For me, Weyerhaeuser (NYSE:WY) is an example of why valuation always matters. Generally well-valued (if not richly-valued) for its high-quality timberlands and wood products operations, Weyerhaeuser has lagged the S&P 500 for total returns for quite some time. Even when you account for the tax benefits of its REIT status and the housing slump, I would argue that shareholders have had to pay a price for Weyerhaeuser’s often-rich valuations, as well as several strategic missteps in the past.

I believe that Weyerhaeuser is now a better-run company and I do see some upside in the shares now. The Wood Products segment may be nearing its peak, but I expect healthy ongoing contributions from the Timberlands segment, and I believe Weyerhaeuser is a leaner, better-run, and more focused company than it has been in a long time. Coupled with a reasonable valuation, there could be some opportunity here for patient investors.

Leaner And Better

The last three years have been transformative for Weyerhaeuser. In addition to acquiring Plum Creek and a few other smaller timber transactions, the company sold the cellulose business, restructured some of its Wood Products operations, added talent to its management team, completed an evaluation of the optimal use of its timberlands, and made progress with ongoing operational improvement initiatives.

Fortunately, Weyerhaeuser has continued to demonstrate that it is a disciplined player in its markets. More focused on margins than market share, the company has fought the urge to reinvest in capacity growth. That has been true for most of its competitors as well, and Weyerhaeuser, Louisiana-Pacific (NYSE:LPX), Boise Cascade (NYSE:BCC), and Norbord (NYSE:OSB) have enjoyed an uncommon run of healthy capacity utilization, pricing, and margins during the last couple years of this recovery.

Looking at the last quarter, Weyerhaeuser posted a six-point improvement in adjusted EBITDA margin (to over 29%), and the company’s margins are now about 10 points higher than they were before the Plum Creek deal and before the recent recovery in prices. Weyerhaeuser remains one of the most profitable lumber producers in North America (generally second to West Fraser) and the most profitable manufacturer of OSB and engineered wood products (like i-joists) ahead of rivals like LP, Norbord, and Boise Cascade.

Timber – Waiting Remains The Hard Part

While there have been quarterly wobbles, the performance of the Timberlands business has been improving. Very tight West Coast markets have driven the business, with EBITDA margin exceeding 50% in the last quarter on 20% growth in West Coast log prices. Export sales continue to help boost West Coast results, with high-margin sales to Japan continuing to grow (and overall export revenue up 7% in the quarter).

Looking ahead, a key question is when the Southern segment will recover. A lot of people writing about timber companies like to say that these companies are protected (if not immunized) from price weakness by the fact that they can just defer harvests and let the trees continue to grow. That’s not really true for a number of reasons – there are ongoing costs in maintaining forested acreage whether you harvest or not, including silviculture costs and property taxes. What’s more, there’s a “sweet spot” for harvesting trees; yes they will continue to grow beyond that point, but the value accretes at a slower rate and relative to the costs you can reach a point where it destroys value. Last and not least, you have to harvest and sell those trees at some point, and thus the price does matter.

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Between overinvestment in timberlands (it was a hot alterative investment option) and weaker demand from housing/construction, industry-wide deferrals in the South averaged around 30% from 2009 to 2012, about half that in 2013 and 2014, and only started hitting breakeven in 2015. That has led to a lot of harvest inventory to run through and log prices have remained sluggish (down 1% yoy in Q4’17 after dropping 8% yoy in Q4’16).

Weyerhaeuser management believes that Southern log prices will improve in 2018, but then they thought the same thing about the 2017 market in late 2016. There are reasons for optimism, including hurricane-related reconstruction, developing export markets, and growing housing demand, but I believe it will probably be 2019, and perhaps 2020, before there’s any real strength in log prices in the Southern region.

On the flip side, I think Weyerhaeuser’s Pacific Northwest timberlands will continue to do very well. Between supply issues (insect damage, fire, etc.), regional housing demand, and consistently growing demand from Japan, I see no particular reason to expect prices to weaken. And here again is a credit to management’s discipline – while the very tight market (and attractive prices) might tempt some timber owners to over-harvest, Weyerhaeuser is taking a conservative, disciplined approach.

Wood Products – Making Hay (Or Sawdust) While The Sun Shines

Between demand from new construction and repair/remodel and uncommonly disciplined capacity growth, the operating environment for Weyerhaeuser’s Wood Products business improved markedly in 2017. Weyerhaeuser saw very strong price realization growth in the fourth quarter (lumber up 19%, OSB up 31%) and that helped fuel exceptional margin leverage – adjusted EBITDA margin for lumber exceeded 22% and adjusted EBITDA margin for OSB was over 44%.

I don’t believe Weyerhaeuser is going to do much to upset the apple cart. Weyerhaeuser hasn’t really added much capacity in recent years, and I don’t see that changing. Instead, I believe the company will continue to look to maximize pricing power when and where it can, while also focusing on best operating practices to maximize the efficiency and margins of its mills and plants.

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For lumber, prices are close to multiyear highs and there’s really no way to tell if the U.S. and Canada will hammer out a new Softwood Lumber Agreement (or SLA) any time soon. In addition to the already-acrimonious NAFTA renegotiation attempts, neither side has shown any willingness to budge on the SLA, even though Canada has typically prevailed when appealing U.S. tariffs at the WTO. At a minimum, I’d say the outlook for at least the next year is pretty strong for Weyerhaeuser’s lumber business and that strength could persist if meaningful restrictions/tariffs remain in place on Canadian lumber.

OSB is a different story, though one that is still likely to benefit Weyerhaeuser in 2018 and likely into 2019. Between newly-built plants and restarts of idled facilities, it looks like supply will increase by over 10% in 2018, and that is likely to put pressure on prices that averaged over $350/msf in 2017. That said, industry capacity utilization is still likely to remain north of 90%, and that has traditionally supported prices of over $300 – a level where Weyerhaeuser’s very efficiently-run operations can make very good cash flow.

Weyerhaeuser’s engineered products business isn’t as significant in EBITDA contribution terms, but the story is roughly similar – capacity growth has been pretty responsible and ongoing growth in housing should be supportive of good prices and healthy margins.

More Juice From Better Use?

One of the “secret weapons” that timber companies like Weyerhaeuser have long enjoyed is the opportunity to monetize forested acres for non-forestry purposes. This is referred to as “higher and better use” (or “highest and best use”). The concept is pretty simple – a given acreage might be worth $2,000/acre as timberland, but real estate developers (or other parties) may be willing to pay well above that to convert the land to another purpose (like a housing or commercial development). This has happened a lot over the past decade and a half that I’ve lived in the Carolinas; as cities grow, bordering land that was used for commercial forestry is now turning into cookie-cutter McMansion developments and strip malls.

In conjunction with the Plum Creek transaction, Weyerhaeuser has revalued its timberland holdings and determined that around 12% to 13% of it could be optimized for use as something other than timberland. That’s a potentially meaningful store of value, but I’d caution investors on a few points. First, there are already expectations for HBU built into the valuation. Second, Weyerhaeuser isn’t going to sell all of that land at once, and sales are likely to proceed in irregular “drips and drabs”. Third, rebasing the value of Plum Creek’s land in the acquisition is going to make it a little harder to evaluate the real value of these transactions.

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Nevertheless, the revenue that Weyerhaeuser generates from land sales and energy/resource rights is lucrative, with EBITDA margins sometimes into the 90%’s. The only downside to this is the unpredictability of the timing of those sales; Weyerhaeuser has missed quarterly expectations more than once largely due to that line-item and I’m all but certain it will happen again.

The Opportunity

There are multiple ways to value Weyerhaeuser, each with their own advantages and disadvantages. A sum-of-the-parts approach better captures the inherent value of those timberlands and the HBU opportunities, but it can take a lot of legwork for a regular investor to track down good information on how to value the acreage. Free cash flow can work, but it’s difficult (if not impossible) to model the cyclicality of the business and sometimes all you end up doing is replacing a few tidy guesses (“I believe Weyerhaeuser’s Pacific acreage is worth $3,800/acre”) with lots of smaller guesses (year-by-year volume and price estimates, margins, etc.). EV/EBITDA is certainly a simpler approach, but it only captures the value of one year in time unless you try to use cycle-average figures, and then you still have the issue of the “right” multiple to use.

I use all of these methodologies and then try to sort through the results to get an idea of a fair value range. In the case of Weyerhaeuser today, I believe a range of $36 to $40 is fair, with the higher end coming from my sum-of-the-parts model (wherein the timberlands are overwhelmingly the largest value driver) and the lower end from my cycle-average EV/EBITDA. I’m using a 13x multiple for my cycle-average EBITDA; although that multiple is well in excess of the EBITDA growth I expect, it does reflect the quality of the business, the uncaptured value of the timber assets, and the benefits of the REIT structure.

The Bottom Line

Relative to Louisiana-Pacific (which has no timberlands to speak of), Weyerhaeuser looks a little undervalued. I believe investors will have to have patience with these shares, but there is a decent dividend and Weyerhaeuser has been making some small increases to its payout in recent years. I believe Weyerhaeuser is on a much better path now relative to the pre-Plum Creek era and I think the long trailing record of underperformance should improve from here.

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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