I would like to turn the call over to Duncan Davies, President and CEO.
Thanks very much, Carol. Good morning, everyone. Thanks for joining us. We're here today to discuss Interfor's third quarter results and our outlook for the balance of the year. Joining me as usual, is Bart Bender, our Senior Vice President of Sales and Marketing, who will comment on the current state of the lumber market, both North American and offshore, in a couple of minutes. Martin Juravsky, our CFO, who normally joins us on these calls, is not available this morning. We're gonna keep our remarks brief, as we always try to do, and we'll turn the meeting over to you for questions as soon as we can.
The dominating feature of the third quarter this year was the drop in lumber prices that began in late May and early June, and continued unabated through the third quarter and into the fourth quarter of the year. Pricing volatility is a fact of life in the lumber business. If you look at product prices over the last 10 years, it will show that prices often move CAD 70-$80 a 1,000 board feet from high to low over the course of a year, and the third quarter is often the weakest as distributors reposition inventories moving into the fall and winter. The situation this year, however, has been unprecedented.
Other than a brief pause in late March, prices rose steadily through the first five months of the year, exacerbated by logistics issues, which trapped supply in Western Canada during the winter months and slowed truck shipments in other regions. After opening the year in the CAD 430 range, the Western Spruce composite gained CAD 145 in 23 weeks, peaking at record levels in the last week of May. Over the same period, the Southern Pine composite gained more than CAD 150 a 1,000 board feet. This is often the case, studs are even more volatile, gaining more than CAD 200 from the first week of January through the last week of May. Since then, as we're all place.
From its peak, the SPF composite dropped almost CAD 280 to a low of CAD 296 in the space of 21 weeks, and Hem-Fir studs lost more than CAD 300 a thousand. Southern Yellow Pine prices fared a little better, but still dropped CAD 180 a thousand between the end of May and the end of October. In our view, the current state of the lumber market makes little sense. Overall, demand and supply is in reasonable balance, and the outlook for consumption overall remains positive, in spite of some softening in the new home construction market.
In our view, the drop we've experienced in the last few months is more of an overreaction to an overreaction that occurred earlier this year, with a combination of incremental supply becoming available in the short term, at the same time that intermediaries in the supply chain have chosen to destock in order to rid themselves of higher-priced inventory. The good news is the market is dynamic, and prices for the Western commodities appear to have bottomed. Random Lengths is reporting this week that the spruce composite is up CAD 15 from the trough. Southern Yellow Pine has continued to ease down somewhat, and today sits at CAD 378 a thousand board feet, but we believe the bottom is near for Pine as well.
Looking at prices for the main benchmarks in the third quarter relative to the immediately preceding quarter, the spruce composite was off CAD 98 or 18%, Hem-Fir studs were off CAD 94 or 17%, and the Yellow Pine composite was off CAD 63 or 12%. The drop in pricing had a material impact on our results in the third quarter. Net earnings were CAD 28.1 million, and EBITDA, after accounting for the effects of share-based compensation, was CAD 69.4 million on sales of CAD 571 million. This compares with net earnings and EBITDA of CAD 63.8 million and CAD 123.8 million, respectively, on sales of CAD 620 million in the second quarter. The drop in lumber prices accounted for approximately 70% of the drop in EBITDA during the third quarter.
Other factors impacting our results included a drop in shipment volumes, which accounted for 5% of the decline, higher log costs in the BC Interior, which accounted for 18%, and higher operating costs in the U.S. South, which is attributable to higher maintenance spending and downtime associated with a couple of adverse weather events, accounted for 15%. The increase in log costs in the BC Interior was due in part to higher stumpage charges, in part to higher hauling costs and other costs of production, and part of it was due to higher inventory valuation adjustments triggered by the drop in lumber prices. As prices reverse and start to increase, that inventory valuation adjustment should reverse. A total of CAD 15.9 million in export duties were expensed in the third quarter, compared to CAD 14.8 million in the second quarter.
Production in the third quarter came in at 674 million board feet, down 14 million board feet or 2% quarter-over-quarter, driven primarily by the maintenance and weather-related downtime in the South, and by a reduction in operating hours in the Northwest, as we adjusted production volumes in line with market weakness. On a regional basis, capacity utilization rates were 47% on the Coast, 99% in the Interior, 86% in the Northwest, and 89% in the South, for a total of 87%, compared with 89% in the second quarter. In the third quarter, Interfor generated CAD 69.7 million in cash from operations before changes in working capital … bringing the total over the last twelve months to just over CAD 350 million or more than CAD 5 per share.
Capital spending in the quarter reflects the ramp up from our strategic capital projects and was CAD 38.5 million in the quarter. We also repurchased 597,000 shares in the quarter at a cost of CAD 12 million. During the third quarter, net debt was reduced by CAD 30.6 million, coming in at CAD 3.4 million or 0.4% of invested capital. We closed the quarter with more than CAD 550 million of available liquidity.
Turning for a minute to our strategic capital activity, I'm able to report that good progress is being made on our phase I and phase II projects, with the Meldrim and Monticello projects on track for completion in early 2019, and the Thomaston, Eatonton, and Georgetown projects on track for completion in stages over the period from 2019 to 2021. We've also come to the conclusion that the greenfield project we've been looking at should be postponed indefinitely. This decision will allow us to focus on completing our phase I and phase II strategic projects and pursue other capital investment and allocation alternatives that we believe offer better return opportunities, at this point in time.
At this point, what I'd like to do is I'm gonna ask Bart if he'd provide an update on what he's seeing in the lumber market on a go-forward basis, and then he'll come back to me, and then we'll open it up to you, folks, for questions. So Bart, please?
Okay. Thanks, Duncan. I'll comment on the current state of the lumber market. I think Duncan coined it well when he said that what we're experiencing is an overreaction to the overreaction that took place in the first half of 2018. Since the end of Q3, lumber prices have continued to decline. Likely, we'll finish the quarter with a quarter-over-quarter drop. Inventories in the marketplace also continue to decline as distribution and end users adjust to these lower prices. It is quite likely that North America will finish 2018 at even lower end market inventories than we did in 2017. It's important to remember that low end market inventories set the stage for the peak prices that we saw in the first half of 2018.
There have been a number of curtailments, including our own, that have been announced recently, and I'm also sure that there are other curtailments that don't get announced, all in an effort to balance supply to the demand that we are currently seeing from our customers, who are in the process of reducing their inventories. We pay a lot of attention to inventories in the marketplace, and our feeling is that they have been reduced significantly over the past few months. With the drop in pricing, our competitiveness overseas has increased. Our sales certainly reflect this, and we are hearing this is the case for others as well. I think it's worth pointing out, too, that the opposite can be said for lumber imports. I don't believe that any significant inventories are increasing at manufacturing sites. Certainly, at Interfor, year to date, we're shipping our production.
There seems to be an expectation that substantial North American production will present itself in 2019. It's our view that labor constraints, costs, and equipment lead times will result in delays. This production will come to the market slower than what is expected. From the demand side, even though we are seeing some slowdown in new home construction, we expect continued growth in North American lumber demand. Repair and remodel fundamentals support growth. There continues to be pent-up demand for housing. The work that's getting done by the Softwood Lumber Board is growing the demand for lumber, all of which is supported by a strong U.S. economy, high employment rates, and wage growth. As Duncan said, pricing volatility is a fact of life in the lumber business, and we fully expect this to continue as we complete a good year.
We continue to be optimistic about 2019. Back over to you, Duncan.
Great, Bart. Thanks. I think at this point, it would be more useful for our guests if we turned it over for questions. So Carol, if you could open up the line, please.
Certainly. Just a reminder, if you would like to ask a question, please press star followed by the number one on your telephone keypad. Our first question this morning comes from Ketan Mamtora from BMO Capital. Please go ahead.
Good morning, Duncan, Bart.
Hi, Ketan. How are you?
First question: Can you talk about some of the key factors behind the deferral on the greenfield mill?
Sure. Ketan , as you know, we've, we've been very interested in, in finding an opportunity, for a greenfield investment, and have put a lot of time and effort into it over the last year or so. And but at the same time, we had very strict criteria for... that needed to be met, to trigger a, a positive decision to, to move forward with, with the project. And, over the last number of months, it became, it's become readily apparent to us that, equipment lead times, contractor services, steel prices, and a number of other cost factors, were increasing to the point where we weren't comfortable that we could generate the kind of returns, that we felt were necessary to go forward with a project of, of that magnitude.... And, that was the, the primary factor.
And so, as that became apparent to us, we made the decision and recommended to our board, and they agreed with us that we should table or defer that project for an indefinite period of time. It's not like we'll never do it, but for the next couple of years, we think it makes more sense to focus on delivering the high return projects at our existing facilities and limiting the distraction associated with doing another project with marginal returns at the same time. We also think that the currently overheated market for equipment and services and the like will tend to moderate somewhat as things progress, which will create a better potential for attractive longer-term returns that meet our criteria going forward, Ketan. So for now, we're tabling the project.
We'll revisit it over the course of the next couple of years. But, if we were to go ahead with it, and there's no guarantee we would, if we were to go ahead with it, it would be a few years out.
Got it. That's helpful. And then, Duncan, you highlighted other capital opportunities that you all see, you know, versus the greenfield at this point. Outside of the projects that are going on right now, would you be able to sort of comment or give any color on what those could be?
Well, we have what we call phase III of our strategic capital initiative, Ketan. Those are projects that are in the South and in other regions as well. We haven't got to the point yet where we've announced any of those, but they would be consistent with the capital spend rate that we talked about publicly over the course of the last couple of calls, where we talked about spending something in the range of, you know, CAD 500 million on discretionary activities over the course of the next four or five years. These would fit into that. They would be much smaller projects than the ones that we've got on the drawing board currently.
And they would likely, we would have projects that we would do, beginning next year and probably stretching out through the next two or three years after that.
Got it. That's helpful. And then, you know, in your view, is this sharp drop in lumber prices, you know, triggering any changes around assets that are for sale or, you know, impact on valuation?
Well, nothing that I've seen at this point in time, you know, other than for the publicly traded company. We haven't, you know, we haven't been. We've looked at a few things, Ketan. They haven't met our criteria for reasons other than price.
Mm-hmm.
So, we haven't gone much further on that. I think it'll really boil down to what people expect, prices will look like on a more normalized basis rather than in the peaks and troughs of a highly volatile market that we have currently.
Got it. And then just last question from me, would you look at any acquisitions outside of lumber?
Well, we're a lumber company, and you know, our primary focus is the lumber business. We operate in four regions in North America. You know, we'll look at some things that we think are synergistic with our business. That might include something outside of pure lumber focus, but there'd have to be a compelling reason to want to do it, and both from a financial standpoint and from a strategic standpoint, before we would do that.
Got it. That's helpful. I'll turn it over. Good luck into 2019.
Yes, thanks, Ketan.
Our next question comes from Hamir Patel from CIBC Capital Markets. Please go ahead.
Hi, good morning.
Hi. Hi, Hamir.
Duncan, on the greenfield, are you able to share with us where the final cost estimate ended up when you decided not to go ahead?
I'd prefer not, other than to say it was quite a bit higher than the initial guidance that we had provided, Hamir. And to the point that we weren't comfortable that it met our criteria for risk-adjusted returns, which we've indicated are, you know, in the 20% range. So we, we couldn't see, we couldn't see our way clear to achieve that, given our view of the lumber market and the log markets going forward. And so it just...
We were actually all quite comfortable just to say to down tools at this point in time and focus on the other projects which have, by definition, much higher returns because they tend to be smaller, and they're building off of an existing asset base, as opposed to the risk associated with a brand-new project in a brand-new region or brand-new area for us.
Okay. Fair, fair enough, Duncan. But, I mean, based on that analysis, do you have a feel as to maybe how much of the capacity that's been announced maybe actually gets built?
I haven't gone through the list, but I wouldn't be surprised to see other announcements similar to ours, that people have either canceled projects or deferring them for a period of time. And it's been our contention, as you know, we've talked about this, that the number of projects that have been announced, we indicated some time ago, that we would be surprised if all of those projects were built and all of that capacity that people have been assuming is gonna come onto the market here over the course of the next little while is gonna get built or will get built as anywhere near as quickly as people have been thinking it might get built.
... Right. Okay. No, thanks. That, that's helpful. And just turning to BC, you know, do you have a sense as to where log decks for the industry are? And, you know, given the weaker prices, do you think there's maybe a risk that the industry might not invest enough in the log decks heading to winter?
Well, you know, it's not an issue of desire, Hamir. It's I think it's an issue of the impacts of both declining allowable cuts and exacerbated by the impacts of the fires that we saw both in 2017 and again this year. And while the fires this year didn't disrupt production to the same extent that they did in 2017, certainly significant amounts of standing timber inventory was burned, and which will impact supply in the near term as we move over the course of the year. So, I think I'm not aware of any. Put it this way, I'm aware of log decks being tight in some areas, and in some cases, including ours.
And we're very aware of what we think is a rational behavior as the industry looks to, you know, capture supply to maintain operations. And that creates a dynamic which drives log prices up, that we just don't think makes a bunch of sense. And so I wouldn't be at all surprised to see less production coming out of the BC interior over the course of the next 6-12 months, simply as a result of availability of timber supply and log costs that don't make sense given the lumber market environment that we're likely going to be dealing with over the course of the next year or so.
So based on that, Duncan, would that suggest that the 20% curtailments in the interior that you've taken, that those might persist into 2019?
Well, for us, it became a question of timing, and our sense was we'd be better off to be disciplined in the current market environment, and position ourselves to be able to operate in a normal course in the early part of next year would be a better operation as opposed to continuing a curtailment during that period of time. But I think others who've chosen to run more actively in the current market environment may find themselves with less timber supply available to support their operations going forward.
Fair enough. Thanks. That's all I had. I'll turn it over.
Yeah. Thanks, Hamir.
Our next question comes from Sean Steuart from TD Securities. Please go ahead.
Thanks. Good morning, guys.
Hi.
A few questions. On the cost side, the CAD 11.5 million inventory revaluation, was that fully baked into cost of sales this quarter?
Yep.
Okay. Some of the other cost items this quarter, I think we have a pretty good sense of the fiber cost inflation in BC. The maintenance, downtime you took, though, and I guess preventative downtime ahead of the hurricane, can you guys quantify that impact beyond just lost production?
I think, I think I tried to do that with my comments about what the cost of that was. It accounted, I think... I don't have the number right exactly in front of me right now, Sean, but I think it was, you know, 15%-20% of our, the difference in EBITDA in the quarter was attributable to the, to the downtime in the South.
Okay.
It was a combination of a bunch of things. It was, you know, we took Georgetown down in South Carolina in anticipation of Hurricane Florence.
Mm-hmm.
And I think we were out for, I think it was 5-7 days. I can't remember exactly. And we did the same thing in the fourth quarter with the hurricane that rolled through the Florida Panhandle and into southern Georgia, but that's not a third quarter item. The other spending, you know, the maintenance spending, even though you take it on without anticipating it's gonna generate any significant returns for you, you know, the mills will operate better as a result of it, and it's all part and parcel of our program of bringing the operating standards and practices up to something that we're more comfortable with in the South, similar to what we've got in the West and the Northwest.
And some of it was project related. So at Monticello, for example, where we're in the process of rebuilding the mill, there are times when you take different machine centers down, or you'll take the whole mill down for a tie-in of new equipment. So that was the impact that had on both production and on profitability. Part of it was related to the capital projects that we think are positioning ourselves going forward.
Got it. Second question I had, the marketable securities you guys acquired this quarter, is that just treasury management, investment in fixed income, that sort of stuff?
Yes. Yes.
Okay.
Strictly. We've got this significant cash balance, and so we're moving some of that cash into, you know, marketable securities that generate higher returns for us. So it's just a cash management thing.
Okay. That's all I have for now. Thanks, guys.
Yeah, thanks, Sean.
Our next question comes from Paul Quinn, from RBC Capital Markets. Please go ahead.
Yeah, thanks very much. Morning, guys. Hey, I guess this is a question to Bart, but Bart, you talked about inventories in the pipeline being at very low levels. Just wondering how you're gauging this?
Well, I mean, obviously, there's the information that you get from, you know, sources such as FEA and whatnot, who track those things closely. But I would say the majority of that is just through discussions with our customers. You know, we stay tight with our customers in general, and that's a question that gets asked all the time. And I would say right now, more than any time I've seen in the recent past, you hear comments like, "You know, I'm no lo- I'm not carrying 60 days of inventory, I'm now carrying 45," or, some cases, "45, I'm taking them down to 30." And so I think, I think there is a commonality in the marketplace where people would like to work through their inventories, as they approach year-end.
There's obviously an incentive to do that. And the way the market is and with availability and lead times, I think it can afford them that opportunity. You know, and our position is that you take inventories down two weeks, well, that if everybody does that, that can be a significant volume that goes out of the marketplace. And I don't think that volume is being accumulated elsewhere, so that's gone.
Okay. And then just with the customers themselves, I mean, one of the concerns in the U.S. housing market is affordability, and just wondering, you know, as you talk to your U.S. home building customers, what's the sense that you've got of their ability to shift, you know, their construction to more affordable homes? And, you know, how likely is that to occur, and you see evidence of that happening?
Doug, you want me to take that?
Yeah.
Okay. It's an interesting question. I think for that end use sector, which is what, I guess, in total, 30% of the lumber consumption in North America, they're working through those realities as well. You know, it's very interesting. We get some differing comments, you know, where the new home entrant is actually still very active segment of the marketplace, and that really a lot of the impact on affordability is being impacted through the move-up. So people that own homes and you know want different homes. And so I think as that industry works its way through, there's a combination of things that are gonna take place. First, they're gonna redesign their homes to address the affordability issue.
But the other piece that I think is a meaningful move in the marketplace is this whole concept of off-site construction. And the idea that assembling wall panels or roof trusses or any of those types of things is a mechanism that they can use to bring more affordability into the into you know their construction costs. So I you know I really think that sector is really dynamic right now and shifting to make sure that they're responsive to to the needs in the marketplace. And so in our conversations more times than not the response to us is that they see the current situation as more of a pause than a real change in demand for homes.
Okay. And then just lastly, just on the question of, or the avenue of off-site construction, what do you see those efficiency gains, or what do you hear in those efficiency gains are, i.e., to build the same type of house inside, I suspect they'll use less lumber. Is that a 5% less? Is that a 10% less? Do you have any idea what that is?
Well, you know, Paul, I think the big driver is not the usage of lumber. I mean, you hear about some ideas that they can reduce, but really not essentially that much. I think the real driver there is labor and the constraints of labor. And so the efficiencies that you gain, not only within a factory environment, cost and quality, coupled with the efficiencies that you gain in assembling these structures on site, just require quite a different amount of labor. And so you know, that's why our view is that off-site construction is real, because it addresses two factors: cost and labor availability.
Paul, I think it's got the potential for a positive impact on total demand for lumber because there continues to be a significant pent-up demand for housing. Labor availability is one of the big factors which has constrained new home construction. So if builders can find other ways to construct homes and to match those homes with where the market demand is, I think it's got the potential to increase overall home construction starts and to increase the volume of lumber consumed. So we're pretty optimistic about that and have been working actively with our with home builders on exactly that kind of discussion.
Great. That's all I had. Best luck, guys.
Thank you, Paul.
As a reminder, star one in order to ask a question. Our next question comes from Chris Damas from BCMI Research . Please go ahead.
... Hi, Duncan.
Morning.
I wondered if you could comment on what's going on in the Southeast. We had two major hurricanes hit. It seems like a long time ago. Really, it was September, mid-September, was Florence, more of a flooding event, and then we had a direct hit to, Florida and South, South Georgia. How did that affect your mills? What do you see in terms of the fiber basket and, the construction, the home building business down there?
Yeah. So, in terms of our mills, there was no damage at all to any of our mills as a result of the hurricanes. But, both in the Carolinas and then subsequent in southern Georgia, we took a, we took a precautionary approach by taking our mills down in advance. We're very focused on making sure that our, our workforce is safe, and they're able to do what they need to, to do to, to look after themselves and their families and their homes. And so we took those facilities down, and I, I can't remember exactly what the numbers, but I think Georgetown was down, you know, 5-7 days during that period of time.
Then we lost about a week of production in our Georgia facilities as a result of the preparations for Hurricane Michael. The bigger issue, and it doesn't affect us so much, but in southern Georgia there was some significant damage that occurred on the timberlands in a couple of areas that will have longer term implications for that marketplace. None so much on us, just because of where we're located. But for other operations, I think it's they're having to take account of the amount of damage that has taken place down in that area from a timber supply standpoint.
In terms of the housing market itself, you know, you go through periods of time where the, you know, the weather's, you know, wet or there are hurricanes or whatever it is, that slows down, you know, the rate of construction. And by slowing down the rate of construction, by definition, it slows down the rate of lumber consumption. Texas, in particular, has been quite wet this year. That's had an impact as well. But, you know, I think we continue to believe that the South is gonna be the major market, in North America, as it has been for many years now, from a lumber consumption standpoint and from a, from a home construction standpoint. And, and you never, you never like to, you know, look at a natural disaster like that and, think about what that impact is on construction.
But natural disasters tend to, you know, have a positive impact on the amount of construction that is required to rebuild homes. So it tends to impact the overall demand piece positively longer term, with after some short-term dislocations.
How much, Southern Yellow Pine are you exporting relative to domestic demand down there?
We were exporting, I think, Bart, somewhere in the 5%-7% range of our production. Is that about right, Bart?
Yes. Yeah.
With the tariffs on being placed by the Chinese on U.S. product imports, that slowed down a little bit. But we would expect over time that common sense would prevail. At least we hope it will, and that we'll be able to move back into increasing our rate of shipment from the Southeast to the Asia Pacific market in particular, and also to the Indian market. One of the benefits of whether it's Interfor or the other big Western Canadian producers operating in the U.S. Southeast is we have established customer bases and distribution channels in most of the major markets of the world.
That's what we've been doing, is moving product on a backhaul out of East Coast ports into the Pacific markets, which is quite cost competitive and has been met with a fairly enthusiastic response in the marketplace.
Great. Thanks very much.
You're welcome.
Our next question comes from Ketan Mamtora from BMO Capital Markets. Please go ahead.
Thank you. Just a couple of quick ones. Duncan, any sense of CapEx for 2019?
I think a round number would be CAD 200 million, Ketan. We're ramping up the phase. The phase I projects will be completing in the first part of next year, and the phase II projects will be starting to ramp up, and some of the phase III projects we believe will be underway in 2019. As I said earlier, you know, we've got CAD 550 million worth of liquidity today, so we're pretty comfortable with the rate of CapEx that we've got on the drawing board here, both next year and for the next few years.
Got it. That's helpful. And then, just one more on log cost inflation. So in BC, do you expect the log cost to come down with this sharp correction in Western SPF? Is that sort of your base case estimate for at least the first half of 2019?
Yeah, I think just like you've got an overreaction in the lumber market to different demand supply conditions, I think you've got some overreactions happening in the log markets as well, driven by a combination of reductions in standing timber inventory because of wildfires and other factors. And just the drop in lumber prices, I think, will force log consumers to be more disciplined in their buying activity. If they're not gonna do that, it's like putting a loaded gun to your temple and spinning the chamber and seeing how it works out. So I'm much more comfortable managing our business in a disciplined way. And I think generally what that will do is tend to put downward pressure on log prices going forward.
Got it. That's very helpful. And then in the U.S. South, are you assuming any log cost inflation or sort of still flat?
No, we think the demand-supply balances and the inventory levels in the U.S. South will mitigate any significant upward pressure in log costs next year and for some period of time going forward.
Got it. That's all I had. Thank you.
Okay, Ketan. Thank you.
We have no further questions in the queue at this time. I'll turn the call back over for closing remarks.
Okay, thanks, Carol. Thanks, everybody. We very much appreciate your interest in the company. Unfortunately, you know, Martin is dealing with a personal situation today, so he's not able to be with us. I expect he'll be available this afternoon and over the course of next week. I know a number of you like to talk to Martin and get his insights, so I would encourage you to do that as the day rolls on and into next week. In the meantime, our expectation is, you know, the pricing that we've seen through the first part of the fourth quarter will impact our results in the fourth quarter.
But we continue to be very optimistic, both about the lumber market and how we're positioned relative to that lumber market and with the benefits of all of our capital programs. So we look forward to reporting to you again early next year and updating you on the progress that we're making internally with our capital activities. In the meantime, feel free to call Martin or call myself if you want any more insights. On that, thanks very much, have a good day, and thanks for your interest in our company. Bye now.
This does conclude today's conference. You may now disconnect.