April 16 (Bloomberg) -- Weyerhaeuser Co. agreed to protect land around a historic waterfall east of Seattle in 2004 in exchange for rights to build houses nearby. The deal worked well for the waterfall.

Dirt plots marked with blue and orange stakes outnumber finished homes in a Snoqualmie, Washington, neighborhood where Weyerhaeuser carved subdivisions out of a hillside. Record profits from real estate in 2005 turned to $847 million in losses for the company last year. So much residential property is for sale in Snoqualmie that there’s a three-year backlog, said George Isaacs, a local real-estate agent.

“Remember the movie ‘The Perfect Storm?’ We’re in that boat right now,” Isaacs said.

The misadventure in Snoqualmie helps explain why the largest U.S. lumber producer is in a financial crisis so deep it turns down the heat in its offices to save money and is contemplating upending its corporate structure after 109 years to become a real estate investment trust.

Other U.S. timberlands managers have converted to REITs to slash corporate taxes. The move would reward Weyerhaeuser shareholders, who held their annual meeting today at the headquarters in Federal Way, Washington, by returning most profits to them as dividends. At the same time, it may force the spinoff of more non-timber assets.

55 Degrees

The company has been shedding them under Chief Executive Officer Daniel Fulton, who has closed 10 wood-products mills this year, halved capital expenditures, sold off packaging businesses, frozen salaries and eliminated almost half of the workforce, now at 19,850.

A record $1.2 billion loss on $8 billion in revenue last year and the likelihood of negative cash flow through 2010 put Fulton into “conservation” mode, said Joshua Zaret, an analyst with Independence, Ohio-based Longbow Research.

“His priorities are stemming the cash leakage and battening down the hatches,” said Zaret, who has a “neutral” rating on the shares.

Weyerhaeuser has lowered the thermostat at headquarters to 55 degrees on weekends and after hours, said Bruce Amundson, a spokesman who wears a sweater when he works late. Fulton also cut costs this month by shutting a public bonsai garden, eliminating one full-time and one part-time position.

“We missed the depth and severity of this homebuilding crisis,” Fulton, 60, who headed the real estate unit for seven years before becoming CEO last April, said in an interview. “The primary business going forward is the one we started with in 1900, which is timberlands ownership and management.”

‘Not Fighting’

Fulton told reporters after the annual meeting that the U.S. housing market may hit bottom later this year.

“We’ll start to see some modest recovery in 2010 and pick up steam in 2011,” he said.

Weyerhaeuser, which calls itself “the biggest homebuilder you’ve never heard of,” was slow to consider REIT status partly because it didn’t want to shrink, Zaret said. Under the rules, 75 percent of pretax income must come from real estate property. No more than 25 percent can come from manufacturing, including homebuilding.

Now, Fulton is telling shareholders that Weyerhaeuser qualifies for 2009 REIT status, after selling businesses including a packaging unit for $6 billion to International Paper Co. in August. It may make the REIT switch as early as April 2010, when the company files income taxes, he said.

“I’m not fighting it,” Fulton said.

No Taxes

The Weyerhaeuser of the future may be two companies, with its timber business separate from its lumber and real estate arms, said Robert Willens, president of New York-based Robert Willens LLC, a tax advisory firm. While residential real estate could still be a taxable subsidiary of a REIT, shareholders might prefer a pure timber business, Willens said. A REIT pays no corporate income tax on timber sales.

Weyerhaeuser would follow Seattle-based Plum Creek Timber Co., which converted to a REIT in 1999, and Potlatch Corp. of Spokane, Washington, which made the move in 2006.

Plum Creek is the largest non-government owner of U.S. timberlands, with 7.4 million acres. Weyerhaeuser, which got its start in 1900 when German immigrant Frederick Weyerhaeuser bought a swath of Washington state forest the size of Rhode Island, is No. 2, with 6.4 million acres.

“Plum Creek has a huge advantage,” Willens said. “They’re avoiding taxes on 35 percent of their pretax income, so they have that much more to invest in their business and share with shareholders in the form of higher dividends.”

Underlying Asset

Weyerhaeuser rose $1.55, or 5 percent, to $32.42 today in New York Stock Exchange composite trading. The shares have slumped 49 percent in the past year, compared with a 21 percent decline for Plum Creek.

Timberland owned by Weyerhauser may be worth $10 billion, more than the $6.5 billion market valuation for the company as a whole, said Russell Croft, a fund manager at Croft-Leominster Inc. in Baltimore, which holds 250,000 shares among $600 million in assets.

“They have that underlying timberland asset, which is one of the reasons we like the stock,” Croft said.

The challenge will be preserving cash as the housing market remains depressed, said Ed Sustar, a senior paper and forest- products analyst at Moody’s Investors Service. Moody’s put Weyerhaeuser on review for a possible multiple-notch credit- rating cut in February.

‘Twin Peaks’

In the fourth quarter, timber was the only profitable business for Weyerhaeuser, which expanded into packaging in 1949, fine paper in 1961 and residential housing in 1969. It now owns six homebuilders across the U.S., including Pardee Homes in Los Angeles and Phoenix-based Maracay Homes, the latter added at the height of the bubble in 2006 for $213 million, plus a $40 million deferred payment in 2007.

“I did it; I’m the guy,” Fulton said, acknowledging he misjudged the market.

In February, the U.S. recorded 357,000 annualized single- family housing starts, down 79 percent from the peak of 1.7 million in 2005, according to U.S. Commerce Department figures. As the economy recovers, housing starts should return to 1.2 million to 1.4 million a year, Fulton said.

The slump in Snoqualmie, known to fans of the 1990s television series “Twin Peaks” for the scenes shot at Snoqualmie Falls and around town, shows how long the rebound may be in coming.

‘Shadow’ Inventory

From 2000 to 2007, the town 30 miles (48 kilometers) from Seattle was the fastest-growing in Washington state. Population surged 361 percent to 7,516 from 1,631, according to U.S. Census figures, as Weyerhaeuser’s Quadrant homebuilding arm developed a master-planned community called Snoqualmie Ridge.

In 2004, Quadrant agreed to provide $8.7 million toward preserving 150 acres adjacent to Snoqualmie Falls and Weyerhaeuser yielded development rights to 3,450 acres of forestland. Lots for houses Quadrant had wanted to build near the falls were allocated to a second phase of ridge development.

Today, only 400 of as many as 2,150 homes planned for that phase have been built, said Bob Larson, the city administrator. Isaacs, the realtor, said he’s watching foreclosures rise and buyers fall behind on payments, creating a “shadow” inventory.

“We knew it was a growing community, and it was supposed to be a wealthy community,” said Olivia Oliver, 42, who started the Artisan Table, a gourmet market, in June 2007. Now she’s selling furniture and fixtures to make the monthly rent.

Weyerhaeuser is also finding cash scarce, and may have to stretch to cover the cash portion of an estimated $6.5 billion dividend it would have to give shareholders before becoming a REIT, said Sustar, the Moody’s analyst. The company had $4 billion in cash and bank credit lines at the end of last year.

“The burning issue is how to minimize the cash bleed,” said Zaret, the Longbow analyst. “Everything’s going to depend on the timing of a housing recovery, and at this point there’s no light at the end of the tunnel.”

To contact the reporter on this story: Peter Robison in Seattle at robison@bloomberg.net; Christopher Donville in Vancouver at cjdonville@bloomberg.net.

Last Updated: April 16, 2009 16:55 EDT