Description

Thesis:

Weyerhaeuser (WY) is a forest products company that is undervalued on a sum of the parts basis as it will convert its timberlands into a tax-advantaged structure (or sell the timberlands in a tax-advantaged manner).  Following this conversion/sale, WY is conservatively worth $87 and potentially $100 relative to the current price of $70, resulting in 24%-42% upside.  Given pressure from a 12/13/06 Franklin Mutual 13D, (7.6% owner and active investor that pushed PCH to convert to a REIT about 2 years ago) the timing of an announcement should be Spring 2007 – likely around the April annual meeting. 

 

Detail and Value of Timberlands:

Many other forest product companies that owned timberland have divested these assets to tax-advantaged owners (e.g., pension funds) or converted to a REIT.  WY is one of the largest timber companies and one of just a handful that pays taxes – it is a competitive disadvantage. 

 

WY had been pushing for a legislative change in the tax code (proposed that C-corp timberland owners would also be able to avoid taxes), but in light of Republicans losing Congress, this is very unlikely.  In its 12/14/06 reply to Franklin Mutual, WY stated “in light of the uncertainties surrounding a legislative remedy we are now revising alternatives.”  Most analysts felt that this was a watershed event for WY and signaled that it is on its way towards a corporate action that maximizes shareholder value. 

 

There are a few possible corporate actions that WY could take.  The first is for WY to divest enough non-REIT businesses to qualify as a REIT (timberlands would need to be 75% or more of assets and profits).  If businesses are sold/spun-off, it is likely that these transactions can also take place without incurring taxes: (i) the recent asset sale to Domtar avoided taxes; (ii) there are assets, such as those acquired from Willamette in 2002 that have a high tax basis; and (iii) businesses like homebuilding or packaging could be spun-off as stand-alone companies.  Another option would be for WY to sell its timber assets and use a bank as an intermediary so that the actual sale for tax purposes does not take place for 30 years (this structure has been used in the past).  This lowers the tax burden to ~5% of proceeds.

 

There are numerous ways to look at the value of timberland REITs (and it is a worthwhile exercise to triangulate between valuations), but the most straight forward is through dividend yield.  The present dividend yield on other timberland REITs:

PCL: 4.17% dividend yield

RYN: 4.58%

PCH: 4.57%

LFB: 4.30%

Average: 4.41%

 

WY’s estimated 2006 timberland EBIT is $765mm and a 5% tax rate is assumed (some of earnings will likely be taxable) resulting in $727mm of income.  Applying this average 4.41% dividend yield results in $16.5b of value.  To be conservative, I take an approximate 10% discount to arrive at $15.0b of timberlands value.

 

Timberland REITs tend to trade above the value of the land if used to grow timber as there is a “real estate story” –> higher and better use (HBU) of the land.  Growing timber is generally not the highest and best use of land – it’s literally watching trees grow.  So if the land can be turned into real estate for homes and sold it’s worth more.  PCL, in particular, does a great job selling the investment community on the value of its land for other purposes and therefore has the lowest dividend yield.

 

However, EBIT from real estate sales is less valuable than EBIT from timber sales as it is not as stable nor is it as recurring (in case of PCL there is plenty of land for additional years of sales, but it is finite).  In 2006, Morgan Stanley estimates that 41% of PCL EBIT will be from real estate sales (it was 31% in 2005 and PCL mgmt has given guidance for it to increase in 2007 as timber EBIT declines because of weakening timber prices).  While WY does not explicitly detail real estate sales as a % of timber EBIT, the sellside estimates that it is 8-18%.  While this is a large range, it is still well below PCL’s approximate 40% of timber EBIT from real estate sales.  Therefore, it stands to reason that either WY has real estate that it can also sell to increase EBIT or its earning stream is more valuable.  To the first point, it has been commented to me that WY does a poor job exploiting HBU opportunities, particularly given its huge land holdings in the Pacific Northwest.  Therefore, if I valued WY’s timber at a 4.0% dividend yield (a slight premium to PCL for better earnings quality), I get $18.2b.  This gives me comfort in my $15.0b estimate of WY’s timberland.

 

Valuation:

The below analysis details the value I ascribe to each of WY’s business units (I also compare to valuations of both Citi and Morgan Stanley, both reasonably good analysts – in 2 divisions I have values above sellside, but in 2 divisions I’m well below):

Pulp: $2.5b – slightly below 7x 2007E EBITDA (in-line/slightly above sellside)

Packaging: $6.0b – slightly below 8x 2007E EBITDA (in-line/slightly above sellside)

Wood Products: $3.5b – slightly below 11x 2007E EBITDA (below sellside by about $1.0b – very cyclical business)

WRECO (homebuilder): $2.0b – Just above 1.0x BV (below sellside)

Owner Timberlands: $15.0b – as noted above, this is a discount to PCL

Corporate: $(2.5)b – 10x 2007 EBITDA

Current Net Debt: $(7.4)b – includes $1.35b of cash to be received from Domtar

Mkt Cap: $19.1b

Value of Domtar Stock: $2.4b – WY sold assets to Domtar; deal to close in next 1-2mths

Q306 FD S/O: 248mm – does not give credit to current buyback

Value/shr of WY: $87/sh

Value/shr of WY if timberlands valued at $18.2b: $100/sh

 

Note: Net debt figure includes capital leases, minority interest, but ignores pension and OPEB net underfunding of $823mm as annualized expense (running through income statement) is slightly more than $100mm/yr ($85mm YTD).

  

Note: The Packaging segment is the largest source of value for WY outside of the timberlands so I’m providing some additional disclosure.  In 2006, Packaging will produce EBITDA of $640mm and CX spending will be $221mm (Morgan Stanley estimates).  2007 EBITDA is projected at $779mm and CX spending is projected at $225mm (MS estimates).  Therefore my $6.0b value is 7.7x 2007 EBITDA, which is close to SSCC trading at 7.3x 2007 IBES EBITDA.

 

Note: $2.0b value of WRECO (homebuilder) is below average valuation of 1.31x BV of Centex, DR Horton, KB Home, Lennar, Pulte, and Toll Brothers.  Some argue that WRECO’s significant Southern California land holdings deserve a higher value than peers, but given current turmoil in homebuilding space, I would rather value WRECO at a discount to peers to give a margin of safety (my valuation is 1.04x 9/30/06 BV).

 

Some sellside analysts (notably Lehman) believe that WY has also under-managed its assets.  The argument is that WY timber profits have subsidized the manufacturing operations and that as standalone operations WY’s timberlands would be more profitable.  By looking at the “efficiency” of cutting (using the appropriate sized tree for the appropriate end-use), Lehman estimates WY’s efficiency with its timber assets at just 55% while PCL is at 78%.  By separating the assets there is an incentive to maximize value – avoid using a 11” log that should be sold as chip & saw for $0.65/cubic foot for pulp wood sold at $0.15/cubic foot (only logs under 8” in diameter should be used for pulp wood).  Finally, Lehman believes that WY has been too conservative in its cutting practices resulting in an average tree age that is too old (estimated at 55yrs in Pacific Northwest vs others below 40 years).  Therefore Lehman believes that a new owner “could step up harvesting for a decade” in order to lower the average tree age while reaping the additional profits.  While both increased efficiency and increased harvesting seem plausible, it is very difficult to prove and therefore I’m not inclined to pay for it.  However, it should be highlighted as an area of additional potential upside.

 

Finally, WY does not have a defined real estate strategy, which could also add upside to a transaction involving the timberlands as others, such as PCL, have shown the value that the market attaches to HBU real estate sales.

 

Concerns:

1. Profitability under pressure in many of the business segments:
1. Wood Products – analysts are projecting 2007 EBIT that ranges from breakeven to about $200mm.  As 2006 EBIT will likely be $150mm this is not dramatically different, but is down significantly from $1.0b in 2004;
2. Timber – price of lumber is coming down with homebuilding weakness.  YTD timber prices are down about 5-8% in the Southeast;
2. Timberland values are quite high as can be implied by cap rates between 4-5%.  In the near-term there does not appear to be a reason for cap rates to increase, but if WY delays a transaction, cap rates could increase in the future.
3. Upside isn’t huge so important to be price sensitive when buying (there is plenty of liquidity with an average of more than $100mm of daily value traded). 
4. If WY decides to convert to a REIT, it cannot get a ruling in advance of the conversion.  Therefore, WY would sell/divest assets, convert to a REIT and then hope that the IRS blesses it.  While this sounds risky, other forest companies have converted to REITs, sold timberlands, etc.  Tax experts at investment banks have indicated that they believe it will be possible.  Also, to be clear there are numerous ways to execute a tax advantaged transaction and converting to a REIT appears to be one of the more difficult transactions.

Catalyst

1. Pressure of Franklin Mutual.
2. April annual meeting (date not yet determined), but conversations indicate that this is the line in the sand for management to announce a transaction.
3. The valuation arbitrage appears fairly obvious opening the door to private equity if management does not move fairly quickly.