ODLUMBROWN.COM ODLUM BROWN REPORT

11 2016 The ABCs of Matchmaking Speed dating is an unusual matchmaking process. People meet at an event and rotate through a number of potential mates, typically only having three to five minutes to get to know someone and determine if there is any interest. At the end of each event, participants submit a list of who they would like to see again, and couples who match will exchange contact information. According to The New York Times, matches occur on average two or three times for every 10 dates.

The auction process by which companies put themselves up for sale has similarities with speed dating, except it’s called “exploring strategic alternatives.” Recently, Twitter decided it was time to find a buyer, and, according to sources, met with a number of potential suitors, including Alphabet, Disney and Salesforce.com. Unfortunately for Twitter, the dating process failed to result in a match. #StillSingle INSIDE THIS ISSUE As Alphabet (NASDAQ: GOOG) shareholders, we have an interest in the way the company chooses to spend Page 1 capital. We think Twitter is a unique product and a great tool for consuming information; however, the company The ABCs of Matchmaking suffers from a number of issues. First, CEO Jack Dorsey runs two public companies: Twitter and Square. For most executives, the challenges of running one company are plenty. Second, Twitter’s cost structure is massively Page 2 bloated; the relaxed attitude toward excessive spending, especially with respect to stock rewards, is notable Timber! Don’t Get Hit by a Trade when compared to its peers. War While it is difficult to say whether Twitter would be a good fit for Alphabet, we know that Alphabet’s approach to capital allocation and decision-making is solid. Co-founders Larry Page and Sergey Brin have made reference Page 4 to Warren Buffett and Berkshire Hathaway’s “An Owner’s Manual” in the past, and their focus on business Odlum Brown in the Community durability and long-term value creation was undoubtedly behind the decision to transition Google into a holding company in August 2015.

Naturally, Alphabet will look to acquire companies to supplement its internal research and development efforts. What stands out to us is the way Alphabet manages its earlier-stage technology experiments, such as driverless Odlum Brown Limited Suite 1100 - 250 Howe Street cars and glucose-sensing contact lenses, as well as the company’s venture capital portfolio. As part of the BC V6C 3S9 Alphabet restructuring, these investments are now managed independently from the company’s core Search business. Alphabet’s commitment to operating in this manner is important in that decentralization and the Main 604 669 1600 placement of responsibility and ownership further down the ranks tend to distinguish the great capital allocators Toll Free 1 888 886 3586 from the rest of the field. Kelowna 250 861 5700 Victoria 250 952 7777 Technology investing can be challenging because successful newcomers are often susceptible to an inertia Chilliwack 604 858 2455 that prevents them from continuing to adapt. Yesterday’s disruptors become the next incumbents, ready to be Courtenay 250 703 0637 disrupted. Alphabet has cultivated a company culture determined to avoid this all-too-common outcome. The Email [email protected] company spent roughly $4.5 billion on experimental projects and investments over the last year, and, perhaps more importantly, it remains focused on closing down projects that fail to deliver results. While it may still be Odlum Brown Limited too early to pass judgement on Alphabet’s capital allocation track record, we believe that their endeavours, including acquisitions, internally developed projects and the avoidance of ill-suited businesses, make the @Odlum_Brown company a perfect match for patient shareholders.

Odlum Brown Community STEVEN ZICHERMAN, MBA, CFA Equity Analyst @OBDifference Timber! Don’t Get Hit by a Trade War

With a much weaker housing backdrop For the last decade, there has been peace between and the United States on the lumber “ trade front, and 2x4s have crossed the border with relative ease. Unfortunately, we think that is this time around, the U.S. industry appears all about to change.

The Softwood Lumber Agreement between the two countries expired on October 12, 2015. Since then, the more focused on achieving a hard cap on industry has operated under a one-year grace period designed to allow negotiations to continue without trade action. That window is now closed. As , we are hopeful that cooler heads will prevail. However, it’s market share. In contrast, Canadian likely only a matter of time before punitive duties will be imposed on Canadian producers, leading to another costly trade war. producers would prefer a straight fee The last time the industry operated without a trade agreement, a 27% tariff was levied against Canadian lumber structure, which leads us to the current exports. At the time, demand for lumber was on its way to a multi-decade high, and there was an elevated need for Canadian wood products. Yet, it took five long years and US$5.4 billion in duties before a deal was reached. stalemate. The signing of the 2006 Softwood Lumber Agreement coincided with the peak in U.S. home construction. It was structured with a sliding tax based on the price of lumber. In good markets, the tax would fall to zero, and in poor markets it would rise to 15%. Of course, this seemed like a bargain relative to a flat rate of 27%.

With a much weaker housing backdrop this time around, the U.S. industry appears more focused on achieving ” a hard cap on market share. In contrast, Canadian producers would prefer a straight fee structure, which leads us to the current stalemate.

Complicating matters is the fact that the market is not static. Canada’s market share averaged roughly 33% for the five years prior to the signing of the last agreement. Since then, it has averaged 30% and even dipped below 26% following the financial crisis of 2008/2009. Canada’s share of the lumber market is now back to approximately 33%.

The U.S. Lumber Coalition has suggested that Canada deserves just 22% market share. While that proposal is undoubtedly a negotiating ploy, it highlights how far apart the two sides are in terms of expectations. Government agencies can’t even agree, with Statistics Canada and the USDA Foreign Agricultural Service reporting vastly different market share statistics over the past year. Nonetheless, it is clear that Canadian producers ramped up exports to the U.S. during the one-year grace period at a growth rate of somewhere between 20% and 40%, depending on the source. This has not been lost on U.S. producers and has likely strengthened their resolve to regain market share.

We shouldn’t be surprised by the controversy regarding softwood lumber exports. Disputes over timber have been going on since the 1930s, and this will be the fifth lumber trade war between Canada and the United States.

The underlying argument made over and over again by U.S. producers is that Canadian lumber is unfairly subsidized by the government. This is because most Canadian timber is logged on crown lands, whereas logging in the U.S. is primarily done on private timberlands. Private land owners sell timber at the market price, which is typically higher than stumpage paid to the Canadian government to access crown lands. While this is a valid point, the issues run much deeper.

There are three contributing factors making negotiations particularly contentious:

1) Canadian producers enjoy a much more favourable exchange rate today than was the case for much of the last decade.

2) Falling demand from has increased the flow of lumber from Canada to the United States.

3) Rising protectionism has created a toxic environment in which to negotiate a trade agreement.

2 The Canadian dollar was near parity in the fall of 2013. The depreciation of our currency since then has meant Within the forestry sector, there are some a 25% lift in lumber prices in Canada because prices are set in U.S. dollars. This is an intolerable competitive “ advantage from the perspective of American lumber producers. Ominously, the last lengthy trade dispute excellent options to participate in occurred when the loonie was similarly depressed.

rising housing starts. Our favoured names One of the big stories for B.C. forestry in recent years has been the rise of Chinese lumber imports. Local companies, such as Canfor, were quick to address the market and eagerly shipped lumber overseas. However, that market has softened and demand has declined in recent months. The timing couldn’t be worse. A shrinking export pie in the sector continue to be Norbord (TSE: hurts everyone and puts the focus squarely back on the U.S. market. OSB) and Weyerhaeuser (NYSE: WY). Protectionism is a difficult factor to measure but has almost certainly played a greater role at the negotiating table this time around. Look no further than commentary from presidential hopefuls Donald Trump and Hillary Clinton. It Importantly, neither business should be has become popular to publicly blame trade deals such as NAFTA for lost American jobs. The idea that Canada is taking a greater share of the lumber market does not sit well with many Americans and their elected leaders. negatively impacted by a prolonged With a trade dispute looming, the market has already discounted trouble ahead for domestic forestry companies that sell into the United States. Stock prices for Canfor and West Fraser are down 26% and 17%, respectively, lumber dispute. over the past year (as of October 20, 2016). While such discounts pique our contrarian instincts, it may be too early to bargain hunt given the likelihood of a protracted dispute.

A rational response to the risk and uncertainty of another softwood lumber dispute would be to avoid forestry stocks altogether. However, we believe that the U.S. housing market is in the middle innings of a multi-year recovery and represents an attractive area for investment. The industry has underbuilt for almost a decade, ” and we expect significant demand for homes with the rising trend of new household formations.

U.S. HOUSING STARTS REMAIN BELOW THE LONG-RUN AVERAGE

2,500 –

2,000 – Average Housing 1,500 – Starts = 1.4 M Thousand Units Thousand

1,000 –

500 – ‘66 ‘68 ‘70 ‘72 ‘74 ‘76 ‘78 ‘80 ‘82 ‘84 ‘86 ‘88 ‘90 ‘92 ‘94 ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12 ‘14 ‘16 Year

Within the forestry sector, there are some excellent options to participate in rising housing starts. Our favoured names in the sector continue to be Norbord (TSE: OSB) and Weyerhaeuser (NYSE: WY). Importantly, neither business should be negatively impacted by a prolonged lumber dispute.

Norbord is a global panel producer, and panels are not subject to any of the trade restrictions placed on softwood lumber. Moreover, we believe that the outlook for oriented strand board, the material from which Norbord’s products are primarily made, is attractive given capacity constraints and our expectation for improving U.S. building activity.

Weyerhaeuser owns extremely high-quality timberlands and operates predominantly in the United States. Near-term restrictions placed on lumber imports will provide an immediate benefit to the company. Over the long term, we think Weyerhaeuser will be able to increase earnings as the value of its land grows and demand for building products accelerates.

CORY O’KRAINETZ, B.SC. Equity Analyst @OBDifference 3 Odlum Brown in the Community DISCLAIMER & DISCLOSURE Odlum Brown Limited is an independent, full-service The spirit of philanthropy and community giving has long-standing roots at Odlum Brown Limited, starting investment firm focused on providing professional investment advice and objective research. We respect with General Victor Odlum and Colonel Tom Brown. We are pleased to be able to honour these leaders your right to be informed of relationships with the issuers or through the following initiatives. strategies referred to in this report which might reasonably be expected to indicate potential conflicts of interest with Juno Beach Centre: respect to the securities or any investment strategies discussed or recommended in this report. We do not act as a “From Vimy to Juno” market maker in any securities and do not provide investment banking or advisory services to, or hold significant positions Travelling Exhibit 2016-17 in, the issuers covered by our research. Analysts and their associates may, from time to time, hold securities of issuers BC Tour discussed or recommended in this report because they per- sonally have the conviction to follow their own research, but we The Juno Beach Centre th have implemented internal policies that impose restrictions Canada will commemorate the 100 anniversary on when and how an Analyst may buy or sell securities they of the Battle of Vimy Ridge in 2017. One of our cover and any such interest will be disclosed in our report in founders, General Victor Odlum, served our country accordance with regulatory policy. Our Analysts receive no direct compensation based on revenue from investment in both and II. To mark this anniversary, banking services. We describe our research policies in greater as well as the 150th anniversary of Canada, the Juno detail, including a description of our rating system and how we disseminate our research, on the Odlum Brown Limited Beach Centre launched a new multi-year national website at odlumbrown.com. initiative called the “From Vimy to Juno Education Campaign” in March 2016. This bilingual, national This report has been prepared by Odlum Brown Limited and is intended only for persons resident and located in all the commemorative program explores the connections provinces and territories of Canada, where Odlum Brown between Canadian experiences during the First and Limited's services and products may lawfully be offered for sale, and therein only to clients of Odlum Brown Limited. This Second World Wars in the lead-up to the centennial of the Battle of Vimy Ridge in 2017. report is not intended for distribution to, or use by, any person The campaign is comprised of a national travelling exhibition, an educational website or entity in any jurisdiction or country including the United States, where such distribution or use would be contrary with pedagogical resources, and a series of pan-Canadian special events at museums to law or regulation or which would subject Odlum Brown and cultural centres from coast-to-coast. General Odlum will be featured in the exhibit Limited to any registration requirement within such jurisdiction General Victor Odlum and profiled on the program website. or country. As no regard has been made as to the specific investment objectives, financial situation, and other particular circumstances of any person who may receive this report, Odlum Brown is pleased to honour our founder, General Victor Odlum, by partnering with the Juno Beach clients should seek the advice of a registered investment advisor and other professional advisors, as applicable, regarding Centre as the Presenting Partner of the leg of the tour, with stops in Vancouver, Victoria and the appropriateness of investing in any securities or any Kelowna, communities in which we have offices. investment strategies discussed or recommended in this report.

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