Lumber Companies Will Profit From Millennials

Favorable U.S. demographics should lift lumber companies Canfor and West Fraser Timber to record profits in the years to come. But due to an eventual supply response and the lack of economic moats, heady profitability is likely to prove fleeting, and we don't regard either stock as a buy.

The largest generation in U.S. history--the millennials--are entering their 30s, the age at which Americans tend to form households. To date, their arrival has been disappointing, as employment and wages for this group have been slow to recover from the financial crisis.

But with improving job prospects and stronger finances, enormous pent-up demand is set to be released. We expect housing starts to approach 2 million units by 2021 as that happens, up 55% from 1.22 million in 2017, before fading as the demographic boom draws to a close.

More new homes will require a lot more lumber. With industry capacity utilization already at 87%, existing capacity will be pressed to the limit. That should lift lumber prices to $520 per thousand board feet in real terms by 2021, up 27% from a 2017 average of $410 per mbf. We expect a combination of volume and price growth to nearly double EBITDA for Canfor and West Fraser.

High prices will eventually elicit a supply response. Idle high-cost mills will restart, and new mills will be built. As the demography-led boom ends and lumber demand wanes, capacity utilization will fall. In the long run, we expect inflation-adjusted lumber prices will fall to just $335 per mbf and industry profit margins will sharply contract.

Following a lumber price-led runup in their shares in 2017, we no longer regard Canfor or West Fraser as undervalued, but we'd be interested in both in the event of a sentiment-driven sell-off. Such a scenario seems a strong possibility. Lumber prices are roughly 10% higher than warranted by current fundamentals and look ripe for a short-term pullback.

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