Why Lumber Is Now the Better Play

Paula is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Right now, something is happening across the US.  Some welcome it, others dismiss it, many question it, and no one can stop it.  The housing recovery is upon us, evidenced by a surge in new home sales, building permits, housing starts and homebuilder confidence.  Markets, too, have shown faith in this investment theme, judging by the meteoric rise in the housing sector.  Builder stocks and related securities – from sellers of appliances to paint – have become a decidedly crowded trade.  Let’s take a look at some performance and valuation metrics for a sampling of stocks in this group.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>1   Year Return</strong></p> </td> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p><strong>Average P/E</strong></p> </td> <td> <p><strong>Price/Cash Flow</strong></p> </td> <td> <p><strong>2013  EPS Growth Estimate</strong></p> </td> </tr> <tr> <td> <p><strong>Lennar</strong>  </p> </td> <td> <p>124%</p> </td> <td> <p>24</p> </td> <td> <p>13</p> </td> <td> <p>12</p> </td> <td> <p>-47%</p> </td> </tr> <tr> <td> <p><strong>Toll   Brothers</strong> <span class="ticker" data-id="205787">(NYSE: <a href="http://caps.fool.com/Ticker/TOL.aspx">TOL</a>)</span></p> </td> <td> <p>83%</p> </td> <td> <p>30</p> </td> <td> <p>68</p> </td> <td> <p>49</p> </td> <td> <p>65%</p> </td> </tr> <tr> <td> <p><strong>DR   Horton</strong> </p> </td> <td> <p>85%</p> </td> <td> <p>24</p> </td> <td> <p>8</p> </td> <td> <p>7</p> </td> <td> <p>-67%</p> </td> </tr> <tr> <td> <p><strong>Home   Depot</strong> <span class="ticker" data-id="203819">(NYSE: <a href="http://caps.fool.com/Ticker/HD.aspx">HD</a>)</span></p> </td> <td> <p>70%</p> </td> <td> <p>19</p> </td> <td> <p>21</p> </td> <td> <p>16</p> </td> <td> <p>14%</p> </td> </tr> <tr> <td> <p><strong>Sherwin-</strong><strong>Williams</strong> <span class="ticker" data-id="205418">(NYSE: <a href="http://caps.fool.com/Ticker/SHW.aspx">SHW</a>)</span></p> </td> <td> <p>69%</p> </td> <td> <p>18</p> </td> <td> <p>22</p> </td> <td> <p>19</p> </td> <td> <p>21%</p> </td> </tr> </tbody> </table>

Although all of these companies will benefit from the housing recovery longer-term, at current prices they aren’t exactly the stuff of value investors’ dreams. 

An Alternative to Overbought Homebuilders

Fortunately, buyers who want to avoid the most overheated names can capitalize on the housing trend through the timber and lumber stocks.  According to Natural Resources Canada, prices for North American lumber – from premium spruce-pine-fir to composite paneling and OSB – have risen significantly this year.  The International Wood Markets Group expects pricing for softwood and molding – two of the principle materials used in residential construction – to gain momentum from renewed building in the US and China in 2013.

Two companies whose charts reflect improvements in the building sector are timber REIT Weyehaeuser (NYSE: WY) and Canada’s West Fraser Timber (TSX: WFT).  With respect to risk, market cap, and even corporate structure, WY and WFT share few commonalities other than wood and strong recent performance.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Market Cap</strong></p> </td> <td> <p><strong>Dividend Yield</strong></p> </td> <td> <p><strong>1 Year Return</strong></p> </td> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p><strong>Average P/E</strong></p> </td> <td> <p><strong>Price/Cash Flow</strong></p> </td> <td> <p><strong>2013  EPS Growth Estimate</strong></p> </td> </tr> <tr> <td> <p><strong>Weyerhaeuser</strong> (WY)</p> </td> <td> <p>14.8 B</p> </td> <td> <p>2.5%</p> </td> <td> <p>64%</p> </td> <td> <p>30</p> </td> <td> <p>57</p> </td> <td> <p>20</p> </td> <td> <p>88%</p> </td> </tr> <tr> <td> <p><strong>West Fraser Timber</strong> (WFT)</p> </td> <td> <p>2.7 B</p> </td> <td> <p>NA</p> </td> <td> <p>47%</p> </td> <td> <p>15</p> </td> <td> <p>28</p> </td> <td> <p>12</p> </td> <td> <p>89%</p> </td> </tr> </tbody> </table>

Although analyst expectations for these forest and wood products producers are high, weak trailing earnings make for relatively easy year-on-year comparisons.  Both companies were devastated by the US housing collapse, and their shares also took a beating when the S&P 500 corrected last year.  While Weyerhaeuser began posting positive earnings in 2010, West Fraser only returned to a more reliable profitability in Q2 2012.  Last month, TD Securities and BMO Capital Markets upgraded West Fraser Timber, and RBC Capital Markets upgraded Weyerhaeuser from sector perform to outperform.

What Investors Can Harvest from Weyerhaeuser

With six million acres of forested real estate, Weyerhaeuser holds some of the most valuable assets on the continent.  Both investors and the company should continue to benefit from the REIT structure, which requires Weyerhaeuser to return 90% of its taxable income to shareholders.  Recently, Weyerhaeuser increased its dividend by 13%, and analysts expect further hikes in the mid-term.  In the most recent quarter, net sales in the wood products segment (where housing-related revenues are reported) increased by 5% sequentially and 35% over 2011.  

Why Investors Are Playing US Housing From Canada

Canada offers many more small and near-pure plays on lumber than the US.  West Fraser, Canfor Corp. and International Forest Products have all posted improved earnings on the back of recovering lumber prices.  But two additional factors are contributing to the strong performance of Canadian producers – reductions in import duties and the withdrawal of US plywood from Canadian markets.  In an effort to restrict Canadian lumber from crossing the border, the US government charges import duties on softwood on a scale inversely correlated to price.  This means that higher realized softwood prices automatically reduce duties paid by Canadian producers who want to compete in the US.  And lower duties mean lower costs for companies like West Fraser Timber. 

Second, the gradual recovery in the homebuilding industry in the US has absorbed US production that would otherwise have travelled north into Canada’s plywood markets.  Less competition in Canada has translated into higher prices and revenues for local wood products companies. 

Seeing the Forest for the Trees

While the housing recovery may still feel like too little too late, its gradual nature may give companies such as lumber producers time to revise their cap ex plans, re-tool long-dormant mills, and – yes – to hire people to realize these plans.  In the meantime, and until housing starts reach a healthier plateau, it’s not too late to invest in one of the greatest comeback stories of our time.

webscribe has no positions in the stocks mentioned above. The Motley Fool owns shares of Sherwin-Williams and Weyerhaeuser Company. Motley Fool newsletter services recommend The Home Depot and Sherwin-Williams. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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