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Edited Transcript of CFF.TO earnings conference call or presentation 14-Aug-19 2:00pm GMT

Q2 2019 Conifex Timber Inc Earnings Call

Aug 24, 2019 (Thomson StreetEvents) -- Edited Transcript of Conifex Timber Inc earnings conference call or presentation Wednesday, August 14, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Hans Thur

Conifex Timber Inc. - EVP

* Kenneth A. Shields

Conifex Timber Inc. - Chairman, CEO & President

* Yuri Lewis

Conifex Timber Inc. - CFO & Corporate Secretary

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Conference Call Participants

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* Hamir Patel

CIBC Capital Markets, Research Division - Director of Institutional Equity Research & Paper and Forest Products Analyst

* Paul C. Quinn

RBC Capital Markets, LLC, Research Division - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to the Conifex Q2 Conference Call. I would now like to turn the meeting over to Mr. Ken Shields, Chief Executive Officer. Please go ahead, Mr. Shields.

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Kenneth A. Shields, Conifex Timber Inc. - Chairman, CEO & President [2]

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Okay. Well, thank you, Debbie, and good morning, everyone, and welcome to this call covering our Q2 2019 results. CFO, Yuri Lewis; and Executive VP, Hans Thur, are with me here in Vancouver, and we're all available to respond to your questions at the end of this call.

First, let's cover off 3 points about the financial information we'll be referring to. Number one, we'll be making forward-looking statements and references to non-IFRS measures and, therefore, call your attention to the disclaimer on the second slide. Second, we will be referring to adjusted EBITDA, which is EBITDA adjusted for the noncash impact of foreign exchange translation gains or losses on our U.S. dollar-denominated long-term debt.

As you know, most of our borrowings are in US dollars because most of our debt was drawn down to fund the development of our lumber business in the U.S. So -- and so we believe that adjusted EBITDA is the better indicator of our performance in any reporting period. Please note that adjusted EBITDA reported for Q2 excludes the gain on the sale of duty refunds that we will discuss shortly.

Third, our Q2 results and results of our proceeding and comparative quarters have been reclassified to give effect to the sale of Lignum Forest Products that we completed early in April.

We've been asked by a number of our shareholders to clarify the scope and scale of our lumber operations as we closed out 2019 and entered 2020, and we've also been asked to summarize our plans to deal with our above-normal financial leverage and our below-normal liquidity. So rather than focus on the detailed operating and prior period information covered in the shareholder materials we released this morning, we'd like to use our time today to cover off 2 topics: number 1, outline a clear and coherent strategy to augment liquidity and to reset our financial leverage ratios; and second, to summarize the steps we're taking to position our company for significant cash flow generation in the future.

There are no easy fixes to the challenges we're facing. So it may take us 20 minutes or so to review the variety of initiatives we have underway or we have under consideration to achieve our financial and cash flow generation objectives.

Across our entire organization, our Board and leadership team are focused on and committed to making Conifex a more valuable company.

Before getting into specifics, permit us to review 2 overarching industry competitiveness considerations that underpin our approach to building a successful company. First, the U.S. South. The business transformation model underway at Conifex recognizes that the U.S. South softwood lumber supply region has the potential to provide lumber producers significant cash flow generation for years to come. Sawtimber represents the majority of the cash cost of producing number, and we believe delivered log costs in the U.S. South will remain highly affordable for a number of years.

In the regions we operate, increases in the number of maturing plantations, coupled with rising plantation productivity, will continue to create a growing inventory of harvestable sawtimber. While new mills coming onstream will help reduce the backlog of timber on the stump, improved mill recoveries will likely keep a cap on the growth in sawtimber demand and, thereby, limit increases in delivered log costs.

We continue to believe that sourcing the majority of our lumber production from the more profitable U.S. South lumber supply region is the ideal response to recent changes in competitiveness between the major North American softwood lumber supply regions.

Next, we'd like to share our observations about forest industry rationalization in the interior of B.C. as well as the reasons we believe that the ingredients are in place for improved cost competitiveness in the B.C. interior. It was inevitable that B.C. would find itself with too many sawmill complexes and not enough timber supply to keep all mills operating on a 2-ship basis. It was also logical to expect mills would bid up timber prices as competition for shrinking sawtimber supply intensified. Mill closures and/or ship eliminations would kick in once -- would kick in once it became apparent that operators found they had either too little liquidity or too little fortitude to continue funding cash operating losses that exceed shutdown cost.

We believe industry operators are now acting in a more financially responsible manner. Additional capacity reductions can be expected and bid prices for purchased wood are now retreating in the region we operate. We understand that the harvest level in the interior region of B.C. will decline by about 5 million cubic meters in 2019 compared to the previous year. This reduced log supply represents a supply contraction of around 1.5 billion board feet of lumber capacity. We also understand that approximately 5 million cubic meters or another 1.5 billion board feet of lumber capacity will come off the market over the next 5 years.

Against this background, we believe that the period of most severe negative cash flow generation has passed and that the interior B.C. forest sector will migrate to a lower position on the lumber industry cost curve in 2020 and beyond.

Once rationalization has largely run its course, we forecast an extended period when the interior B.C. lumber industry operates a smaller, more profitable footprint. We believe the transition to this more investor friendly economic circumstance will become evident in 2020 for 2 main reasons. First, although a number of closures have been announced, there is a lag of a few months between the timing of our curtailment announcement and the point in time that shipments are curtailed because of the rundown in log and lumber inventories. And the remainder of this year, reduced shipments reflecting previously announced closures, coupled with a more normal lumber demand environment, should result in tighter lumber markets and higher prices. Second, in the past few weeks, we are starting to see evidence of more responsible bidding behavior at timber sale auctions. We expect our delivered log costs at Mackenzie in 2020 to be materially lower than in 2019.

In summary, the combination of a biological limit to sawlog supply, coupled with a lumber industry that's less willing to sustain cash operating losses, support a forecast for a more favorable supply/demand balance in SPF lumber. As long as housing and lumber demand remain relatively stable, our outlook is for lumber pricing to gradually increase as we progress through the remainder of 2019 and into 2020. Beyond then, we expect prices to continue to fluctuate but to average out at levels that are reasonably high by historic standards.

So having shared with you our up-to-date thinking about lumber industry competitiveness, let's move on to review our financial position. Conifex is at a materially different stage in its development than the other more seasoned public Forest Products companies. The others completed their transformational acquisitions years ago, while we completed ours in July of last year when we acquired the Cross City, Florida, and Glenwood, Arkansas, sawmill complexes.

Following their major acquisitions, the other companies generally relied on cash flow from operations to reduce leverage. In our case, lumber prices collapsed, cash flow dried up and we have to release cash from other sources to reset our leverage and liquidity ratios.

Let's review the various initiatives we have underway or under consideration that are designed to restore our financial position. In June, we announced that we entered into a definitive agreement to sell our Fort St. James sawmill and associated tenure for $39 million. We anticipate the mill will remain curtailed between now and the closing of the sale expected in October. We expect to close the sale promptly upon receipt of approval from the Minister of Forests to the tenure transfer. We plan to use the proceeds from the sale to retire debt and to augment liquidity.

In addition to receiving a solid price for the Fort St. James' assets, we believe the transaction adds credibility to our belief that a private market transaction would take place at a big premium over the balance sheet carrying values of our Mackenzie sawmill complex in tenures.

Turning to the duty transaction, as we reported in late June, we arranged to sell our interest in potential refunds of duties that we had deposited in connection with our 2017 and 2018 lumber exports to the U.S. We observed that the recent trading prices for the public Canadian lumber-producer stocks appeared to factor in little if any value for the possibility that duties will be refunded at some future date. In our case, the duties we had on deposit were almost equal to our entire equity market capitalization.

These low expectations likely reflect the belief that protectionist trade restrictions will remain an important plank in President Trump's platform and that President Trump could be re-elected for a second term.

We are not aware of any material negotiations taking place nor plan to take place between the U.S. and Canadian governments or between the U.S. and Canadian lumber producers. Activity on the trade file has shifted over to the litigation channel available under NAFTA and the WTO.

With appeals, it is reasonable to assume that quite a few years could pass before a definitive final outcome is arrived at. We also believe that the chances of a negotiated settlement are slim since the U.S. industry is committed to imposing Canadian -- to imposing quotas on our shipments to the U.S., and this is an outcome that certain key lumber-producing provinces in Canada strongly oppose.

As you all know, estimating the net present value of potential duty refunds is a function of 3 highly uncertain variables, more specifically: one, the number of years in the future, duty deposits will be refunded; two, the portion of the duties on deposit that will be refunded; and three, what the recipients income tax rate is at the time of any refund.

Given the nominal value investors presently accord potential duty refunds, and given our current nontaxable status, we decided to sell our interest in potential duty refunds for 42.5% of the deposits paid in 2017 and 2018. We believe the benefits of immediate liquidity and debt reduction provided by this monetization outweigh the disposition discount.

The transaction resulted in a gain of $12.6 million, which we recorded as other income in our Q2 results. This gain is not included in the adjusted EBITDA we reported for the quarter and the proceeds, of course, were received in July and used to repay debt and augment liquidity.

This morning, our materials also revealed that we have engaged an investment banking firm to assist us in a review of the merits of a potential sale of a majority of, or entire interest in our Mackenzie Power Plant. When we brought the plant onstream, we thought we would broaden the base of investors interested in Conifex. With the passage of time, we learned that investors in lumber stock have limited interest in power generation. We learned that our share price generally tracked the trend in housing starts, the price of lumber and the share prices of the other lumber producers, and we have also been told that investors prefer pure-play lumber companies.

Infrastructure assets, such as our power plant, trade at higher multiples than the 4x to 5x EBITDA lumber companies are often accorded. With the base level EBITDA of around $14-plus million at our power plant at the 4.5x midpoint multiple, a capitalized value of just over $60 million is derived for our Mackenzie Power Plant.

Note 11 to our financial statement discloses that the power plant is funded with $65 million in term debt. With the capitalized asset value about equal to the value of the related debt, it follows that there is little if any value accretion to Conifex shareholders through our continued ownership of the Mackenzie Power Plant. This raises questions about whether Conifex shareholders are the most appropriate owner of the plant, whether the plant would be better positioned as part of an entity that focuses on the power business and whether Conifex shareholders benefit if we convert our ownership interest into cash and use the cash to augment liquidity and pay down debt.

We've always recognized that we may sell all or a portion of our power business. This is one of the reasons we kept our power business separate and nonrecourse to our lumber business and why we arranged for the debt associated with the plant to be assumable by a new owner of the plant. We're nearing the end of our market test that our investment bank has underway for these assets and towards the end of the third quarter, we expect to be able to provide you an answer as to whether we believe the transaction values available to us are sufficiently compelling to incent us to release all or some of our ownership interest.

Turning to our finances. Our MD&A discloses that net debt at June 30, 2019, decreased by $33.4 million to $273 million from $307 million at December 31, 2018. We view this as a considerable achievement since we incurred negative adjusted EBITDA of $15.9 million during the 6 months' stretch. We managed to reduce debt by actively managing all controllable expenses and working capital levels to optimize liquidity by scaling back our capital expenditures in the face of lumber price uncertainty and by monetizing investments that -- in areas that are not central to our mid- and long-term development as a North American lumber producer such as Lignum Forest Products.

Our MD&A discloses that we are actively working with our lenders to amend certain requirements under our credit facility, which we expect to complete shortly. Although we successfully negotiated amendments earlier this year and expect to do so again, there is no guarantee that our lenders will grant us a further amendment. Our MD&A also discloses that we have $91.5 million in debt retirement obligations over the next 12 months.

Based on the preceding discussions, the duty deposit transaction we completed last month, our Fort St. James sale scheduled to close in October and the market testing we are close to completing for our Mackenzie Power Plant, we anticipate we will secure sufficient funds from these 3 main sources to meet the $91.5 million in debt repayment obligations. Our net debt-to-capitalization ratio was 47% at June 30, giving pro forma effect to $91.5 million in debt repayments and $65 million in debt that will be assumed by a potential new owner of our Mackenzie Power Plant, our net debt-to-capitalization ratio would decline from the present level of 47% to a more acceptable ratio of just under 30%.

So having covered off our finances, we will now move on to review our lumber production plans for the remainder of this year on a mill-by-mill basis. At El Dorado, yesterday, we announced that we are indefinitely curtailing the sawmill complex. Those of you who recall our history at El Dorado will remember that our objective has been and continues to be to build a like-new sawmill complex by modernizing and upgrading the site.

We believe that the EBITDA for 1,000 board feet of lumber produced at El Dorado will be substantially equivalent to the EBITDA from a greenfield site. But because we did not have sufficient capital to complete the entire project on Day 1, we undertook to complete the project in 2 phases. In Phase 1, we installed a suite of new primary machine centers and restarted operations at the site, reusing mill components that were part of the original site.

We anticipated that lumber prices would be sufficiently buoyant to enable us to generate positive EBITDA upon completion of Phase 1, even though the site was far from fully optimized. Based on our recent experience, however, we find that the reused machine centers that we scheduled to have replaced and upgraded in Phase 2. We find that they're not capable of providing us the labor productivity, lumber recovery and great outturns necessary to generate positive EBITDA under current and immediately foreseeable lumber prices.

This is why we are curtailing production at El Dorado for 6 months or so, while the mill is down, we'll complete our engineering and our productivity-enhancement reviews, so we can undertake Phase 2 and resume operations later. We are guessing at this time, but in order of magnitude, something like $10 million of additional capital will likely be required to undertake Phase 2. We're also prepared to consider bringing in a financial partner to accelerate the launch of the Phase 2 capital program.

At Glenwood, abnormally high and prolonged rainfall in many parts of Arkansas in the first half of this year led to log shortages and fewer operating days. On his analyst call 2 weeks ago or so, PotlatchDeltic's CEO, Mike Covey, reported that the bad weather hampered May lumber production in the state of Arkansas more than in any other state in the U.S. This resulted in local log shortages and ship curtailments at several mills in Arkansas.

And to me, the shortfall in Arkansas lumber production due to weather was a key reason why the U.S. South lumber industry production in May was 16% lower than it was in 2018 and 7% lower than it was in May of 2017. So clearly, our Glenwood mill and several other mills in the state were adversely impacted by weather. We converted Glenwood over to a one-shift basis in June because we are confident we can procure sufficient volumes of affordable sawtimber to operate one shift consistently rather than two shifts sporadically. We are now in the process of expanding the weekly operating hours at the site and believe Glenwood has the potential to achieve positive EBITDA under current and immediately foreseeable lumber prices.

At Cross City, Florida, we've got stable two-shift production underway and positive EBITDA being generated.

At our Mackenzie B.C. sawmill, we plan to resume production on September 3. We are exploring various initiatives with the Ministry of Forests, the district of Mackenzie and the remaining operating Mackenzie-based forest industry stakeholders. And collectively, we're looking at ways where we can all sustain operations through the remainder of this year and to next year. We expect improved Q4 EBITDA from our power and lumber operations hosted at Mackenzie.

Summing up to this point and based on the preceding discussion, you can appreciate that Q3 of 2019 was very much a transition quarter because shifts were either curtailed or reconfigured at all but one of our sawmill sites. In Q4 of 2019, with 3 mills operating, we are targeting something like 115 million board feet of production, and at least 60% of that will be sourced from the more attractive U.S. South supply region.

We thank you all for taking your time today to learn more about our company. We trust you agree with us that the steps we are taking to improve our balance sheet makes sense and will prove to be successful. We're now pleased to respond to any questions analysts or shareholders may have about our recent results and about the steps we are taking to make Conifex a stronger company of more interest to investors.

With that background, we'll turn the meeting back to Debbie, our operator.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from Hamir Patel at CIBC Capital Markets.

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Hamir Patel, CIBC Capital Markets, Research Division - Director of Institutional Equity Research & Paper and Forest Products Analyst [2]

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Ken, the third party, you sold duty deposits to, are they an industry player or a financial company?

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Kenneth A. Shields, Conifex Timber Inc. - Chairman, CEO & President [3]

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Financial.

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Hamir Patel, CIBC Capital Markets, Research Division - Director of Institutional Equity Research & Paper and Forest Products Analyst [4]

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Okay. And it looks like you got another $6 million of deposits in the first half of 2019. Is that something that you'll be looking to monetize as well?

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Yuri Lewis, Conifex Timber Inc. - CFO & Corporate Secretary [5]

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Hamir. Potentially, yes.

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Operator [6]

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(Operator Instructions) The next question is from Paul Quinn at RBC Capital Markets.

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Paul C. Quinn, RBC Capital Markets, LLC, Research Division - Analyst [7]

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Just a question, I guess following up on Hamir's question on deposits. Maybe you could just review some of the assumptions that you made to come up with the value that you transacted the deal at?

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Kenneth A. Shields, Conifex Timber Inc. - Chairman, CEO & President [8]

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Well, I -- assumptions are assumptions, Paul. But if you had a $100 of potential duties on deposit, there's a precedent for $80 to be returned at a future date, and there is a potential for 27.5% or 28% income tax rate. So if we start with $100 and $83 funded and we pay a little over $20 of income tax to fund receipt, we end up with something like $60 or slightly less, and we thought getting $0.425 today compared to $0.60 at some future date made business sense, given our circumstances.

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Paul C. Quinn, RBC Capital Markets, LLC, Research Division - Analyst [9]

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Okay. That's helpful. And then are you surprised at where lumber prices, especially in Canada, currently sit, given the widespread curtailments that we've had?

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Kenneth A. Shields, Conifex Timber Inc. - Chairman, CEO & President [10]

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I'm not really surprised, Paul, and because of what I mentioned earlier, the lag between the announcement of ships elimination or a production curtailment and working all the log and lumber inventories through the system. And in addition, in B.C., it strikes me that every lumber producer knowing that stumpage rates were increasing on July 1, the log yards were just as full as they could possibly be, in May and June, and so there's a period of -- because people wanted to have their logs in the yards before the stumpage rates went up. And so from a cash flow point of view, even if you're incurring negative EBITDA, you're still positive by liquidating your log inventories, so I think we're going through the log inventory liquidation stage now, which adds cash to the industry bankbook, and I think that what we are now seeing is that people are much more cautious in terms of committing to 2019 harvest programs and more cautious in bidding for B.C. timber sale of wood, and that's why we think that we're going to have a lower delivered log cost in Mackenzie in 2020 than we're currently experiencing.

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Paul C. Quinn, RBC Capital Markets, LLC, Research Division - Analyst [11]

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Then just wondering what you're seeing in overseas markets, it doesn't seem that they've been able to help out the industry, at least the Canadian side thus far in 2019?

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Hans Thur, Conifex Timber Inc. - EVP [12]

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Yes. Paul. Yes, definitely on the overseas markets, when we look at China, we're still seeing tremendous competition coming out of Russia there, and we just haven't seen any movement or upward movement in pricing at that end. Japan just continues to hold its own, but again, those 2 combined along with some of the other countries just have not given us enough to enable us to move lumber prices up.

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Operator [13]

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(Operator Instructions) There are no further questions registered at this time. I would like to turn the meeting back over to Mr. Shields.

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Kenneth A. Shields, Conifex Timber Inc. - Chairman, CEO & President [14]

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Okay. Well, thank you, Debbie, and thanks to all of you. We covered a lot of factual information in our remarks today. If any of you have some follow-up questions, feel free to reach out to Yuri or myself, and we'll respond to your questions. Thank you, everyone, and enjoy the rest of your week.

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Operator [15]

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The conference has now ended. Please disconnect your lines at this time. Thank you for your participation.