Last month, bankrupt Smurfit-Stone announced it was done in Montana. However, a more-important news item passed with little notice the next day. On Dec. 15, Weyerhaeuser’s board of directors “determined that conversion to a real estate investment trust (REIT) would best support the company’s strategic direction.” CFO.com reports the conversion should occur by Dec. 31, 2010.
In other words, the transformation pioneered by Montana’s very own Plum Creek will be complete. With Weyerhaeuser’s conversion, America’s last major integrated timber company, the biggest, baddest timber beast of them all, will be no more.
Now, Weyerhaeuser liked being a timber beast, but Congress and Wall Street left it no choice. While the REIT conversion process is complex, the bottom-line math is simple and brutal: Integrated manufacturers pay a corporate tax rate of 35 percent on net income, and stockholders are further hit with capital gains. But a REIT pays no corporate income tax. Instead, the income is “distributed” to shareholders who pay the lower gains rate of 15 percent.
On $100 in an integrated company that nets $10, you’ll net about $5.52 after taxes. On $100 in an otherwise-identical REIT, you’ll net around $7.65, much better.
The flip side of this bargain is that the IRS’s cut shrinks from $4.48 to $1.35, a tax loophole so vast, the timber industry threw millions of acres and hundreds of mills through it. How did Congress respond? They gave Weyerhaeuser $172 million in tax breaks in 2008, lowering its tax rate to match that for its REIT competition, in essence a bribe not to become a REIT. Worked well, didn’t it?
Weyerhaeuser spent 2009 shifting its mills into “taxable REIT subsidiaries” or selling them. The sales have generated $6-billion-plus in retained earnings which Weyerhaeuser must now clear off the books, distributing it to its shareholders, most likely in the form of stock. The money came mostly from a 114-facility deal with International Paper – a former integrated that was spun away from its land base. Helping IP swing the deal is, according to the blog Dead Tree Edition, $2 billion of “black liquor” tax credits from taxpayers. Incidentally, Reason reports Stone scored $500 million.
Current shareholders will get that stock, and because the effective rate of return on each dollar of REIT stock value will go up 38 percent, each share will be worth at least that much more than integrated stock. Weyerhaeuser stock was trading at under 20 bucks a share in March. As I write this, it’s $44 and climbing.
Clearly, despite being last in line, going REIT will be good for Weyerhaeuser stockholders. What about for everyone else? Or for the forests?
Well, integrateds used to make money either by buying cheap wood or growing their own “free” wood, then efficiently milling it into finished products. They made money primarily from manufacturing.
But for REITs, manufacturing is a sideshow. Federal law mandates that manufacturing assets held in a “TRS” can only be 25 percent of total holdings and can only produce 20 percent of total earnings.
REITs can, and do, sidestep the manufacturing earnings limit by shifting costs internally. Milling must still be efficient, but if the REIT-owned TRS buys wood from the REIT at a premium price, the premium goes straight into REIT profit at a lower tax rate. Most if not all profit therefore comes from selling wood off the real estate for milling, or, if the profit from land sales is higher, by selling the dirt – preferably after cutting as many trees as possible.
What’s the bottom line? Crosscut.com nailed it: “forests are no longer about timber; they’re about harvesting tax-advantaged money.” Giant chunks of what we used to think of as the forest-products sector no longer focus on making forest products. They are focused strictly on making money; as much as possible in the most tax-favorable way in the shortest possible time.
America’s timber beasts aren’t dead. All of them, from Plum Creek to Mead to Longfibre to Potlatch and Weyerhaeuser have simply evolved … into money beasts. They still roam the forests, and they’re hungrier than ever, for your money. I’ll explain how next time.