Canadian lumber stocks are diving this morning following a report from BMO analyst Mark Wilde who writes that "prospects for a near-term settlement of the U.S./Canadian lumber dispute have faded", prompting him to downgrade the main players in the space. The report has sent the stocks of West Frasier Timber (WFT), Canfor (CFP) and Interfor (IFP) as much as 6%, 4.6% and 6.2% lower, respectively.
What prompted the bold call? As the BMO analyst notes, "our sources report little substantive negotiation between Canadian and U.S. interests and little real movement in positions. Moreover, there appears to be internal divisions on both sides of the border."
These include differences between U.S. Commerce Secretary, Wilbur Ross, and U.S. Trade Representative, Robert Lighthizer. Ross is reportedly more inclined to take a deal, while the USTR is apparently taking a firmer line in negotiations. There also appear to be differences amongst members of the U.S. Lumber Coalition.
On the Canadian side, the divisions are mainly between the East and the West. Large, low-cost Western Canadian producers are more inclined to take a harder approach, pursuing litigation and paying countervailing (CVD)/anti-dumping (ADD) duties in the interim.
So with no near-term resolution to the ongoing lumber dispute between the two NAFTA neighbors, the alternative is a steadily progressing trade war. As a result, as Wilde writes, "we anticipate a period of countervailing and anti-dumping duties on Canadian lumber imports as well as continued litigation around those duties." As regards the 3 abovementioned stocks, the analyst notes that at current stock price levels, "we think the big risk is downside disappointments. Thus, we are downgrading West Fraser, Canfor, and Interfor to Market Perform. We are also downgrading Weyerhaeuser and Rayonier ratings to Market Perform. The key issue in timber is continued soft pricing on southern sawlogs. We are not making any changes to our price targets."
Finally, here are the summary highlights from the BMO report which, if accurate, suggest that even as Trump prepares to launch trade war with China, the ongoing "lumber war" with Canada is set to get worse before it gets better.
- Comments by high-ranking Canadian government officials and some U.S. corporate executives have fed hopes that a negotiated settlement is close at hand. Our sources report little substantive negotiation between Canadian and U.S. interests and little real movement in positions. Moreover, internal divisions exist on both sides of the border. On the U.S. side, there appear to be differences between U.S. Commerce Secretary, Wilbur Ross, and U.S. Trade Representative, Robert Lighthizer, as well as amongst members of the U.S. Lumber Coalition. On the Canadian side, the divisions are between Eastern and Western Canada.
- Continued uncertainty on the trade issue isn't good for lumber stocks. Moreover, the combination of continued countervailing and anti-dumping duties during 2018 and a strengthening Canadian dollar are both apt to put pressure on FY18 earnings estimates. In our view, it's hard to see the stocks pushing much higher in the near term in the face of that headwind. For that reason, we are downgrading West Fraser, Canfor, and Interfor to Market Perform from Outperform.
- To be clear, we aren't arguing the cycle is over for lumber producers. The "medium term" looks much more constructive. Over the next three-five years, we think the combination of reduced lumber supplies from Canada, improving lumber demand, and continued low southern sawlog prices could produce a period of abnormally rich margins for southern sawmills. We may be entering something of a Golden Age for southern sawmills. The three largest Canadian lumber producers have been increasing the proportion of their production in the southern U.S. and should benefit from the sawlog cost/lumber price arbitrage.
- The timeline on recovery in southern sawlog prices remains unclear. A decade of subpar demand and improving forest productivity has created significant inventory build in southern plantation forests. That "overhang" has southern sawlog prices at ~60% of 2005 levels - in nominal terms - and threatens to dampen/delay a recovery in sawtimber pricing across many parts of the south. Indeed, after a modest price recovery, southern sawlog prices have declined for the past seven quarters. In private conversations, we're encountering an increasing sense of caution - and even, skepticism - about the recovery among timber investment professionals. As such, we are downgrading WY and RYN to Market Perform from Outperform.