Weyerhaeuser (WY) was founded as a timber/lumber enterprise. In the 1970s or thereabouts, many wood products (lumber/plywood) producers diversified as a form of integration into paper and packaging products. The reason was lumber mills produced waste material (chips, etc) which could be used in making paper pulp. Thus, WY added paper, as did Georgia Pacific, while International Paper (IP) went the other way by getting into the wood products business.

Now WY is unwinding that diversification and returning to its roots. Just guessing at the strategic rationale: the paper business is very capital intensive, does not grow much if at all, is energy intensive as well, and has pollution control costs. Also, the industry despite consolidation remains very competitive.

With the pending sale of its containerboard and packaging segment to IP, WY will essentially be out of the paper business except for its pulp operations.

Business Analysis

First some comments on the aforementioned IP transaction. WY is selling the operation on an uptrend, as strength in linerboard prices due in part to the weak dollar exchange rate produced a healthy 45% operating gain in ’07. The price at 1.16X trailing revenues seems fair to good for the seller. The total is $6 bil. in cash. I do not have the net proceeds at this time, to account for the taxes due (this is a sale of assets, and there will likely be gain vs. book value.) I am using a metric of free cash flow to average total assets to assess WY business segments. The business being sold to IP had a 9.5% FCF/assets in 2007, up from 6.3% the year before.

That is OK, but not great. Keep in mind this type of business is only average at best and has been highly cyclical so getting out during good times seems sensible. Also, the segment has 14,300 employees, almost 38% of company total, even though revenues in 2007 were 31.7% of the total. Considering that these are typically union workers and heavy on pension costs, etc. there may be some productivity improvements at least in terms of revenue/employee.

WY’s pulp business, which the company calls “Cellulose fibers”, had FCF/assets of 10% in 2007, vs. 4.4% the prior year. This illustrates the less than wonderful and cyclical nature of what has historically been called “market pulp”, sold as raw material for making paper. WY also makes board used in liquid packaging in this segment. Market pulp prices were up 14% in 2007 and are up a lot over the last five years as well. Even so, this is a tough business in which to make meaningful returns.

The wood products business lost money in 2007 after posting a 13.8% FCF/assets in 2006. The main driver is construction activity. Needless to say, volumes were down and pricing was soft. The principal products are lumber and plywood or OSB panels, plus some other structural wood specialties. WY has downsized this segment by closing a number of facilities. Illustrating the magnitude of volatility in pricing, Douglas fir 2X4’s, kiln dried, were down 39% on average in 2007, vs. the highs of 2004, while OSB was off 57% and southern plywood down 20%.

More recently, according to the trade source Random Lengths, a composite of framing lumber is off 7% from a year ago, having recovered nicely from lows but now looking toppy per the latest data. The Random Lengths composite panel price has held up a lot better (this is plywood and OSB) but also looks toppy near term.

All that said, WY’s wood products division has tremendous recovery potential due to the operating leverage driven by commodity prices. This segment is the main driver for WY’s earnings recovery, but with housing still depressed one should see this as an event well beyond 2008 and contingent on the absorption of a considerable amount of excess inventory in the housing channel.

Closely related is WY’s own homebuilding subsidiary, which the company says is among the top 20 in the U. S. While obviously under tremendous pressure now, I like this business a lot for its recovery potential.

1. Generally in the right states, places where people actually want to live or retire
2. Highly profitable when going well, as evidenced by 22% FCF/assets in 2006 before the industry woes hit
3. Mid range price point around $400K
4. Seems conservatively financed although I do not know about any off balance sheet items. The company did book write downs on land values in each of the last 3 years, with $128MM in 2007 being fairly significant
5. Theoretically WY should have some material cost advantage since it is integrated backward on framing wood and floor/roof sheathing, which comprises a significant portion of new home cost.

We complete the segment review with the Crown Jewel, WY’s timber division. This segment includes the 5.7 million acres of timber fee owned, plus extensive long term harvest rights on other land. This timber furnishes raw material to WY’s other divisions as well as sale of logs to third parties. Unlike wood products pricing, log prices held up well in 2007 – again, the weak dollar assisted since exports are key, but in general log pricing has been much more stable. This segment had a 16.3% FCF/assets in 2007, compared to 19.8% in 2006. A recent major positive is passage of the TREE (Timber Revitalization & Economic Enhancement) Act.

While I cannot quantify the financial impact to WY, it will be very substantial, especially in the out years when we can model housing recovery and “normalized” earning power. This is because the legislation provides for a 60% deduction of timber cap gains against corporate income. It will enable WY to have tremendous flexibility in managing its taxes.

Simplistically, if the company has ordinary income from its other businesses, it can offset this with the 60% deduction, which potentially can lower the company’s tax rate into the teens. But, if the other businesses are not making money, this deduction won’t have value. Thus, WY can cut high cost timber in years when ordinary income is low, and harvest low cost timber when ordinary income is high.

We can certainly debate the lack of wisdom of this legislation – it seems typical of the upside down thinking of the current Congress. It is basically a gift for the timber companies. It won’t do anything to produce a recovery in housing, and one has to ask why a few corporations get an effective rate cut while the others do not. Regardless, for WY investors, as well as others engaged in timber harvest, it is a clear positive longer term.

Side comment: Asset rich companies like WY are potentially good investments/inflation hedges, but clearly the asset has to be in demand. These cycles can be dormant for a long time. Witness the 20 year drought in gold, and a similar lean cycle in oil/gas to say nothing of iron ore, corn/soybeans, agricultural land, wheat, and so forth. For now, WY is out of favor because its asset has negative demand, and the recovery will be certain, but slow.

General Comments

Reviewing the CEO’s letter in the 2007 Annual Report disclosed a lot of fluff and not much in the way of objectives/targets/goals/financial specifics. A similar conclusion is reached for the slides accompanying the recent Analysts meeting. In fairness, I believe the company is dealing with miserable market conditions in 2008, and there is not a lot they can say or do about it. Additionally, the company is clearly in major transition and probably does not have a clear view at this point of what the final structure will be.

The magnitude of this transformation is quite striking. As noted, divesting all the paper related assets. And on May 29, said it was mulling alternatives for its rail and shipping assets, including sale. The balance sheet is already in solid shape, but the company says it will allocate a “substantial” portion of the IP sale proceeds, set to close in Q3, to debt reduction. Interest costs have already been slashed by $245MM from 2005 to 2007, but it easy to see another $150MM or more in interest expense cuts.

That raises the question of what is the company going to do with this fortress balance sheet and the torrent of cash flow which will ensue when earnings recover? Here is how I am modeling that recovery. In round numbers, I am estimating earnings of $5 per share. That is based on a decent rebound in the Wood Products division, but none in the Homebuilding segment. Or, Wood Products could recover less but Homebuilding could snap back a lot more. Or if both recover more than I am modeling, that 5 dollar eps number will be higher.

The timing is unknown. WY management seems cautious about seeing much in 2009, so if we accept that premise and call it 2010, the stock is still pretty cheap. The issue is, those earnings have time value, and given the current headwinds, it is not surprising the stock has sold off again, to $56, and my guess is it remains uninteresting for quite a while longer.

That said, the variables to monitor are pretty simple: housing inventory, housing pricing, housing demand, particularly in the states where WY operates, and wood products prices. I would expect WY shares to begin to discount a recovery somewhat in advance once housing inventory is worked off.

Remember, this is a company making essentially no money currently, and with Street estimates standing at $1.29 for ’09 in a range of 50 cent loss to $3.15 positive, very low expectations. I guarantee that analysts will drastically underestimate the operating leverage when the turn comes, and this is how you make money in commodity companies, buy a little when the macro factors turn better, buy some more on the first blow out earnings quarter, and keep buying as the Street tries to catch up to the ultimate earning power on the upside. On the sell decision, start to scale out when the Street finally catches up (that is, on the first in-line quarter) and monitor incremental margins as well as commodity prices. When those flatten or roll over, time to sell.

Another reason the stock has sold off is a perceived catalyst was taken off the table on May 30 when the company said it was shelving possible plans to convert to a REIT. One reason to be a REIT is to save taxes, but WY paid drastically less taxes in 2007, and this will persist certainly in 2008. I do not think the REIT decision is a deal breaker for the stock. As noted above, it will do OK just on earnings recovery, regardless of the structure of the company.

I will close on one final intriguing question. My earnings model produces about $550MM in free cash flow before dividends, and by that time WY’s balance sheet should be very underleveraged. The logical conclusion is the company could do a major share repurchase. Moreover, there has been some excellent research on the notion that having debt is beneficial (within reason) to shareholders, owing to the effect of paying off with depreciated dollars in an environment of chronic inflation.

Can anyone doubt that the current situation as well as the outlook is one of inflationary bias? Since WY has long term assets, i. e. land and trees, it makes sense for the company to also have long term liabilities in some prudent amount.

And WY shares have not made much progress for ten years now, a wide trading range with a modest upward trend.

Since WY assets are shrinking, and long term debt is also markedly lower, it is logical to shrink the equity base as well so as to create even more upside eps leverage when the cycle turns.

Disclosure: Author has a short position in WY puts