Oct 26, 2018
Executives
David Ure – Senior Vice President, Finance, Chief Financial Officer and Secretary David Gandossi – President and Chief Executive Officer
Analysts
Sean Steuart – TD Securities Hamir Patel – CIBC Capital Markets Andrew Kuske – Credit Suisse Joe Pratt – Stifel Adam Zirkin – Knighthead Dan Jacome – Sidoti Tony Graves – The Hartford
Operator
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.
David Ure
Good morning, everyone. I will begin by taking a few minutes to speak about the financial highlights of the quarter and then I will 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 at Celgar and Friesau, annual maintenance at our Rosenthal mill, the final stages of maintenance on two 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 productivity as our mills wrapped up to full production. In Q3, lost production and direct costs related to annual shuts impacted EBITDA $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 product segments contributed EBITDA of $0.6 million. As we took significant downtime at Friesau to install and optimize the new sawline and automatic grading system.
As usual, you could find additional segment disclosures in our 10-Q. In Q3 the average European pulp list price was up $30 a ton relative to Q2.
While the average list price in China was down roughly $25 a ton, quarter-over-quarter. Compared to Q2, higher pulp prices positively impacted EBITDA by approximately $10 million.
Our pulp sales volume totaled about 320,000 tons, which was down 18,000 tons 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 optimize our latest capital investments at Celgar. In addition to the late vessel departure, we built considerable pulp inventory in the quarter because we were required to stage product to match break pulp shipments schedules.
A situation we believe will largely reverse itself in Q4. Consolidated electricity sales total 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 five $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 sawline 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 spend 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 payments. On a trailing 12 month basis, our net debt is about 1.4 times 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’ll have seen from our press release yesterday, our Board has approved a quarterly dividend of $0.125 of shareholders of record in December 13th, which payment will be made on December 20th, 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.
David Gandossi
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 and optimization of the new equipment 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’re on track to drive noticeable improvement in Q4 and future periods. Celgar’s digester upgrade is now generating incremental tons 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 at the departure of a break pulp festival 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 production was down relative to Q2, due to the sawline upgrade and the new automated grading scanner system.
Both are high return projects that have increased in those 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 Rosenthal mill. Turning to our markets.
The pulp markets remain steady through Q3. In Europe, Q3 list prices average $1,230 per ton compared to $1,200 in Q2.
European market remains in balanced after the industry's maintenance season, which created significant tightness last quarter. October list price is also $1,230 per ton and we expect steady prices through Q4.
In China, the Q3 average price was $887 a ton, which is down from $910 per ton in Q2. Q3 saw pricing slipped to $865 per ton, 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 input 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.
Obviously, 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 gets 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 year, pricing has been more stable, but it declined slightly in Q3, due to increased volumes with beetle and storm damaged wood. The Random Lengths U.S.
benchmark for western SPF number two and better average $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 European market. Despite the recent price softening in the U.S., the European lumber market is 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 are focused on harvesting sawlogs rather than pulp logs. Looking forward, we expect to see prices decreased slightly in Q4 as harvesting continues to improve, which will allow us to access lower cost wood.
As we've 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 will 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 yield to 600 million board feet. Over $14 million of our investment in Celgar's digester is also proven to be successful.
Since the end of July, the mills is operating in an annualized rate of $490,000 per thousand tonnes per year with daily rates as high as 1,700 tonnes per day. In Q3, as we mentioned, we upgraded our fiber line at Rosenthal and it doing so achieved higher pulp yield and we reduced the wastewater fees.
Also, as I mentioned last quarter, we are 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 more 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 a mini three-day shut at Santanol.
Now, as you know, we've recently announced the acquisition of the Daishowa-Marubeni International Inc. and the Santanol sandalwood business.
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 are disciplined approach to growth is framed by Mercer's core competencies, which include NBSK and other grades of pulp wood products with 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 our 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 to the questions.
Thank you.
Operator
Thank you. [Operator Instructions].
Our first question comes from Sean Steuart, TD Securities. Your line is open.
Sean Steuart
Thanks. Good morning.
Few questions. With respect to the pulp inventory build this quarter.
Can you give us context on how much the vessel delayed China was? And of the 44,000 tonnes you built up this quarter, how much of that would you expect to unwind in Q4?
David Gandossi
Hi, Sean. Yes, so the big picture is, you had low inventory in Q2.
You picked up the 44,000 tonnes builds, 42,000 tonnes at the end of Q3, 85,000 times at the end of our – 42,000 tonnes at the end of Q2, 85,000 tonnes at the end of Q3. So we were building inventory to meet the two schedule vessels for October, which is per plan and we'd had one vessel that was late.
And I think, it was about 18,000 tonnes on the delayed vessel that would have 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 43,000 tonnes is not going to unwind, when we – really what we have to do is look at what the target inventory it's going to be at the end of Q4.
So I can guide that's going to be somewhere between 65,000 tonnes and 70,000 tonnes of inventory. So you'll have some unwinding.
But it does contribute to the mess in the quarter, obviously, if you – for example, I mean if you could have sold and the market was there for it, but if we'd sold 40,000 tonnes in the quarter that inventory buildup that's $10 million for that EBITDA.
Sean Steuart
Okay. On the fiber costs, you guys explained the trends in Europe and BC pretty well, Q4.
Can you quantify any relief you might expect to get on a sequential basis from Q3?
David Gandossi
Well, it's not going to be huge, but Europe is moving in a good direction. There has 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 supply glut which helps to bring the price down. And also if there – as it for us it’s little stressed than 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 six months, maybe longer, we're going to see more wood coming onto market and a general downward direction.
So we've got to work through our existing inventory and continue to buy this more available wood. So in Q4, it's a 5% reduction moving, maybe a little more than 5% that might be as much as you could expect, but it's generally moving.
We're going to see quite some significant moves, I think coming in the future quarters. So the Canadian market, it's not the same thing.
I think that we've got programs there to help mitigate any inflationary impacts through sawmiller activity in our region. We've got the round wood chipping programs and so on.
So we're about calling things flat going into the fourth quarter and hope we can hold the line there. And as a reminder, that's in U.S.
dollars per ton a pulp that's something in a $235 to $240 wood cost in a ton of pulp, which is not bad and it maintains a good level of profitability for us.
Sean Steuart
Got it. Okay, I'll get back in the queue.
Thanks guys.
Operator
Thank you. Our next question comes from Hamir Patel, CIBC Capital Markets.
Your line is open.
Hamir Patel
Good morning. David, could you maybe comment on a 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?
David Gandossi
Yes. Well, it's a little hard to see just at the moment in your – 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 kind of hold to temporarily in China.
And I think it's really more a reaction to a lot of the recent political news. So it doesn't feel like a sustainable situation to us, but there it is.
Businesses transacting at around the $850 level, I think, LM came out $30 down, so that takes them to the $820, that's the Russian softwood, which was probably illustrated about $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 usual 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 and 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 will see work itself out fairly quickly. At least that's our expectation.
Hamir Patel
Okay, thanks. That's helpful.
And just turn to the lumber side with a Western SPF, at least a Prince George crisis at around $300 now. Is it still economic for free to ship from Friesau to the U.S.?
David Gandossi
Yeah. 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 three quarters of our business in the European market, which is holding up very nicely and we've also got these big synergy like the – you can almost justify the sawmill on a synergies, to be honest, but I'm expecting a good epitaph quarter for Friesau, like something like 4-ish for the fourth quarter combined and not including synergy. So synergy is on top of that.
So I just it's so important for investors to understand that this is not a global wipe out. It's just, it's a – 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 for 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'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 role, it would be something that I think is very attractive to U.S.
based customers. So we want to keep that going.
Hamir Patel
Thanks, Dave. That's helpful.
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 it able to reflect that mills?
David Ure
Yes. No, see, you're right, Hamir.
It'll be accounted for as an equity investment, but the structure of it is such that you're going to see the rollup of 50% of the EBITDA. You'll see that rollup into our financials.
And the reason for that is that the way the bill is structured. The transfer of pulp for the transfer of earnings from CPP to the two shareholders, it's actually done at cost.
So if you could imagine a pulp getting transferred, all of the pulp that comes out from CPP, 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 two 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 sales volumes. So I think you'll find it's pretty transparent.
Hamir Patel
Great. Thanks for that Dave.
That's all I had. I'll turn it over.
Operator
Thank you. Our next question comes from Andrew Kuske, Credit Suisse.
Your line is open.
Andrew Kuske
Thank you. Good morning.
I'm just continuing on DMI. Obviously, you've spent the last few years really cleaning up the whole Mercer structure as much simpler than it was in the past.
But when you look at DMI, how do you think about financing options around it. Obviously, you're seeing a lot of cash, a lot of balance sheet flexibility.
How do you think about effectively the transaction on the structure that you have around it?
David Gandossi
Yes. Well, I'll start, David might have a comment here behind me, Andrew.
But the financing, we thought a committed facility that is being led by Credit Suisse. 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 form.
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.
Andrew Kuske
Okay. So it's just pretty plain vanilla in the grand scheme of things.
David Gandossi
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 any more complexity to the balance sheet.
Andrew Kuske
Okay. That's helpful.
And then just shifting gears on the lumber side of it and then freeze out. Obviously, the U.S.
market has been very good and you make comments earlier in 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 big enough viable market within Europe to really place those volumes in a very profitable basis?
David Gandossi
Well, absolutely. Yes, for sure.
I mean 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.
And we got very efficient logistics to that market, in fact, our lumber can get to the 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 just not going to overreact and adjust the strategy just because we've got a quarter or two of weakness.
I mean the medium or long term fundamentals for lumber are great. I mean, if you listen to any lumber producers in a conference call in North America is going to say, we've got demand growing at 2 billion board feet a year and you got capacity company at 1 billion and then – well, everybody would love to build more capacity in the U.S.
sale between the cost of steel and the time takes to get equipment and finding labor, to do it all and then the harvesting and all that kind of stuff is going to be years and years and years before you catch up. And meanwhile, U.S.
housing stocks 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 they did. But my own feeling is it's overblown.
Andrew Kuske
That's good perspective. And then just one final one on fiber costs escalation that's happening in Europe right now and there's some unique circumstances, and as bit different than what 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 three or so years ago on when German fiber costs went out of control to what you're seeing now, is it more measured now?
David Gandossi
Yes. So I mean if you go back to the big escalation that was the situation.
I think we're in Central Europe, there was pretty rapid buildup 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 would coming into Central Europe and the price got away from everybody for a while.
One of our strategies, as you know, is the focus on logistics and build an import structure. So we're permanently in Poland, Czech Republic, the Baltic’s, you name it, and we bring in more than usually about a 1.5 million meters of wood into either Germany.
Prices have come down. A lot of these wood consuming entities couldn't survive and moved east like all the particle board, panel plants basically all kind of moved east – wrapped up and moved east.
The pellet sides struggled. We've had a pretty nice run for the last three 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 – and the summer is a great time to harvest.
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 Baltic’s. We had a bit of that in Germany, not quite as severe, but to Germany and Austria were pretty wet, it finally froze up a later in March.
And then we moved into the summer and we had a very dry summer. So again, the guys up North Scandinavia in Sweden in particular, really struggled with harvesting because of fire risk.
They did have some forest fire, nothing like what we see in Western Canada, but I think it was a significant event for them. So wood cost started to move up based on just the lack of harvesting and then we had the realization of the bulk-bill.
And we had a couple of storms and all of a sudden, there's just a lot of what 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 wall of woodcutting 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 going to depend a lot on what next summer looks like or – and so on. But right now there is a lot of wood.
So, we thought, we’ve learned over the years to move our witness 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.
Andrew Kuske
Okay. That’s extremely helpful.
Thank you.
Operator
Thank you. Our next question comes from Joe Pratt from Stifel.
Your line is open.
Joe Pratt
Hi, good morning, Dave and Dave. just a minor accounting thing here, I see year-to-date net income $83 million.
And then I’d subtract a $22 million, my estimate for the dividends paid. So, I would expect equity to go up by $60 million, but it’s gone up by $20 million.
Can you help me out there?
David Gandossi
We shouldn’t get into too much detail, Joe. But I’m guessing its other comprehensive income, foreign currency translation to OCI, but maybe we could take that offline with you later.
That’s all right with all the other callers.
Joe Pratt
Okay, fine. Thank you.
Operator
Thank you. Our next question comes from [indiscernible] from RBC Capital Markets.
Your line is open.
Unidentified Analyst
Hi, good morning guys.
David Gandossi
Good morning.
Unidentified Analyst
Just a quick question on DMI, just in terms of DMI’s customers mix by geography and end-use, how does that change with Mercer or does it change or what does it mean for mercer overall?
David Gandossi
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 operating or marketing activities of DMI.
I can tell you that their geographic mix traditionally is about one third China, one third North America, one third Japan. And we have noticed that they have different levels of mill there, then maybe, we would have expected.
And so we – we see some room to change that a little bit and maybe optimize based on our customer relationships and so on. but it’s – just it’s too early for us 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.
Unidentified Analyst
And unlike having that hardwood in the mix now for your strategy, how does that play out like you – can you comment on that?
David Gandossi
Yes. Well, if we talked about hardwood three or four years ago, we think, it seems there’s a lot of hardwood coming, a lot of eucalyptus pulp coming and who – I’m sure that I am in softwood, fast forward and all these things that I talk about that impacts off, but also impacts hardwood.
So impacts on recycling, closing agricultural based pulp and paper in China, I mean, it’s the growth in pulp generally is about 5% a year and the biggest component of that is hardwood, and hardwood like softwood, because there is not a wall of pulp coming anymore. I mean that there’s few projects in the ground for eucalyptus pulp coming.
.
Unidentified Analyst
And just going on you try to keeping on this hardwood and softwood. A conversation like the world 20 stats are showing a more market pickup in hardwood obviously, are we missing something within the broader softwood categories or meaning more, a more nuanced look at NBSK demand versus a 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 of globally with the price differentials.
David Gandossi
Yes. That’s a little substitution question – the way I see it and the way to think about 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 the softwood too much higher, then guys will do what they can at the margin to use more hardwood.
And then when its spread narrows, guys would shift back into softwood. And we kind of see that over and over, but it’s just that the margin, like 75% or 80% of the end uses of NBSK are specialty products, tissue, pulp, specialty papers that, that really don’t have a huge amount of flexibility to shift, because their either low grammage or their high performance or they run at super high speeds, all those kinds of things.
So, there’s NBSK, which is the premium, long fiber pulp, there’s – there’s not much threat against it. And it’s actually – what I really like about the NBSK thing is, it’s more consumer-driven demand.
It’s not – it’s not a 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 much less volatile grade going forward. on the hardwood side, what’s interesting to think about is, is how much consolidation there has been on the – on the production side.
So, there’s always – we’re not a big player in that regard, but you’re seeing players with north of 7 million tons of capacity now. So that’s a lot more discipline in the market than there would have been historically, which should help to smooth that out as well.
Unidentified Analyst
And you talked about a tissue-driven demand, is there – I would say tissue producers globally are under quite a bit of pressure with pulp cost, is there any incentive to ease of a bid on contracts with them or given the potential future growth or a driver of that tissue is?
David Ure
Yes. Well, our strategy is always to be in market.
Like you 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 and that if for paper guys to get the prices up, they need to point to something and you see what they do is, pulp prices are up. So if they’re 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 keep pushing their price. Tissue guys can’t do it every month.
But the pulp side does, like these tend to be more quarterly or semiannual or even some of the lock in annually. So it takes them longer and they get some margin squeeze on the way through.
But at the end of the day, if your belief 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.
The law of supply and demand will take their prices up, that’s the way it will work.
Unidentified Analyst
All right, thanks for the market color. That’s it for me.
David Ure
Okay.
Operator
Thank you. Our next question comes from Adam Zirkin, Knighthead.
Your line is open.
Adam Zirkin
Hi, David. How are you?
David Gandossi
Good, Adam.
Adam Zirkin
So a couple questions. I want to go back to this inventory issue and make sure I just understand why it builds in and how it’s releasing.
It seemed first of all, David, when you put forward your target inventory numbers you are expecting a build in the fourth quarter absent August.
David Gandossi
Yes. Well we build inventory to ship in October.
We had two vessels to go in October. So 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 so important. So you build in anticipation of that.
We also had roughly 18,000 tons that should have shipped at the end of the quarter in Q3 that didn’t ship because the vessel was late arriving. So that compounded the issue.
Adam Zirkin
And those vessels have since that said pulp has been shipped.
David Gandossi
Yes.
Adam Zirkin
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 tons right below – the numbers you had in the third quarter, so I understand that.
David Gandossi
We expect somewhere between 65,000 and 70,000 times for Q4 target. That’s a normalized number and all things being equal, we should achieve that.
Q3 has 85,000 tons, which means that there will be some beyond what produced; there will be some further sales with pulp.
Adam Zirkin
That also seems to imply that the inventories at the end of the second quarter were abnormally low.
David Gandossi
They were, absolutely true at 42,000 tons. That was very, very low.
Adam Zirkin
Got it. Okay.
So approximately 20-or-so-thousand tons should reverse, right in the four quarter?
David Gandossi
Yes, yes. And I think it’s also important to reflect on the work that we’ve done at all three mills and they’re all running 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.
Adam Zirkin
Got it. And 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 have been if not for those startup issues?
David Gandossi
Well, let’s go through a couple of things. So on the sawmill – we didn’t really guide what the production change is 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 what we did was we – the main sawline which is a link mill, we upgraded it to the most current technology available in link.
And so that’s cutting out sections and putting in new pieces. We optimize log rotations, side shifting, board height optimization, put a horizontal saw in, we put it into maximum horsepower upgrades, which increases the speed and the product quality.
So it was a big effort. We have a second line and in some of the originals 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 for 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, 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, it was in the second quarter.
And what we did at Celgar, just to remind listeners, we debottlenecked our digesters. So that mill has been running at roughly 430,000 to 440,000 tons a year.
And that’s the best we could do through the digester and working with both Celgar and Stendal we had two concepts we could look at where we changed the way the digester flows work. So we put in 14 new nozzles around the middle of the digester.
He put in double decks screens, which significantly improves the washing and debottlenecks the digester. So that digester is debottlenecked today to take us up to 540,000 tons, which is our goal.
So we have other bottlenecks in the middle 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 tons, 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 two to learn to run the mill when you’ve had a new heart put in, it took a little while.
So, guys you can’t drive a – 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 change in the pulp mill.
You just have to start running and suffer those disruptions, while everybody learns what the standard operating procedures, how to adjust all the flows and temperatures and chemical dosings and everything else that happens. You learn by trial and error as you work your way through.
Guys had a great job, they’ve got a handle on it now and as I say, it’s running really well, but we did lose tons in the front half of the quarter that had not been anticipated.
Adam Zirkin
So what was the production of Celgar in the quarter?
David Gandossi
Total production for Celgar, I’ll give you just a second. The Celgar’s production in Q3 was 114,000 tons.
Adam Zirkin
Okay. So you lost 6,000 tons or 7,000 tons off the run rates – 6,000 tons in terms of the run rate.
David Gandossi
Yes. Q4 target could be approaching 130,000 kind of thing.
Adam Zirkin
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.
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?
David Gandossi
I don’t know how to quantify that. We sell so many different products Adam, it’s not like an SPF random links.
There is no guide like that over here and you can shift in different products in different markets where you see opportunities. For example, we could push lumber at the UK market or we could push lumber at the KBH.
So I mean, I think the best I could do is, I’m expecting something like $4 million EBITDA quarter for lumber. That’s the best I can do at the moment for you.
Adam Zirkin
But the real realizations, right, went from sort of sequentially, right, from about $433 per 1,000 feet, right, $409 or so, right? Where would you expect this on average, yes?
Right, where would you expect that to shakeout in the – where would you expect that to shakeout in the fourth quarter?
David Gandossi
I don’t know, I’d be trying to get that to you Adam. It depends on whether the U.S.
market stays where it is at this $300 level or not. Europe, has always been a lot more stable than any other market.
So let’s – it’s fallen off slightly but not significantly. There are 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.
Adam Zirkin
U.S. will be close to breakeven, you’re saying for a short period of time.
David Gandossi
Yes.
Adam Zirkin
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?
David Gandossi
Well, not much change frankly, what we can see today.
Adam Zirkin
Okay. That’s helpful.
Thanks.
David Gandossi
Yes. You’re welcome.
Operator
Your next question comes from the line of Dan Jacome, Sidoti. Your line is open.
Dan Jacome
Good morning. Just a couple of housekeeping oddball questions on Daishowa.
So the Alberta DMI mill, it looks like they do mostly hardwood pulp. I just curious how quickly can the capacity there swing from one pulp grade to the other, so hardwood to softwood and then vice versa?
David Gandossi
They more or less have been doing it on the fly. And the mills 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 ran roughly 25% NBSK and that’s the 400 – that gives you the 475,000 ton capacity.
If you ran for hardwood, would you be maybe 510,000 or 515,000 tons, for example. So it’s an operating strategy that will be informed by the price of pulp grades and the wood availability and the cost and those kind of things.
Dan Jacome
No, I like the flexibility. Would you to get that – would you be able to get that capacity to 100% NBSK or is that just kind of a stretch?
David Gandossi
Yes. No, you can’t Dan.
Dan Jacome
Okay.
David Gandossi
I mean, it has a huge forest management agreement that, you need to harvest the wood that’s fair and predominantly aspen. But it could run sustainable at 40% softwood, if that were our decision to do that.
Dan Jacome
Okay. No, 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, just curious where that is right now? Are we still kind of in the 30% to 35% range or where is that?
David Gandossi
I don’t have it on a piece of paper here in front of me.
Dan Jacome
Okay, no worries. I’ll send you an email.
And then on – you were talking about the global convergence of softwood producers going to possibly full off pulp. And sorry if I missed it, but do you have like a timeline on that?
When would you expect maybe that first capacity switched to take place? I mean, would it be starting in the first quarter of 2019 or the end of 2019 because I don’t have access to do that these days.
David Gandossi
Yes. I think it starts with beginning of 2019 and carries on through the year and some of it will come in 2020.
Dan Jacome
Okay.
David Gandossi
Albizia for example is 500,000 ton softwood mill that has been stated to convert to pulp, but they’ve got or to dissolving that 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 that Celgar and other mills that are coming.
Dan Jacome
Okay.
David Gandossi
Japanese mill that’s integrating another 130,000 tons in the paper. Like there’s a lot of – and some of it’s happened, more of it’s coming.
Dan Jacome
Got you. So it starts first…
David Gandossi
Mistake, 200,000 to 300,000 tons of softwood out of the market term because they’re now required to process the harvest. So just pull those over.
Dan Jacome
Okay. I might have missed that.
All right, so it starts in the first quarter of 2019 and it seems to be spread out to 2020?
David Gandossi
Yes. Maybe for 2019 I’d say, although Albizia has done, I do the Japanese [indiscernible] all 2019’s and I’d say, the ramp up, ELM is – ELM is just happening every year, it is extra hardwood and substitution for softwood.
Dan Jacome
Okay, great. Thank you.
David Gandossi
And Dan just before we lose you, the days – the inventory days for hardwood is 41 at the moment.
Dan Jacome
Thank you.
Operator
Your next question comes from the line of Tony Graves, The Hartford. Your line is open.
Tony Graves
Good morning. Thanks for taking my question.
Just out of curiosity, you guys have completed three 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, the sawmill greenfields going forward?
David Gandossi
Sure. Yes, so I guess if we go right up the big picture.
We see ourselves as a growth company. We are aggressively intending to grow both organically and through M&A.
We have four main areas. We have pulp, lumber, energy and extractors, extractors would include byproducts from our existing processes.
But also extractors from other forms of material that can – where you can take a low value substance, either downstream processor that produces a product that the market needs. So those are the four areas of focus.
We’re also a dividend paying stock. When you speak about allocation, we want to have a safe healthy balance sheet.
We want to redeploy 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 of 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 discipline group with analysts who’ve been following us for the last few years would have been hearing me say, we are 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 that 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, so 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 that, if we can put high return capital into our existing assets, we can hit a three year payback or better. That’s a good capital deployment.
We should be trading at 6%-plus, and you can put capital in the ground at 3%. Let’s do it all day long.
So we’re going to have steady, consistent growth through combination of M&A and organic growth, process optimization and so on. And doing it all in a way where we maintain a strong balance sheet.
And another operating philosophy, 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 the top of the cycle. 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.
Tony Graves
Yes. That’s helpful.
Thank you. And then just a follow-up, could you give us an update on what the production and shipments were by mill?
I know you had Celgar earlier.
David Gandossi
Yes, I think Dave’s got a schedule here.
David Ure
Yes. We’ll rattle through them.
So in thousands of tons of a sales volume for Rosenthal 78.9, for Stendal 166.4, for Celgar 74.6 of the sales tons and the production volumes again in thousands Rosenthal 78.5, Stendal 170.6 and Celgar 114.4.
Tony Graves
Thank you very much.
David Gandossi
Welcome.
Operator
Thank you. Our next question comes from Sean Steuart, TD Securities.
Your line is open.
Sean Steuart
Thanks. Just one more is we’re getting long in the call here.
With DMI in the mix, do you guys have a view on CapEx budget for 2019 at this point?
David Gandossi
Too early for that, Sean. Sorry, I just don’t have a really good feel on either Cariboo or Peace River at this stage.
And what 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 over promise and under deliver. So we’ll size that to be appropriate based on everything else that’s happening, because the timing of those things can be discretionary obviously.
So yes, it was a quarter and we’ll give you a better picture by the end of the year.
Sean Steuart
Okay. Thanks, guys.
Operator
Thank you. [Operator Instructions].
And I see no further questions in the queue at this time. I’ll turn the call back over to management.
David Gandossi
.
But in terms of bridging from here to where we’re going, I just want to maybe make the points of the translating from the next Q2 to Q3, what does that mean for Q4? So maybe just summarize sawmill running well and Q4 should be our highest production volume ever, somewhere around 120 million board feet.
All three pulp mills are running well. So it should be a great production quarter.
We’ve got that 20,000 extra tons, we’re going to see coming through inventory. The wood cost, assume they’re relatively flat with some improvement in Europe.
But things are progressing on a very positive way. There are no issues with volumes.
We’ve got reduced maintenance costs in the fourth quarter. Remember, we put in our review, you can read in the press release $10.8 million of costs and Rosenthal, it won’t be there.
The three days of Stendal might be about two. So you got to pick up of eight.
And the inventory changed referred to earlier, just 20,000 tons around numbers $5 million of EBITDA. So when we got to – we had $5.9 million, we didn’t talk about this, but it turns of gigawatt hours lost because of the maintenance on the turbine.
That was about $5.9 million hit in the second – in the third quarter. Everything’s running full with all of the third quarter or fourth quarter.
So that’ll all pick up as well. So bit of a mess in the third quarter, but it’s going to be a strong fourth quarter.
So don’t over blow things. It’s my message.
And so thank you all for joining the call and look forward to speaking to you all again in February.
Operator
Thank you very much, ladies and gentlemen for joining us today. This concludes today’s conference.
You may now disconnect.