Weyerhaeuser (WY) announced that its subsidiary, Weyerhaeuser Real Estate Development Business (WRECO), will merge with TRI Pointe Homes, Inc. (TPH) in a Reverse Morris Trust transaction. The Weyerhaeuser shareholders will receive approximately 130 million shares or 80.5 percent of the new entity on a fully diluted basis. Total value of the transaction is $2.7 billion. Cash payment of $700 million will be made to Weyerhaeuser. Transaction is expected to close in the second quarter of the fiscal year 2014.
As a result of this transaction, the new entity will be among the top ten homebuilders. The Reverse Morris Trust Transaction structure will allow WY to record non - taxable gains from the sale of its asset. To successfully close this deal, WY will spin off its WRECO business segment, which will merge with TPH. The combined entity will issue a majority stake to the shareholders of the previously parent company. In this case, the new company will issue 80.5% of its stake to WY shareholders. Doyle Simons, Weyerhaeuser president and chief executive officer, said, "As a result of the strategic review of our homebuilding business, the Board of Directors has determined that combining Weyerhaeuser Real Estate Company with TRI Pointe creates the greatest value for our shareholders. The combined company will be a strong standalone homebuilder, and the separation of our homebuilding division allows us to focus on driving performance in our forest products businesses to deliver further value to our shareholders."
Impact of deal on Weyerhaeuser's performance
Weyerhaeuser generated approximately 15 percent of its total revenues from its real estate segment in FY12. Weyerhaeuser is expected to report total revenue of $9.34 billion in FY14, out of which $1,401 million will be generated from its real estate segment (assuming the ratio of 15% of total revenue from real estate). On the other hand, TRI Pointe is expected to produce $957.79 million in the full fiscal 2014. Therefore, total revenue from Weyerhaeuser's real estate segment and TRI Pointe is expected to be $1,898.83 million in the fiscal year 2014. It is clearly seen that after the deal, Weyerhaeuser will be able to post higher revenue from the real estate segment in the future relative to revenue from real estate segment without the merger.
Key Growth Driver for Real Estate
Housing starts growing by a 25% a year in 2012 and 2013. New home construction dropped below 500,000 a year in 2009. However, it is expected to reach the level of 1.5 million by 2015 or 2016. Increased new home construction will drive the demand for the new company's products that will eventually give a boost to the earnings of the Weyerhaeuser. Moreover, increasing trend in demand for the new company products will also drive the demand for the products of other segments of Weyerhaeuser, which will also eventually have a positive impact on the Weyerhaeuser's earnings.
Lower than Industry
As shown in the following graph, the company's operating margins and net margins were well below than the industry average over the trailing 12 months. Due to lower net margins, ROE of the company was 12.3% relative to the industry average of 16.4%.
Although the company did not perform better than its peers over the last twelve months, however, it is cheap on the basis of multiples. I believe that the company's earnings will improve in the long run because of an increasing demand for its products and services. I believe that the company's earnings will improve in the long run as a result of the recent deal and increasing demand for its products and services.
It is time for financial performance of the segments. The company's margin for timberlands segment did not change on quarter-on-quarter basis. Gross margin and operating margin remained stable at 30% and 25%, respectively, on QOQ basis.
On QOQ basis, earning will not change for the fourth quarter as well. Due to the acquisition of Longview Timber, Western fee harvest volume will increase. However, increased southern logging costs will almost offset the impact of the increased western fee harvest volume. Moreover, the company is also expecting slightly lower earnings from disposition. However, a strong growth in the real estate segment will also have a positive impact on the bottom line of Timberlands Segment.
Wood Products Segment
The quarter-on-quarter decline in gross margin for this segment was 4%, which was primarily attributable to a higher cost of products sold as a percentage of the total sales in the third quarter. The company's operating margin also declined from 13% to 8% on QOQ basis.
Wood Products segment's performance worsened on QOQ basis. In the fourth quarter of the current fiscal year, a further decline in earnings is expected as per the company's guideline. The decline in earnings will be attributable to softening prices for the products of this segment. Moreover, the higher log costs for lumber will also negatively impact the earnings in the last quarter of 2013. Nevertheless, on the positive side, recent transaction will create demand for the products of Wood Products segment, as products of this segment are used as a raw material for homebuilders.
As shown in the following table, Cellulose Fibers' performance worsened on QOQ basis. Both, gross margin and operating margin declined in third quarter owing to a higher than anticipated maintenance cost, increased fiber costs and higher chemical costs.
Cellulose Fibers could not perform well in the third quarter. However, pulp sales realizations and volumes are expected to be higher in the last quarter of FY13 owing to an increased demand. Moreover, maintenance expense and chemical costs will also be lower in the last quarter, which will fuel the earnings of this segment. Therefore, the company's earnings of this segment are expected to rise significantly in the fourth quarter of fiscal 2013. Moreover, the recent deal of Weyerhaeuser will also fuel the demand of this segment.
On QOQ basis, both gross margin and operating margin increased significantly because of seasonally higher closing volumes and increased earnings from land and lot sales in the third quarter.
The company is expecting higher earnings from this segment in the upcoming quarter because of the higher average closing prices. Selling related expenses will also be higher due to an additional closing volume; however, these expenses will increase at a lower percentage than the increase in revenues due to higher average closing prices and home closings.
Timber industry suffered more when the US economy slid into recession in 2007. Now, there is really a bright future ahead for timber growers due to the expected increase in prices over the long term. Prices are expected to mount for the next few years. Therefore, those investors who held on to their timber investment will be rewarded.
Several factors will drive the upswing.
- Timber demand will also remain strong in the key growth region like China. Moreover, wood pellets are creating demand for pulpwood. As the European governments restrict the use of coal, wood pellets have become an alternative. Therefore, I believe that the timber demand in the Europe will increase. Moreover, US production will also rise to capitalize the growing demand for timber around the globe. However, demand will be higher than the supply that will give a boost to the earnings of the timber growers.
- Rising demand will push up the prices over the next few years. Lumber prices declined to $300 per 1,000 board feet in 2012, but some analysts expect that the lumber prices will reach the level of $550 in three years. Therefore, I believe that high limber price in the future will eventually lead to high earnings of the company
But there are some risks associated as well.
- If the housing recovery slows down, then there it will be a great threat for timber producers.
- If euro plunges and causes another crisis or the demand in China declines sharply then the industry might suffer a lot owing to decrease in demand for its products. Lumber prices may be volatile; however, the expected level is higher.
The global economic outlook is still fragile. However, the recent upswing in North American lumber and timber prices has created reasons for bright outlook of producers. Higher prices in North America will eventually pile up on the profit margin of the Weyerhaeuser.
According to the analyst estimates, Weyerhaeuser is expected to post $9,340 million of total revenues in the fiscal year 2014, while TRI Pointe is expected to post $957.79 million revenue in fiscal 2014. According to the terms & conditions of the deal, Weyerhaeuser will report $1,011 million in total revenues. Using historical net profit margin, total earnings of the company is expected to be $778.58 million after the deal, which gives an EPS of $1.34 in FY14. Using this EPS and Industry P/E, intrinsic value of the stock is calculated as $30.19 a share, which gives an upside potential of 1.52%. However, I believe that the net margin of the company will improve and reach a level of 9 percent. In that case, intrinsic value of the stock is calculated as $35.29 which gives an upside potential of approximately 19%. In best-case scenario, I assumed the net margin of 11%, which gives stock price of $43.13 or 45% higher than current share price.
On quarter-on-quarter basis, the company's performance deteriorated in the third quarter. Its margins are lower than the industry average. Moreover, short-term outlook of the Wood Products segment, which contributed about 26% in earnings in the third quarter, is also not good. Timbers segments, the largest contributor in earnings, is also expected to post same earnings per share as it reported in the third quarter.
However, I believe that the long-term outlook of the stock is pretty well because of increasing demand for the products and services of timber. Moreover, the company is also undervalued on most of the price multiples. The earnings will increase in the long term due to an increasing demand of timber, pulp wood and wood pellets. Thus, I believe that the stock price will mount and price multiples will revert to the industry average. Therefore, I would recommend the long-term investors to take a long position.