Residential housing construction is coming back to life. Although progress has been unsteady and comes off of an unsustainably weak base, demand is improving and Louisiana-Pacific (NYSE:LPX) is seeing the benefits. The stock has already roared back from its going-out-of-business-sale price, but these shares could continue to appreciate if Congress can avert the fiscal cliff and if other building material companies remain rational and prudent with their capacities and pricing.
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Third Quarter Results Come up Light, but Progress Is Evident
For better or worse, many housing-exposed stocks such as LP, Weyerhaeuser (NYSE:WY), Armstrong World Industries (NYSE:AWI) and Mohawk Industries (NYSE:MHK) started their recovery runs ahead of real improvements in the actual numbers. Since then, the progress in the actual financial improvements has been a little less steady, albeit still directionally encouraging.
LP reported that revenue rose 33% from last year and 9% from the June quarter; numbers that came in just a little below expectations. Oriented strand board (OSB) is the most significant revenue contributor at LP, and this quarter was no exception as sales rose 63% on an 11% increase in sales volume and a 50% improvement in pricing. Siding saw a 20% improvement, with double-digit increases in volume for SmartSide and Canexel, while engineered wood product revenue rose 12%.
With these higher volumes (and relatively benign sawlog prices from timber companies such as Plum Creek (NYSE:PCL)) gross margin improved about 13 points from last year and more than five points from the second quarter. Operating income also continues to improve as the company better leverages its fixed costs - operating income reversed a year ago loss and almost doubled from the second quarter.
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Will Rivals Stay Rational?
One of the factors helping OSB pricing has been the extent to which major producers have curtailed production capacity over the past few years. Looking at various sell-side and company reports, it looks like active capacity is around three-quarters of what it was in 2005. The question, however, is how long companies will leave capacity idle if prices stay firm.
On one hand, the top five companies in the industry (LP, Georgia Pacific, Norbord (TSE:C.NBD), Weyerhaeuser and Ainsworth (OTC:ANSBF)) account for about three-quarters of the industry and ought to know better than to engage in homicidal/suicidal behavior regarding production and pricing. On the other hand, they all have bills to pay and I don't think anybody wants to get left behind if the housing rebound proves real.
How Long and How Strong?
Another very relevant question for LP investors is just how strong this housing rebound really is, and how durable it will be. New housing construction has improved, and companies ranging from Universal Forest Products (Nasdaq:UFPI) to Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) have offered evidence that both new construction and remodeling/renovation activity are picking up. On the flip side, the much-discussed "fiscal cliff" in 2013 could effectively sweep the recovery's legs out from under it.
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The Bottom Line
Investors have a wide range of choices when it comes to playing a possible housing recovery. Building product companies such as LP, Weyerhaeuser, and Plum Creek all would certainly stand to benefit, but then so would the home builders, other component suppliers such as Mohawk or Masco (NYSE:MAS), and a range of companies from WESCO (NYSE:WCC) to Terex (NYSE:TEX) to Stanley Black & Decker (NYSE:SWK). That said, LP looks like a pretty clean pure-play on residential housing construction, as it has about one-quarter of the OSB market and roughly 80% of OSB goes into residential housing.
Valuing LP right now is no easy task. In the good times, this company did produce in excess of $400 million in annual free cash flow and the current projections for 2012 revenue are about 40% below the prior peak. Assuming that the next five years will see significant improvements in revenue and free cash flow, these shares do still look undervalued, and perhaps significantly so. That said, investors should remember that LP's performance has never been consistent, and models that project smooth, consistent increases in free cash flow are probably too optimistic on a long-term basis.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.