Weyerhaeuser: Building A Positive Surprise

| About: Weyerhaeuser Co. (WY)


Investors in Weyerhaeuser have had a wild ride over the last year or so, and may wonder whether, despite its yield, its shares are worth the risk.

Several factors have affected the company's share price performance, and while a couple of them remain issues, most of the rest have resolved in Weyerhaeuser's favor.

Cost savings it has already achieved, more than it can expect to, and an improved operating environment suggest that analysts' expectations are too conservative.

When I last wrote about Weyerhaeuser (NYSE:WY), its agreement to acquire Plum Creek Timber was ten days old, and several uncertainties surrounded the company as well as its intended transaction. Both its and Plum Creek's shares were trading oddly, suggesting that investors expected (implausibly) that the price to which it had already agreed might be raised. In fact, the price distortion that was confusing the arbitrage was driven by a very attractive dividend capture trade that the deal created in Plum Creek shares.

The sale of Weyerhaeuser's cellulose assets had also just been announced ─ a development I applauded, although I was concerned about its ability to find buyers and obtain an appropriate price. Lumber prices were under pressure and the outlook for housing starts remained clouded. And the Softwood Lumber Agreement with Canada, which restricted lumber imports from that country, had expired the month previously, leaving it an open question whether Canadian lumber would once again flood U.S. markets.

There was also concern about the outlook for exports to the Far East, which are very important to logging operations in the Pacific Northwest. Demand from China, South Korea and Japan declined in 2015, and the market share of U.S. producers suffered from the enhanced competitiveness that weak currencies lent to New Zealand and Canadian production. Exports actually recovered somewhat during 2016, and Weyerhaeuser expects further improvement in the current year.

Fifteen months later, it turns out that the Plum Creek acquisition went through smoothly and surprisingly quickly, closing within three months. Sale of Weyerhaeuser's cellulose businesses also proceeded rapidly: the last transaction of the process closed on December 1. Housing starts continued their gradual, and still very noticeably sub-par improvement from the depths of the housing recession, and lumber prices bottomed in mid-2016.

In the meantime, it repurchased nearly a quarter of the shares issued in connection with the purchase of Plum Creek, at the same time that it substantially reduced its financial leverage, raising equity from 38.3% of its balance sheet total to 47.7%.

The Softwood Lumber Agreement placed a standstill on any U.S. tariff increases for twelve months following its expiry. However, after twelve months tariffs could be imposed retroactively. The uncertainty this created probably did more to prevent Canadian producers from (allegedly) dumping lumber in U.S. markets than a new fixed tariff would have.

Progress toward renewal or replacement of the Agreement was never going to be easy ─ it has always been contentious in both countries. But it has been complicated by the prime ministerial election in Canada, then the U.S. presidential election and now by the apparent desire of the Trump administration to fold discussions into a renegotiation of NAFTA. It is questionable whether any resolution can be obtained this year, and the issue is likely to hang over timberland owners for some time to come. Weyerhaeuser expects the imposition of countervailing duties at the end of this month, and anti-dumping duties in June.

However, this issue will be of less concern to Weyerhaeuser than to other timberland REITs, because it manages more acres of timberland under renewable long-term contracts with four Canadian provinces than it owns in the U.S. Canada's ability to flood U.S. markets (and to compete in Far Eastern markets) has, in any case, been constrained by the infestation of mountain pine beetle in much of western Canada. But despite this, Canadian lumber exports to the U.S. have recaptured 26% market share, up from 15% in 2011.

Through all of this, Weyerhaeuser's shareholders were subjected to a fairly wild ride.

Its share price fell precipitously in the wake of the Plum Creek announcement, due to the dividend trade mentioned above. It finally found a bottom shortly before the transaction closed. It then bounced back even more dramatically, recapturing the ground it had lost in less than a month. Subsequently it has traded all over the map, with volatility well in excess of twice that of the Standard & Poor's 500 Index, although broadly tracking it. Recently, the shares (which are an income vehicle currently yielding 3.65%) have been affected by competition from rising bond yields.

I suspect that much of this price behavior is due to investors' uncertainty as to how to regard the shares. Weyerhaeuser is one of the largest REITs, but it is not simply a more or less passive real estate investor. It is very much an operating company, with 10,400 employees and 37 manufacturing facilities in three countries. It is exposed to the housing cycle, to price fluctuations in its principle products and to seasonal influences on both its ability to supply its products and on customer demand for them. So its revenue stream is more volatile over short time horizons than is typical of the revenue generated by more familiar REIT assets such as office buildings or shopping malls.

Nevertheless, Weyerhaeuser has managed to increase dividends at a 12.9% annually compounded rate since it exchanged its corporate status to a REIT structure in 2010. This is probably a surprise to many investors, who might expect the REIT requirement that 90% of its volatile income stream must be distributed would result in variable dividends, such as those they are accustomed to receiving from mutual funds. However, Weyerhaeuser's Wood Products division is a taxable subsidiary of the REIT, and contributed 40% of total EBITDA in 2016. It can retain earnings, which can be used to smooth dividends in years when 90% of the net income from timberland would otherwise result in a dividend decrease.

Wood Products is subject to most of the same influences that create volatility in timberlands revenues, and a few of its own. Investors are right to be cautious about Weyerhaeuser's ability to maintain its payout through thick and thin. It has sold its taxable pulp activities, which were solid profit contributors and provided significant economic diversification. If the U.S. sustains another housing crisis comparable to the recent one, Weyerhaeuser will not be able to maintain its dividend.

But fear of a housing crash and resulting collapse of lumber prices is an example of the cognitive bias toward looking for a repetition of recent experience. It is simply not on the cards at present. Analysts are cautious about Weyerhaeuser's outlook for 2017, expecting earnings to decline 25% Y-on-Y in Q1 (to be released April 28) and a 24% decline for the full year. That is, they expect flat earnings from continuing operation: the decline results from the absence of the pulp activities' contribution. This seems to me to be pretty grudging, even for the seasonally weak first quarter, given the improvement in most of Weyerhaeuser's operating conditions discussed above. Granted, management guidance is cautious, but then it always has been.

Expected operating synergies from the combination with Plum Creek were obtained sooner than expected, and additional potential savings have been identified. The flooding that interfered with Carolina low country operations last year is unlikely to be repeated. While HBU real estate sales may not match 2016 levels this year, Weyerhaeuser's program of portfolio optimization has identified numerous opportunities for realizing higher value than just timber can provide. Much of it can probably be realized by the end of 2018. As part of this process it may dispose of its activities in Uruguay, which are comfortably profitable and should attract a reasonably good price.

Weyerhaeuser's outlook over the next several years is better than either analysts or investors expect. The risks remain, and they are real, but they are not likely to affect its earnings or its ability to pay an increased dividend over a two or three year time horizon. Even though it is clear that interest rates will rise over the course of this year, Treasury yields will not challenge Weyerhaeuser's dividend yield, and that yield is safe in the foreseeable future. Investors may not want to chase the recent rally in its share price, but purchase of Weyerhaeuser shares will repay investors even if they purchase at current prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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