Description

Investment Thesis:

WY is a high-quality timber REIT whose significant transformation is not fully appreciated by the market. WY is now a pure play timber company that should be a beneficiary from the ongoing US housing recovery and a more inflationary environment going forward. We also believe the company will likely be a prime beneficiary of the Trump administration’s “America’s First” agenda.  The real call option for the story is the Canadian soft lumber agreement which has lapsed but is due to be restored in some capacity. This serves to level the playing field for the US timber producers who have seen Canadian market share of lumber spike 500bps. WY is the company best positioned when the new tariffs are enacted and market share shifts back to normalized levels.

Company Background

WY is the largest US timber company. Starting in 2013, current CEO Doyle Simons, became the company’s internal activist by shedding non-core assets. As shown in the table below, in 2012 WY had a broad range of assets ranging from timberlands, wood products, cellulose fibers, and a homebuilding division. Since 2012, management has spun-off the homebuilding division and sold its cellulose fibers business while deploying capital into M&A via the purchase of Plum Creek Timber. Today, timberlands now make up the majority of the company’s assets. WY owns 13mn acres of some of the most productive and diverse timberland assets in the world. The combination of attractive assets and strong execution drives WY’s industry leading EBITDA per acre. The remaining assets are the company’s industry leading, low cost wood products manufacturing assets.

Table 1: WY has transformed into a pure play timber company

Housing Recovery Beneficiary

We are constructive on the ongoing housing recovery in the US and recent commentary from home builders appears to support our view. The long run demand for housing has historically been 1.3mn to 1.4mn housing starts. Today housing starts are around 15% below normalized levels, however, even more importantly for WY, single family starts are 25% below normalized levels. Based on recent conversations with homebuilders, we believe the housing outlook remains attractive driven by low mortgage rates, favorable demographics, and rising wages. We think bank deregulation may lead to a quid pro quo – i.e. banks get less deregulation but government encourages an improvement in mortgage availability – a headwind during the current housing recovery.

A favorable housing environment should drive a continued improvement in timber related operating rates, which are forecasted to approach 90%. We believe this provides a foundation for favorable lumber pricing in the future.

Recent homebuilder commentary from Raymond James Conference

“We’re in a pretty stable housing market right now. The visibility that we have in our business is as good as it's ever been” – DR Horton, 3/07/17

“We've had continued population growth in household formations and we have roughly seven years of pent-up demand that's going to start releasing or is starting to release right now. Mortgage rates are still low. Unemployment is great. We're seeing job growth. We're seeing wage growth.” – Toll Brothers, 3/6/17

Table 2: Significant production deficit of homes

Table 3: Single family starts 25% below average

Table 4: Gradually recovery in lumber demand

America’s First Beneficiary: Canadian lumber restrictions

We believe WY should be a large beneficiary from any revision to the Soft Lumber Agreement (SLA) with Canada. To-date, a significant amount of the recovery in the US lumber demand has been filled by Canadian lumber. Canadian lumber exports to the US have accelerated driven by the expiration of the Softwood Lumber Agreement in October 2015 and the pursuing one year standstill agreement. For perspective, Canadian market share has risen to 34% into the end of last year.

Background of US-Canada lumber dispute:

The Canadian government owns over 93% of Canadian timberland and effectively sets the price of sawlogs (the main raw material used to make lumber) through the stumpage fees it charges Canadian lumber producers. For over 30 years, US lumber producers have argued that these stumpage fees were below-market and injured the US lumber industry as Canadian producers exported lumber to the US at a lower price than US producers could compete. Since duties were first implemented in 1986, total duties have ranged from about 7% to 27% until the duty-based system ended in 2006 (at which time an 11% duty had been in place).

The duty-based system was replaced in 2006 by a negotiated Softwood Lumber Agreement (SLA) between the US and Canada.  The SLA implemented a tiered duty/quota system for lumber imports in exchange for terminating the previous countervailing and anti-dumping duties imposed on Canada. On October 12, 2015, the SLA expired with no replacement trade barriers enacted (in part due to a 1-year standstill provision ending October 2016).  Consequently since that date there have been no trade barriers (i.e. duties, tariffs, or quotas) on Canadian lumber imports.  Subsequently, Canadian lumber imports increased 31% YoY in 2016, and now account for 34% of US lumber demand. As a result, US lumber producers like WY have reported lower-than-expected growth considering the strong housing market data in 2016.  Given the surge in imports since the expiration of the SLA, lost market share for US producers, and weaker-than-expected earnings reports from US producers, the USLC submitted petitions to the DOC in support of countervailing and anti-dumping duties on November 25, 2016. On January 9,, 2017, the USITC determined that there is reasonable indication that the US industry is being materially injured by the softwood lumber imports from Canada. As a result of the USITC determinations, the US Department of Commerce will continue to conduct investigations.

Based on our conversations with various timber companies we believe Canadian lumber production has likely reached a limit. Log supplies in British Columbia are declining due to the pine beetle issues and allowable cuts are declining as well. In addition, management teams are anticipating some form of countervailing duties and antidumping duties and/or negotiated Softwood Lumber agreement to reduce Canadian market share going forward. We believe any outcome will likely lead to a decline in market share in Canadian timber and the demand will be filled by increased production from the US South and a rise in lumber prices.

According to WY management, the combination of high lumber demand and Canadian lumber production constraints could drive a 5% to 10% annual increase in Southern lumber production. The timing depends on the magnitude of the reduction in Canadian market share. For perspective, a 200bps decline in Canadian market share equates to around 1 billion board feet of additional lumber demand. A return to Canadian market share near historical levels – below 30% - would be the equivalent to several years of incremental demand growth which would suggest a strong recovery in southern saw log prices in 2018 where prices remain 25%-30% from peak levels across the region. Any favorable trade outcome could significantly improve US lumber pricing and volumes as whole, lead to higher US southern saw log prices, and drive higher timberland value in the US. Goldman recently ran a scenario analysis for the impact of various Canadian lumber scenarios which suggest anywhere from a 7% to 24% uplift to EBITDA for WY.

Table 5: Large increase in Canadian lumber market share in the US

Table 6: US South lumber production continues to recovery

Table 7: South sawlog pricing remains depressed

Table 8: EBITDA scenario analysis

Valuation

In our valuation framework, we value the 3mn western timberland assets at $4,000 per acre ($12bn), the 7mn southern timberland assets at $2,000 per acre ($14bn), and other timberland assets at $1,000 per acre ($2.5bn). We apply 7x-8x EBITDA multiple to the wood products business (~$6bn) and around $500mn in value for the Twins Creek minority interest and JV’s value. Less the net debt we derive a NAV of $37 to $38 per share. We believe any favorable outcome from Softwood Lumber agreement would provide an additional uplift to NAV driven by a more favorable industry structure and profitability. All in, we believe WY shares can compound at a double-digit return with moderate risk considering the company’s attractive hard asset profile in an inflationary environment combined with almost a 4% dividend yield.

Catalyst

Catalysts:

-       Strong housing data points as the 2017 spring selling season begins

-       A positive resolution on the Canadian lumber dispute

-       Improvement in lumber prices