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Iamgoingtogiveabriefglimpseintotheperfectstormthatisemerginginthelumberindustry.

Followingtheindustryupdate(withafocusontheUShousingmarketthemainindustrydrivers),Iam

goingtooutlinemythesisforinvestinginWestFraserTimberCo.Ltd.theworldslargestlumber

producerandacompanydomiciledinCanadawithassetsinbothCanadaandtheUnitedStates.In

short,lumberdemandisimprovingoffofhistoricallowswhilesupplyremainstightwithlittle

incrementalcapacity

expected

in

the

near

to

medium

term.

As

US

housing

recovers

from

trough

(more

appropriatewordisdepression)levels,NorthAmericanlumbercompanieswithhighoperational

gearingwillseesubstantialmarginimprovementandsharepriceappreciation.Thecurrentdynamicsin

thelumbermarketofferahighlyasymmetricpositiverisk/rewardopportunity.

IndustryTrends:

From1966tothepeakofthehousingmarketin2005,UShousingstartshaveneverfallenbelow1mn

unitsperannum.Meanhousingstartsoverthattimeperiodwerec.1.5mnwithastandarddeviationof

c.450mn.In2008,UShousingstartsfellto554ka2standarddeviationeventbuthaveincrementally

improvedsincethen;theyarestill,asthisgraphshows,wellbelowanormalrangeofvalues.H1data

from2012supportarunrateof740750khousingstartsbutthisisstillwellbelowtrend.Theabovedata

provideadiversifiedsampleofobservations:theyincludeyearsofhigh/lowgrowth,yearsofhigh/low

inflation,andyearsofbull/bearequitymarkets.Fromthisgraph,theonlyconclusionisthatUShousing

startsareatunsustainablylowlevels,andunlesssomefundamentalchangehasoccurredinUS

demographictrends,incrementalpositivechangeinthedirectionofthemeanisnotonlystatistically

likelybutsociallynecessary.

0

500

1000

15002000

2500

1966

1969

1972

1975

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1981

1984

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1993

1996

1999

2002

2005

2008

2011

USHOUSINGSTARTS(in000's)

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0

50

100

150

200

250

300

350

400

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

USPOP CANADAPOP US+CANADAPOP

0.0%

0.5%

1.0%

1.5%

2.0%

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

USPOPGROWTH CANADAPOPGROWTH

00.5

1

1.5

2

2.5

3

3.5

4

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

INCREMENTALPEOPLEADDEDINUS(inmillions)

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Ihave

included

various

graphs

that

illustrate

the

same

point:

there

has

been

no

radical

shift

in

US

demographictrends.IhaveincludeddemographictrendsinCanadawhichistheotherchiefend

marketforNorthAmericanlumberandbothcountriesaregrowingathealthyrates.Therehasbeena

slowdowninpercentagegrowthratesthisisexpected,asmostgrowthtrendstendtoexhibitqualities

ofnonlinearitybutincrementalpopulationadditionsontheaggregatehavenotslowed.Thefinal

graphinthissequenceshowsthatUShousingstartshavenotkeptupwithincrementalpopulation

additionsandabacklogofdemandislikelyaccumulating.

0

200

400

600

800

1000

1200

USHOUSINGSTARTS/INCREMENTALPEOPLEADDEDINUS

0

100

200

300

400

500

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

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1996

1998

2000

2002

2004

2006

2008

2010

2012

LUMBERPRICE(CPIADJ)

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0%

20%

40%

60%

80%

100%

40

50

60

70

80

2005 2006 2007 2008 2009 2010 2011 2012F

DEMANDONNASAWMILLS NACAPACITY

OPERATINGRATE

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GiventhedepressionthatwearecurrentlyexperiencinginUShousing,lumberpriceshaveheldupwell.

Thetopgraphshowsinflationadjustedspotpricessince1972.Wearealreadynearthelowerendofa

midcyclepricingrangeandUShousingis750kunitsbelow50yeartrendlevels.Thereasonforthis

relativepricingstrength,asthenext3graphsshow,islogicallyrelatedtotightnessonthesupplysideas

wellasanincrementalandsustainedpickupinexportdemand.ThesecondgraphshowsNorthAmerican

capacityfalling

by

about

12.5bn

fbm

between

2005

and

2012.

The

housing

depression

has

forced

out

marginalproducersandmuchofthiscapacityreductionisbelievedtobepermanent.Additionally,

demandonNorthAmericansawmillshasrecentlypasseditsinflectionpoint;thereasonforthistrendis

twofoldobviously,UShousingisrecoveringmodestly,butasignificantcontributingfactorisrelatedto

exportgrowth.China(asthecountryincreasinglyuseswoodasasubstitutebuildingmaterial)has

increaseditsexportdemandfrom152mnfbmin2005to2.662bnfbmin2011.Thefinalpointto

consideronthesecondgraphistheuptickinoperatingrates.Operatingratesreflecttheoverall

tightnessofsupplyanddemandinthemarket.Asoperatingratescontinuetoimprove,lumberprices

willlikelyfollowsuit(i.e.,amongotherthings,demandgrowthshiftsbargainingpowerinthedirection

ofsuppliersandpricesnaturallyappreciate);finally,anobviouspoint,aswespeculateaboutarecovery

inindustry

margins,

higher

operating

rates

will

drive

higher

margins

(i.e.,

fixed

costs

get

spread

out

over

moreunitsofoutput).ThefinalgraphinthissectionhighlightsthenegativeeffectsoftheMountainPine

BeetleepidemicinBritishColumbiascentralinterior.Whiletheepidemicisexpectedtobeless

impactfulthanearlyobservationspredicted,theultimateoutcomewillbelessforestlandavailablefor

harvesting.Futureproductiontenuresi.e.,annualallowablecutswillneedtoberesetdownward.

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Onamorecompanyspecificlevel,theoperationalgearingoflumberproducersoffersattractivereturns

duringanupcycle;additionally,taxationinCanadaallowsforlowerratesaslumberpricingaccelerates.

ThetopchartshowsthepositivebenefitsoftheCanadiantariffpolicynamely,lowerlumberprices

receiveexport(exports,here,applyonlytoexportsfromCanadatotheUS)dutiesof15%,whereas

pricesabove$355arenotsubjecttoanyduties.Thebottomcharthighlightstheoperationalgearingof

lumberproducers(inthiscase,thecompanyhighlightedisWestFraser,buttheoperationalgearing

storyissimilarthroughouttheindustry).ForWestFraser,a$10changeinlumberleadstoa$48million

dollarchangeinearnings.

WestFraserTimberCo.Ltd.:TheNorthAmericanlumbermarketishighlyfragmented.Accordingly,WestFraseristhelargest

operatorinthespace,butits5.7bnfbmsofcapacityrepresentslessthan8%ofthemarket.An

acquisitionof13USsawmillsin2007addedroughly1.2bnfbmtoaggregatecapacity,andsimilar

acquisitionsgivenastrongbalancesheet(withnetdebt/equity=15%)canbeexpectedasthe

industrymovestowardamoreconsolidatedstructure.

WestFraserhas3divisionslumber,panels(i.e.,plywood),andpulpandpaper.ThebulkofWest

Frasersearningscomefromlumber,butpulpandpaperisaprofitabledivisionforthecompanyAsian

demandhasbenefitedpulppricing,andonthepaperside,WestFraserisinvolvedina50/50joint

venturenewsprintbusinessthatissmallbutconsistentlyprofitable. Thepanelsdivision,evenmoreso

thanthelumberdivision,hassufferedfromaweakhousingmarket;importsfromtheUSintoCanada

haveaddedadditionalcompetitivepressures.Littleisexpectedfromthepanelsdivision,butitcould

offerupsidesurprisetotheinvestmentthesis.Therecentsuccessofthepulpandpaperdivisionis

somewhatworrisomemoreonthepulpsidethanthepaperside(thenewsprintbusinesshas

consistentlyrealizedstablepricing)andwecouldseemarginerosionifmacroconditionsworsen.The

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bullswouldarguethatsupplyconditionsinpulpremaintight(littleincrementalgreenfieldcapacityis

beingadded),butwithpricingabovelongtermaverages,prudenceshouldbeusedinvaluingthis

segmentofthebusiness.Intheirrecentlyquarterlyearningsreport(Q22012),WestFraserstrucka

cautiousnoteontheneartermoutlookforthepulpbusiness:Weexpectpulpmarketstoweakenin

thesecondhalfof2012asadditionalpulpfromBrazilandRussiaislikelytoputdownwardpressureon

pulpprices.

Any

pulp

production

downtime

or

improvement

in

the

European

economy

would

mitigate

furthershortertermpriceweakening.

AstheanalysisoftheUShousingmarkethasshown,thecurrentpriceoflumberisalreadyatdecent

levelsdespiteacontinueddepressioninUShousingstarts.Thethesispositedtoexplainthis

phenomenonwasthatsupplytighteningbroughtonbytheclosureofhighcostsawmillshas

acceleratedpricerationalization(withslightbutgrowingdomesticdemandandexportgrowthhelping).

Further,itappearsthatmanyofthesesawmillclosuresarepermanentandthatdemandwillonlyneed

toexpandtonearaveragelevels(i.e.,lessthanLTaveragesof1.5millionhousingstarts)beforeeven

strongerpricingresumes;itseemsplausible,forinstance,that$400lumbercouldbereachedatonly1

millionhousing

startsa

number

that

is

still

well

below

trend.

Whenbuyingequitiesofcommoditycompaniesduringapredictedupcycle,thereisobviouscredence

tothenotionofbuyingjunkoverquality(i.e.,whenthecycleisturning,buythecompanieswiththe

highestoperationalgearing,wheretheearningsupsideisthestrongest).Inthecaseofthelumber

industry,thisrelationshipstillholdstrue,butthechoices,overall,arelimitedthereareonlyafew

listednames,andthemajorityofthemareilliquid.Moreover,WestFraserwhichrepresentsthe

qualitynameinthespaceisnotpricedatasignificantpremiumtoitspeergroupandthemargin

upside,iflumberpricesbegintoappreciate,isverysimilar.WithWestFraser,thesharepriceis

protectedonthedownsidebythecompanysabilitytogeneratepositivecashflowthroughoutthecycle

(even

during

2009a

year

where

housing

starts

reached

levels

unseen

since

the

1940sthe

company

generatedpositiveoperatingcashflow)andastrongbalancesheet,andtheupsidestory,characterized

byhighoperationalgearing,remainsintact.

0%

5%

10%

15%

20%

25%

30%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

EBITDAMARGIN Average

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400

200

0

200

400

600

800

1000

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

OperatingCashFlow

400

200

0

200

400

600

800

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

FreeCashFlow

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Theprevious5chartsillustrateboththemarginupsidestoryforWestFraserandthevariousquality

aspectsofthecompany.Asthefirst2chartsshow,EBITDAmarginsarewelloffofhistoricallevels14%

groupEBITDAmarginshavebeenthenorm,withLTlumbermarginstrendinghigherat16%.Thefirst

chartshows

group

marginswhich

appear

at

first

glance

to

be

less

depressed

than

might

be

expected

(i.e.,theUShousingmarketisinadepressionandEBITDAmarginsareonlymarginallybelowLT

averages),butthereasoncanbeexplainedbyadecentpulpmarketin2010and2011andthesecond

chartshowslumbermargins.Thethirdandfourthchartsshowoperatingcashflowandfreecashflow,

respectively,andthefifthchartshowsthestrengthofWestFrasersbalancesheet.Indowncycles,the

companyisprudentaboutmanagingcostsandinventorylevels;since1995,2007wastheonlyyearwith

negativeoperatingcashflow.Similarly,freecashflowisgenerallypositivewhichis surprisingforan

industrycharacterizedbyhighcapitalintensitybutfreecashflowyieldsarestillrelatively

unimpressive.Finally,thebalancesheethasstrengthenedovertheyearsandcurrentlydisplayslow

gearing.Asmentionedearlier,thebalancesheetstrengthaffordsroomforbothfutureM&Aandhigher

capitalexpenditures

to

expand

the

current

production

footprint

and/or

upgrade

current

capacity

with

newlowercosttechnology.Thefragmentednatureoftheindustrycombinedwiththepresenceofa

strongbalancesheetalmostassuresthatWestFraserwillmaintainacostadvantageoverthe

competitionindefinitely.

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

NETDEBT/EQUITY

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Thecatalyst

for

West

Fraser

is

obvious:

incremental

improvements

in

the

US

housing

market

will

lead

to

betterlumberpricing,marginexpansion,andultimatelysharepricegains.Withtightenedsupplyand

increasedexportdemand,midcyclelumberpricingof$340$350/mfbmcanlikelyberealizedwithouta

returntoLTaveragehousingstarts(i.e.,1.5millionperannum);1millionhousingstartsorslightlyless

maybesufficienttocreatethistypeofpricingenvironment. Withhousingstartsexpectedtotrendnear

750kfor2012,IhaveestablishedabasecasevaluationforWestFraserbasedontheassumptionthat

UShousingstartsbegintoapproach1millionin2013or2014.Thebasecaseassumesamidcycle

lumberpriceof$340/mfbmandmarginalcontributionsfromtheother2divisions.Basedonamidcycle

multipleof5.5x,asharepriceof$66.53isdeterminedac.18%premiumtothecurrentsharepriceof

$56.52.

Thebasecaseisnotsuperexciting(althoughitshowsthatunderfairlyconservativeassumptions,the

companyisunderpriced),andIamprobablybeingoverlyconservativeaboutthecontributionsfrom

pulpandpaper.However,inthesecondvaluationthebullcaseIhaveadoptedmoreaggressive

pricingassumptions(consistentwithpeakpricesachievedoverthepastdecade)whileloweringthe

multipleto4x,andatheoreticalpriceof$99.80isdeterminedac.76%premiumtocurrentshares.The

pricingassumptionsinthebullcasewouldbemoreconsistentwith1.5millionhousingstartsorgreater.

Iamnotgoingtomakeanyassumptionsaboutwhenhousingstartsreturntotheselevels,butitcould

besoonerratherthanlaterdemographictrendsremainunchangedandabacklogofdemandislikely

growing.Further,myassumptionsarebasedoncurrentcapacitylevelsandfailtorecognizeWest

Frasers

potential

as

a

future

industry

consolidator.

As

West

Fraser

adds

capacityadding

debt

to

its

veryfrugalcapitalstructuretheseassumptionscanchangedramatically.