Mercer International Inc (MERC) 2018 Q3 法說會逐字稿

Good morning, and welcome to Mercer International's Third Quarter 2018 Earnings Conference Call. On the call today is David Gandossi, President and Chief Executive Officer of Mercer International; and David Ure, Senior Vice President, Finance, Chief Financial Officer and Secretary. I will now hand the call over to David Ure.

Good morning, everyone. I'll begin by taking a few minutes to speak about the financial highlights of the quarter, and then I'll pass the call to David to discuss the markets, our operational performance, strategic activities and our outlook into Q4. Please note that in this morning's conference call, we will make forward-looking statements. And according to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, I'd like to call your attention to the risks related to these statements, which are more fully described in our press release and in the company's filings with the Securities and Exchange Commission.

Our strong Q3 performance was punctuated by stable NBSK prices, temporarily lower productivity during the ramp-up of our recent asset upgrades of Celgar and Friesau, annual maintenance at our Rosenthal mill, the final stages of maintenance on 2 of our turbines as well as the timing of pulp shipments to Asia.

Our Q3 consolidated EBITDA was $86.7 million compared to $60.5 million in Q2. When compared to Q2, our Q3 results were positively impacted by significantly lower annual maintenance spending and slightly improved pulp realizations, which were partially offset by lower productivities as our mills wrapped up to full production. In Q3, lost production and direct costs related to annual shuts impacted EBITDA by $10.8 million compared to $59 million in Q2. In terms of business segments, our pulp segment contributed $89.6 million of EBITDA, and our wood products segment contributed EBITDA of $0.6 million, as we took significant downtime of Friesau to install and optimize a new saw line and automatic grading system.

As usual, you can find additional segment disclosures in our 10-Q. In Q3, the average European pulp list price was up $30 a tonne, relative to Q2 while the average list price in China was down roughly $25 a tonne quarter-over-quarter. Compared to Q2, higher pulp prices positively impacted EBITDA by approximately $10 million.

Our pulp sales volume totaled about 320,000 tonnes, which was down 18,000 tonnes from Q2 due to a late departure of a vessel at the end of the quarter and lower productivity in the early days of the quarter as we optimized our latest capital investments at Celgar. In addition to the late vessel departure, we built considerable pulp inventory in the quarter, and we were required to stage product to match break bulk shipments schedules, a situation we believe will largely reverse itself in Q4.

Consolidated electricity sales totaled 157 gigawatt hours, which was up about 47 gigawatt hours relative to Q2. The majority of the higher energy sales was due to the completion of scheduled maintenance on a turbine at both Stendal and Celgar. You will recall both turbines were down for most of Q2 and came back online in early Q3. We estimate the value of foregone energy revenues in the quarter as a result of the turbine maintenance to be about $5.9 million. We expect normal energy production levels in Q4.

On the wood product side of our business, we sold the equivalent of about 84 million board feet of lumber in the quarter, with about 25% of this volume being sold in the U.S. market. Our lumber sales total was down 29 million board feet for Q2 due to the reduced production levels for our new saw line and automatic grading system installation.

We reported net income of $41.2 million for the quarter or $0.63 per share compared to net income of $16.8 million or $0.26 per share in Q2.

Turning to cash flow. Despite our much higher level of EBITDA, we consumed about $27 million of cash in Q3, compared to net cash generation in Q2 of approximately $56 million.

The decrease in cash in the current quarter was driven by a significant net increase in working capital as we build raw material inventories in advance of winter, a season that has less predictable weather for harvesting operations, and as I noted a moment ago, we had a pulp inventory build that will clear in Q4.

We spent approximately $27 million during the quarter on capital projects. David will speak to the capital projects in a moment.

Our cash outflows in the quarter also included our quarterly $8.2 million dividend payment.

On a trailing 12-month basis, our net debt is about 1.4x EBITDA, which has remained unchanged relative to Q2. And our healthy credit metrics are one of the reasons why Moody's on Wednesday upgraded the company's rating to BA2 while maintaining its stable outlook.

And you will have seen from our press release yesterday, our board has approved a quarterly dividend of $0.125 for shareholders of record on December 13, for which payment will be made on December 20, 2018. That ends my overview of the financial results and I'll now turn the call over to David Gandossi, to discuss market conditions, our operational performance and strategic activities.

Thanks, Dave, and good morning, everyone. Overall I'm generally pleased with our Q3 performance. This quarter was, in a way, a transition quarter, following significant capital upgrades. Our pulp production was lower this quarter due to the ramp up in optimization of the new equipment that we installed at Celgar in Q2, and at Rosenthal in Q3 during their annual maintenance shuts. In both mills, we're already seeing the benefits of the equipment upgrades and they are on track to drive noticeable improvement in Q4 and future periods. Celgar's digester upgrade is now generating incremental tonnes, and we're seeing reduced chemical usage; and Rosenthal completed work on their fiber screener in this quarter that will increase the fiber yield. The lower than planned production and the delay of the departure of a break bulk vessel to China negatively affected our financial results, but our quarterly EBITDA result was still one of the best quarterly EBITDA results we've seen, and this has also positioned us very well for a strong result in Q4.

As expected, our Friesau sawmill's production was down relative to Q2 due to the saw line upgrade and the new automated grading scanner system. Both are high return projects that have increased the mill's productivity and great outturn. In Q3, Friesau produced almost 80 million board feet of lumber, which is down from 112 million board feet in Q2. Despite lower sawmill production, we did achieve $3 million of synergies in the quarter and about $10 million of synergies so far in 2018, primarily between Friesau and our Rosenthal mill.

Turning to our markets. The pulp markets remain steady through Q3. In Europe, Q3 list prices averaged $1230 per tonne compared to $1200 in Q2. The European market remains in balance after the industry's maintenance season, which created significant tightness last quarter. October's list price is also $1230 per tonne, and we expect steady prices through Q4. In China, the Q3 average price was $887 a tonne, which is down from $910 per tonne in Q2. Q3 saw pricing slip to $865 per tonne then bounce back to $885 in September. Pricing in China appears to be softening slightly on a slower-than-expected post-summer pickup. My view is we're seeing pricing settling in at around the $850 range based on what we're seeing at the moment.

We continue to believe that the tightness in the pulp markets is reflecting steady demand from paper producers, combined with constrained global NBSK supply. These include: There is no meaningful expansion plan for either NBSK or hardwood pulp, which will keep pricing pressure on both. We're seeing increased levels of unscheduled downtime throughout the industry. China's recent environmental initiatives that include the closure of highly polluting agricultural based pulp and paper mills along with limitations on the import of recycled fiber are all combining to create a noticeable supply tension in the market. There have been and will be -- will continue to be softwood conversions to convert paper grade pulp to either fluff or dissolving grades. In 2019 and 2020, the list adds up quite quickly to well over 1 million tonnes of softwood paper grade pulp leaving the market.

Offsetting these generally positive factors, we have just recently seen a general slowdown in China, which I link in my mind, primarily to the consumer sentiment probably related to the deteriorating China-U. S. trade relations. Other than that, we don't see a fundamental change in paper demand or supply. It's really just more of a consumer sentiment at the moment, something that may correct fairly quickly.

Lumber markets in the U.S. dropped significantly in the quarter, down over 40% from Q2 highs. This is primarily due to large buyer inventories built up in anticipation of summer supply shortages. In Europe, the pricing has been more stable but did decline slightly in Q3 due to increased volumes of beetle and storm-damaged wood. The Random Lengths U.S. benchmark for Western S-P-F #2 and Better averaged $481 per thousand board feet in Q3, which was down $120 from Q2. In Q3, 25% roughly of our lumber sales were in the U.S. market, with the majority of the; remainder of our sales in the European market. Despite the recent price softening in the U.S., the European lumber market has continued to experience steady demand and only slightly reduced pricing. Overall, our realized average sales prices declined to $409 per thousand board feet in Q3 compared to $433 in Q2. In Q3, we experienced slightly higher fiber prices relative to Q2. In Germany, low fiber inventories carried over from Q2. And although harvesting levels improved, strong demand for fiber kept prices up. In Western Canada, similar low inventory conditions exist with the sawmills focused on harvesting sawlogs rather than pulp logs. Looking forward, we expect to see prices decrease slightly in Q4 as harvesting continues to improve, which will allow us to access lower cost wood. As we mentioned on previous calls, we are optimistic regarding the long-term impact of our 2018 CapEx program. The Friesau sawmill investment has already demonstrated that we'll achieve the expected improvement in our lumber yield and grade outturn. The new planer, which will be completed in the middle of next year and the sorting lines and kilns that will follow will increase Friesau's production from the mid-400 million board feet of lumber a year to 600 million board feet.

Over $14 million of our investment in Celgar's digester is also proving to be successful. At the end of July, the mill was operating at an annualized rate of 490,000 per tonnes per year, with daily rates as high as 1700 tonnes per day. In Q3, as we mentioned, we upgraded our fiber line at Rosenthal and, in doing so, achieved a higher pulp yield, and we reduced the wastewater fees. Also as I mentioned last quarter, we're continuing to invest in expanding our customized railcar fleet in Germany. This railcar program is a continuation of our initiative to replace shorter-term equipment leases with customer-efficient equipment. We expect to see the first of the next 300 new railcars in early 2019. And all 300 are expected to be delivered by early 2020. In Q4, we have a scheduled mini 3-day shut at Stendal. Now as you know, we've recently announced the acquisition of the Daishowa-Marubeni International Inc. and the Santanol sandalwood businesses. Both will advance our long-term value creation strategy to deliver sustainable profitable growth. These businesses leverage our core competencies and complement Mercer's world-class assets. As we move closer to the closing of the Daishowa-Marubeni acquisition, we will focus on ensuring a smooth integration process to allow us to maximize our identified synergies. My team continues to focus on growth opportunities, and our disciplined approach to growth is framed by Mercer's core competencies, which include NBSK and other grades of pulp, wood products, wood derivatives and extractives as well as green energy and biochemicals. It is these core competencies that will drive long-term value creation for our shareholders. And I do want to reemphasize that while capital work on existing assets can cause short-term disruptions, we also view our equipment and process optimization as attractive growth opportunities to drive longer-term shareholder value creation. So I'll stop there, and turn the call over for questions. Thank you.

(Operator Instructions) Our first question comes from Sean Steuart with TD Securities.

2 questions. With respect to the pulp inventory build this quarter, can you give us context on how much the vessel delay to China was? And of the 44,000 tonnes you've built up this quarter, how much of that would you expect to unwind in Q4?

Sean, so the big picture is, we had no inventory in Q2. You picked up the 44,000 tonne build, so 42,000 tonnes at the end of Q3, 85,000 tonnes at the end of -- 42,000 tonnes at the end of Q2, 85,000 tonnes at the end of Q3. So we're building inventory to meet the 2 scheduled -- we have 1 scheduled vessels for October, which is per plan, and we had one vessel that was late. And I think it was about 18,000 tonnes on the delayed vessel that would've been sold in the quarter. And I don't think you can give us credit for the full -- like it's not going to -- the full 43 is not going to unwind. Really, what you have to do is look at what the target inventory is going to be at the end of Q4. And so I can guide that's going to somewhere between 65,000 and 70,000 tonnes of inventory. So you'll have some unwinding. But it does contribute to the miss in the quarter. Obviously, if you -- for example, if you could have sold -- and the market was there for it, but if we had sold 40,000 tonnes in the quarter, that inventory build, that's $10 million worth of EBITDA.

Yes. Okay. On the fiber costs, you guys explained the trends in Europe and B.C. pretty well. Q4, can you quantify any relief you might expect to get on a sequential basis from Q3?

Well, it's not going to be huge, but Europe is moving in a good direction. You know there's been -- there have been quite a few beetle problems over the summer because of the dry weather. And so what that translates into is rapid harvesting of wood, which produces a supply glut, which helps to bring the price down. And also if the -- as the forest is a little stressed, then if you have storm damage, that's kind of the next layer. So this is something that we actually think is going to be more of a longer-term impact, like some of these are pretty big. So my feeling is for the next at least 6 months, maybe longer, we're going to see more wood coming on the market in a general downward direction. So we -- we've got to work through our existing inventory and continue to buy this more available wood. So in Q4, if it's a 5% reduction moving maybe a little north of 5%, that might be as much as you can expect, but it's generally moving -- we're going to see some -- quite some significant moves, I think, coming in the future quarters. For the Canadian market, it's not the same thing. I think that we've got programs there that help mitigate any inflationary impacts through sawmill activity in our region. We've got the roundwood chipping programs and so on. So we're more or less calling things flat going into the fourth quarter and hope we can hold the line there. And as a reminder, that's in US dollars per tonne of pulp, that's something in the $235 to $240 wood cost in a tonne of pulp, which is not bad and maintains a good level of profitability for us.

Our next question comes from Hamir Patel CIBC Capital Markets.

David, could you maybe comment on where you see pulp inventories in China and from what I understand there's a fair bit of paper capacity slated to come online, so how do you see that playing out?

Yes, well, it's a little hard to see just at the moment, Hamir. You know, normally when you come out of golden week you expect to see a ramp-up of paper production and a lot of paper moving, and things just seem to have kind of halted temporarily in China. And I think it's really more a reaction to a lot of the recent political news. So I think it doesn't feel like a sustainable situation to us. But there it is. Business is transacting at around the $850 level, I think you know Ilim came out $30 down so that takes them to the $820, that's the Russian softwood, which always does trade at about a $30 discount. So just kind of slow and sluggish at the moment. Paper inventories, I think, are relatively high compared to normal periods. But as we all know, once China starts moving, that's not unusual for paper producers to run with fairly high inventories and they'll go to great lengths to switch grades and do whatever they can to keep going and keep it moving. So I'm not overly concerned at this stage, considering how tight Europe and the U.S. is, and the coming conversions, I think this is kind of a short-term thing in China that we'll see work itself out fairly quickly. At least that's our expectation.

That's helpful. And just turning to the lumber side, with Western S-P-F, at least, Prince George price at around $300 now. Is it still economic for you to ship from Friesau to the U.S.?

Yes, well it depends on where the floor is.

But it's getting close in the U.S. market for us. But having said that, we've still got 3 quarters of our business in the European market, which is holding up very nicely, and we've also got these big synergies like you can almost justify the sawmill on synergies, to be honest. But we're all expecting a good EBITDA quarter for Friesau, like something like 4-ish for the fourth quarter. It combines -- and not including synergies, so synergies on top of that. So I guess it's important for investors to understand that this is not a global wipeout, it's just -- I mean, it's been a massive correction in the U.S. market and that's having a significant impact on Canadian producers, but for Mercer here with our European sawmill we have many other options. The reason that we will keep moving lumber into the U.S. market is to maintain our market share. We're not going to lose money doing that. But we are -- we've been building a steady customer base, we've got a very nice product for the U.S. market, and our expansion plans going into the future will be something that, I think, is very attractive to U.S.-based customers. So we want to keep that going.

That's helpful. And maybe just one for Dave. With respect to the DMI transaction, when that closes, how do you expect to report those results? I'm just thinking about the JV mill in there, is that going to be an equity investment. And then when you report EBITDA, will you be able to reflect that mill?

Yes, yes, you're right, Hamir. It will be -- it'll be accounted for as an equity investment, but the structure of it is such that you're going to see the roll-up of 50% of the EBITDA, you'll see that roll-up into our financials.

And the reason for that is that the way the mill is structured, the transfer of pulp or the transfer of earnings from CTT to the 2 shareholders, it's actually done at cost.

So if you could imagine pulp getting transferred. All of the pulp that comes out from CTT, 50% of it goes to one shareholder, and 50% goes to the other shareholder. But that transfer is done at cost. And then it's sold by the 2 shareholders independently. So at DMI and in the future, Mercer will be picking up the full EBITDA up at the DMI level.

So in a nutshell, when you see it, you're going to have full clarity of EBITDA, you'll see 50% of the EBITDA from that mill will show up in our financials, you'll see 50% of the revenues. We'll make sure that we include 50% of the production, the volumes and the sales volumes. So I think you'll find it's pretty transparent.

Our next question comes from Andrew Kuske, Crédit Suisse.

I'm just continuing on DMI. Obviously, you spent the last few years really cleaning up the whole Mercer structure. It's much simpler than it was in the past. But when you look at DMI, how do you think about just financing options around it? Obviously, you're sitting on a lot of cash, a lot of balance sheet flexibility. How do you think about effectively closing the transaction on the structure that you'll have around it?

Yes, well I'll start, and David might have a comment here behind me, Andrew. But the financing, we've got a committed facility that is being led by Crédit Suisse. And so that's what we'll be using. It's a $350 million U.S. facility that will be -- it's a bridge facility, and we can take it out with another forum, it'll likely be senior notes.

We'll go to the market with some senior notes here shortly, to take out that bridge facility. And I think with that $350 million U.S. facility, that will be sufficient to make the acquisition, including the working capital that's associated with the mill.

Okay, so it's just pretty plain vanilla in the grand scheme of things?

Yes. I don't think you'll find we're introducing any complexity. It'll be another tranche of senior notes essentially. But I don't think you'll find it's introducing anymore complexity to the balance sheet.

Okay, that's helpful. And then just shifting gears on the lumber side of it and then Friesau. Obviously, the U.S. market's been very good. You made comments earlier on the call about you maintaining the customer base there, do you see the opportunity if the U.S. market just -- if the pricing erodes and it's not economic to put volumes there, do you have a good -- a big enough viable market within Europe to really place those volumes on a very profitable basis?

Well, absolutely, yes, for sure. This is not a huge volume in the grand scheme of the European market. We choose to be in the U.S. for all the reasons I explained. We've got very efficient logistics to that market. In fact, our lumber can get to that Eastern seaboard cheaper than you can from Prince George, cost plus freight all in. So I think we can be there to stay, I just don't believe that if lumber prices are at a point where we're not making money in the U.S. market, then there's going to be just a ton of guys in Canada that don't run. So I don't see this as a long-term condition. We're just not going to overreact and adjust the strategy just because we've got 1 quarter or 2 of weakness. The medium and long-term fundamentals for lumber are great. If you listen to any lumber producers in a conference call and North America, he's going to say we've got demand growing at 2 billion board feet a year and you've got capacity coming at 1 billion. And though everybody would love to build more capacity in the U.S. out, between the cost of steel and the time it takes to get equipment and finding labor to do it all and then the harvesting and all that kind of stuff, it's going to be years and years and years before you catch up and meanwhile, the U.S. housing stock just gets older and older.

So we feel pretty good about it. And it's -- we've never seen lumber prices ramp up as fast as they did and we've never seen lumber prices ramp down as fast as they did, but my own feeling is it's overblown.

That's good perspective. And then just one final one on the fiber cost escalation that's happening in Europe right now. There's some unique circumstances, and it's a bit different than you saw a few years ago in Germany. But could you just give us maybe a bit of a compare and contrast to what you saw, I think it was 3 or so years ago when German fiber costs went out of control to what you're seeing now. Is it more measured now?

Yes, so we -- I mean if you go back to that big escalation, that was a situation I think where in central Europe there was pretty rapid build of fiber consuming capacities, whether it's lumber, plywood, particle Board, pellets, all that kind of stuff. And we all talked a lot about pellets. But there were a lot of other demands on the forest and things just happened too quickly, so the supply-demand got out of balance. There was very little import wood coming into central Europe and the price got away from everybody for a while.

One of our strategies, as you know, is to focus on logistics and build an import structure, so we're permanently in Poland, Czech Republic, the Baltics, you name it. And we bring in more than -- usually about 1.5 million meters of wood into Germany. Prices have come down. A lot of these wood consuming entities couldn't survive and moved east, like all the particleboard was beat and all the panel plants kind of moved east, wrapped up and moved east. The pellet side struggled and we've had a pretty nice run for the last 3 years. What happened last winter really was, for a while, winter didn't happen. And so normally winter frozen ground is a great time to harvest and dry time in the summer is a great time to harvest. And in Scandinavia, winter just really didn't happen for them for several months. So they had difficulty getting into the forest to get wood. So they put pressure on the Baltics. We had a bit of that in Germany, not quite as severe. But Germany and Austria were pretty wet. It finally froze up later in March. And then we moved into the summer, and we had a very dry summer. So again the guys up north, Scandinavia and Sweden in particular, really struggled with harvesting because of fire risk. They did have some forest fires, nothing like what we see in Western Canada. But I think it was a significant event for them. So wood costs started to move up based on just the lack of harvesting and then we had the realization of the bug kill and we had a couple of storms, and all of a sudden there's just a lot of wood available. And in those situations, the typical approach is to get that wood off the forest floor and out as quickly as you can. So there's a lot of wood coming and prices are falling for roundwood. And we see that continuing as I was saying earlier for potentially an extended period of time. A lot of -- how long that continues is going to depend a lot on what next summer looks like and so on. But right now there's a lot of wood. So we've got -- we've learned over the years to move our wood as close to our pulp mills as we can so that regardless of the winter conditions, we can get access to the wood, and so I think we'll be well positioned to run full through the winter, regardless of what happens and my expectation is to see a steady decline in wood costs over here.

Our next question comes from Joe Pratt with Stifel.

Just a minor accounting thing here. I see year-to-date net income $83 million, and then I subtract $22 million, my estimate for the dividends paid, so I would ask expect equity to go up by $60 million but it's gone up by $20 million. Can you help me out there?

We shouldn't give you too much detail, Joe, but I'm guessing it's other comprehensive income for currency translation to OCI. But maybe we can take that off-line with you later if that's all right with all the other callers.

Okay, fine.

And the next question comes from Charan Sanghera with RBC Capital Markets.

Just a quick question on DMI. Just in terms of DMI's customer mix by geography and end use, how has that changed with Mercer or does it change or what does it mean for Mercer overall?

Well, that's a good question. I'm not really prepared to speak too much on this call. We're in the middle of the competition review. And so we really don't have any role in the current upgrading or marketing activities at DMI. I can tell you that their geographic mix traditionally is about 1/3 China, 1/3 North America, 1/3 Japan. And we have noticed that they have different levels of mill net than maybe we would have expected and we see some room to change that a little bit and maybe optimize based on our customer relationships and so on, but it's too early to get into customer discussions and rearranging logistics and all that kind of stuff. So it's a great question, but we'll have more to say on that probably -- maybe by the first quarter call. But we see a nice opportunity there. It's going to be a nice fit for us.

And like -- having that hardwood in the mix now for your strategy, how does that play out, like do you -- can you comment on that?

Well, yes, if we talked about hardwood 3 or 4 years ago, we'd think, there's a lot of hardwood coming, a lot of eucalyptus pulp coming, and I'm sure glad I'm in softwood. Fast-forward and all these things that I talked about that impact softwood also impact hardwood. So impacts on new cycling, closing agricultural base pulp and paper in China. It's -- the growth in pulp generally is about 5% a year. And the biggest component of that is hardwood. And hardwood like softwood, there is not a wall of pulp coming anymore, and there's very few projects in the ground for incremental hardwood pulp coming. So I'm feeling pretty good about it. I think it's a great complement to us. I think -- I can't think of one customer that buys NBSK from us that probably wouldn't want some Aspen pulp if it was sort of a joint offering. So it'll be new for us but I think it's the right time to be getting into good quality hardwood now.

Just going on -- keeping on this hardwood and softwood conversation, the world 20 stats are showing more market pickup in hardwood obviously, are we missing something within the broader softwood category? Is there more -- a more nuanced look at the NBSK demand versus the softwood number this year, just because we've been hearing incrementally that people are slowing down paper machines and using more hardwood in the mix, globally, with the price differentials.

Yes, that's the old substitution question. I -- the way I see it, and the way we think about it at Mercer is, substitution happens in the margin. And it really comes down to what's the spread between the price of hardwood and the price of softwood. And if the spread gets too great, like softwood too much higher, then guys will do what they can at the margin to use more hardwood. And then when the spread narrows, guys will shift back into softwood. And we kind of see that over and over. But it's just at the margin, they -- 75% or 80% of end-uses of NBSK are specialty products, tissue, towel, specialty papers that really don't have a huge amount of flexibility to shift because they're either low grammage or high performance or they run at super high speeds, all those kind of things. So NBSK, which is the premium long fiber pulp, there is not much threat against it. And it's actually -- what I read about the NBSK thing is it's more consumer driven demand, it's not like a commodity advertising thing that goes up and down, it's consumable products that people use every day like toilet paper and cup stock and thermal papers and that kind of thing. So it's a little -- it should be a less volatile grade going forward. On the hardwood side, what's interesting to think about is how much consolidation there has been on the production side. So we've always -- we're not a big player in that regard but you're seeing players with north of 7 million tonnes of capacity. And so that's a lot more discipline in the market than there would've been historically, which should help to smooth that out as well.

And you talked about tissue driven demand, is there -- I would say tissue producers globally are under quite a bit of pressure with pulp costs. Is there any incentive to ease up a bit on contracts with them or -- given the potential future growth driver that tissue is?

Yes, well our strategy is always to be in market, like say, you don't want to destroy demand by killing your customers and we certainly would never want to do that. But the market is what it is and we follow. There's another dynamic in this whole thing in that if the paper guys could get the prices up, they need to point to something, and you see what they point to is pulp prices are up. So if there were all of a sudden some form of correction on pulp pricing it actually harms the paper guys and their price discussions. So as long as people don't freak out and generally people believe that pulp prices are going to do what I think they're going to do, then that gives the paper guys the opportunity to keep pushing their price. Tissue guys can't do it every month the way the pulp side does. Like these tend to be more quarterly or semiannual or even some of them lock-in annually. So it's -- it takes them longer and they get some margins squeeze on the way through. But at the end of the day, if you believe high pulp prices are here, the paper guys are going to have to get their prices up or they're going to be in trouble. But the law of supply and demand will take their prices up. That's just the way it'll work.

Our next question comes from Adam Zirkin, Knighthead.

So a couple of questions. I want to go back to this inventory issue and make sure I just understand why it builds and how it's releasing. It seems, first of all, David, that when you put forward your target inventory numbers, you were -- you're expecting a build in the fourth quarter absent all this?

We build inventory to ship in October. We had 2 vessels to go in October. So you know you're building inventory for those vessels. Some of it's in line to be sold and some of it will be sold, but you can't -- until you put it on the vessel, it's not sold pulp. So you build in anticipation of that. We also had roughly 18,000 tonnes that should've shipped at the end of the quarter in Q3 that didn't ship because the vessel was late arriving. So sort of compounded the issue.

And those vessels have since -- that pulp has been shipped?

Yes.

Okay, so I guess my question was, you had given a target inventory for the end of the year that was less than those 42,000 tonnes.

Right below...

The only thing I said in my comments on this call is we should expect somewhere between 65,000 and 70,000 tonnes by -- for Q4 target. That's a normalized number and all things being equal, we should achieve that. Q3 has 85,000 tonnes, which means that there will be some -- beyond what's produced, there will be some further sales of pulp.

That also seems to imply that the inventories at the end of the second quarter were abnormally low?

They were, absolutely true. That 42,000 tonnes, that was very, very low.

Got it. Okay. So approximately -- it would seem approximately 20,000 tonnes or so should reverse, right, in the fourth quarter?

Yes, yes, and I think it's also important to reflect on the work that we've done at all 3 mills, and they're all really running really well. So we're going to have a big production quarter, and we're going to have this additional little boost to come through. So there's going to be a good volume of sales in the fourth quarter, strong quarter.

Got it, got it. Can you also then, you talked about the issues with maintenance and ramping up the mills. Frankly, when I looked at the release, my eyes focused on the inventory number, the production number looked okay, but what do you think the production number would've been if not for those startup issues?

Well, let's go through a couple of things. So on the sawmill, we didn't really guide what the production change was going to be as a result of the capital spend there but if you look at it after the fact, we produced about 80 million board feet of lumber in the quarter. In the previous quarter, we produced about 112 million. With the sawmill upgrades I think the fourth quarter is going to come in pretty close to 120 million. So it's the -- what we did was we -- the main saw line, which is a link mill, we upgraded it to the most current technology available in length. And so that is cutting out sections and putting in new pieces. We optimize log rotations, side shifting, board height optimization, put a horizontal saw in, we put in the maximum horsepower upgrades, which increases the speed and product quality. So it was a big effort. We have a second line and in some of the original concepts we thought we'd run the second line and produce lumber during this thing, but as we got into it we realized how sensitive it was and how tight it was with the workers on site, we just decided for health and safety reasons and for efficiency of the capital work, we shut down the second line completely and just got everybody focused on maintenance and things. So something that we didn't signal for the market but again it's a short-term pain for long-term gain, is the way we have to think about it. On the pulp side, you know I think things went really well with Rosenthal's maintenance shut. A couple of little hiccups getting started but nothing really notable. And Celgar, as you know, is in the second quarter and what we did with Celgar, just to remind listeners, is we debottlenecked our digester, so that mill has been running at roughly 430,000 to 440,000 tonnes a year. And that's the best we could do through the digester and working with both Valmet and Andritz, we had 2 concepts we could look at where we changed the way the digester flows worked. So we put in 14 new nozzles around the middle of the digester, you put in double decks of screens which significantly improves the washing and debottlenecks the digester. So that digester is debottlenecked today to take us up to 545,000 tonnes, which is our goal. So we have other bottlenecks in the mill that will come which we will address step-wise going forward. But since the end of July, that mill has been running at an annualized rate of about 490,000 tonnes, which is exactly what we signaled in the last call we expected to achieve. So mission accomplished. We've got lots of sprint capacity in the digester, but to learn to run the mill when you have a new heart put in, it took a little while. So we -- the guys -- you can't drive -- you can't teach somebody to drive a Ferrari until you put their hands on the wheel, and that's exactly the way it is when you do this kind of a change in a pulp mill. You just have to start running and suffer those disruptions while everybody learns what the standard opening procedures, what -- how to adjust all the flows and temperatures and chemical dosings and everything else that happens. It's just a -- you learn by trial and error as you work your way through. Our guys did a great job, they've got a handle it now. And as I say, it's running really well but we did lose tonnes in the front half of the quarter that had not been anticipated.

So what was the production at Celgar in the quarter?

Total production for Celgar I'll have to give you that in just a second. So Celgar's production in Q3 was 114,000 tonnes.

I see you lost 6 or 7 tonnes off the run rate. 6,000, 7,000 tonnes off the run rate.

Yes, yes, and Q4 target could be approaching 130, that kind of thing.

Got it, okay. Turning to lumber for a second David, it's very easy for me to see pricing data for the U.S. market. I don't see it as well for the European markets. So can you just give me and perhaps others who don't know a sense of how modest pricing declines have been over the last couple of months or whatever timeframe you feel is relevant?

Yes, I just don't know how to quantify that. We sell so many different products, Adam, it's not like at S-P-F random lengths. There is no guide like that over here. And you can shift different products in different markets where you see opportunities. For example, we could push lumber at the U.K. market or we could push lumber at the KVH. So I think the best I could do is, I'm expecting something like a $4 million EBITDA quarter for lumber. That's the best I can do at the moment for you.

But the realizations, right, went from sort of sequentially, right, from about $433 right, per 1000 feet right, to $409 or so, right? Where do we expect that...

That's an average, yes.

On average, yes. Where would you expect that to shake out in the fourth quarter?

Yes, well, I don't know. I'd be throwing a guess at you, Adam. It depends on whether the U.S. market stays where it is, at 300 level or not. Europe has been stable. Europe has always been a lot more stable than any other market, so it's fallen off slightly but not significantly. There is still pockets of good areas for us and anything that we sell in the U.S. market today will be close to breakeven for a short period of time. Unless things rebound.

The U.S. will be close to breakeven, you're saying, for a short period of time.

Yes, yes.

I guess I'm trying to understand David, what sort of price behavior in Europe is embedded in the $4 million estimate that you just gave us?

Well, not much change frankly from what we can see today.

Your next question comes from the line of Dan Jacome, Sidoti.

Just a couple of housekeeping oddball questions that show on -- so the Alberta DMI mill. It looks like they do mostly hardwood pulp, I'm just curious how quickly can the capacity there swing from one pulp grade to the other, so hardwood to softwood, and vice versa?

Yes, they more or less have been doing it on the fly. And the mill's capability is sort of on average I think they could go up to about 40% softwood, 60% hardwood. You could run that mill 100% hardwood if you wanted to. I think in the last year, it ran roughly 25% NBSK, and that's the -- that gives you the 475,000 tonne capacity. If you ran full hardwood, you'd be maybe 510,000 or 515,000 tonnes, for example. So it's an operating strategy that will be earned by the price of both grades and the wood availability and the cost and those kind of things.

Great, and I like the flexibility. Would you be able to get that capacity to 100% NBSK or is that just kind of a stretch?

Yes, no, we can't. It has a huge forest management agreement that you need to harvest the wood that's there and it's predominantly aspen but it could run sustainably at 40% softwood if that were our decision to do that.

Okay, that's good, and then on the hardwood pulp global days of supply, I think you said 33% for softwood. Do you have that data point for the hardwood grade by any chance handy? If you don't I understand, I'm just curious where there is right now or are we still kind of in the 30% to 35% range, or where is that?

Yes, I have it, it could be more than -- I don't have it on a piece of paper in front of me.

All right, no worries, I'll send you an email. Then on -- you were talking about the global conversions of softwood producers going to possibly fluff pulp, sorry if I missed it, but do you have a timeline on that? When would you expect maybe that first capacity switch to take place? Would it be starting in the first quarter of '19? Or the end of 2019, because I don't have access to that these days.

Yes. Yes, I think it starts with -- at the beginning of 2019 and carries on through the year and some of it will come in 2020. So -- I mean, it's a whole list of them. Valdivia, for example, is a 500,000 tonne softwood mill that has been slated to convert to fluff, but they've got -- or to dissolving, but they've got a eucalyptus plantation that they need to begin harvesting so that's all converted to hardwood now. There's a couple of mills in Scandinavia, there's Celgar and the other sawmills, that are coming. There's the Japanese mill that's integrating another 130,000 tonnes into paper. There's a lot of -- and some of it's happened and more of it is coming.

Got you, okay. So starts from first Q?

Just to remind you, Ilim has taken maybe 200,000 to 300,000 tonnes of softwood out of the market because they're now required to post this to hardwood, so just all those over.

Okay, I may have missed that. So it starts in the first quarter '19, and then it seems to be spread out through 2020?

Maybe for '19, I'd say -- well, Valdivia is done. The Japanese Ulu and Celgar are all '19s and I'd say the ramp ups -- Ilim is happening every year, this extra hardwood substituting for softwood.

And, Dan, just before we lose you, the days -- the inventory days for hardwood is 41 at the moment.

Your next question comes from the line of Tony Graves, The Hartford.

Just out of curiosity, you guys have completed 3 pretty different acquisitions over the past call it, 18 months. Could you maybe give us an update on what the capital allocation priorities are? And how you're thinking about future softwood -- not softwood, sawmill greenfields going forward?

Sure, yes, I guess the rate of -- big picture, we see ourselves as a growth company. We are aggressively intending to grow both organically and through M&A. We have 4 main areas, we have pulp, lumber, energy, and extractors. Extractors include byproducts from our existing processes but also extractors from other forms of material where you can take a low-value substance, feed the downstream processor that produces a product that the market needs. So those are the 4 areas of focus. We are also a dividend paying stock. When you speak about capital allocation, we want to have a safe, healthy balance sheet, we want to deploy all of our earnings into growth but we want to also reward shareholders with a reasonable size dividend. We've said over the years we always intend to increase our dividend slowly and steadily over time. But we need to balance that with the pace of growth and it really depends on what will inform the pace of growth, and the dividend will be the extent of activities that we have on the growth side. Daishowa is a great acquisition for us. We're a disciplined group. Analysts have been following us for the last few years, have been hearing me say we're going to grow, we're going to grow, but we're not going to pay too much for something. And the valuations have been challenging and I think we're very pleased with the DMI deal, the Peace River Mill is a great mill. It's got a great workforce. It's got tremendous long-term fiber supply, good access to the markets, it's a high quality pulp, really quality mill so we're thrilled with that. We've got organic growth in our existing assets and we're always pushing that. As I mentioned earlier in my comments, if we can put high return capital into our existing assets, or we can hit a 3-year payback or better, that's good capital deployment. We should be trading at a 6-plus and we can put capital in the ground at a 3, let's do it all day long. So we're going to have steady, consistent growth through a combination of M&A and organic growth, process optimization and so on. And doing it all in a way where we retain a strong balance sheet. And another operating philosophy for Mercer is a continuous improvement company. We have these core competencies, we talk about them all the time, and what's important about that is that Mercer will be a strong operator throughout the cycle, no matter what happens. If you're lower on the cost curve, you can hit it out of the park at the bottom of the cycle or at the top of the cycle. You just -- that's where you want to be. So we're always focused only on high-quality assets and assets that you can position at the low end of the cost curve. So a lot of -- quite a bit of stuff there, but that's the capital allocation strategy going forward.

Yes, that's helpful, and just a follow-up. Can you give us an update on what the production and shipments were by mill? I know you had Celgar earlier?

I think Dave's got a schedule here.

I'll rattle through them. So in thousands of tonnes, the sales volume for Rosenthal, 78.9; for Stendal, 166.4; for Celgar, 74.6. Those are the sales tonnes, and the production volumes, again in thousands, Rosenthal 78.5; Stendal, 170.6; and Celgar, 114.4.

Our next question comes from Sean Steuart, TD Securities.

Just one more as we're getting along in the call here. With DMI in the mix, do you guys have a view on CapEx budget for 2019 at this point?

Too early for that Sean, sorry. I just don't have a really good feel on either Caribou or Peace River at this stage. And while we've got all these great opportunities for existing pulp mills, I want to wait until we've seen how the financing goes and I just don't want to overpromise and under deliver. So we'll size that to be appropriate based on everything else that's happening. Because there -- the timing of those things could be discretionary obviously. So give us a quarter and we'll give you a better picture by the end of the year.

(Operator Instructions) And I see no further questions in the queue at this time. I'll turn the call back over to management.

Yes, okay, thanks for that. I guess -- and just -- maybe just a couple of closing comments. So, I think in every single analyst report I read this morning, you talked about the miss. And it's just one of those things where when you're doing capital upgrades, it's difficult to signal or guide precisely and in fairness to the analysts, there's some things that you just couldn't have picked up. Maybe we've could have -- we'll do a better job next time. But in terms of bridging from here to where we're going, I just want to maybe make the points that translating from the miss Q2 to Q3, what does that mean for Q4. So maybe to summarize, we see the sawmills running well and the Q4 should be our highest production volume ever, somewhere around 120 million board feet. All 3 pulp mills are running well, so it should be a great production quarter. We've got that 20,000 extra tonnes we're going to see coming through inventory. The wood costs, assume they're relatively flat with some improvement in Europe, but things are progressing on a very positive way there, no issues with volumes. We've got reduced maintenance costs in the fourth quarter. Remember we put in our -- you can read in the press release, $10.8 million of costs at Rosenthal, it won't be there. The 3 days of Stendal might be about 2, so you've got a pickup of about 8. And the inventory change referred to earlier, just 20,000 tonnes around numbers, $5 million of EBITDA. So all in, we've got -- we had a $5.9 million, we didn't talk about this but in terms of gigawatt hours lost because of the maintenance on turbines, that was about $5.9 million hit in the second -- in the third quarter. Everything's running full for all of the third quarter -- fourth quarter, so that'll all pick up as well. So a bit of a miss in the third quarter but it's going to be a strong fourth quarter so don't over blow things. That's my message. So thank you all for joining the call. I look forward to speaking to you all again in February.

Thank you very much. Ladies and gentlemen, for joining us today, this concludes today's conference. You may now disconnect.