By Dimitrios Koutsoumpos
This should be a very short post about Canfor Pulp (CFX.TO) as a cyclical bargain. That’s because the content is the refined and enriched version of a whatsapp group chat between attendees of the Quality Value Investing, a meetup group in London. The idea behind publishing it, is that a good investment idea should be described in a few sentences, even if it has demanded more work, and research in the background.
Canfor Pulp, a paper pulp & paper producer in Canada, is worth considering as it trades at around 5x its estimated earnings power of $70 million*, calculated through a 15-year period (6.1%) average profit margin applied on current revenue. Also, net debt is very low ($36 million).
*All values are in Canadian Dollars ($CAD)
I initially bought before the pandemic, I increased my position during it, and almost exited while the stock moved towards my fair value estimation. After that, the stock soon returned to lower levels, because the environment evolved as follows.
Amid the post-pandemic recovery, the price of paper pulp, the product the company mainly produces, skyrocketed, but also the price of the main input, lumber, exploded, and because of some serious supply issues in Canada (long effects of a beetle), transportation constraints, and downtime, the pulp producer could not capitalise well the situation.
This has created a false perception among investors, that this must be a bad business, as it cannot earn good money at best times. The error occurs by ignoring that best times for Canfor Pulp are not necessarily there just because the pulp price is high.
Contrary to the vertically integrated parent company Canfor Corp (also listed: CFP.TO) which indeed hugely benefited, Canfor Pulp (CFX.TO) pays for the lumber, and gets paid for the pulp. Thus, the one high price offsets the other, and profitability can remain poor. This business activity is similar to an oil refinery in an economic sense, which buys the crude oil and sells diesel, gasoline, etc. Margins dictate favourable or unfavourable conditions and not the oil, or lumber price alone.
In this investment, as I generally do in cyclicals, I have been patiently waiting for conditions to reverse. I am time agnostic because I believe that this is the path for a human to become a “prophet”, a very lucrative idea if applied in investing (read more here). What is more important is to make sure that the company will survive until the reversal of the conditions. The net debt of only $36 million compared to the equity of $482 million, is on my side on this matter.
Although I am against timing, it is a fact that, very possibly, this moment of greater margins and lofty profits is coming. The lumber price has collapsed due to demand destruction, mainly in home construction, but the pulp experiences record prices, because of energy and lumber supply issues in Europe, linked to Russia, resulting in severe shortage of paper and pulp. Furthermore, North America right now has an important competitive advantage compared to Europe over energy, and paper pulp production is energy intensive.
When the inputs are getting cheap and the output expensive, it’s a recipe for cyclically favourable earnings. As a reference, the last time we had very favourable conditions in 2018, the stock went 5.5x from where it trades now. That year, Canfor Pulp reported earnings of $184 million, and distributed $163 million in dividends.
Now think that at $5.16 per share, you can buy the whole business for just $336 million. Mr Market, the same way he punishes the stock when the financial results are poor, can get very enthusiastic when he learns about record profits. His behavior won’t make me change the idea I have for the real value of this business, which I conservatively reckon is somewhere around 10x times my estimation of earnings power ($70 million), translating to a market capitalization of $700 million ($10.73 per share).
What I can do is to buy this value cheaper from him for just $336 million ($5.16 per share), and have the opportunity to happily sell back much higher, if he ever gets enthusiastic.
Dimitrios Koutsoumpos
*Content presented on Investorblog does not present any recommendation for stock transactions. All investors are advised to conduct their own independent research into individual stocks before making a purchase decision.
My thoughts on timing, and on how the lumber price could affect the costs seem to be inaccurate. After some more research I realized that a large percentage of fibre from Canfor Corp are residual chips, a by-product.
The company does not disclose the ratio between residuals and the higher-cost whole log chips, and does not reveal detailed information about the pricing. I am doing more research on it.
This doesn’t change the big idea on cyclicality. Basically it enforces it, because provided that you have lumber industry in Canada, and by-products, you must also have pulp industry which has to take care of the by-products.
If the Canadian lumber industry is about to decline, then the pulp industry has to downsize. But even then, it has to survive and thus retain margins long-term.
This a very revealing source of information, especially the graph with the flows of fiber on page 12:
https://www2.gov.bc.ca/assets/gov/farming-natural-resources-and-industry/forestry/fibre-mills/2019_mill_list_report_final.pdf
Maybe there is more pain ahead, but at some point the pulp production capacity will downsize in the area, and will survive. My sense after reading more, is that mid-term conditions are more challenging (still, there is possibility for short-term earnings spike due to high pulp price), but for the very long-term, my opinion is that Canfor Pulp is more resilient than I had thought before. Some production should, and will stay in the area.
The fact that they deal with a by-product is not helpful in a downturn for lumber, and the limited BC lumber supply is a big problem. But when you have as an input a by-product in a specific area, this is a big moat for your long-term survival.