I recently covered the outlook for the timber industry in 2013 and briefly touched on how the housing recovery trends played into that outlook. I now want to take a step back and look at this from the other side. Given the structural changes in the timber market, what does that mean for housing?
As with any market, timber's pricing is determined by simple supply and demand. Over the past few years two major shifts have begun to disrupt this market. On the supply side is the mountain pine beetle infestation in Canada that's ravaged its forestland and forced producers to flood the market with timber before it became unmarketable. Now, the long-term supply coming out of Canada will be reduced for decades.
This comes on the heels of skyrocketing demand for lumber by China. In 2008, North American lumber exports to China were about a half a billion board feet, with U.S. exports representing just a fraction of that number. In 2011, exports to China hit more than 3.5 billion board feet, with U.S. exports hitting nearly half a billion board feet.
It's estimated that between 5% and 7% of the total North American lumber market will be exported to China. Couple that with 7%-15% of the market being cut by Canadian harvest reductions, and all told there is a 12%-22% estimated effect on the market. On the low end of things, these structural changes will impact 15% of the total North American timber market. That's equal to 600,000 housing starts or, put another way, 40% of the long-term average for housing starts.
When housing recovers to normal levels it means much higher timber prices. This has many leading timber producers planning to boost harvests for the foreseeable future to capture this upside.
Will housing even recover?
As you can see in the graph below, housing has started to climb back over the past year, but it's still nowhere near its historical norm of 1.5 million units annually.
Just last month, housing starts came in at an annualized 954,000 which was well above the estimated rate of 885,000, and a huge jump from November's rate of 851,000. That's giving rise to a number of estimates that see housing shifting into high gear over the next two years. This is before settling into a range of 1.6 million-1.9 million annual units by 2015 in order to make up for several years of underinvestment.
Sure, one month does not make a trend, but take a look at what those closest to the situation are saying. Hovnanian (NYSE:HOV) CEO Ara Hovnanian late last year told CNBC:
We are undoubtedly well on the recovery route. It's not a question of are we beginning it. I'd say it began at the beginning of this year and that's not just for Hovnanian, that's for the entire industry.
Or take luxury homebuilder Toll Brothers (NYSE:TOL) CEO Douglas Yearley's comments on the company's fourth-quarter conference call last month:
We have been positively surprised that the growth in contracts, because traffic has been relatively consistent with recent years, meaning weak. We're experiencing our highest converging ratio from visitor to agreement in the history of the company, as the quality of the traffic is superb and visitors are very serious about buying. When traffic returns to normalize levels, we believe there is strong possibility of significant increases in absorptions and therefore pricing power.
It's not a matter of if housing will ever recover; it's already happening. What will be key to watch is how quick the pace becomes and if it starts to yield any commodity inflation. The comments from Yearley are important to keep in mind, especially when it comes to pricing power.
Price always matters
Timber producers, for example, won't all be affected to the same degree. Weyerhaeuser (NYSE:WY) for example is much more heavily levered to housing. While a quarter of the company's revenue comes from commodity timberland, a majority of its revenue comes from its wood product and home building businesses. As housing continues to recover, Weyerhaeuser can take advantage of its cost structure and scale to capture pricing power.
Likewise, Toll Brothers has the same ability for pricing power because it serves the higher end of the market. The same can't necessarily be said for other homebuilders like Hovnanian. Last quarter was the company's first report of a pre-tax profit in the last 25 quarters. While a rising housing market will certainly be a big boost to the company, it's unlikely the company will be able to easily combat the rising input costs that'll likely follow.
Painting a full picture
On the other hand, those companies whose products don't have timber as an input costs are likely benefit even more from housing's recovery. Take paint maker Sherwin-Williams (NYSE:SHW) its input costs have actually been falling. The company emerged from the financial crisis with leaner operations, and the recovery in housing is likely to give a big boost to the its bottom line.
Housing's rise will boost more than just makers of paint; I mean, all that paint needs to be applied on something. Even though it's at its 52-week high, USG Corp. (NYSE:USG) is another building supplier to watch. The longtime holding of Warren Buffett, USG is one of North America's leading producers of gypsum wall boards and joint compound. According to company CEO James Metcalf, the company is still seeing "modest demand improvement" even though "wall board demand still remains significantly below historical averages." A full recovery in housing will go a long way in boosting its shares.
Final Foolish thoughts
All signs seem to indicate that housing is at least in the early stages of a recovery. Investors in timber companies like Weyerhaeuser have enjoyed this early recovery. Given all the structural changes to the timber market, continued outperformance isn't likely to stop anytime soon.
Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Sherwin-Williams. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.