Timber REITs Benefit from Small Business Jobs Act of 2010

From the desk of Neena Mishra, Director of Equity Research:

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010, which includes a key provision that benefits public timber REITs.  The new law (1) enhanced and extended a number of tax incentives included in the original Economic Stimulus Act of 2008 and American Recovery and Reinvestment Act of 2009 and (2) shortens the holding period for S-Corp built-in gains from seven years to five for dispositions in any tax year beginning in 2011, if the fifth year in the recognition period precedes 2011.

This second provision was designed to benefit corporations initially structured as C-Corps, but elected to be taxed as S-Corps and had net built-in gains when they made the S-Corp election. This may provide some tax benefits to the timber REITs – Plum Creek (PCL), Rayonier (RYN) and Potlatch (PCH) – in the near-term.

A built-in gain is the difference between the fair market value of an asset and its tax basis at the time the election is effective. The built-in gains tax applies to gains recognized within the ten-year period following the merger date from asset sales. Built-in gains tax is generally not payable on dispositions to the extent the proceeds from the disposition are reinvested in qualifying like-kind replacement property (i.e. 1031 like-kind exchanges). Also, the built-in gains tax does not apply to income generated from the sale of timber pursuant to a stumpage sale agreement or timber deed. The 2009 Recovery Act temporarily shortened the traditional 10-year holding period to seven years for dispositions in tax years beginning in 2009 and 2010.

As a result of the enactment of 2009 Recovery Act, Plum Creek recognized a $3 million deferred tax benefit in 2009 and reversed $5 million of tax expense related to the built-in gains that accrued in 2008. Further, as a result of the Small Business Jobs Act of 2010, the company reduced its deferred tax liability by $1 million during the first nine months of 2010.

For Rayonier (RYN), this provision eliminated the built-in gains tax for 2011. The built-in gains tax was ~$9 million in 2008 and is expected to be ~$6 million in 2010.

Weyerhaeuser’s (WY) Dividend as a Timber REIT

From the desk of Neena Mishra, Director of Equity Research:

While Weyerhaeuser (WY) has completed all steps required for converting to REIT status, it technically becomes a REIT upon (1) filing its tax return in early 2011 and (2) electing the REIT status in the tax return, effective January 1, 2010.

Among the steps taken for conversion, Weyerhaeuser reorganized businesses and paid out accumulated earnings and profits. Whereas the parent company (which will be a REIT) continues to hold the majority of the timber assets, the non-REIT qualifying assets are held in a wholly-owned taxable REIT subsidiary (TRS).  TRS assets include Weyerhaeuser’s Wood Products manufacturing, Cellulose Fibers business and the Weyerhaeuser Real Estate Company (comprised of five home building subsidiaries). Additionally, the activities of the timberland segment which do not qualify for REIT status, such as sales of higher-and-better-use (HBU) lands, mineral income, R&D activities, nurseries/seedling orchards etc. will reside in the TRS. Furthermore, the debt of the company has been assumed by the TRS, which is expected to service the debt and support the dividend in the long term.

WY’s annual dividend, currently $0.20 per share, will increase as the company assumes REIT status. Management will provide guidance for future dividends in December.

Currently, the average dividend yield for the three publicly-traded timber REITs is ~5%. If applied to WY’s share price of ~$17 per share, this translates to a potential annual dividend of $0.85 per share. However, we expect WY’s near-term dividend to be below that level as its Homebuilding and Wood Products manufacturing businesses remain severely impacted by the down housing markets. A dividend of ~$0.50 to $0.60 per share appears feasible given current cash flow levels from timberlands. As a REIT, the company will be required to distribute 90% of its earnings; but the company has some flexibility with its timberland earnings as it can continue to defer harvest or change the harvest mix.

A modest rebound in the housing markets would directly benefit WY. Growing export demand, particularly from China, will support log prices while the shortfall in Canadian harvests due to the Mountain Pine Beetle infestation and rising demand for biofuel remain long-term positives. The company also stands to benefit from the current tax ruling for cellulosic biofuel credits and expects $240 million of potential tax credits in Q4 2010. Thus, we have a positive outlook on the dividend payout, especially in the case of an advanced cyclical recovery.

Timber REITs: RYN and PCL Benefit from Rejection of Florida’s Amendment 4

Earlier this month, Florida voters rejected a constitutional amendment that would have changed the state’s development approval process. “Amendment 4” – sponsored by the non-partisan Florida Hometown Democracy – would have required a voter referendum whenever a local government amended its comprehensive plan.  The amendment would have made the entitlement process in the state more complicated.

The rejection of the amendment favors Rayonier (RYN) and Plum Creek (PCL), which have HBU (“higher-and-better-use”) lands with development potential in the state.  This is especially true for Rayonier, which currently has three major projects in Florida. The company seeks entitlements for 24,000 acres in Nassau County and 6,300 acres in Palm Coast, Florida. Rayonier expects to complete the entitlement process for these lands in the next 2-3 years. In all, Rayonier has identified about 200,000 acres of HBU property in the I-95 coastal corridor between Savannah, Georgia and Dayton Beach, Florida.

Marginally, Plum Creek also benefits from the Amendment 4 rejection. The company owns about 590,000 acres in Florida. However, most of these acres are strategic timberlands and not HBU development properties. In all, Plum Creek has identified 150,000 acres nation-wide (of ~6.9 million acres owned) as having HBU development potential.

Timber REITs Benefit from Cellulosic Biofuel Tax Credit on Black Liquor

Black liquor, a byproduct of the wood pulping process, is an alternative fuel under the IRS Code.  In addition, when black liquor is combined with at least 0.1% diesel fuel, it is eligible for the Alternative Fuel Mixture Credit (AFMC). During 2009, the IRS allowed a $0.50 per gallon tax credit for the alternative fuel mixtures produced and used as a fuel. AFMC expired on December 31, 2009.

This year, in an IRS memo dated June 28, 2010, the IRS concluded that black liquor sold or used in 2009 also qualifies for the Cellulosic Biofuel Producer Credit (CBPC) at $1.01 per gallon. Thus, black liquor potentially qualifies for either AFMC or CBPC (but not both on the same gallon of black liquor), and the IRS has provided instructions which would allow a taxpayer to refund AFMC credits already received and claim the higher CBPC.  Under current law, only qualified fuel produced between January 1, 2009 and December 31, 2012 for use in the U.S. may be eligible for CBPC.

Last year, Weyerhaeuser (WY), which is in the final stages of converting to a REIT, used approximately 688 million gallons of the alternative fuel mixture through December 31, 2009, resulting in $344 million of credits. Additionally, WY produced approximately 238 million gallons of black liquor, which did not qualify for AFMC. The company now expects $240 million of potential CBPC on these gallons in Q4 2010. The company also stated that it is evaluating both credits to determine which credit or mix of credits will be most valuable.

Rayonier (RYN) qualified for tax credits of approximately $215 million in 2009 for AFMC. The company will now file an amended 2009 federal income tax return to claim the cellulosic credit. Rayonier expects to realize the entire cash benefit during 2011 to be a refund of 2009 and 2010 taxes and offsetting 2011 estimated taxes.

Timber ETFs versus Timber REITs: Recent Performance

From the desk of Neena Mishra, Director of Equity Research:

While investing directly in timberlands requires high starting capital, retail investors can choose from other vehicles which provide exposure to timber and forest products such as REITs, related C-Corporations or ETFs (exchange traded funds). The suitability of these vehicles depend on the capital, liquidity and cash flow requirements, as well as the tax situation, of the investor.

Currently, there are two primary ETFs related to timber: Guggenheim Timber Index ETF (CUT, launched in November 2007) and iShares S&P Global Timber and Forestry Index (WOOD, launched in June 2008).

CUT tracks the performance (before Fund’s fees and expenses) of the Beacon Global Timber Index. The Index is designed to track the performance of common stocks of global timber companies. All stocks in the Index are selected from the universe of global timber companies that own or lease timberland and harvest that timber for commercial use and/or sale of lumber, pulp, paper, packaging, and other forest products. The fund currently has 27 securities and a weighted average market capitalization of $3.2 billion. The exposure to U.S. companies is 31.36% currently (as of September 30, 2010).

WOOD tracks the performance (before Fund’s fees and expenses) of the S&P Global Timber and Forestry Index. The Index is comprised of 25 global publicly traded companies that own, manage, or are involved in the “upstream supply chain” of forests and timberlands. The Index constituents may be forest products companies, timber REITs, paper or packaging products companies, or agricultural product companies. As of September 30, 2010, the exposure to domestic companies is 46.42%.

The table below shows the comparative YTD (as of close of November 3, 2010), since 2009 and since 2008 performances of the ETFs versus the FTR Index (Forisk Timber REIT Index, market weighted Index of the three publicly traded timber REITs) and the S&P 500.

Please note: these ETFs do not provide a good proxy for investing directly in timber. In addition to tracking firms that own timberlands, they maintain a substantial exposure to manufacturing companies. Compared with CUT, WOOD has a greater weighting towards domestic producers and contains more pure-play timber names. The difference in the performances as seen in the table stem from differences in exposure to markets (global versus domestic) and sectors.