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, our Senior Vice President of Sales and Marketing, to go over Interfor's second quarter results and our outlook for the balance of the year. I'm gonna keep my remarks brief, and I'll turn the session over to you for questions as soon as I can. To the extent that you've already seen the results of most 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 a slower-than-ideal supply response, which taken together, has created an overhang on the market. A slowing of the pace of lumber exports from North America has compounded the situation. Viewed on a quarter-over-quarter basis, prices for the main commodity benchmarks were off 6%-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 and the like, our sales average recorded on a pre-duty basis was $603 per 1,000 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 CAD 10.8 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 the BC Interior that have come about as a result of the 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 were 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 a CAD 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 BC operations. This expense, reported in the second quarter, compares to the recovery of CAD 4.1 million in the first quarter of the year. I think as most of you know, inventory adjustments of that nature are reported in production costs. We also received compensation during the quarter of CAD 7.7 million from the BC government as a settlement for the cancellation of two timber licenses on the BC coast in 2017. Of this amount, CAD 6.6 million is reported in pre-tax income, but it is not reported in the 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 US 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 BC Coast, which continues to be impacted by log supply issues, 81% in the BC 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 project-related curtailments at our Phase One 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 were considered.
Capital investments totaled CAD 65 million in the second quarter, including just a little under CAD 52 million in the Phase One and Two discretionary projects in US South. Net debt closed the quarter at CAD 198.2 million, the equivalent of 18% of invested capital, leaving the company with a very strong balance sheet and available liquidity of just over CAD 390 million. In terms of our strategic capital initiatives, I'm pleased to say that our Phase One 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 start-up costs were expensed rather than capitalized, which we expect will reverse in the current quarter. We're now turning our attention to the Phase Two projects at Georgetown, Eatonton, and Thomaston, which will complete in phases over the next two to three years. Finally, before I turn the session over to Bart for his comments on the lumber market, I just want to touch base briefly on the transaction that we had entered into in early June with Canfor to acquire the cutting rights in the Adams Lake area of BC, 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 BC 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 if 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 are affected by the closures. Acquiring those licenses will strengthen Adams Lake's long-term timber supply position and support the continuation of its two-shift operating program in the face of declining allowable cuts in the region. I'd also note that since our transaction was announced, that a number of other permanent closures have been announced in the region, which will also help take pressure off log markets.
The transaction is subject to various consents, including that of the BC government, and we're working through that process currently. Bart, I think what we'd like to do is turn it over to you for some comments on what's happening in the lumber market, our outlook for the balance of the year, and then we'll come back, and we'll take questions from our 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 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, excuse me, interest rates reduction from the U.S. Federal Reserve is expected to help.
That said, from a lumber market point of view, July continued to be a very challenging continued to be very challenging, with downward price pressure from June, particularly in the West. So far in August, we have mixed results, with price volatility seen both in the Southeast and in the West. For Interfor, on the 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, in the US-China trade dispute, the ensuing uncertainty is an area of caution. Our specialty business demand for both cedar and Reserve Pine boards continues to be steady, and we expect similar results through the balance of the year.
From a supply side point of view, extensive curtailments have been announced so far this year, most significantly from British Columbia. 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 shipped. 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.
Okay. If you'd like to ask a question, please press star one on your telephone keypad. We will pause just a moment to compile the Q&A roster. Your first question comes from Ketan Mamtora. Your line is open.
Thank you. Good morning, Duncan, Marty, Bart.
Thank you.
First question. You know, we've seen, as you talked about in your prepared remarks, we've seen some permanent capacity curtailment announcements. Weather has also improved more recently, yet, you know, lumber pricing remains quite weak and volatile. What, in your view, are the key issues? Is it really a demand offtake 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, you know, Ketan, I think it's a combination of all those things. You know, demand clearly has been weaker through the first half of this year than we otherwise expected. And, you know, we attribute it to, in part, at least, to, you know, the adverse weather conditions. But there's also a bunch of other factors that are at work there. And to an extent, you know, the weather piece is a bit of an excuse, though, 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, you know, as I said during 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 pace of shipments, when mills close, it just means that, if anything, they've got too much inventory. 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 of one form or another and when the actual impact on shipments tends to occur. And so as we monitor volumes over, you know, the last number of months, shipment levels haven't declined to the extent that production has come off.
But I think that's coming. You know, as these mills run their inventories down, there's just less product available to ship into the market, and that's when you're going to start to see the rebalancing of that overall demand/supply equation. As Bart indicated, we would expect to see more tension between available supply and demand and better pricing resulting from that.
... Got it, that's helpful. And then just on that, is it fair to say that, you know, it takes about 3-4 months typically to work through, you know, kind of inventories at the mill and in the channel? Is that, you know, a typical kind of average?
You know, 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 announcement's made. You know, a mill would normally have a month or a month plus of inventory in a normal operating configuration. 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's a bit long.
Got it. Okay, that's helpful. And then, while on the topic of demand, can you also touch upon what you guys are seeing in the R&R market?
Well, you know, 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 difficulty sort of 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. You know, the recent Harvard study that came out indicated that some of their indicators are suggesting a slowing in the R&R market. It's something that we're watching, you know, 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, the biggest difference has been in the new home construction market, where, you know, 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 keeping an eye on.
Got it. That's helpful. Just last question from my side. When you think about capital allocation, Duncan, at this time in the cycle, how do you think about, you know, the different tools that you have? You know, more recently, you've been focused on internal investments, but, you know, as you look at the stock price today, you know, the tool of share repurchases versus M&A, you know, perhaps seller expectations have come down given what has happened. Kind of how do you think about, you know, capital allocation?
Well, I can tell you, we think about it a lot, Ketan. We haven't seen any evidence that seller expectations have, you know, fallen back more in line with what we would consider, you know, reasonable price levels from an M&A standpoint. So we're not wildly motivated to step up and do anything from that standpoint yet, though I think the continued weakness in the market tends to bring a bit more of a 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, it's the best approach for us to take from a longer term strategic positioning standpoint. We're also, I think, you know, as you know, very cognizant of managing our balance sheet in a volatile business. There's a fair degree of uncertainty from a broader economic standpoint. There's certainly 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 it's all done within the constraint of a prudent balance sheet and debt structure.
Thank you for your thoughts, Duncan. I'll turn it over.
Okay. Thanks, Ketan.
Your next question comes from Hamir Patel. Your line is open.
Hi, good morning.
Hi, Hamir.
Duncan, I wanted to ask you about BC log costs. We've seen purchase log costs move higher. I think it's up about 10% through May. I know the stumpage equation's pretty complicated, but does that sort of bidding behavior, which seems irrational, mean that we probably shouldn't expect much stumpage relief at the next July 1st revision?
Our statistics right now indicate that we should see some relief, you know, next July. We'll also, if lumber prices remain weak, we'll also see some relief in the quarterly updates as well, Hamir. But our indications now suggest that we could see some softening or realignment of stumpage rates with lumber prices next July.
Thanks, Duncan. That's helpful. A question from Marty. You know, 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?
Yeah, exactly.
Yeah, we're gonna start to see that in the third quarter. so obviously, as Duncan talked about, there's a couple of moving pieces. So some of that's gonna find its way in, in the third quarter, and the rest will leak in in the fourth quarter. But at the same time, then there's 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 terms of the July 1st increase.
Okay, great. 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.
I would say that there's weakness in both markets. The Japanese market not nowhere 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, particularly China, you know, they've got heavier than normal inventories that they're working with over there.
I think they also have you know, some shifts going on the demand side as well. So working through that you know is a bit of a challenge. However, you know, for our business, the most recent quarter, we saw an increase in what we did over there. And I think you know, China's an interesting market. They take a number of different species and a number of different products. By having that breadth of mix that we sell over there, we're able to pick our spots on where we wanna participate and don't participate and try to avoid, you know, the products that are under significant price pressure.
Great. Thanks, Bart. That's, that's all I had. I'll, I'll turn it over.
Thanks, Hamir.
Your next question comes from Paul Quinn. Your line is open.
Yeah, thanks very much. Good morning.
Hi, Paul.
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?
You know, 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. You know, 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.
Okay. And then one of the issues that you and others have faced, especially in the U.S. market, is tight labor conditions. You know, we've got a number of shuts in BC. Any chance of being able to shift some of the workforce in BC down south to alleviate some of the problems there, down there?
You know, I think, I think that's a bit of a challenge. It's not something that we have looked at too actively. What we find more often than not, when there's mill closures, people tend not to wanna leave the community that they're involved in. There's a few maybe on the margin. In the case of the Vavenby situation, you know, we've been able to place a couple of former Canfor folks at a couple of our operations in the BC Interior. But the likelihood of being able to move south would run into a bunch of immigration issues, I think, and just really wouldn't be the kind of thing that's likely to be much of an opportunity.
Okay. And then just on, You detailed the cost overrun on, on phase two, which was almost 12%. Was there a contingency on that as well, that you went through, and, and what are we looking at for phase two?
Yes, we have a contingency on all projects. So by definition, we did run through that. You know, and there's some lessons learned. You know, the good news for us is that, you know, 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 mill construction rebuild market. I think that contributed to some of those costs. For example, you know, escalation in steel prices and some things like that. I think we've learned a lot. We've reviewed the phase two projects and the contingencies associated with the phase two projects.
The bids we've got coming in on those projects so far are well within our budgeted amounts. So we're pretty comfortable that, you know, the numbers that we've posted on those projects are valid. Offsetting all the overrun stuff, Paul, I think, is the fact that 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've reported.
Well, what can you detail a couple of the learnings that the key controllables that you you know would like to fix as you go through phase two that you didn't quite catch in phase one?
Well, I'm not gonna get into, you know, a lot of detail on that. But we spend a lot of time planning our projects. We've got, I think, a pretty good track record of, you know, delivering projects well with respect to sort of budget performance and also, you know, the gains that we achieved on these projects. And if anything, what we've learned is, through this one, working with a number of new suppliers, as opposed to some of our traditional suppliers, takes a little bit more time and effort. Interestingly enough, there are some of our traditional suppliers from 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 a bunch of other folks are learning this lesson as well, is when there's a scramble in the business on capital projects, being able to access the quality of folks from a contracting standpoint, and yeah, 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 this size. So there are lessons learned. We're fully cognizant of, and 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 two and phase three projects.
All right. Thanks for the help. That's all I.
Thanks, Paul.
Again, if you'd like to ask a question, please press star one. Your next question comes from Sean Steuart. Your line is open.
Thanks. Good morning, guys.
Hi, Sean.
A couple questions. You guys took, I think, about 40 million board feet of BC Interior downtime in Q2. Are you extending anything into Q3, given that prices haven't lifted much to this point?
Right now, no, nothing specific, but we're watching it really carefully. You know, we try to be proactive in this regard. You know, I'm a big believer that demand is demand and supply is supply. If you don't match the two, you're gonna pay the price. 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 we won't hesitate if more downtime is required.
Okay. I want to revisit capital allocation and the absence of buyback activity in recent months. Just as I, you know, sort of think backwards about this, you phase two was well laid out a year ago. You guys knew you were gonna be spending this capital. You know, you were still buying back your shares more aggressively late last year into Q1. I guess the only difference is the CAD 60 million you're paying to Canfor for the AAC availability. Can I... I mean, can we read some of the more cautious approach to the NCIB as 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.
Just maybe how your NCIB approach relates to your, your outlook for, for lumber prices over the next little while?
I'm gonna let Marty answer that one, Sean.
Sure. So, Sean, you know, in some ways, your comment about Vavenby is a perfect example, and your comment about flexibility emphasized this theme as well, which is, you know, we're looking at all those various tools all the time, but having enough 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, a CAD 60 million, tenure acquisition, in spite of the fact that the market's not all that terrific right now. And having that ongoing flexibility is really important to us to allow us to pick the alternatives that make sense from a long-term perspective. And the tenure acquisition is a 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 a tremendous opportunity in terms of long-term value. We're continuing to reevaluate CapEx plans. And as M&A opportunities are out there, whether it's a tenure acquisition or other things, having that flexibility in our balance sheet is, 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, making sure that we do have flexibility at all times.
Okay. Thanks, Marty. One last one, Duncan. The board appointment 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 be reading too much into that to say that maybe you want to broaden horizons over the long term? 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, you know, the CEO of USG Corporation, who joined the board yesterday. You know, sells a product into very similar markets to what we do. And, you know, whereas 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 may have a slightly different perspective on what's happening in distribution channels, involved with our business to bring a different perspective.
Because our expectation is, going forward, you know, 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, similar issues and maybe a slightly different perspective than we do, we think would be really a helpful addition to our board. Similarly, Rhonda Hunter, who joined our board in May, was a former VP Timberlands of, you know, Weyerhaeuser, which I think people know. It brings a really interesting perspective to what's going on, both in the Pacific Northwest and in the U.S. South.
She lives in Arkansas, where we have an operation, and is able to, you know, 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, those two appointments, I think, are, are bang on the sweet spot, for us as we go forward.
Understood. Thanks for the context, Duncan.
Thank you.
Your next question comes from Ketan Mamtora. Your line is open.
Thank you. Just on the log costs in the U.S. South, we are seeing 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, you know, come down as you look at the back half, or are they still elevated?
Hey, hey, Ketan. 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 uptick, and most of it was seasonal, weather conditions and obviously some challenges in terms of supply at that point. Things improved a little bit in Q2, and in fact, they improved through Q2. So I'd anticipate that when we look at Q3, the log costs in the South are probably gonna be on average to what we saw during much of 2018. Q1 was a little bit of an uptick, which, again, I characterize more as an aberration, and we're back into, normal zone, comparable levels to what we saw the back part of 2018.
Got it. That's helpful. And then just one other question on the Phase Two project. I noticed that you are now talking about investments, you know, through 2022, and earlier it was through 2021. Am I reading too much into it, or have you all kind of, you know, you know, said that, "Okay, maybe we need to go a little slower?" Any thoughts or perspective?
Well, that, I can't remember who I was responding to, but one of the lessons learned on the phase one 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 looked 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 gonna be pushed out a few months, and that's really what that reflects.
Understood. Very helpful. Good luck in the back half of the year.
Yeah, thanks, Ketan.
There are no further questions. I turn the call back to the presenters for any closing remarks.
Okay, thanks, operator, and thanks, everybody. We very much appreciate your interest in our company. Happy to respond to any questions that you might have. Marty and I are around, you know, for at least the next couple of hours here today, if you have any follow-up you would like on, or we'll be here, be around next week, if you'd like to, like to chat. Anyway, thanks very much. Have a good day, and we'll talk to you again at the end of the next quarter. Thanks, everybody.
This concludes today's conference call. You may now disconnect.