Iamgoingtogiveabriefglimpseintotheperfectstormthatisemerginginthelumberindustry. Followingtheindustryupdate(withafocusontheUShousingmarketthemainindustrydrivers),Iam goingtooutlinemythesisforinvestinginWestFraserTimberCo.Ltd.theworldslargestlumber producerandacompanydomiciledinCanadawithassetsinbothCanadaandtheUnitedStates.In short,lumberdemandisimprovingoffofhistoricallowswhilesupplyremainstightwithlittle incrementalcapacityexpectedintheneartomediumterm.AsUShousingrecoversfromtrough(more appropriatewordisdepression)levels,NorthAmericanlumbercompanieswithhighoperational gearingwillseesubstantialmarginimprovementandsharepriceappreciation.Thecurrentdynamicsin thelumbermarketofferahighlyasymmetricpositiverisk/rewardopportunity.

IndustryTrends:
2500 2000 1500 1000 500 0 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 USHOUSINGSTARTS(in000's)

From1966tothepeakofthehousingmarketin2005,UShousingstartshaveneverfallenbelow1mn unitsperannum.Meanhousingstartsoverthattimeperiodwerec.1.5mnwithastandarddeviationof c.450mn.In2008,UShousingstartsfellto554ka2standarddeviationeventbuthaveincrementally improvedsincethen;theyarestill,asthisgraphshows,wellbelowanormalrangeofvalues.H1data from2012supportarunrateof740750khousingstartsbutthisisstillwellbelowtrend.Theabovedata provideadiversifiedsampleofobservations:theyincludeyearsofhigh/lowgrowth,yearsofhigh/low inflation,andyearsofbull/bearequitymarkets.Fromthisgraph,theonlyconclusionisthatUShousing startsareatunsustainablylowlevels,andunlesssomefundamentalchangehasoccurredinUS demographictrends,incrementalpositivechangeinthedirectionofthemeanisnotonlystatistically likelybutsociallynecessary.

4 3.5 3 2.5 2 1.5 1 0.5 0 0.0% 0.5% 1.0% 1.5% 2.0% 1967 1970 1973 1976 1979 1982 1985 1969 1972 1975 1978 1981 1984 USPOP 1966 USPOPGROWTH

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Ihaveincludedvariousgraphsthatillustratethesamepoint:therehasbeennoradicalshiftinUS demographictrends.IhaveincludeddemographictrendsinCanadawhichistheotherchiefend marketforNorthAmericanlumberandbothcountriesaregrowingathealthyrates.Therehasbeena slowdowninpercentagegrowthratesthisisexpected,asmostgrowthtrendstendtoexhibitqualities ofnonlinearitybutincrementalpopulationadditionsontheaggregatehavenotslowed.Thefinal graphinthissequenceshowsthatUShousingstartshavenotkeptupwithincrementalpopulation additionsandabacklogofdemandislikelyaccumulating.

500 400 300 200 100 0 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 LUMBERPRICE(CPIADJ)

100% 80 70 60 50 40 2005 2006 2007 2008 2009 2010 2011 2012F DEMANDONNASAWMILLS OPERATINGRATE NACAPACITY 80% 60% 40% 20% 0%

GiventhedepressionthatwearecurrentlyexperiencinginUShousing,lumberpriceshaveheldupwell. Thetopgraphshowsinflationadjustedspotpricessince1972.Wearealreadynearthelowerendofa midcyclepricingrangeandUShousingis750kunitsbelow50yeartrendlevels.Thereasonforthis relativepricingstrength,asthenext3graphsshow,islogicallyrelatedtotightnessonthesupplysideas wellasanincrementalandsustainedpickupinexportdemand.ThesecondgraphshowsNorthAmerican capacityfallingbyabout12.5bnfbmbetween2005and2012.Thehousingdepressionhasforcedout marginalproducersandmuchofthiscapacityreductionisbelievedtobepermanent.Additionally, demandonNorthAmericansawmillshasrecentlypasseditsinflectionpoint;thereasonforthistrendis twofoldobviously,UShousingisrecoveringmodestly,butasignificantcontributingfactorisrelatedto exportgrowth.China(asthecountryincreasinglyuseswoodasasubstitutebuildingmaterial)has increaseditsexportdemandfrom152mnfbmin2005to2.662bnfbmin2011.Thefinalpointto consideronthesecondgraphistheuptickinoperatingrates.Operatingratesreflecttheoverall tightnessofsupplyanddemandinthemarket.Asoperatingratescontinuetoimprove,lumberprices willlikelyfollowsuit(i.e.,amongotherthings,demandgrowthshiftsbargainingpowerinthedirection ofsuppliersandpricesnaturallyappreciate);finally,anobviouspoint,aswespeculateaboutarecovery inindustrymargins,higheroperatingrateswilldrivehighermargins(i.e.,fixedcostsgetspreadoutover moreunitsofoutput).ThefinalgraphinthissectionhighlightsthenegativeeffectsoftheMountainPine BeetleepidemicinBritishColumbiascentralinterior.Whiletheepidemicisexpectedtobeless impactfulthanearlyobservationspredicted,theultimateoutcomewillbelessforestlandavailablefor harvesting.Futureproductiontenuresi.e.,annualallowablecutswillneedtoberesetdownward.

 Onamorecompanyspecificlevel,theoperationalgearingoflumberproducersoffersattractivereturns duringanupcycle;additionally,taxationinCanadaallowsforlowerratesaslumberpricingaccelerates. ThetopchartshowsthepositivebenefitsoftheCanadiantariffpolicynamely,lowerlumberprices receiveexport(exports,here,applyonlytoexportsfromCanadatotheUS)dutiesof15%,whereas pricesabove$355arenotsubjecttoanyduties.Thebottomcharthighlightstheoperationalgearingof lumberproducers(inthiscase,thecompanyhighlightedisWestFraser,buttheoperationalgearing storyissimilarthroughouttheindustry).ForWestFraser,a$10changeinlumberleadstoa$48million dollarchangeinearnings. WestFraserTimberCo.Ltd.: TheNorthAmericanlumbermarketishighlyfragmented.Accordingly,WestFraseristhelargest operatorinthespace,butits5.7bnfbmsofcapacityrepresentslessthan8%ofthemarket.An acquisitionof13USsawmillsin2007addedroughly1.2bnfbmtoaggregatecapacity,andsimilar acquisitionsgivenastrongbalancesheet(withnetdebt/equity=15%)canbeexpectedasthe industrymovestowardamoreconsolidatedstructure. WestFraserhas3divisionslumber,panels(i.e.,plywood),andpulpandpaper.ThebulkofWest Frasersearningscomefromlumber,butpulpandpaperisaprofitabledivisionforthecompanyAsian demandhasbenefitedpulppricing,andonthepaperside,WestFraserisinvolvedina50/50joint venturenewsprintbusinessthatissmallbutconsistentlyprofitable.Thepanelsdivision,evenmoreso thanthelumberdivision,hassufferedfromaweakhousingmarket;importsfromtheUSintoCanada haveaddedadditionalcompetitivepressures.Littleisexpectedfromthepanelsdivision,butitcould offerupsidesurprisetotheinvestmentthesis.Therecentsuccessofthepulpandpaperdivisionis somewhatworrisomemoreonthepulpsidethanthepaperside(thenewsprintbusinesshas consistentlyrealizedstablepricing)andwecouldseemarginerosionifmacroconditionsworsen.The

bullswouldarguethatsupplyconditionsinpulpremaintight(littleincrementalgreenfieldcapacityis beingadded),butwithpricingabovelongtermaverages,prudenceshouldbeusedinvaluingthis segmentofthebusiness.Intheirrecentlyquarterlyearningsreport(Q22012),WestFraserstrucka cautiousnoteontheneartermoutlookforthepulpbusiness:Weexpectpulpmarketstoweakenin thesecondhalfof2012asadditionalpulpfromBrazilandRussiaislikelytoputdownwardpressureon pulpprices.AnypulpproductiondowntimeorimprovementintheEuropeaneconomywouldmitigate furthershortertermpriceweakening. AstheanalysisoftheUShousingmarkethasshown,thecurrentpriceoflumberisalreadyatdecent levelsdespiteacontinueddepressioninUShousingstarts.Thethesispositedtoexplainthis phenomenonwasthatsupplytighteningbroughtonbytheclosureofhighcostsawmillshas acceleratedpricerationalization(withslightbutgrowingdomesticdemandandexportgrowthhelping). Further,itappearsthatmanyofthesesawmillclosuresarepermanentandthatdemandwillonlyneed toexpandtonearaveragelevels(i.e.,lessthanLTaveragesof1.5millionhousingstarts)beforeeven strongerpricingresumes;itseemsplausible,forinstance,that$400lumbercouldbereachedatonly1 millionhousingstartsanumberthatisstillwellbelowtrend. Whenbuyingequitiesofcommoditycompaniesduringapredictedupcycle,thereisobviouscredence tothenotionofbuyingjunkoverquality(i.e.,whenthecycleisturning,buythecompanieswiththe highestoperationalgearing,wheretheearningsupsideisthestrongest).Inthecaseofthelumber industry,thisrelationshipstillholdstrue,butthechoices,overall,arelimitedthereareonlyafew listednames,andthemajorityofthemareilliquid.Moreover,WestFraserwhichrepresentsthe qualitynameinthespaceisnotpricedatasignificantpremiumtoitspeergroupandthemargin upside,iflumberpricesbegintoappreciate,isverysimilar.WithWestFraser,thesharepriceis protectedonthedownsidebythecompanysabilitytogeneratepositivecashflowthroughoutthecycle (evenduring2009ayearwherehousingstartsreachedlevelsunseensincethe1940sthecompany generatedpositiveoperatingcashflow)andastrongbalancesheet,andtheupsidestory,characterized byhighoperationalgearing,remainsintact.
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1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 NETDEBT/EQUITY

Theprevious5chartsillustrateboththemarginupsidestoryforWestFraserandthevariousquality aspectsofthecompany.Asthefirst2chartsshow,EBITDAmarginsarewelloffofhistoricallevels14% groupEBITDAmarginshavebeenthenorm,withLTlumbermarginstrendinghigherat16%.Thefirst chartshowsgroupmarginswhichappearatfirstglancetobelessdepressedthanmightbeexpected (i.e.,theUShousingmarketisinadepressionandEBITDAmarginsareonlymarginallybelowLT averages),butthereasoncanbeexplainedbyadecentpulpmarketin2010and2011andthesecond chartshowslumbermargins.Thethirdandfourthchartsshowoperatingcashflowandfreecashflow, respectively,andthefifthchartshowsthestrengthofWestFrasersbalancesheet.Indowncycles,the companyisprudentaboutmanagingcostsandinventorylevels;since1995,2007wastheonlyyearwith negativeoperatingcashflow.Similarly,freecashflowisgenerallypositivewhichissurprisingforan industrycharacterizedbyhighcapitalintensitybutfreecashflowyieldsarestillrelatively unimpressive.Finally,thebalancesheethasstrengthenedovertheyearsandcurrentlydisplayslow gearing.Asmentionedearlier,thebalancesheetstrengthaffordsroomforbothfutureM&Aandhigher capitalexpenditurestoexpandthecurrentproductionfootprintand/orupgradecurrentcapacitywith newlowercosttechnology.Thefragmentednatureoftheindustrycombinedwiththepresenceofa strongbalancesheetalmostassuresthatWestFraserwillmaintainacostadvantageoverthe competitionindefinitely.

 ThecatalystforWestFraserisobvious:incrementalimprovementsintheUShousingmarketwillleadto betterlumberpricing,marginexpansion,andultimatelysharepricegains.Withtightenedsupplyand increasedexportdemand,midcyclelumberpricingof$340$350/mfbmcanlikelyberealizedwithouta returntoLTaveragehousingstarts(i.e.,1.5millionperannum);1millionhousingstartsorslightlyless maybesufficienttocreatethistypeofpricingenvironment.Withhousingstartsexpectedtotrendnear 750kfor2012,IhaveestablishedabasecasevaluationforWestFraserbasedontheassumptionthat UShousingstartsbegintoapproach1millionin2013or2014.Thebasecaseassumesamidcycle lumberpriceof$340/mfbmandmarginalcontributionsfromtheother2divisions.Basedonamidcycle multipleof5.5x,asharepriceof$66.53isdeterminedac.18%premiumtothecurrentsharepriceof $56.52. Thebasecaseisnotsuperexciting(althoughitshowsthatunderfairlyconservativeassumptions,the companyisunderpriced),andIamprobablybeingoverlyconservativeaboutthecontributionsfrom pulpandpaper.However,inthesecondvaluationthebullcaseIhaveadoptedmoreaggressive pricingassumptions(consistentwithpeakpricesachievedoverthepastdecade)whileloweringthe multipleto4x,andatheoreticalpriceof$99.80isdeterminedac.76%premiumtocurrentshares.The pricingassumptionsinthebullcasewouldbemoreconsistentwith1.5millionhousingstartsorgreater. Iamnotgoingtomakeanyassumptionsaboutwhenhousingstartsreturntotheselevels,butitcould besoonerratherthanlaterdemographictrendsremainunchangedandabacklogofdemandislikely growing.Further,myassumptionsarebasedoncurrentcapacitylevelsandfailtorecognizeWest Fraserspotentialasafutureindustryconsolidator.AsWestFraseraddscapacityaddingdebttoits veryfrugalcapitalstructuretheseassumptionscanchangedramatically.