Louisiana-Pacific, Berkshire, and the Housing Shortage. $LPX
"Unlike 07/08 we actually have a structural shortage in single-family homes going into this" - Stanley Druckenmiller
“There's a steady demand for new housing and there's been a shortage. There was probably too much housing built in 2006 and 2007 bubble, and that actually was a bubble. But since then, the build rates have come down a lot and they've stayed well below the long-term trend. Population keeps growing. From my perspective, it's a very lumpy business, but it's a very high-quality business. And the market perceives it as a low-quality business because it is true that depending on macroeconomic circumstances, you don't really know what the profits are going to be a year from now or two years from now or even necessarily six or nine months from now, which makes it challenging for investors…….It's the old comment you want a smooth 8% or 6% or a lumpy 15%. This is the lumpy 15%.” - David Einhorn.1
Many investors try to stay away from cyclical businesses, and for good reason. DCFs are always fraught with error, but there’s a sense in which modeling growth businesses is fairly straightforward. It’s enormously difficult to predict an unprofitable tech company’s growth rate with real precision, but you don’t have to worry that the price of said tech company’s product might drop 50% in the space of just over a year and leave you with negative gross margins.2 Nor do you have to try and predict whether OPEC will cut or expand production output, which is probably more challenging than trying to figure out the average Shopify customer’s true lifetime value. Recently, however, cyclical businesses have experienced somewhat of a boom in popularity. While oil and gas stocks have struggled in 2023, they meaningfully outperformed last year and investors continue to hold them based on both the companies’ capital allocation plans and a belief that supply will be constrained going forward. Berkshire’s the most notable investor in this category, and has received a lot of press for its Chevron and Occidental investments. However, little has been mentioned about the conglomerate’s position in Louisiana Pacific, a building materials manufacturer whose success has historically been tied to single-family housing starts.3 Like oil and gas, the building materials industry is brutally cyclical, particularly when tied to just one portion of the market.4 Louisiana Pacific’s products can be broadly split into two segments:
Oriented Strand Board (OSB) - a type of engineered wood used for structural construction in residential homes. In Louisiana Pacific’s case, OSB can be further divided into two categories: its commodity product and its structural solutions products, which are higher margin. The structural solutions are more specialized, and include FlameBlock and WeatherLogic, which are fire-resistant and water-resistant, respectively. Structural Solutions accounted for 38% of sales volume last year, and commodity OSB accounted for 31%.
Siding - material that covers the outside of a building to protect it from heat loss and exposure to the elements. Only 40% of Siding product volume is related to single-family housing starts, making it significantly less tied to housing than LPX’s OSB business. That being said, the other 60% is predominantly from sheds and repair and remodel. These experienced a boom during covid, and so are less likely to be tailwinds over the next few years.5 While siding demand still has elements of cyclicality it’s not a commodity product, and made up 29% of sales volume last year.6 It’s also a fast-growing segment, and so revenue is likely less cyclical now than it will be once the business matures. Housing starts were roughly flat over the 2020-2022 period, but siding revenue grew by over 50%.7
Broadly speaking, the narrative behind holding Louisiana Pacific is threefold: It’s a company shifting its business to higher margin, less cyclical products, with an intelligent capital allocation framework, that’s still predominantly indexed to single-family housing, of which there is currently a structural undersupply. Point one is well illustrated by the difference between LPX’s last two annual reports. Had you looked at this business last year, you would’ve noticed one more business segment: engineered wood products (EWP), which are also used in new home construction. Much like commodity OSB, engineered wood products are low margin, and demand is heavily cyclical. As management has focused on transitioning away from its more cyclical business lines and leaning into siding, it’s increasingly shifted facility production from these commodity products to specialized ones. Consequently, the move into siding products was accompanied by a corresponding decrease in EWP production. Due to this declining production, a lessened EWP product portfolio, and “an inability to consistently earn the cost of capital”, management announced in late 2020 that the company would begin to explore strategic options for this business.8 In February 2022 LPX sold its equity interest in two joint ventures related to its EWP line, and in August 2022 the entire division was sold to Pacific Woodtech for 210mm.
It’s impossible to overlook the whipsaw nature of the market that LPX operates in, which in recent years has basically been inversely correlated to oil and gas. OSB prices went through the roof during Covid, then came crashing down between 2022 and 2023. Excluding income from discontinued operations, earnings per share came in at 0.29 for the most recent quarter, compared to 4.89 in the year prior.9 Management’s goal with its siding and OSB structural solutions products is to mute this cyclicality, and there’s been some success thus far. In Q1, LPX missed revenue estimates but beat on earnings, driven by better than expected performance of its higher-margin products. Single-family housing starts were down 30%, but siding revenue was flat compared to the previous year, with price increases making up for more tepid product volume. While OSB commodity prices dropped 76% from Q122 to Q123, LPX’s OSB revenue dropped 68%, buoyed by its structural solutions offering. A 68% revenue drop YoY remains far from ideal, and revenue volatility will always be a feature of LPX’s business, but management has avoided the common cyclical business mistake of building out additional commodity capacity when profits are elevated. Investing profits from a cyclical business into a less cyclical and growing one is a smart move.
“As a reminder, that strategy is to first own the cash then to invest in growth and only then to return the remainder to stockholders via dividends and share repurchases. In the fourth quarter, as OSB prices and cash flow fell, we did not repurchase any shares, leaving our share count at about $72 million” - Alan Haughie, LPX CFO, Q42022 earnings call
LPX’s capital allocation strategy looks meaningfully different now than it did prior to late 2018. Like many building materials businesses, the company experienced a brutal 2008, and suspended both dividends and share repurchases during the Great Recession. However, as the business improved over the next ten years it increasingly looked like a company listed in Japan, which is to say it began to hoard cash on the balance sheet rather than return anything to shareholders. Consequently, the business was sitting on nearly a billion in cash by the end of 2017. This changed when D.E. Shaw came in as an activist investor, and LPX has since re-evaluated its cash needs, introduced a dividend, and spent over 3 billion on share buybacks, including repurchasing over 2B in shares from the beginning of covid through the present day.10 The capital allocation decisions made during the pandemic reflect well on management, who benefited from surging, but unsustainable, OSB prices.11 LPX announced another 600mm share buyback authorization in 2022 and still has 200mm left to work through, but given the recent macro management has expressed skepticism that those repurchases will occur in 2023.
The dominant question for LPX going forward is how the business will fare during the current housing starts slowdown and a potential recession. History fails to be a useful guide for a few different reasons. The first is the business’ increased focus on non-commodity products over the past five years, which means it has yet to face an economic slowdown when it’s not predominantly selling commodity OSB and EWP. The second is that the Great Recession was caused primarily by housing, and so, predictably, housing starts dropped precipitously when the economy went sideways. This stands in stark contract to today, where there’s an undersupply of single family homes that has yet to be addressed. This doesn’t mean that housing is no longer sensitive to the macro environment; single-family housing starts dropping 30% last quarter is good evidence that it is. But the undersupply may mean that housing starts drop less than expected even if there is a recession. Both Einhorn and Druckenmiller have spoken about this recently, with Druckenmiller saying that “Unlike 07/08 we actually have a structural shortage in single-family homes going into this (a potential recession).”12 D.R. Horton, the largest homebuilder in America, handily beat both revenue and earnings expectations last quarter, and wrote that “Although higher interest rates and economic uncertainty may persist for some time, the supply of both new and existing homes at affordable price points remains limited, and demographics supporting housing demand remain favorable.”13 This lack of supply is easily seen in available data on the number of single-family and condo units for sale, which is down meaningfully over the past 10 years.
US For Sale Housing Inventory:
It’s worth noting that the best way to play the housing shortage so far this year has been to buy public homebuilders like D.R. Horton, which is up 25% YTD. LPX, on the other hand, is up a more modest 7%. Given that only about half of LPX’s siding volumes are tied to homebuilding, this makes sense. The company’s currently in an odd position where having a business that’s no longer solely tied to housing starts is hurting them, but the bet over time is that this will result in a more resilient, higher-margin earnings stream.
Louisiana Pacific had gross margins of negative 2% in 2008.
For those of you who follow Anomaly Capital (whose largest position is entertainingly a frozen french fries producer) it’s worth noting that they also currently have large oil and gas/building materials investments.
There’s an interesting question as to how cyclical the overall construction market actually is, and Procore’s done a lot of work trying to show investors that it’s actually characterized by steady demand throughout economic cycles. See their investor day presentation for more info!
“I would say the shed business is probably one of our slower-performing segments right now. There was, I would say, of all the segments that we've played in during COVID, I do think there was some pull forward demand in shed.” - Brad Southern, Louisiana Pacific’s CEO, Q12023 earnings call
According to pg 29 of LPX’s 2022 Annual Report.
“Looking back, single-family starts grew by 14% from 2020 to 2021, then fell by 11% in 2022, ending essentially flat over 2 years. Over that same 2-year period, we have grown Siding Solutions revenue by more than 50%. Siding is not immune to a housing slowdown, but it has consistently outperformed the underlying market.” - Q42022 earnings call
LPX’s Q42020 earnings call provides the rationale behind the decision.