I have written before that I do not recommend selling stocks in response to a dividend cut. That is because cyclical industries–ranging from industrial conglomerates to the larger firms dotting the energy sector–often need to cut their dividend in response to a commodity pricing slump rather than any difficulty resulting from production. There is also the general issue that dividend cuts are almost always preceded by poor earnings reports, and poor earnings mixed with dividend cuts tends to lead to lower stock prices. There is a substantial risk of selling low and locking in losses if you adopt the policy of selling a stock after a dividend cut.
But merger activity invites a distinctly different scenario–the company you hold is often trading at a 25% to 50% premium price compared to where it was trading before the buyout offer occurred. Contrary to having the risk of selling low, you instead have the opportunity to capture a windfall created by the acquisition premium. This inflated valuation is a great time to reassess whether or not you want to own the newly merged entity.
The acquisition that has recently caught my interest is the news that Weyerhaeuser has agreed to buy Plum Creek to own a significant amount of timberland throughout nineteen Northwestern U.S. states and nearby parts of Canada. If you own a commodities portfolio that features timber, you probably one of these two stocks.
I’ve never written about Plum Creek–I should have given its 14.5% annual returns since 1989–because the timber company manufactures medium density fiberboard (MDF). It sounds innocuous–it’s glued sawdust–but serves as an avenue to cause furniture consumers economic and bodily harm.
The economic harm is that people do not know the difference between wood furniture and medium density fiberboard furniture, and furniture built with MDF only lasts 1/10 as long as true wood furniture. This has created a trend wherein household furniture lasts only 25 years rather than being something capable of being passed down from generation to generation for 250 years. Increasing the amount of MDF in furniture is how furniture companies have slashed costs to stay competitive with wholesalers from China that provide furniture at a fraction of the cost.
The bodily harm is that MDF is a carcinogen because it uses formaldehyde in manufacturing, and leaks are possible. Your loved ones could be sleeping on a carcinogen without knowing about it, and the immorality lies in the fact that these risks are not adequately conveyed to customers (if people were aware of the health risks and inferior quality of the wood-like quality, it is substantial that some people would refrain from buying the product altogether.)
These concerns aside, it is also clear that Plum Creek has been a superior business. Costs have been scrupulously controlled (lowest harvesting costs in the industry), there is no off-balance sheet liabilities or pensions or preferred stock to weigh on earnings, and the dividend yield has historically been in the 5% range. The company has built up a portfolio of 6.6 million acres of timberland.
Just like healthcare investors that own Becton Dickinson, Plum Creek has been one of these commodity investments that is exceptionally well run and high quality despite never quite entering the general public’s consciousness. The deal for Plum Creek to combine with Weyerhaeuser is an all-stock transaction that will give existing Plum Creek shareholders 1.6 shares of Weyerhaeuser for every 1 share of Plum Creek currently held.
The problem for long-term timberland investors? Weyerhaeuser is a junk company despite twice the size of Plum Creek. It has a $6.5 billion pension that only contains $5.5 billion. That is problematic when you are company that has difficulty growing earnings. Weyerhaeuser made $3.31 per share in 1999, it is only going to make $1.05 in 2015. It dilutes shareholders heavily–there were 226 million shares in 1999 and there are now 514 million shares–and the dilution hasn’t corresponded to acquisitions that have justified the dilution.
Unlike Plum Creek, which makes a wide variety of wood products, Weyerhaeuser is largely focused on providing wood for the real estate sector. The health of the firm is almost entirely reliant on home construction, whereas Plum Creek sells to the consumer at large products that contain wood. The 2008-2009 period gave investors an important view of how these two distinctly different business models hold up during times of crisis.
In 2008, Weyerhaeuser lost $1.8 billion. In 2009, it lost $600 million. This is the danger of relying on homebuilders to support your earnings. The share count ballooned from 211 million to over 500 million during this two-year period. It was issuing equity at a time when the price of the stock fell from $80 to $20, significantly diminishing the value of what it was receiving in exchange for diluting the existing ownership base. That’s the danger of being a business with over $5 billion in debt that was making only $300 million in net profits in 2007.
Plum Creek, meanwhile, sailed through the recession–profits of $242 million in 2007 stayed stagnant throughout the recession–it made $236 million in 2008 and $233 million in 2009. When the price of the stock fell by 50%, it actually repurchased 10 million shares.
It is not a coincidence that Weyerhaeuser has only delivered 6.5% annual returns since 1973. It ebbs and flows with the housing sector, and the timber gains brought about by a rising real estate expansion is quashed by big losses that demand heavy share dilution and high-interest debt accumulation during the bad times. Plum Creek’s tree farms are put to a wider variety of products, and this helps Plum Creek maintain timber customers during periods of economic contraction.
If I owned Plum Creek stock, I would sell it now. The price of the stock is close enough to the merger price that the opportunity cost of waiting until the merger completion is negligible. This analysis is easiest to perform if we are assuming that the stock is held in some type of tax-advantaged account. If you are sitting on a large capital gain, the obviousness of the sale decision diminishes. However, I would still do it. Weyerhaeuser is such a thoroughly inferior company, with a clearly documented history of inferior returns and a business model that perpetuates the previous status quo, that I would pay the capital gains tax and search for greater than 6.5% elsewhere. Heck, the dividend alone from Royal Dutch Shell right now would probably give you higher dividend income right now than the amount of total capital gains plus dividend income you’d receive from Weyerhaeuser over the long haul.
I have a strong presumption towards low turnover. The historical studies indicate that stock spinoffs and dividend cuts are not wise times to make a sell decision. But much of that has to do with valuation–dividend cuts coincide with cheapness, and the unknown fundamentals at a spinoff company also create a tendency towards cheapness. Merger activity is a bird of a different feather. The acquired stock is trading at a premium, and it is wise to check out the other offerings in the henhouse.
My subsequent action would fall into one of three categories:
If the business doing the acquiring is nearly equal or superior to what I held (based on balance sheet strength, earnings quality, and growth profile), then I would continue to hold the stock regardless of whether it was in a taxable or tax-advantaged account.
If the business quality of the firm was 10% to 25% worse than what I held, my decision would depend upon the holding structure of the account. If I held in a tax-advantaged account, I’d sell and find a better alternative elsewhere. If I held the stock in a taxable account, I’d continue to hold the stock.
And if the business quality of the acquiring firm is 25% or more worse than the firm being acquired–and although the number I cite is precise, it is a judgment call to make this determination–then I’d sell the stock even if I were sitting on a large capital gain in a taxable account.
Weyerhaeuser’s junked-out balance sheet, share dilution, poor performance during recessions, heavy reliance on homebuilders, and inferior performance since 1973 lead me to the conclusion that owners of Plum Creek should sell their stock as soon as practicable. I’d be willing to absorb a large tax hit if those were my personal circumstances, as the inferior quality of the Weyerhaeuser business model does not merit the long-term capital of a loyal investor.