Continuing Consolidation

Consolidation in the forest industry continued during 2000 and analysts see more mergers and acquisitions for the coming year.

By Paul MacDonald

After a year in which there seemed to be a feeding frenzy going on in the Canadian forest industry with takeovers the order of the day the forest industry continued on the consolidation path during 2000, although the pace did not seem quite as frenetic. There were still deals happening, but they seemed somewhat less dramatic in scope compared to some of the takeovers Weyerhaeuser absorbing MacMillan Bloedel for example that took place in Canada in 1999. This was especially true because many of the deals in 2000 were international in scope, such as Norske Skog taking over Fletcher Challenge and International Paper taking over Champion International, which owns BC based Weldwood of Canada.

"These are huge international scale deals that are unprecedented in the industry," said forest industry analyst Reid Carter of National Bank Financial in Vancouver. "Many of the Canadian forest companies who did major deals the year before were digesting and integrating during the year," added Francois Perron, forest industry analyst with Merrill Lynch in Montreal. "It would be premature for them to do further acquisitions until they optimized what they had already acquired." But there was still some dealing within Canada, notably Abitibi Consolidated purchasing Donohue Inc back in February in a $7.1 billion deal.

Undoubtedly the lackluster softwood lumber markets cast gloom over the industry. This came despite a still quite robust US economy, which continued to do extremely well during the year. The red hot pace of growth slowed in the second half, however. The low prices were and remain a genuine reflection of a classic oversupply situation in commodity lumber markets. In reaction to the poor markets, and keeping in mind lumber quotas under the Softwood Lumber Agreement with the US, some producers opted to take downtime, which somewhat helped a market that at times seemed to be awash in lumber. After seeing the share prices of some forest companies go through the roof in 1999, the sector was badly beaten up on stock markets in the last half of 2000, with many companies trading at far off their highs of the last year.

In fact, some companies now see an advantage in investing in themselves, rather than looking for takeover candidates. Weyerhaeuser in the United States and Interfor in Canada both instituted share buyback programs during the year. Essentially, publicly traded corporations see buying back their shares when they are trading at low prices as a better use of their capital than buying assets, such as other companies. Forest industry consultant Russ Taylor of Vancouver's R E Taylor and Associates said it is "staggering" how many companies are involved in stock buyback programs. "That offers the best return on capital for them, which is a sad state of affairs," he added, noting there is a pattern to acquisition trends.

When times are good and companies have very positive cash flows, there is pressure to do deals. The deals that are done are usually near the top of the market, so the acquisitions tend to be quite expensive. The time when acquisitions are not expensive, such as now, coincide with poor lumber prices, poor cash flows and pressure from shareholders to sit pat and not do deals. "The exceptions are some of the aggressive companies and privately owned companies who will look at buying now." There are "many, many" acquisitions still to come, said Taylor. "To be a player, you are going to have to have the economies of scale."

He said that while it may be fine to be an independent "boutique" with a focus on specialty lumber markets, it is not going to work if a company is a boutique in the commodity markets. The Canadian industry continues to get the attention of both American and European forest companies, the latter on the pulp and paper side with such deals as Norske Skog /Fletcher Challenge and Repap being taken over by UPMKymmene. But there's still more to come on the wood side, said TD Securities forest industry analyst Sean Stuart in Toronto. The TSE forestry sector hit record levels in May, but it has since been battered. "The stock market valuations on forestry companies are so cheap," he said. "I don't think we're done in terms of consolidation.

There are a lot of attractive takeout candidates." While Stuart believes Canadian forest companies are likely to be the acquirees rather than the acquirers there was one deal that worked the other way during the year. BC's West Fraser Timber bought Plum Creek's southern US lumber manufacturing operations in Joyce, Louisiana and Huttig, Arkansas. The two mills have the capacity to produce 300 million board feet of lumber per year and West Fraser plans to move that up to 400 million board feet. The company says this acquisition allows them to take their successful, low-cost lumber manufacturing approach closer to their traditional market area while building an asset base with a long-term, plantation based fibre supply.

Within Canada, the future deals are likely to be on a smaller scale than in the past. "In the Canadian realm, we're running out of big companies," said Stuart. Further deals could happen among midtier companies such as West Fraser and Slocan Forest Products. He noted that companies such as BC based Interfor, which has been trading at a low cash flow multiple, is "unbelievably cheap" in terms of its market value. The sector as a whole seems to be out of favour with investors. Forest companies are generally viewed as being "old economy" in a stock market that has been driven by "new economy" dotcom and technology companies such as Nortel.

Many Canadian companies are seen as being part of a resource economy of mines and forest companies the so called "rocks and trees" sector. While many of the industry takeovers were driven by the pulp and paper side, there was also long term strategy happening on the lumber side, with consolidations delivering access to expanded fibre bases and customers. But in terms of future industry moves, the Softwood Lumber Agreement with the United States, which expires at the end of next March, remains the unknown factor that could have a huge influence on markets and prices.

How this is resolved will have a direct impact on the future and fortunes of companies that have a strong weighting in lumber production, such as Canfor and Tembec. "I don't know how it is going to be resolved," said analyst Francois Perron. But he believes that, regardless of the eventual lumber arrangement, it is likely going to create more supply, rather than less. "I doubt very much it will cause North American lumber supply to decline." It's clear, he added, that the industry is in an oversupply situation and it may take hitting lumber prices of $185 to $190 a thousand board feet before "things start to happen" in terms of permanent closures. "We've seen mills closing down on a temporary basis, but we haven't seen permanent mill closures." He said he is more optimistic about 2002 than about 2001 for the forest industry and that it is still a solid industry. "It's still a good business to be in, long term."

Sean Stuart of TD Securities was heartened by the moves companies are making to manage the excess supply of lumber in the market. The Softwood Lumber Agreement, Stuart said, is the "wild card" in lumber prices. On another front, there are concerns that rising energy prices could move inflation higher in the United States, with a resulting increase in interest rates. This would have a direct impact on mortgage rates and could cool off what has been a very healthy US economy. Regardless, it's generally thought the US growth rate in 2001 will be slightly lower, which will have an impact in key areas such as housing starts and demand for lumber. "In spite of that, we're still looking at 1.5 million housing starts, which is still a healthy number," said Stuart.

Politics could have more of a role to play on the provincial front. If an election is held in BC and the NDP government is voted out, there could be some wheeling and dealing done there. The forest industry has been saddled with extensive regulation and huge additional costs under the NDP government. There is a general feeling that a new government would be more receptive to the industry's needs, especially because in BC the province is essentially the owner of the forest. "Who your landlord is has a direct impact on costs," Russ Taylor noted. National Bank forest industry analyst Reid Carter said there are still some deals to come in BC, noting that Tolko has been taking a growing interest in Riverside Forest Products. "Slocan is a logical candidate for takeover," he added.

But Carter noted that many lumber producers now have a "batten down the hatches" approach and intend to ride out low lumber prices. In terms of further takeovers, he noted that deals looked more attractive to companies when their own share prices were high, and they could do "paper deals", issuing stock to get the deals done. Many forest companies were issuing shares and using that stock as "currency" to make acquisitions of other companies. But when share prices are at such low levels, companies are wary about diluting their stock. And many companies who have been burned before by borrowing too much money are not interested in doing debt financing.

While Carter thinks 2001 is going to be a volatile year for lumber prices, he believes they will be around "$225, plus or minus $25". Realistically, it can't go lower than $200 because of mill production costs, he said. Carter believes there will be a period of great volatility in the months leading up to and following the expiry of the Softwood Lumber Agreement. "I think we will see wood piling up on the border like we've never seen just prior to the expiry of the agreement." It's generally thought the US growth rate in 2001 will be slightly lower.

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