A Costly Payday for Weyerhaeuser Shareholders?

The prospect of a company's declaring a special dividend valued at $5.6 billion—and higher regular dividends in the future due to a tax-exempt corporate structure—should put a smile on investors' faces, right? Not necessarily.

Weyerhaeuser (WY), a major U.S. timber company, announced on July 12 that it will pay a special dividend in that amount in September to shareholders of record July 22. The special dividend represents all the earnings and profits the company has accumulated and not paid out in the form of dividends to investors since its inception more than 100 years ago. This is the latest step toward the company's eventual conversion to a real estate investment trust (REIT), which will exempt it from paying corporate income taxes. That's good news for investors, who are required by U.S. tax law to receive at least 90 percent of the company's net taxable income in exchange for Weyerhaeuser not having to pay corporate taxes. The shareholders will be responsible for the taxes on any dividends they receive.

On a conference call July 12, the company said the special dividend will include the regular quarterly dividend of roughly $11 million and that shareholders can choose to take the dividend as cash or stock, with the total cash payment limited to 10 percent of the total distribution, or $560 million. Weyerhaeuser's wood products, fibers, and homebuilding busineses will be placed into a separate subsidiary, whose net income will remain taxable.

Becoming an Income Play

Conversion to a REIT certainly would turn Weyerhaeuser into more of an income stock, says Dan Rohr, mining and timber analyst at Morningstar (MORN).

"Weyerhaeuser will have to offer a dividend payout commensurate with what other timberland REITs are paying, something on the order of a three, four, or five percent dividend [yield]," he says. In June, the company paid a dividend of 5¢ per share (a yield of just 0.5 percent), vs. Plum Creek Timber's (PCL) 42¢ quarterly dividend in May (a yield of about 4.67 percent) and Rayonier's (RYN) 50¢ payout for a 4.31 percent yield in June.

For shareholders, the only disadvantage of the conversion is the timing of their tax payment, says Rohr. "You get hit upfront, and you save over the longer haul," he says. "The pie that's available to shareholders for distribution is ultimately larger, because the government isn't taking a piece of the pie before distribution."

In a July 12 note, Credit Suisse Equity Research went so far as to say that the possibility of increased volatility in the stock price prior to the presumed ex-dividend date of July 20 could prompt some taxable investors to sell their shares "to avoid this massive $26.49 per share dividend reflected in their brokerage 1099s [tax forms] next February, and then buy the shares back after the ex-date." Conversely, any weakening in the stock price over the next six trading days could be a buying opportunity for tax-exempt investors, the note said.

Reasons Not To Sell

Dan Genter, manager of dividend mutual funds at RNC Genter Capital Management in Los Angeles, said he sees no benefit in selling shares in a company about to incur a special dividend, since you'll still be taxed at the capital gains tax rate, the same rate you would pay on the special dividend.

The additional income of $26.49 shouldn't come as a surprise to investors, because the company has signaled for the last three to four months that the payout would be around that level, says David Segal, portfolio manager of a handful of equity funds at the Mutual Series Group, part of Franklin Templeton Investments.

The Mutual Series Group owned more than 14 million shares, or more than 6.8 percent of Weyerhaeuser's total shares outstanding, in its mutual funds as of Mar. 31, 2010. Segal and Peter Langerman, chief executive of the Mutual Series Group, said they see REIT conversion as the right move at this time.

Before Tax Cuts Expire

Institutional investors have been clamoring for Weyerhaeuser to become a REIT since 2007, when the company's accumulated earnings and profits, which are required to be distributed as the special dividend, were significantly higher than today, says Morningstar's Rohr. The company told shareholders last year that it planned to complete the conversion by the end of 2010, presumably to beat the anticipated expiration of the Bush Administration's tax cuts slated for Dec. 31, 2010. But Weyerhaeuser may well have delayed the conversion as long as possible in order to reduce the accumulated earnings and profits, he says.

"With all the losses that the wood products business has been generating, it can use those losses to offset the accumulated profits and earnings, which ultimately results in a less onerous tax bill for your shareholders," he says. The company's homebuilding business has also taken some big hits due to the prolonged housing market downturn.

The company posted a net loss of $545 million, or $2.58 per share, in 2009, following a net loss of $1.2 billion, or $5.57 per share, in 2008. The weakness has been reflected in the stock price, with the shares bouncing 43.3 percent in 2009 after a 55.4 percent decline in 2008. After the special dividend was announced, the shares shot 8.4 percent higher, to close at $38.86 on July 12.

Restructuring Its Basic Business

Langerman attributes the stock's underperformance in the past two years to a public perception that the company has a high exposure to the weak homebuilding industry, with the value of its timber assets not being fully appreciated. But the company has restructured its timber business by increasing its productivity and reducing the cash burn in its lumber business, selling its container board business to International Paper (IP) and exiting the uncoated copy paper business.

On the July 12 conference call, Weyerhaeuser's chief executive, Dan Fulton, tried to make the case that the company will continue to be regarded as a growth play after becoming a REIT, but that's a hard case to make. Turning over 90 percent of its taxable income to shareholders leaves just 10 percent to be reinvested in the company or put toward buying additional properties. That dramatically limits your flexibility in retaining cash flow to expand your business, says Brett Johnson, chief investment officer at fund company Grubb & Ellis. But in return for limited growth, shareholders are getting a much more reliable income stream in the future, he says.

Although Johnson hasn't made a list of land-rich natural resource companies that are potential REIT candidates, he says he doubts there are any outside the timber industry. The reason that no oil and natural gas producers, or mining companies—some of which have extensive land assets—have ever converted to a REIT, he suspects, is that none has a big enough percentage of its income coming from its real estate assets to meet the qualifying tax criteria.

Over time, there's been a rising correlation between the performance of the REIT market and financial stocks and between REITs and the Standard & Poor's 500 index, says Johnson. He hopes the high dividend income from REITs will create a different pool of investors, one willing to look past the stocks' volatility and value them more for their consistent income stream.

Before it's here, it's on the Bloomberg Terminal.