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May 2004

Industry Overview

Fighting the effects of a higher C$ and the countervail

In spite of a rising Canadian dollar and a countervail that sucked much-needed cash out of the lumber side of the industry, the Canadian forest industry continues to push forward, with some forecasting stronger lumber prices ahead.

By Paul MacDonald

The move by forest companies to re-tool their sawmills and expand operations has allowed them to realize cost reductions and improve earnings, despite sometimes mediocre lumber prices.

To paraphrase a literary term, 2003was not the best of years for the Canadian forest industry, but neither was it the worst of years. Speakers at the Pricewaterhouse-Coopers (PWC) Global Forest and Paper Industry Conference held in Vancouver in April had that message and a few others for the year ahead, with some predicting downward drifts in lumber prices, while others think the year ahead should be a strong one for lumber prices. According to analysis by PWC, the global forest and paper industry experienced a slight improvement in overall earnings in 2003, which is positive news for an industry that in the past year has endured fluctuating currencies, continued fragmentation and the stifling impact of oversupply.

The early part of 2004 revealed encouraging indicators towards the long road to recovery for Canadian sawmills, notably an upward trend in lumber prices.

The early part of 2004 revealed more encouraging indicators towards the long road to recovery, most notably an upward trend in lumber prices. “The single biggest impact on the global industry in 2003 was the dramatic increase in value of the Euro and the Canadian dollar against the US dollar, and the trickle-down impact this had on the entire industry,” said Craig Campbell, leader of PricewaterhouseCoopers' global forest and paper industry performance improvement practice. The Canadian dollar has appreciated almost 12 per cent, or 8 cents, on average since 2002. For Canadian forest and paper producers, this increase in value against the US dollar has translated into a revenue reduction of over $4 billion on an annual basis.

European producers have also been impacted by the drastic appreciation of the Euro, which increased 20 per cent on average in 2003 against the US currency and six per cent on average in 2002. Like Canadian producers, the increase in the value of the Euro puts European producers at a disadvantage to those in the US as the global industry prices its products in US dollars. If the industry does in fact start to make more money in the future with higher prices, it should be bumping up spending, according to figures from PWC.

In 2003, both globally and in Canada, the return on capital employed (ROCE) was again well below the generally accepted minimum and the levels generated in the 1990’s. The forest products industry is one of the most capital intensive in the world, and ROCE is a key business indicator for global forest products, measuring the industry's profitability generated from the capital invested. Globally, the industry's ROCE in 2003 was 3.9 per cent. It was 4.3 per cent in 2002, down from 4.6 per cent in 2001 and 6.6 per cent in 2000—far below the generally accepted minimum return of 10 to 12 per cent. In Western Canada the industry posted ROCE figures of 4.4 per cent in 2003, an increase from 3.0 per cent in 2002. In Eastern Canada the industry ROCE figures were 3.9 per cent in 2003 vs 4.5 per cent for 2002.

Last year saw mortgage rates continue to hold at record lows, pushing US and Canadian housing starts towards record highs. Despite this trend driving increased demand for lumber, volatility due to ongoing fragmentation and resultant oversupply continued to plague any sustained growth in the industry. The Canadian industry also suffered as a result of ongoing countervailing and anti-dumping duties of 27 per cent on average on softwood lumber shipments to the US since May 2002.

Lumber prices peaked at US $340 in September 2003. In spite of this, lumber market price volatility due to oversupply kept the average price at US $268, up only two per cent from the 2002 average of US $262. As lumber prices rose, the Canadian dollar strengthened, enabling Canadian producers to realize positive returns from relatively constant prices in 2003. "Forest and paper products companies are truly operating in a global marketplace," said Craig Campbell. "Survival in the industry largely depends upon being a low-cost producer. North American forest and paper products producers are now carefully watching emerging global competitors such as Russia. Russian sawmills have some of the world's lowest costs for logs and sawmilling and currently they only cut about 16 per cent of their annual sustainable harvest."

The financial picture for British Columbia’s forest and paper industry improved slightly in 2003 versus 2002. The BC industry’s position as an efficient and low-cost producer allowed it to weather the loss of over $1 billion in revenue from the dramatic appreciation of the Canadian dollar and the payment of $635 million in duties on softwood lumber shipments to the US. The BC forest and paper sector earned $400 million in 2003, up from $100 million in 2002. Significantly, Campbell noted that if the BC industry had not been hindered by the eight per cent improvement in the average value of the Canadian dollar from 2002 to 2003, nor been handcuffed by the 27.2 per cent penalty on softwood lumber exports to the US, BC's earnings would have been almost $2 billion and ROCE would have been close to the minimal accepted level of 10 to 12 per cent.

“The BC industry has endured 2003 in the face of unprecedented pressures, including duties on US-bound lumber and having taken a $1 billion hit from the appreciation of the Canadian dollar,” he said. “A big reason for the success of BC’s industry is the low-cost, efficient model the industry has been fostering for the past few years. By running more efficient and larger mills, lumber companies are able to improve recoveries and profits.” In the US, ROCE in 2003 was 3.5 per cent, slightly lower than in Canada.

The overall Canadian industry's ROCE statistics are 4.0 per cent in 2003, unchanged from 2002. Logs are the highest single cost of producing lumber. The ability for companies to efficiently extract the most value from logs and convert them to lumber, with the lowest costs possible, is critical to maximizing ROCE and profitability. The strong earnings in 2003 are a result of the fact that BC companies have implemented practices, re-tooled mills and expanded operations that are now allowing them to realize cost reduction earnings at mediocre prices, says Campbell. The lumber recovery factor (LRF)—the volume of lumber extracted from a log—in the BC Interior region has increased every year for at least the past 17 years from 1986, the first year of the annual PricewaterhouseCoopers survey. The balance sheet for BC companies improved significantly in 2003 in relation to 2002.

The debt equity ratio at December 31, 2002 was 0.66 and it fell 21 per cent to 0.52 at December 31, 2003. It is noteworthy that BC public companies have the lowest debt equity ratio in the world. Comparatively, Eastern Canada sits at 1.26, the US at 1.41 and Europe at 0.78. “Western Canadian companies have among the strongest balance sheets in the world with debt being only 52 per cent of equity in 2003—which is down from 66 per cent just one year ago,” said Campbell. “To put this in context, the entire BC industry has a debt equity ratio of 0.52 and a debt of approximately Cdn $6 billion. Three of the largest US forest and paper companies each have over US $10 billion in debt and debt equity ratios of close to 2.0.” One of the highlights of the conference was a presentation by Paul Newman, director of market access and trade for the Council of Forest Industries of BC, on the growing importance of China, which he termed the “world’s workshop.”

China is now the fourth largest global trader, with its economy doubling every decade at its current rate of growth. Its exports in 2003 were US $438 billion, up a staggering 34 per cent from 2002. Its imports were US $413 billion, up a considerable 40 per cent. At a time when industrialized countries are ecstatic to see growth of three or four per cent, growth in China has averaged eight per cent in each of the last three years. The presentation noted that there is now more construction underway in the city of Beijing alone than in all of Europe. “A decade ago hundreds of millions in China dreamed of consumer goods. Now increasingly they can afford them,” said Newman.

He added that the country now has over five million households earning over $200,000 a year. In term of specific news affecting lumber producers and the forest industry overall, Newman noted that in 1998, the central government embarked on a housing reform program, selling all state-owned housing and encouraging private home ownership. Newman said that improving circumstances in China are driving demand for wood and fibre products. Based on current economic growth, and coupled with domestic harvesting reductions under the country’s National Forest Conservation Plan, he sees China being a large buyer of wood fibre for a long time to come. By 2010, the country’s fibre deficit is projected to grow to 164 million cubic metres. Newman had some solid advice for those entering the China market.

The Chinese are increasing worldly and companies treating the market as unsophisticated do so at their peril. Companies need to have market knowledge and be “on-the-ground.” They also need to decide on a strategy: either take a very short-term (order taking) view or make a long-term commitment. Newman noted that Canada does have some strong advantages. Canada is recognized for its expertise in wood construction and there is the opportunity to brand this with a “systems-based” approach. The Canadian industry, through groups such as the Council of Forest Industries of BC and Forintek, is already working to develop strong relationships with the Chinese government and the Chinese private sector. Newman noted that a new Chinese code effective January 1, 2004 covers woodframe construction and includes Canadian products and said this was “a major accomplishment.”

In terms of a long-term vision, Newman suggested Canadian producers shoot to create a sustainable position like that in Japan, where SPF lumber commands a 90 per cent share of the 2 x 4 construction market. But he added that the industry should keep its expectations realistic while pursuing goals aggressively.

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