$1.6B About To Pour Into Weyerhaeuser

The Buy Thesis

We believe Weyerhaeuser (WY) represents an outsized reward for its risk due to a combination of valuation, growth and a healthy fundamental backdrop. Industry structure has changed in a way that will allow WY to capture an increased portion of the value generated in the vertical. As the biggest timber REIT with a history of strong performance, WY should trade at about a 5.5% cap rate, which represents upside of 23% from today’s price.

The move could be catalyzed by about $1.6B of fresh capital buying WY through the Vanguard REIT ETF (VNQ). This much incremental buyer interest could significantly increase the market price.

Let us open with a mile-high view of the industry structure and macro forces.

Demand is normal and supply is normal

A substantial portion of demand for lumber is generated by housing and commercial real estate {CRE} construction and in recent years, both have picked up in pace. However, this acceleration is coming off of a tremendous slump in home construction after the bubble burst and a dearth of CRE construction following the financial crisis. As it stands today, home building remains slightly below historical averages at a pace of about 1.2mm units annually.

This is balanced out by CRE development being significantly above average. CRE is above average by a greater magnitude than home construction is below average, but home construction is a bigger demand driver of wood products. Some CRE, such as warehouses can be made largely from metals whereas homes are mostly made of lumber. Overall, we view demand for lumber as fairly normal.

As an owner of a significant number of mills, WY directly produces lumber, but as an owner of vast timberland acreage, they produce far more timber than is internally used to produce lumber. Other big drivers of timber demand are fiber/cellulose products (cell phone screens, cigarette filters, etcetera) and pulp products like paper. Clearly electronic processing is cutting into demand for paper and we view this as a permanent drop. On the flip side, demand for cellulose fibers is in secular expansion. These largely balance out making demand for timber overall in-line with normal.

There is some potential upside to demand if biofuel power plants gain significance. Many of these plants use wood pellets and it could be a massive demand driver. At this point, however, I consider it more of a plausible bonus than something we can hang our hat on as the current EPA does not seem averse to more traditional power generation.

Supply is in a similar position with productivity gains canceled out by reduced acreage and natural disasters. Supply has been reduced by the following factors:

  1. Canadian pine beetle epidemic, which infected and killed large areas of timberland
  2. California wildfires
  3. Timberland increasingly sold for “higher and better use”
  4. Timberlands reserved for nature preservation or other ecological reasons

All 4 of these are roughly balanced out by productivity gains caused by;

  1. Higher levels of CO2 help trees grow faster (as much as 20%-50% according to some research detailed in this article).
  2. Optimized silvicultural practices

Overall, supply and demand seem to be mostly in balance and proportionally in-line with historical norms.

Timber pricing

Transportation costs of timber are substantial as timber is very heavy relative to how much it is worth. It is prohibitively difficult to transport products that are worth about $10-$35 per ton of weight depending on type of wood. Thus, pricing is extremely regional and also varies by product type.

WY has land in many regions with standing inventory as seen below.

Source: WY 10-K

Its largest region is the South so we will look at those prices as a proxy.

Over the past 10 years, stumpage prices have been quite mixed but roughly flat overall. Pine sawtimber prices are down significantly while pine pulpwood is up. Hardwood sawtimber is up almost 50%, but its pulpwood is about flat.

Clearly, there is variance in timber pricing, but overall the trend has been flat nominally and down when adjusted for inflation. I think this is likely the cause of the tepid performance of timber REITs.

Source: SNL Financial

Over the past 5 years, all of the timber REITs have underperformed the broader REIT index. Based on the fundamentals we have reviewed so far, this makes some sense. Balanced supply and demand with falling inflation adjusted stumpage prices would generally lead to some degree of underperformance.

Pricing, supply and demand are indeed important aspects of fundamentals, but far too often deeper aspects of industry structure are excluded from the discourse. It is in the industry structure that Weyerhaeuser’s potential to outperform exists.

Industry Structure

For this analysis, I will focus exclusively on the home construction vertical. People want houses and said houses have a certain amount of intrinsic value to the consumers. This represents the total value of the entire vertical. Costs of the vertical are equal to those incurred by all parties from the growing of the tree to the sales commission paid to the realtor as the freshly constructed home is sold to the end user. The difference between the value and the costs represents the surplus, and this surplus is divided up between each of the participants in the vertical. For clarity, we will simplify the vertical to:

Timberland –> mills –> homebuilders –> consumers.

Each one of these groups must capture some of the surplus or they would not participate, yet the magnitude of surplus captured is not equally divided. Those with more power in the chain will capture the lion’s share. Qualitatively, 2010 was a consumer’s paradise where they had the ability to capture massive surpluses through buying homes at far lower prices than the utility provided. Each other participant in the vertical was merely happy to have some business after surviving the recession.

Since 2010, things have changed. Home prices have skyrocketed to a point where there is minimal value captured by the consumer.

Labor costs have gone up so the incremental costs of the homebuilders will be up, but the cost of timber and mills may have actually gone down. Both have increasingly sophisticated equipment, which has reduced the need for labor and the aforementioned productivity gains from CO2 and silviculture help reduce the cost basis of timber.

In 2017, I think the surplus capture is more favorable to Weyerhaeuser as the mills are capturing the lion’s share but both timber and homebuilders are doing well also with much of the consumer’s former surplus divided between the 3 groups.

Heading into 2018 and 2019, however, I think some of the mill’s surplus will shift to timberlands as new mills are coming online. This will reduce the negotiating power of incumbent mills and give better realization prices to the timberland.

As an owner of both mills and timberland, Weyerhaeuser is happy with both the 2017 surplus capture and the potential shifts in 2018/2019.

Overall, timber and mills have consolidated while consumers have become more fragmented. This shift in industry structure has improved margins of timber REITs.

Let us get some more factual information to solidify this concept.

Consolidation of timber ownership

Following Weyerhaeuser’s purchase of Plum Creek, Potlatch (PCH) is buying Deltic (DEL) and CatchMark (CTT) is acquiring swaths of timberland. In aggregate, US timberland and mills are becoming concentrated in fewer hands. In comparison, consumers are significantly more fragmented than they were in 2010 because the stronger economy means more people have money with which to buy homes.

For these reasons I think it makes logical sense that more of the surplus would be captured by mills and timberlands. The actual numbers agree with this assessment.

source: Data from SNL Financial and graph made in Excel.

Note that sales have not gone up much at all as the small gain from ~$6mm to just over ~$7mm was a result of acquisitions, not organic sales growth. This is in-line with what we would expect given the previously highlighted supply, demand and pricing dynamics. However, cost of goods sold has gone down as a portion of sales, which leads to significantly larger margins.

WY’s gross margins in 2017 are 25.9% as compared to 18.9% in 2010. That is a 700 basis point improvement, which represents the improved surplus capture of timber and mills. As production of timber became more efficient, WY did not have to pass the cost saving down the vertical as the favorable industry dynamics (consolidation of timber and mills relative to fragmented consumers) allowed it to retain this surplus.

Given its newfound ability to capture surplus and the stable fundamentals, we think WY has strong prospects. The question now is whether these prospects are already priced in.

Valuation

Given the 5 years of slight underperformance in terms of market price, it would seem as though the market has not priced in the favorable dynamics that came in over recent years. Cap rate NAV analysis agrees with this conclusion as WY trades at a rather high cap rate of 8% as of data from the most recent quarter.

Source: SNL Financial

As the largest timber REIT with a strong track record, this discount does not make sense. I would consider 5.5% to be a more appropriate cap rate for WY as this would put it at a slight premium to peers. We anticipate significant organic growth from WY as domestic housing starts catch up to historical norms.

Additionally, WY can benefit from global growth through exports. While timber is generally a local business due to value to weight ratios, certain kinds of logs remain strong exports. Specifically, WY grows a vast supply of Douglas fir, which is in high demand in Japan, China and Korea where it is more difficult to grow due to soil, climate or simply lack of available acreage.

This export business is made more viable through the proximity of WY’s western timberlands to major ports.

Another aspect of WY supporting a higher valuation is the strength of its balance sheet. With a debt to capital ratio of just 19%, it has secured an investment grade rating from S&P and Moody’s.

Upside

Timber REITs are somewhat seasonal in terms of NOI, so to calculate the value of WY at a 5.5% cap rate we can average the last 4 quarters.

This suggests a fair value of $45 or about 23% over today’s price of $36.36. Importantly, there is a strong catalyst in place that could help WY get there

Catalyst for price realization

Passive investing has become a large portion of the market and most ETFs are designed to match indexes, which are predominantly market weighted. As a roughly $27B market cap company, Weyerhaeuser is in just about every index with one notable exception; the MSCI US REIT Index (RMZ). It is on this index on which the Vanguard REIT ETF (VNQ) is based and in an effort to accurately track the RMZ, VNQ does not hold stocks that are not in the RMZ. Thus, while it seems like a $27B REIT should be in a REIT ETF, the methodology precludes inclusion.

Vanguard still owns WY through other ETFs such as the total market ETF, but these weights are, for most REITs, in addition to the VNQ. Shown below is a list of Vanguard’s ownership of WY.

Source: SNL Financial

6.5% of outstanding shares is a large holding, but that number would be about 12.5% if WY were in the VNQ.

Well, Vanguard has recognized that it is odd for a REIT ETF to not include some of the largest REITs so it is updating its methodology. Starting in early 2018, VNQ will switch the index it tracks to the MSCI US Investable Market Real Estate 25/50 Index. This will bring the proposed weight in Weyerhaeuser to 2.4%.

Going from 0% to the 6th largest holding in VNQ will make quite a difference. That is about $1.6B of new money pouring in to WY. Incremental demand for about 6% of outstanding shares seems likely to move the needle.

Risks and concerns

WY manages (does not own) about 13mm acres of Canadian timberland, which could be impacted by the recent tariff on Canadian soft lumber. At this point it is unclear how much impact this will have, but my guess is it will be a benefit to their US operations but a possible detriment to the Canadian business segment. Worst case scenario would be that Canada retaliates by kicking the US company out and WY would lose the associated revenues. Your guess is as good as mine as to whether this will happen, but it is a risk of which we should be aware.

Weyerhaeuser’s low leverage is a double-edged sword. If demand for housing rises quickly and timber REITs prove to be the beneficiaries as I anticipate, it may experience less benefit due to being less levered. CatchMark (CTT) has about twice as much leverage as WY and for that reason would likely perform better in bullish outcomes. Some of the leverage amplification is mitigated by WY’s market share, which could cause it to have superior price realizations and some cost efficiencies. WY is the lower risk and slightly lower reward way to play timber.

The bottom line

Timberlands and mills are well positioned heading into 2018. While this will benefit the entire sector, Weyerhaeuser’s power is amplified by its position as the market leader. As it is currently trading cheaper than peers, we see it as an ideal entry point into a good company with significant growth. WY has about 23% upside to fair market value and this could be catalyzed by $1.6B of fresh capital coming in as VNQ changes its methodology.

Disclosure: 2nd Market Capital and its affiliated accounts are long CTT. I am personally long WY and CTT. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements, which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article.

Disclosure: I am/we are long WY, CTT.

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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