Louisiana-Pacific: Building Shareholder Value (NYSE:LPX)

When Berkshire Hathaway (BRK.A) (BRK.B) adds a new holding to its stock portfolio, it’s worth sitting up and taking notice. When the stock purchased represents a boring building products manufacturer with a market cap of less than $5 billion, Berkshire’s involvement becomes even more notable, as Chairman & CEO Warren Buffett is famously averse to making relatively small investments that don’t have the potential to “move the needle” within Berkshire’s massive portfolio of stocks and wholly-owned subsidiaries.

Accordingly, it’s fair to wonder what Berkshire saw in Louisiana-Pacific Corp. (NYSE:LPX) when it violated this general principle by purchasing 5.8 million shares of LPX in Q3 2022, then worth a paltry $300 million (now approximately $350 million). For context, Berkshire Hathaway’s market cap is approximate $700 billion, 2,000x the size of its stake in LPX. Berkshire may plan to add to its LPX position (it may have already done so in Q4), but LPX has a total market cap of just $4.4 billion. Even acquiring half of its outstanding shares would barely register as a blip on Berkshire’s radar. Accordingly, it’s fair to assume that Berkshire views LPX as a particularly attractive investment opportunity.

For those of us who don’t have hundreds of billions to invest, LPX presents an opportunity not only to purchase shares in a rock-solid company at a dirt-cheap price, but also to meaningfully move the needle within our own portfolios. As we will see, LPX is deeply discounted by any valuation metric one chooses to apply. For example, its P/E ratio hovers around 4.

This steep discount to the market average is largely based on an anticipated earnings collapse that has yet to fully materialize, relating primarily to the ongoing slowdown of the housing sector and declines in housing starts and construction activity. Analyst forecasts compiled by CNN Business anticipate a precipitous drop in EPS from $13.97 in 2021 (and a similar amount in 2022) to just $4.24 in 2023. Similarly, sales are expected to fall from $4.6 billion in 2021 and about $4.0 billion in 2022 to around just $3.0 billion in 2023.

It is important to emphasize that these pessimistic forecasts are based on macro factors affecting the entire housing market, not any underlying weakness in Louisiana-Pacific’s business. Even assuming that these bearish predictions play out as analysts expect (which is far from a given, for reasons we will examine), 2023 would most likely mark the low point of the company’s performance. If LPX is in fact a cyclical stock about to hit a major downturn in sales and earnings, shouldn’t its valuation be higher than 14-15x the forecasted trough earnings?

Even if annual earnings per share remain at the $4-5 level in 2024-2025, is it not equally logical to forecast that earnings will return to about current levels or higher in the next housing boom? This is the LPX bull case in a nutshell, and any value investor can immediately see its appeal.

Operations

Louisiana-Pacific Corp. is a rather dull manufacturing business specializing in two main product categories – oriented strand board (OSB) panels and Siding Solutions. Louisiana-Pacific markets these products to builders and homeowners via building material distributors and retail home centers.

OSB panels are widely used, versatile, lightweight structural wood panels that share many of the same strength and performance characteristics as plywood. OSB’s many applications include flooring, construction sheathing, structural insulated panels, industrial containers, and furniture. Louisiana-Pacific actually pioneered the use of OSBs in the United States back in the late 1970s, and the manufacture of OSBs has remained the company’s bread-and-butter to this day.

LPX’s other major segment, Siding Solutions, engages in the manufacture of siding products for building construction and renovation. The Siding Solutions segment consists of a “broad product offering of engineered wood siding, trim, and fascia, including [various brands and products] (collectively referred to as Siding Solutions).”

The company also features a South America segment, which manufactures and distributes OSBs and siding products in South America and certain export markets. This segment conducts manufacturing operations in Chile and Brazil and operates sales offices in six South American countries.

Recent Performance

In the most recently reported quarter, Q3 2022, net sales of OSBs declined by 35% year-over-year to $388 million. Through the first 9 months of 2022, OSB revenue fell by 6% YOY. The snowballing decline in OSB revenue is attributable to lower market prices for these products, as the 35% decline in Q3 came amid a 5% increase in OSB sales volume offset by a staggering 39% decline in average selling prices. So while demand for LPX’s OSB products remains strong, the market is not currently supporting the prices these products were selling for in 2021 and much of 2022.

In stark contrast to OSB sales, net sales of siding products increased by 27% YOY in Q3 and by 23% through the first 9 months of 2022. As a result, the Siding Solutions division surpassed OSBs in net sales in Q3 2022. It’s worth noting that OSB sales have slightly higher margins than siding sales. That said, it’s certainly encouraging that the siding operations continue to grow even in an increasingly challenging environment for construction and the housing sector at large.

The South America segment’s financial performance stagnated in 2022, but it is relatively unimportant to the overall business, with its ~$300 million annual revenue contribution paling in comparison to OSB’s and siding’s combined (roughly) $4 billion.

Fundamentals

Since LPX operates in a cyclical sector that’s currently experiencing a sudden downturn, it is tougher to evaluate than the average stock. Rather than seeking to pin down LPX’s value by offering a price target, this analysis will instead simply review the company’s fundamentals in order to empower the reader to reach his/her own determination as to whether Louisiana-Pacific is undervalued. I strongly believe that it is, for reasons explained below.

Starting with the income statement, LPX’s annual revenue has doubled from $2.3 billion in 2019 to $4.6 billion in 2021, with $4.6 billion in revenue also reported in the TTM period ending September 30, 2022. Expenses have increased by a comparatively small amount. Accordingly, net income attributable to common stockholders has ballooned from -$5M in 2019 to $499M in 2020, $1.4B in 2021, and $1.3B in the TTM period.

Turning to the cash flow statement, we can readily see that LPX does a great job of converting its paper profits into giant mounds of cash. LPX reported free cash flow of $582M in 2020, $1.2B in 2021, and $900M in the TTM period, after accounting for hundreds of millions of dollars reinvested into the business annually. This reinvestment has only ratcheted up in recent years, attesting to management’s confidence in the strength of the business and its opportunities for future growth. Another testament to management’s confidence is the ~$1B spent annually on share repurchases in 2021 and 2022, though management recently indicated that the buyback program will be significantly less aggressive during the present period of anticipated reductions in profit and cash flow.

Unsurprisingly for a Berkshire Hathaway investment, LPX’s balance sheet is also extremely attractive. Assets have grown faster than liabilities year-over-year, the current ratio is close to 3, and tangible book value is close to $1.2B – over a quarter of the company’s market cap. Louisiana-Pacific also has access to an undrawn revolver of over half a billion dollars.

To break all this down into bite-sized figures, LPX sports a TTM P/S ratio of less than 1, EV/S of ~0.7, P/E of ~4-5, and P/FCF of ~5. These figures may seem absurdly low at first glance, but of course they look a lot more reasonable on a forward basis. If we take the above-mentioned consensus analyst estimates at face value and assume that LPX will report $3B in revenue and $4.24 in EPS for 2023, the P/S rises to 1.5, the EV/S rises to 1.1, and the P/E rises to 14.5. Even these forward metrics are below market averages, and they would likely mark a trough in the company’s performance.

Given Louisiana-Pacific’s leading market position, its nature as a manufacturer/wholesaler with huge economies of scale, and its flexibility to adjust the proportion of OSBs vs. siding products manufactured at any time, it’s difficult to imagine its bottom line falling into the red anytime in the near future. It’s also worth noting that elevated PPE investment this year will contribute to the aforementioned earnings decline. Even if the US housing slump turns into a housing crash and the company’s profits fade away entirely, there is no reason not to expect them to return to current levels on the other side of such hypothetical crash. In the meantime, Louisiana-Pacific’s fortress balance sheet ensures that the company can securely weather whatever storms may lie ahead.

Cyclicality

But is a 65%+ earnings drop this year a foregone conclusion? Not really. In order to weigh the likelihood of a calamitous earnings collapse, we must examine whether LPX is truly as cyclical a company as analysts seem to think. Their collective assessment is probably in part based on precedent, as LPX’s earnings and market value have certainly been subject to the vicissitudes of the housing market in the past.

What may be different at the present time, however, is that the company’s product portfolio is now almost evenly split between two product categories, and accordingly LPX is no longer reliant on OSB sales alone. On LPX’s most recent quarterly earnings call, CEO Brad Southern stated that siding pricing has been “very sticky” for “the last 20 years or so,” predicting that Siding Solutions’ “price to cost ratio is going to stay at kind of where it’s at.” With Siding Solutions now constituting half the business by revenue and close to half by profit, this segment’s resilience to cyclical factors would seem to make a 65% earnings drop unlikely. LPX is not as cyclical as it once was, for which reason past may not turn out to be prologue.

Buybacks and Dividends

Louisiana-Pacific’s management has consistently been quite generous with shareholders when times are good. As previously alluded to, Louisiana-Pacific has spent billions on share buybacks since 2018, cutting the company’s share count in half in the span of 4-5 years. (No, that’s not a typo.) While these repurchases are now slowing dramatically, they will likely resume again in earnest once the company’s near-term outlook turns more positive.

In 2018, LPX reintroduced its quarterly cash dividend for the first time since 2008, and has increased the payout each year since. The annual dividend yield currently sits around 1.4% – nothing to write home about, yet serving as still another sign of management’s confidence in the business and determination to act in the best interest of shareholders.

Capacity Expansion

What may be the greatest indicator of management’s underlying confidence in the business is its ongoing investments in expanding manufacturing capacity. While OSB and siding prices will always remain subject to the whims of the market, the expansion of manufacturing capacity represents LPX’s best opportunity to sustain long-term growth regardless of future price fluctuations in its product categories. To this end, LPX has been investing heavily in increasing its overall production capacity while at the same time aligning its production ratios with market demand.

Currently, Louisiana-Pacific operates 22 plants across the U.S., Canada, Chile, and Brazil. The company has spent hundreds of millions of dollars on expanding and optimizing production at these plants in recent years, with favorable results – especially for the Siding Solutions segment. Ongoing expansion/conversion projects at Louisiana-Pacific’s Sagola, Houlton, Green Bay and Bath production plants are expected to drive continued expansion of overall manufacturing capacity, and Siding Solutions’ capacity in particular. The company expects its production capacity of OSBs to remain level over the next 2 years, while siding’s manufacturing capacity is expected to grow by ~25%.

Another point worth noting is that LPX maintains flexibility to switch production ratios between its two primary product segments at any time. For instance, the company is in the process of converting 420 million feet of annual OSB production capacity at its Sagola, Michigan facility into 320 million feet of annual siding production capacity in response to the precipitous drop in OSB prices, which is expected to increase overall siding capacity by ~15%.

Risks

Protracted Housing Downturn

It should come as no surprise that the single greatest threat to Louisiana-Pacific at the current time is the potential for a protracted housing downturn that persists and/or worsens over the next several years. A housing recession of this nature could see Louisiana-Pacific’s profits dwindle away altogether, throwing its valuation into question. I happen to believe that a severe and protracted housing crash is not only within the realm of possibility, but within the range of likely outcomes for the U.S. housing market over the next several years. Why, then, am I bullish on a construction materials manufacturer at the present time?

Firstly, regardless of what happens over the next few years, LPX will survive. Its robust balance sheet and dominant market position ensure this. If we take a truly long-term view of the situation, LPX will continue to thrive on the other side of any realistic-case housing downturn, even a prolonged and nasty one. Housing and construction demand will inevitably return to normal levels at some point, as people will continue to need places to live. No U.S. housing crash has ever lasted forever, and it’s highly unlikely that the next one will. When the housing market returns to growth, LPX will presumably remain in a prime position to capitalize thereon.

Further, the Siding Solutions segment – which now comprises approximately half the business – seems to be rather immune to the vagaries of housing sentiment and construction activity. This is supported by CEO Brad Southern’s representation that siding prices have been stable for 20 years, and the fact that siding is not entirely dependent on new construction; repairs/remodels also play a large role in demand for siding materials.

Lastly, while a vicious multi-year housing crash is certainly possible, it is not probable – let alone a foregone conclusion. With severe future headwinds already priced into the stock, LPX is almost certain to outperform should anything less than a full-blown housing crash transpire.

Demand

As we have seen, demand for Louisiana-Pacific’s products remains strong – with sales volume of both OSBs and Siding Solutions continuing to grow. However, should demand for these products drop off due to housing market factors or other headwinds, LPX could find itself in a very difficult position. While LPX’s well-capitalized balance sheet would help the company withstand such circumstances with minimal long-term value destruction, a drop in demand would be particularly harmful at a time when the company is pulling all available levers to increase production capacity. Evidently management does not expect a significant demand drop, particularly for siding, which simultaneously makes a demand crisis unlikely and a significant risk should it occur.

Margin Contraction

In contrast to demand, LPX’s margins are beginning to drop precipitously in the OSB segment. This presents a significant near-term risk for the company and its shareholders. As margins are expected to continue falling, as evidenced by analyst forecasts, it will be important to continuously monitor the situation to ensure that the company is not on a fast path to sustained and catastrophic margin deterioration. It will be especially important to monitor margins in the siding division – for if they drop meaningfully, then the company’s margin of safety (the strength of its Siding Solutions segment) may begin to evaporate. On the other hand, if margins simply fall in line with analyst expectations, that would be very bullish for LPX’s future stock performance – since, as previously discussed, the analyst forecasts suggest that LPX is deeply undervalued relative to its projected “downturn” earnings.

Market Disruption

Much like every entity to ever exist, Louisiana-Pacific will someday go the way of the horse-and-buggy. For a manufacturing company like Louisiana-Pacific, which produces materials that are generally in high demand, the most likely candidate for Grim Reaper is market disruption. Eventually, some other company will produce a competing product that rivals OSBs or wood-composite siding in convenience, cost, and/or effectiveness – just as OSBs themselves disrupted the use of traditional timber back in the 1970s. When this inevitably occurs, Louisiana-Pacific’s continued survival will hinge on its ability to pivot to newer, more innovative production technologies and/or shift its focus to other engineered wood products.

Conclusion

Louisiana-Pacific is not a perfect company. If it was, it wouldn’t be trading at a bargain-basement valuation to trailing earnings. That said, it’s not a stretch to say that it’s close to a perfectly-run company. Management has consistently demonstrated good judgment, concern for shareholder value, clear operational vision, a reasonably conservative approach, and the courage to make necessary changes in response to market forces outside the company’s control. While Louisiana-Pacific has no say in how ugly the housing downturn might get, the company is financially and operationally prepared for any realistic scenario.

With LPX shares trading at a discount to market averages even on the basis of meager forward earnings, the risk-reward deck is heavily skewed in favor of reward. The company has both the luxury of waiting out any crash in demand or selling prices and the capacity to meet demand in the event that a crash does not materialize. When the market eventually stabilizes and revenue and profits return to around current levels, today’s valuation will look utterly nonsensical. Regardless of when that happens, investors should be richly rewarded for their patience.