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Weyerhauser Falls Prey to Microsoft Financial Pyramid Scheme?

PORTLAND, Ore., June 1, 2001    On Thursday June 7th the Weyerhauser Corporation will attempt a hostile takeover of Willamette Industries.  Specifically, Weyerhauser will try to place three new board members on Willamette Industries Board of Directors at Willamette's annual shareholders meeting.  Willamette is one of two Fortune 500 companies still based in Oregon, the other being Nike.  Weyerhauser is based in Tacoma, Washington,  about 35 miles from the Microsoft headquarters in Redmond, Washington.

Weyerhauser is offerring $5.5B in cash.  This offer not only seriously undervalues Willamette's long-term prospects and subjects shareholders to significant capital gains taxes yet it could also be a financial disaster for Weyerhauser shareholders.  

What Weyerhauser is not advertising is that its largest shareholder is Capital Research and Managment Company, which owns $1.3B or roughly 10.6 perent of all Weyerhauser shares.  Capital also owns 3.5 percent of Willamette Industries. Since Capital manages more than $300 billion in assets, the bulk being in pension plans, Capital should be able to sell most of its Weyerhauser shares after a takeover without a tax consequence since they are mostly in tax deferred retirement acounts.

Parish and Company strongly recommends that Weyerhauser shareholders request that Capital Management guarantee it will not sell its existing Weyerhauser shares for a minimum of 5 years if the takeover is indeed achieved.  This will cause Capital to sharpen its pencil and see the obvious, that is, a better decision would be to sell a substantial portion of its Weyerhauser shares and reinvest them in Willamette Industries.  If Weyerhauser is successful in a takeover attempt its CEO will not only destroy a quality long-term investment, Willamette Industries, but he will also most likely leave Weyerhauser shareholders with significant losses due to being overleveraged.

Willamette Industries is an important company, not only for Portland but also for the global free market economy.  It is a gross breach of fiduciary duty of Weyerhaeuser’s management and a genuine badge of shame for the Weyerhaeuser family itself that they would even attempt such a hostile takeover.  The good news is that Willamette should be able to block the takeover attempt by educating Capital Management regarding the aforementioned better strategy toward achieve a solid long term return.

Let's examine some of the structural dynamics of the financial markets to see how Weyerhauser could attempt such a transaction in the first place. First of all, in this over hyped stock market where companies like Microsoft can post $10 billion in earnings and pay no federal income tax, in addition to not reflecting $15 billion in wage costs, as reported in the NY Times, companies like Willamette with financial integrity are very important for market stability.  As a stand alone company Willamette is a solid long-term investment and that is the best investment.  Sadly, they are probably sufferring from having worked hard to pay down its debt and make long-term oriented strategic purchases of new timber reserves. These were good decisions by Willamette that are not yet fully reflected in its stock price.

It is my belief that financial engineering at Microsoft, that at one time had its stock inflated to almost $700 billion, 40 percent of the entire annual federal budget, has corrupted the free market capital markets and is indeed responsible for Weyerhaeuser’s actions. Microsoft has been using a variety of accounting loopholes, all designed to inflate earnings, in what one might call a pyramid scheme.  Some technology companies have tried to emulate Microsoft, most notably Cisco Systems and AOL, see two AOL report, yet they all fail due to the unique advantages the scheme affords Microsoft.  Cisco recently dismissed 17 percent of its entire work force as its merger strategy, designed to keep pace with Microsoft, failed.

In recent years Microsoft has paid almost 75 percent of its entire wages in stock options on which employees are taxed at ordinary income rates and the amounts included on their W-2 when they exercise the options. Microsoft takes a full tax deduction for these stock option wages even thought they cost them nothing since they represent stock certificates printed up on the equivalent of a photo copy machine in the accounting department.  In addition, due to an accounting loophole these wages are not charged to earnings.  One might ask, why doesn’t Willamette do the same thing?

The net effect is that Microsoft strongly encourages its employees to exercise the options so that they can get the tax deductions yet the employees and other investors are left with inflated paper.  This is a pyramid scheme because the more options that are issued, the more earnings can be inflated and the bigger the tax deductions and more cash are created in the form of non-payment of income tax when employees exercise options..

Since all companies compete for the same pool of capital, Microsoft's pyramid scheme has artificially suppressed the values of companies like Willamette where earnings are genuine.  This is not unlike golfing with someone who is cheating on their scorecard, every hole.

In another example, USA Today wrote a cover story in April regarding how Microsoft had lost $8.4 billion speculating on its own stock in the options market.  These losses will never be charged to earnings.  When people invest in Willamette, they know what they are getting and that is important.

Perhaps Weyerhaeuser, due to its proximity to Redmond, is simply trying to embark on a little financial engineering of its own? Where is Weyerhaeuser going to get $5.5 billion in cash, the announced price?  Will they issue more stock, issue bonds or will Bill Gates pony up a couple of billion dollars this pyramid scheme has pilfered from the pension system in order to diversify his portfolio?

No matter where the financing comes from, Weyerhaeuser will clearly be overleveraged.  Even if they issue stock they will be issuing “watered stock” because it will greatly dilute existing shares.  Of course the worse case scenario would be the company issuing convertible bonds in which someone like Gates got a highly favorable conversion feature.

As a CPA for Arthur Andersen in the late 1980’s, Weyerhaeuser’s current auditor, I’ve seen this cycle before and it is frankly shameful.  Rob the pension by reappraising asset values and future needs, inflate earnings via accounting gimmicks, layoff thousands of people and ship the investment benefits off to some passive investor holding the stock through a hedge fund.

There is a disease among CEO's in Corporate America and this sickness is “merger frenzy.”  The roots of this merger frenzy can be clearly traced to a pyramid scheme at Microsoft that has corrupted the financial markets. Although a strong believer in Corporate America, I also strongly oppose "mega mergers" that result in temporarily industry dominating companies that later always crash from their own weight. It seems that some CEO’s become bored and unable to perform and then decide to go out and acquire other companies to disguise their inability to run a good business.

An excellent example is AOL buying Time Warner in which they took on $22 billion in bank debt, $16 billion in back taxes and $9 billion in stock option debt which combined exceed gross annual revenues.  Not even the Wall Street Journal has fully reported what has happened to AOL, even though it is now in the top 10 in market value in the S&P 500.

Parish and Company's message to Weyerhaeuser’s CEO is simple and sincere -  if you can’t run the company the way you want, why not retire, take up golf and travel a bit.

The only real winners in this situation will be the lawyers, accountants and investment bankers involved who stand to make millions.  Meanwhile, long-term shareholders of both companies, along with employees of both firms, and their communities, end up losers.  Take a lesson from Chainsaw Al and Bernard Ebbars, step back and focus rather than run Weyerhauser off a cliff.

Parish & Company is an independent fee based investment advisor to individuals, pensions and trusts based in Portland, Oregon.  No fees are accepted, either directly or indirectly, from any provider of investment products.  Your comments are most appreciated and please do visit my research archive at www.billparish.com.