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Between surprisingly strong housing activity and an ill-timed supply shutdown, the oriented strand board (or OSB) market is booming, with prices blowing through past peak levels around $450/msf and smashing the old 2004 housing boom pricing records. As the second-largest manufacturer of OSB, that’s good news for Louisiana-Pacific (LPX) shareholders, as the company is going to reap a surge in profits and cash flows.
The downside is that the booms never last. The price spike has been driven in large part by capacity reductions tied to COVID-19 (though some structural/cyclical shutdowns prior to COVID-19 played a role) at a time when building activity has stayed surprisingly strong and renovation/repair work has surged. Producers like Norbord (OSB), LP, Georgia Pacific, and Weyerhaeuser (WY) are scrambling to reactivate capacity to serve this demand, but the high prices won’t last. They never last.
I’m bullish on residential housing through 2021 and capacity additions in the OSB sector have been relatively restrained in recent years. That could leave a little gas in the tank for further share price appreciation, but I think anybody considering the shares ought to have an exit strategy in mind, as a look at a long-term chart will tell you that the cyclical corrections here have been pretty ferocious.
A New High For OSB Prices
OSB prices have been on a tear, rising from around $270/msf in the second quarter to around $650/msf early in September to over $700 more recently. At those late September prices, OSB has topped its former peak prices by around 50%, and that is going to drive sharply higher realizations for LP and other OSB producers, as LP was already back to 90% of available capacity at the end of the second quarter.
The spike hasn’t occurred in a vacuum. Recent house starts have been healthy (up 3% to 1.4M in August), and existing home sales jumped 24% in August to a new record. Moreover, the housing supply is still inadequate relative to long-term needs, and I believe there’s a strong case that housing will remain strong into and through 2021, possibly 2022. Add to that a surge in renovation and repair work since the pandemic began, and you have a robust demand environment.
At the same time, you had an OSB industry that was coming off a weak 2019 where they were curtailing capacity. When the pandemic hit, even more capacity was temporarily closed to comply with lockdown orders and, I suspect, in anticipation of weaker demand. With significant capacity offline and stronger than expected demand throughout the pandemic, channel inventory vanished and builders have been scrambling. At this point, I almost expect to see contactors hanging around OSB plants ready to highjack the trucks as they leave.
Now for the cold water portion of the story – the prices won’t last. About 15% or so of industry capacity was idled at the start of the year (prior to COVID-19), and while not all of that capacity can or will be reactivated, I believe a lot of it will be, easing the shortage. If housing starts stay around 1.2M-1.3M/year, I would expect OSB prices to normalize around $250-$350/msf, and I believe prices above $300/msf would incentivize new capacity additions (probably from less-disciplined parties).
Make Hay While The Sun Shines
Given the efforts management has undertaken over several years, I believe LP will capture good margins and cash flows during this surge, and I expect the company to remain disciplined with respect to capacity additions and acquisitions, and will likely look to return at least some of that capital to shareholders through dividends and share buybacks (as it has been doing for a little while now).
On the subject of near-term performance, LP recently released preliminary numbers for the third quarter, and they looked impressive – with adjusted EBITDA up about 169% qoq at the midpoint, and OSB adjusted EBITDA leaping from $46M in Q2’20 to $185M at the midpoint (a new quarterly record, I believe). Expectations were already high, though, and the shares have basically shrugged off that pre-announcement.
There’s not much that management can do about the boom/bust OSB cycle other than to keep its plants operating as efficiently as possible and remain smart about capacity additions. LP has been through a lot of boom-bust cycles and has learned some difficult lessons.
In contrast, I do still see growth opportunities for the SmartSide engineered siding business. While SmartSide isn’t so special as to be completely immune to the cyclical nature of building materials, the company has continued to see good volume and market share growth, as well as strong margins, with the siding business staying very profitable (high-teens EBITDA margins) even while OSB was loss-making during the trough in 2019.
Rivals have certainly taken notice of LP’s success and have been trying to respond. Out of an addressable market of around $5.5 billion to $6.0 billion, LP has captured solid mid-to-high teens share, and while I still see growth from here, it’s likely to get more difficult to continue outgrowing underlying end-market demand by double-digit percentages.
Long-term cash flow modeling is really only relevant to stocks like LP in the downturns; the shares trade well above long-term FCF-based fair value during the upturns and then overcorrect in the downturns. So, I do expect long-term revenue growth from LP of around 5% and long-term FCF margins averaging out in the high single-digits, but that doesn’t matter much now.
It is possible to get a reasonable estimation of fair value by using EBITDA, my preferred approach is a blended model that combines both the near-term (12-mo) outlook for EBITDA as well as the long-term “full-cycle” EBITDA; that tends to correct for the ups and downs of the cycle. By this approach I believe the shares could trade at $31 to $35.
The Bottom Line
Although siding has become an increasingly important part of LP’s business mix, the shares still trade in large part on OSB prices. It’s going to take time to refill channel inventories, and housing demand could continue to surprise to the good, but sooner or later capacity is going to catch up and the boom is going to end. I don’t pretend to have the skill to time that exactly, and I don’t discount the possibility of a longer boom period, but I think anybody buying in today should do so with an exit strategy already in mind so they don’t caught in one of those step corrections when OSB prices eventually normalize.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.