

Our statistics right now indicate that we should see some relief next July, also, if lumber prices remain weak, we'll also see some relief in the quarterly updates as well there, Hamir. But our indications now suggest that we could see some softening or realignment of stumpage rates with lumber prices next July.

And a question for Marty, based on your log decks, when should we see the higher -- this past July 1st stumpage start to flow through on your costs?

The July 1st increase of this year you're talking about, Hamir?

Yes, exactly.

We're going to start to see that in the third quarter. So, obviously, as Duncan talked about, there's couple of moving pieces.

So some of that's going to find its way in third quarter and rest of week in fourth quarter. But at the same time then there is also the fourth quarter reset associated with the quarterly reset that's more tied to lumber pricing.

So we'll start to see some of that in the third quarter filter-in in terms of the July 1st increase.

And Bart, I was just wondering if you could comment on what you're seeing on the pricing front for lumber in both China and Japan.

Well, I would say that there is weakness in both markets. The Japanese market, not -- nor near as volatile as any other market, quite frankly.

So some mild pressure, downward pressure but still the business in Japan is favorable and attractive. In Asia in particular -- in particular in the China, maybe got heavier than the normal inventories that they're working with over there.

I think they also have some shifts going on in the demand side as well. So working through that is a bit of a challenge.

However, for our business the most recent quarter, we saw an increase in what we did over there. And I think China is an interesting market.

They take number of different species and number of different products. And by having that breath of mix that we sell over there, we're able to pick our spots on where we want to participate and don't participate, and try to avoid the products that are under significant price pressure.

Just following up on the Canfor AAC purchase, I know it's going through the government review. Anything that's come up to-date that you didn't anticipate?

Not really. We obviously put lots of thought into this, and understand the sensitivity and the impacts on people when there's closures like this.

The Bill 22 review process, I certainly understand what the objectives of that are and we're working our way through it. I think in a very professional way with Canfor and ourselves, and the ministry and -- are working pretty actively as we go through this thing.

So no surprises from my standpoint, Paul.

And then one of the issues that you and others have faced, especially in the U.S. market, is tight labor conditions.

We've got a number of shuts in B.C. Any chance of being able to shift some of the workforce in B.C.

down south to alleviate some of the problems down there?

I think that's a bit of a challenges. It's not something that we have looked at too actively.

We find more often than not when there is no closures people tend not want to want to leave the community that they're involved in, there is few maybe on the margin. In the case of the Vavenby situation, we've been able to place a couple of formal Canfor folks at a couple of our operations in the B.C.

Interior. But the likelihood of being able to move south would run into bunch of immigration issues, I think.

And this really wouldn't be the thing that's likely to be much of an opportunity.

And then just on -- you detailed the cost overrun on Phase 2, which was almost 12%. Was there a contingency on that as well that you went through?

And what are we looking at for Phase 2?

We have a constituency on all projects. So by definition, we did run trough that.

And there is some lessons learned. The good news for us is that the lessons were learned on a couple of the smaller projects as opposed to the bigger ones.

And I think if you think back to when those projects were announced and undertaken, there was quite a lot of activity in the no construction rebuild market. I think that contributed to some of those costs.

For example, your escalation to still prices and some of the thing like that. But I think we've learned a lot.

We've reviewed the Phase 2 projects, and the consistencies associated with these Phase 2 projects. The bids we've got coming in on those project so far are well within our budgeted amounts.

So we're pretty comfortable that the numbers that we've posted on those projects are valid. Offsetting all the overruns stuff, Paul, I think is a factor we're pretty conservative on what we've estimated as the benefits of those projects.

So I would tend to think that the additional gains associated with those investments will more than offset the higher costs that we have reported.

Can you detail a couple of the learnings, the key controllables that you would like to fix as you go through Phase 2 that you didn't quite catch in Phase I?

Well, I'm not going to get into more of the detail on that. But we spend a lot of time planning our projects.

We've got, I think, a pretty good track record of delivering projects well with respect to sort of budget performance and also the gains that we achieved on these projects. And if anything, what we've learned is, through this one is, working with a number of new suppliers as opposed to some of our traditional suppliers takes a little bit of more time and effort.

Interesting enough, there are some of our traditional suppliers north of the border that are transitioning into the south, which I think gives us some additional comfort, going forward. I think another lesson and I think the bunch of other folks are learning this lesson as well is when there is a scramble in the business on capital projects, being able to access the quality of folks from a contracting and lead times with equipment and things of that nature tend to be more challenging than people might initially anticipate.

So we're looking really carefully, for example, at the pace at which we're planning to take on the new projects and budgeting in more time for startup than we might have otherwise done on projects of these size. So there are lessons learned, we're fully cognizant.

Ian Fillinger who's our senior operating guy and our capital projects guy, and his team have taken those lessons to heart, I think and are building them into the revised plans for our Phase 2 and Phase 3 projects.

A couple of questions, you guys took I think about 40 million board feet of B.C. Interior downtime in Q2.

Are you extending anything into Q3 given the prices haven't lifted much to this point?

Right now, no, nothing specific but we're watching it really carefully. We try to be proactive in this regard.

And I'm a big believer that demand is demand and supply is supply, they don't match the two to pay the price. And so we talk a lot to our customers and try to balance that equation pretty carefully.

And we're watching it, as I said, very carefully right now and won't hesitate if more downtime is required.

I wonder if there's a capital and the absence of buyback activity in recent months -- just as I think backwards about this, Phase 2 was well laid out a year ago you guys knew you're going to be spending this capital. You were still buying back your shares more aggressively late last year and into Q1.

I guess the only difference is the $60 million you're paying to Canfor for the AAC availability. Can we read some of the more cautious approach to the NCIB is and concerns about this market recovery.

Am I reading too much into that? I know you want to keep a flexible balance sheet.

But the capital I would guess you would have seen coming regardless. So just maybe how your NCIB approach relates to your outlook for lumber prices over the next little while?

I'm going to let Marty answer that one, Sean.

So Sean, in some ways your comment on Vavenby is an perfect example and your comment about flexibility emphasized it seems well, which is we're looking at all those various tools all the time. But having in a flexibility in our capital structure allows us to do a variety of things, in some cases in spite of market conditions.

So we're able to take a look at a situation like Vavenby of $60 million 10 year acquisition, in spite of the fact that the market is not all that terrific right now. And having that ongoing flexibility is really important to us and allows us to pick the alternatives that make sense from a long term perspective, and the 10 year acquisition is really interesting piece for us from a very long term perspective.

So we've done a little bit of share buyback activity earlier this year tail end of last year. Our CapEx program we think has tremendous opportunity in terms of long term value.

We're continuing to re-evaluate CapEx plans. And as M&A opportunities are out there, whether it's 10 year acquisition or other things.

Having that flexibility in our balance sheet is really important to us. So I think that's why we’re constantly trying to recalibrate the various alternatives out there and making sure that we do have flexibility at all times.

Okay, thanks Marty. One last one, Duncan, the board appointments yesterday.

You've got at least a couple of board members that have extensive experience in wood products outside lumber. We always think of Interfor as pure play lumber, and that's all you want to be.

Would I'd be reading too much into that to say that maybe you want to broaden horizons over the long term, your thoughts on the addition to the board and broadening the perspective there?

I think you're stretching a bit on that one, Sean. Chris Griffin, who is the CEO of USG Corporation, who joined the board yesterday, sells product into very similar markets to what we do.

And in other words, they're spending lots of time on what's happening in the new housing market, what's happening in the R&R market and in a bunch of cases, deals with the same customer base that we deal with. And so it was an opportunity to get a guy who we have a slightly different perspective on what's happening in distribution channels involve with our business to bring a different perspective, because our expectation is going forward, we're going to see changes in the distribution segment of our business that we need to understand and participate in.

And having somebody who's got a -- similar issues and maybe a slightly different perspective than we do, we think would be really helpful addition to our Board. Similarly, Rhonda Hunter, who joins our Board in May was a former VP:Timberlands of Weyerhaeuser, which I think people know, brings a really interesting perspective to our what's going on, both in the Pacific Northwest and in U.S.

South. She lives in Arkansas where we have our operation, and is able to add real value to some of the conversations we have about investment plans or operating plans in the region that's extremely useful.

So I think both of -- those two appointments, I think, are bang on the sweet spot for us as we go forward.

Just on the log costs in the U.S. South, we have seen some uptick in log prices in the first half of the year, presumably some of it was driven by wet weather.

Have you seen pricing come down as you look at the back half, or are they still elevated?

You're right in that. In Q1, there was a little bit of an uptick in terms of log costs, not huge but a little bit of an uptake and most of it that was seasonal weather conditions and obviously some challenge in terms of supply at that points, things improved a little bit in Q2.

And in fact, they improved through Q2. So, we'd anticipate that when we look in Q3, the log costs in the South are probably going to be on average to what we saw during much of 2018.

Q1 was a little bit of an uptick, which again I characterized more as an aberration and we're back into normal zone comparable levels to what we saw the back part of 2018.

And then just one other question Phase 2 project. I noticed that you are now talking about investments through 2022 and earlier it was through 2021.

Am I reading too much into it or have you all said that, okay, may be, we need to go a little slower. Any thoughts or perspective?

Well, I can't remember who I was responding to. But one of the lessons learned on the Phase 1 projects is you're better off to sequence these things in a way that gives you more time in the wrap-up phase, Ketan.

And so as we look at the project schedule that we had originally designed, our conclusion was that we're better off to stretch it out a little bit. And so the tail end of one of those projects is going to be pushed out a few months, and that's really what that reflects.

Okay. Thanks, operator.

And thanks everybody. We very much appreciate your interest in our company.

We are happy to respond to any questions that you might have. Marty and I are around for the -- at least the next couple of hours here today.

If you have any follow-up you'd like on, or we'll be here -- be around next week if you'd like to chat. Anyway, thanks very much.

Have a good day. And we will talk to you again at the end of the next quarter.

Thanks everybody.