Each quarter the Census Bureau surveys a broad array of U.S. corporations to create a snapshot of business sector health and activity. The program, known as the Quarterly Financial Report (QFR) survey, has been collected and published for over 60 years by various federal agencies – the Census Bureau being the most recent. These data provide a standardized and comprehensive look at the financial condition of the industry.
Results from sampled businesses are aggregated and reported by the North American Industry Classification System (NAICS) and by asset size category. There are separate NAICS codes for wood product manufacturing (“321”) and paper manufacturing (“322”). Based upon returned sample surveys, the QFR presents estimated statements of income and retained earnings, balance sheets, and related financial and operating ratios by industry sector and asset size category. This blog reports only a sample of the data collected in the QFR survey.
The wood product manufacturing data is categorized by asset size: firms with less than $25 million in assets (“small firms”), firms with more than $25 million in assets (“large firms”), and all firms regardless of size. While the data are somewhat dated, they provide not only a useful perspective on direction and momentum with respect to the current business cycle, but also benchmarks for individual firm performance.
The picture that emerges at an industry level when viewing the 2016Q2 data (see graph below) is significant operating performance improvement on modestly improving sales. Interestingly, this improvement is in the aftermath of the recently expired North American Softwood Lumber Agreement (SLA). However, there are some undercurrents that provide a more complex assessment than the 30,000-foot fly-over look.
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Selected financial results of wood product manufacturers during 2016Q2 are summarized in the table below. Notable highlights include:Net Sales – Aggregate net sales for 2016Q2 were at the highest level in the past 10 years for the industry as well as for the portion of the industry with mill assets $25 million and greater; for the portion of the industry with mill assets less than $25 million, net sales were less than the median level over the past 10 years. Industry sales in 2016Q2 increased by 3.6% over 2016Q1 and 7.0% over 2015Q2. However, differences based on mill asset sizes are notable. For mill assets less than $25 million, 2016Q2 sales increased by 8.6% over 2015Q2 while declining by 9.4% from 2015Q2. Meanwhile, for mill assets $25 million and greater 2016Q2 sales grew by 1.4% relative to 2016Q1 but were 17.0% higher than 2015Q2’s sales level.
One possible cause for the year-over-year (YoY) drop in net sales for companies with less than $25 million in assets could be a disproportionate effect of the end of the SLA in October 2015. Net sales results by quarter for mills with assets less than $25 million can be seen in the last chart on this blog. These companies experienced a major sales downshift in 2015Q3 and have yet to recoup that lost ground despite improving industry sales.
Also notable: During the past 10 years, the median Q1 to Q2 percentage increase in aggregate industry net sales was 11.3%, indicating a strong seasonal element in quarter-to-quarter (QoQ) activity; by contrast, 2016Q2 saw an increase of only 3.6% over 2016Q1. The high level of sales, aggregate QoQ sales growth roughly one-third the median rate of the past 10 years, and the strong QoQ sales growth in the smaller0asset portion of the industry may suggest maturation of the current business cycle.
EBITDA – Aggregate earnings before interest, taxes, depreciation, and amortization (EBITDA) or operating cash-flow performance for the quarter was within the upper quartile of the past 10 years for the industry and both industry sub-components: 79% for mills with assets less than $25 million, 100% for mills with assets $25 million or greater, and 92% for the industry. 2016Q2’s increase from 2016Q1 turned in a solid performance across all industry sectors: 23.9% for mills with assets less than $25 million, 39.2% for mills with assets $25 million and greater, and 34.6% across all sectors. Despite sales falling by 9.4% YoY for mills with assets less than $25 million, EBITDA increased by 78% YoY.
Operating Income – 2016Q2 income was above the 80th percentile of the prior 10 years. YoY percentage change in operating income more than doubled for mills with assets less than $25 million; for the industry, operating income increased by nearly 50% between 2016Q1 and 2016Q2 but still lagged the prior 10-year median Q1-to-Q2 percentage change. Lagging the prior 10-year median Q1-to-Q2 change seems more an indication of business-cycle maturation than a sign of general market weakness; indeed, it is difficult to describe operating income of 48.5% and 65.1% improvement for QoQ and YoY, respectively, as “weak.”
Pre-tax Income – Pre-tax operating income performance generally parallels operating income results.
Net Income – Net income performance generally parallels operating income results.
Operating Margins – Operating margins for all sectors are near the 90th percentile of the prior 10 years and all margins expanded on a QoQ basis. Even more notable, industry-wide margin growth exceeded the prior 10-year median Q1-to-Q2 percentage point change.
ROE and ROA – Despite strong sales and improving operating margin growth, the YoY percentage point change in Return on Equity (ROE) and Return on Assets (ROA) fell for all industry sectors. Despite the drop, ROE and ROA returns remain firmly entrenched above the 10-year 50th percentile for large companies and the industry in total; smaller companies’ returns are roughly at the 50th percentile level of the past 10 years.
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Falling ROE and ROA on a YoY basis despite solid operating margins is consistent with the capacity expansion that has been occurring in the sector. Higher ROA and ROE returns for smaller companies despite lower operating margins than larger companies suggest large firms are responsible for the bulk of industry capacity expansion. Capacity expansion is typically another indicator of business cycle maturation.
The recent uptick in ROE and ROA over the last two quarters (see chart below) could either be the start of a new “up leg” of the business cycle or simply a ”hiccup” in the business cycle playing out. Our current interpretation is that soaring Canadian softwood lumber exports to the United States in the wake of the SLA’s expiration drove out marginal U.S. producers even while profitable companies continued adding capacity – resulting in net capacity expansion across the industry (Note: while the NAICS 321 industry code includes all wood products manufacturing (softwood and hardwood, sawmill, plywood and veneer, OSB, particleboard, secondary wood manufacturers, etc), a significant share of economic activity in the sector is driven softwood sawmills). The combination of curtailment of less inefficient mills during 1H2016 precipitated by increased Canadian imports and ongoing capacity expansion at more efficient mills would explain lower returns compared to a year ago but slight improvement in returns over the prior two quarters.
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Taking a longer view, the divergence between small and large firms is becoming more pronounced (compare next two charts, particularly trend lines). Net sales and operating margins are trending higher for large firms; by contrast, net sales for small firms are trending lower while trends in operating margins are essentially flat. This has resulted in a shift in the sales composition by company size; small companies represented 44% of sales in 2001, but averaged only 31% during the last three quarters (i.e., since the SLA expired).In terms of recent industry impacts, smaller companies represented 36% of sales between 2014Q4 and 2015Q3 (i.e., the four quarters immediately before the SLA expired) compared to 31% since the SLA expired. Thus, since SLA’s expiration, following a 4.1% QoQ drop (-5.2% YoY) in 2015Q4 U.S. industry sales, sales in 1H2016 are up 3.6% from 1H2015 when the SLA was in effect. Even more striking, ror large companies 1H2016 sales were up 13.2% compared to 1H2015; for small companies 1H2016 sales were down 12.7% compared to 1H2015. This reinforces our interpretation that the recent improvement in operating margin for small operators is due more to curtailments of less efficient mills rather than improved business conditions.
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In total, the U.S. industry has improved its competitiveness but a sizeable proportion of that improvement is due to curtailment of less efficient manufacturers; the SLA’s expiration in 2015Q4 hastened their departure, or at least their curtailment. High returns during 2013 and 2014 attracted ongoing capital expansion. The pace of net U.S. sales, while still increasing, has slowed; most recently 2016Q2’s net sales increase was substantially below the median QoQ increase of the past 10 years. The result of increased capacity, and hence capital investment, without a commensurate increase in operating cash flow has resulted in returns falling despite historically strong operating margin results. Such patterns are typical of maturing business cycle characteristics.
