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» lcha - Too fast - Good ECRI points

From www.thestreet.com in its entirety with good stuff from our ECRI friends

When future historians analyze the causes of the great world recession of 2001-2002, they may point scornfully at our otherwise-enlightened era's ruinous appetite for false beliefs on Wall Street and in Washington.

In the late '90s, investors' false belief that the Web changed everything led to a fantastic misallocation of capital -- and we ended up with too many telecom networks, too many dot-com companies and way too much telecom equipment.

Meanwhile, our government developed a false belief that we could prevent attacks on our transportation and financial infrastructure without spending a dime on new airport, border, military or police security. And down in Texas, small-town energy executives Kenneth Lay and Andrew Fastow developed the false belief they could mix math, mendacity and moxie to build Enron (ENE:NYSE - news - commentary - research - analysis) into a merchant-trading monolith -- and possibly the greatest Ponzi scheme of all time.

The money-vaporizing bankruptcies of companies such as dot-bomb Excite@Home (ATHM:Nasdaq - news - commentary - research - analysis) and gas-bomb Enron that followed weren't just about greed, as bears say. They were events that illuminated how gullible and complacent we had all become. How trusting of celebrity, standing and pedigree. How blindly hopeful that things would just turn out all right.

But often things don't turn out -- and in a moment I'm going to explain why the current rally in the market won't, either. Perhaps the debacles will push U.S. investors to desert that strange financial fantasia where more attention is paid to pronouncements by a corrupt web of Wall Street stock analysts and underwriters than to raw facts and common sense.

Let's look at what facts and common sense suggest for the rest of investors today.

Metrics Don't Look Promising
December dawned with the market at a poorly lit crossroads where traders' enthusiasm over the war on terrorism crashed into fears that the economic recovery might not be on track. For the past two months, stock prices have benefited both from a psychological "defiance dividend" as well as from a perception that recession-battered companies' growth rates will begin to revert early next year to levels of the late '90s.
If you accept the notion that lasting upward moves in stock prices only follow sustainable upward moves in the companies' fundamental prospects -- and that large companies' prospects are closely tied to overall U.S. growth -- then to be bullish today you are making a bet that the economy will rebound strongly in early 2002.

Determining the likelihood of rebound doesn't need to be a gut-level guessing game. Independent economists such as Lakshman Achuthan of the Economic Cycle Research Institute have become good at weighing a variety of metrics to determine the timing of the business cycle.

Achuthan's statement in August that a recession had begun near the end of the first quarter of the year was both contrarian and prophetic, considering that there were many economists at the time claiming that recession was still avoidable. (The National Bureau of Economic Research declared last week that the recession began in March.)

Today Acuthan says facts and figures still line up powerfully against investors' hopes for an early 2002 recovery. In fact, he doesn't see the likelihood of a rebound before July. In an interview Friday, he listed three positives weighing in favor of a recovery and eight against. Here they are:

Positives
Rise in equity values. Stock-market moves are a single imperfect ingredient, not the whole enchilada, in economic forecasts. They do lead economic recoveries, but they can also give many false signals. So while it's important to note that the broad market's powerful move up from the Sept. 21 low provides evidence suggesting that an economic rebound is at hand, it's likewise important to realize that it's only half the story.

The bad news is that most people seem to think that the typical lead is six months, but Achuthan says that 50% of the time since World War II the lead has been four months, 25% of the time it's been five months and 25% of the time it's been three months. So if you believe that the September low was the real thing, then the economic rebound has to start in December, January or February.

Will it? Well, great minds will differ. But the well-regarded National Bureau of Economic Research speculated in its press conference that the recovery would begin in July 2002. If you date the stock recovery back three to five months from then, you would expect a cyclical market low -- that is, prices below the September 2001 low -- between February and April 2002. Achuthan notes that his percentages are facts, not guesses, which encompass all cycles in the postwar era. "It's possible we'll get a longer lead this time," he said, "but given our experience, it's not likely."

Decline in energy prices. Oil and natural-gas prices have declined sharply in the past nine months, giving consumers a big boost in their available funds for spending on stuff that can revive the economy. Enough said.

Explosion in the money supply. Eleven interest-rate cuts since January in the United States and other measures in Europe have flooded the global economy with an unprecedented amount of cheap money. Lower borrowing costs are bound to result in higher business and consumer spending - and whatever's left is almost certainly bound to find its way into stocks and support the market.

Negatives
Initial claims for unemployment insurance. Until last week, the bulls were able to argue that this leading indicator of employment had made a change for the better. But on Thursday the thesis was trashed because initial claims spiked back up. The level of jobless claims has to fall in a persistent way before economists can forecast recovery.
Building permits. The market for housing has been great, but when economists look for turning points, they turn to the building permits report. Despite a surprising rise in new-home sales, permits -- especially for multifamily housing -- have been slipping since the start of 2001. In the past few months, they have accelerated in the wrong direction. The number needs to first stop falling, and then rise, to provide a signal that an economic recovery is imminent.

Commodity prices. The JOC-ECRI Industrial Price Index -- made up of 18 components divided into energy, metals, textiles and miscellaneous (e.g. hides, tallow and plywood) -- is resting at multidecade lows. If a nascent recovery were at hand, there should be enough demand to cause a rise in commodity prices. A couple of individual commodity prices have risen lately -- copper's an example -- but turning points are made when the whole slate of commodities rises together. The global recession has pushed the price of rubber to a 30-year low, in spite of the rise in U.S. auto sales thanks to 0% financing. Achuthan says he would like to see a pronounced, pervasive and persistent move up in the index before using it to forecast a recovery.

Bond quality spreads. Just before recoveries, the price differential between junk bonds and investment-grade bonds -- e.g., between bonds rated BBB and AAA -- sharply narrows. Currently the spread is relatively wide. Thus bond buyers are not exhibiting the sort of optimism seen in the stock market.

Vendor performance. Achuthan looks closely at several of the answers given by respondents to the National Association of Purchasing Management (NAPM) survey each month. Response to whether "vendor performance" is high or low has been one of the most prophetic in the past. He's a contrarian on this one, because if performance is high, then there's not enough demand. He wants to hear that things are being delivered slowly. "If this deteriorates a bit, then vendors are busy -- and that's a very good sign," the economist said.

New factory orders. The "new order" series in the NAPM report plunged to a two-decade low in November. This can be a noisy number, with a single big Pentagon order distorting results. But if you strip defense out of new orders and compare November to a preattack month like August, Achuthan said, you see that the indicator does not forecast an imminent recovery.

Price to unit labor cost. This is a fancy measure of profitability, and Achuthan pronounces it "really ugly" at this time. It's almost impossible now for companies to raise prices, and, in a period of diminished sales, that means that profits get hit. When you consider that profits are required to fund corporate investment, you have a real problem with the business side of the recovery. Firms are trying to cut costs by firing record numbers of employees, but at this point in the cycle, layoffs can cost more in severance and other expenses than they actually save.

Synchronous global recession. Very often there are pockets of strength abroad to offset the weakness in the United States. In the 1991 U.S. recession, for instance, both Europe and Asia were still expanding. But right now big multinationals such as General Motors (GM:NYSE - news - commentary - research - analysis) aren't making money anywhere -- something that hasn't happened in 25 years. German economists just announced that their economy had slid into a contraction, and Japan might be on the verge of its worst recession in a whole decade of financial capitulation.

In short, Achuthan warns that stocks may have once again forecast a "false dawn." He knows, and I know, and you know, that eventually the United States and the world will experience a full and complete economic recovery. But it is critical for investors to think for themselves and get the timing right -- and not to simply hope that the market has gotten the timing right.

So let's end with some math. In the spring, it turned out that a 1948-point move in the Dow industrials from the low of March 22 to the high of May 21 incorrectly forecast an autumn recovery -- and the Dow went on to plunge 3102 points before turning around on Sept. 21. If the same script were run from current levels, the Dow would retrace back to the 6750 area -- exactly its 10-year moving average, last visited in March 1997.

I don't think that's likely to happen -- it's simply not the right time of year for a decline, and this market has been an absolute Sir Edmund Hillary when it comes to climbing the wall of worry. At worst, it's fair to expect a return of the September lows by February. But you never know.

-- posted by lcha

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» Rande - Re: Too fast - Good ECRI points

In response to message posted by lcha:

Historically, the market has discounted economic activity 6-9 months in advance. That would be somewhere between Oct. of this year and Jan. of next, given the more "pessimistic" view that recovery is put off until July of next year. Right about where we are now.

-- posted by Rande

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» lcha - Re: Re: Too fast - Good ECRI points

In response to message posted by Rande:

The bad news is that most people seem to think that the typical lead is six months, but Achuthan says that 50% of the time since World War II the lead has been four months, 25% of the time it's been five months and 25% of the time it's been three months. So if you believe that the September low was the real thing, then the economic rebound has to start in December, January or February.

Rande,
Are these facts that Mr. Achuthan suggest not accurate to your knowlegde?

-- posted by lcha

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» Rande - Re: Re: Re: Too fast - Good ECRI points

In response to message posted by lcha:

Icha,

A longer period of data suggests otherwise. Don't forget too that the "market" includes both stocks and bonds. Historically, a normal yield curve (which we have had for some time now) anticipates economic recovery approx. 6-9 months in advance as well, just as an inverted curve anticipates economic downturn. I'd tend to trust the yield curve even more than the stock market, but taken together they do make a case. Not always accurate, to be sure, but the bottom line is that the markets themselves are by far the best indicator we've got. Not something I'd be inclined to take any action on, assuming an appropriate asset allocation and long-term time horizon, but given a choice between trusting the markets themselves or the "dismal science" I'd say it's a no-brainer.

Newsday (New York, NY) November 20, 2001 Tuesday

"The stock markets forecast what the economy will be doing six to nine months down the road," said Albert Fredman, a finance professor at California State University's Fullerton campus. "What they are saying now is that sometime in 2002, we will have better times. ... People should be encouraged by this stock market rally."

-- posted by Rande

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» ACousins - Fed model

From RM

Justin Lahart
Fun with models
12/07/01 2:45 PM ET
Prompted by Aaron I took a look at what the S&P would have to earn over the next four quarters to be fairly valued by the so-called Fed model. 59 bucks. First call bottom-up consensus (which, since it comes from company analysts might be optimistic) is 51.64.

At month-ago levels on the Treasury and the S&P, the S&P would have had to earn 46.75.

I'm not a huge fan of the simplified Fed model (and I doubt the Fed is, either), but I do think that bond yields and earnings expectations have something to do with appropriate valuation.

Interesting if the Fed lowers another 25 bp, it could take MMF returns down to around 1%. Then again if longterm rates go up, people won't be able to pull money out of reduced mortgages.

Then again this is a circuitous and dizzying argument.

-- posted by ACousins

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» mdorsey - Another bubble?-Blame the Editors

By Robert J. Samuelson
Wednesday, December 5, 2001; Page A29

The American economy has officially entered what promises to be the worst recession since the early 1980s and, conceivably, the worst since World War II. But you'd hardly know from the media, which have treated the economic story as a sideshow. To take one example: When the National Bureau of Economic Research -- the academic group that designates business cycles -- declared the recession last week, the New York Times didn't even put the story on Page 1. The indifference stems mainly from the obsession with terrorism and a belief (shared by many economists) that the slump will be brief and mild. But there's also another cause: Wall Street.

On the economic story, editors have subconsciously delegated their jobs to Wall Street. "NBER Sees Recession; the Markets See Recovery," is the title of a recent report by stock strategist Peter Canelo of Morgan Stanley. Editors have adopted that view. Since Sept. 11, major stock indexes have recovered smartly. As of yesterday, the Dow Jones Industrial Average was up 20 percent from its post-Sept. 11 low and was 3 percent above its close on Sept. 10. The story is similar for the Standard & Poor's 500. Having contributed to the last decade's stock mania, the media remain -- at heart -- believers. If the market signals recovery, it must be.

Maybe not. The stock market's record as a "leading indicator" is spotty. Meanwhile, the "real" economy of jobs and production counsels caution. Europe, Japan and the United States are all in slumps. In October, Japan's industrial production was off almost 12 percent from a year ago and was at its lowest level since 1988. Europe's gross domestic product advanced at a meager rate of 0.2 percent in the third quarter. As for the United States, here's a sample of recent bleak reports:

• The Conference Board's index of help-wanted ads dropped in October to its lowest point in 37 years

• Continuing claims for unemployment insurance rose to 4.02 million, the highest level in 19 years.

• The decline in third-quarter GDP was revised to 1.1 percent (at annual rate) from 0.4 percent.

Even some indicators that suggest recovery turn out, on inspection, to be less hopeful. In October consumer spending rose a hefty 2.9 percent, more than offsetting September's 1.7 percent decline. But much of the increase reflected purchases of cars and trucks, buoyed by zero percent loans. The buying surge is surely temporary. In fact, consumers' disposable income declined in September (-1.2 percent) and October (-1.7 percent). Can spending rise if incomes fall? Not likely.

"We're just at the start of the consumption side of the recession," says economist John Makin of the American Enterprise Institute. There's a new worry. Most post-World War II recessions began with declining consumption. By contrast, this one started with lower corporate investment: the result of excess spending on the Internet and communications networks. Consumer buying kept rising -- though at a slower pace -- and sustained overall growth. If consumers now retreat, the recession will deepen.

http://www.washingtonpost.com/wp-dyn/art...

-- posted by mdorsey

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» Rande - The stock market did a pretty good job of forecasting the curren

The stock market did a pretty good job of forecasting the current recession. While folks are looking back 8 or 9 months to say the recession started in March of this year, the market was looking ahead (right in that old 6-9 month range) when it began to roll over in earnest back in the Fall of 2000. Does the market always get it right? Of course not. But put together half a dozen economists and you'll get at least a dozen opinions on where things are headed. Real-world markets trump individual guesswork and/or ivory tower prognostication (probably why Rubin made such a good Treasury Secretary). Greenspan is a good example. If he had been paying better attention to the bond market and commodity prices instead of whatever esoteric "indicators" he likes to use, he might not have raised rates so much in the first place and certainly would have been quicker to ease.

-- posted by Rande

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» Rande - The Latest -- 12/7/01

Another good week. R2000 and MDY approaching positive territory for the year (MDY now up 15.6% and "balanced" up fractionally since 12/31/99). Here's....

The Latest (as of 12/7 close):

YTD 2001:

DJIA -6.8%
S&P -12.3%
SPY -10.6%
VTSMX (W5000 Index Fund) -10.8%
Nas -18.2%
QQQ -28.5%
R2000 -0.5%
MDY (S&P 400 Midcap) -1.4%
VEURX (European Index Fund) -20.4%

Since 12/31/99:

DJIA -12.6%
S&P -21.2%
SPY -18.9%
VTSMX -20.0%
Nas -50.3%
QQQ -54.3%
R2000 -4.7%
MDY +15.6%
VEURX -26.6%
50/50 Total Stock/Total Bond +0.2%
(includes Total Bond through yesterday)

Since Previous Closing Lows:

DJIA (9/21/01) +22.0%
S&P (9/21/01) +19.9%
SPY (9/21/01) +20.2%
W5000 Fund (9/21/01) +21.4%
Nas (9/21/01) +42.0%
QQQ (9/21/01) +48.0%
R2000 (9/21/01) +27.0%
MDY (9/21/00) +24.5%
VEURX (9/21/01) +22.8%

Since Previous Closing Highs:

DJIA (1/14/00) -14.3%
S&P (3/24/00) -24.2%
SPY (3/24/00) -22.5%
VTSMX (3/24/00) -25.3%
Nas (3/10/00; ) -60.0%
QQQ (3/24/00) -64.6%
R2000 (3/9/00) -20.6%
MDY (9/7/00) -7.5%
VEURX (3/24/00) -29.1%
___________________________

Previous Closing Highs

DJIA 11722.98 (1/14/00)
S&P 1527.46 (3/24/00) [back to 1530.09 intraday on 9/1/00]
SPY 153.56 (3/24/00) [back to 153.5938 intraday on 9/1/00]
VTSMX 35.58 (3/24/00)
Nas 5048.62 (3/10/00)
QQQ 117.75 (3/24/00)
R2000 606.05 (3/09/00)
MDY 101.4525 (9/7/00)
VEURX 29.85 (3/24/00)

Benchmark Closing Lows (lows since previous all-time highs):

DJIA 8235.81 (9/21/01)
S&P 965.80 (9/21/01)
SPY 97.28 (9/21/01)
VTSMX 21.40 (9/21/01)
Nas 1423.19 (9/21/01) (intra low -- 1387.06 on 9/21/01)
QQQ 28.19 (9/21/01) (intra low -- 27.20 on 9/21/01)
R2000 378.89 (9/21/01)
MDY 74.45 (9/21/01)
VEURX 16.85 (9/21/01)

Market Cycle Peak to Trough:

DJIA (1/14/00 - 9/21/01) -29.8%
S&P (3/24/00 - 9/21/01) -36.8%
SPY (3/24/00 - 9/21/01) -35.3%
VTSMX (3/24/00 - 9/21/01) -38.2
Nas (3/10/00 - 9/21/01) -71.8%
QQQ (3/24/00 - 9/21/01) -76.1%
___________________________

Index returns are price change only, ETFs and mutual funds including divs/distributions. Returns not guaranteed as to accuracy -- relying on unaudited third-party sources (may have missed a dividend or two, which would understate returns). Returns rounded.

-- posted by Rande

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» JenL_2 - Re: The Latest -- 12/7/01

In response to message posted by Rande:

To illustrate:

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
VTSMX, VFINX, VEXMX Comparison 5 YR Chart

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
3 YR Chart

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
1 YR Chart

<img src="http://pvcharts.quicken.com/bin/icenter...." width=470 height=250>
YTD Chart

…..Jen

-- posted by JenL_2

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» JenL_2 - Timber Company REITs?

To continue our discussion on Lumber & Paper Sector on the other thread. This from 12/10 Barron's:

---

No Pulp Fiction

Rayonier's shares look cheap, especially if the company can realize its timber values

By Sandra Ward

Rayonier (RYN) is about as solid a company you can find. Its business is wood: making pulp and specialty fibers out of wood, and especially growing wood. Top management, led by Chief Executive W. Lee Nutter, commands respect not only for its experience -- he's been at Rayonier for 34 years and his two key lieutenants have been with the company for a combined half century -- but for its ability to innovate and provide decent returns, even when times get tough.

"Shareholder friendly" also aptly describes management. Based in Jacksonville, Florida, since last year's move from Stamford, Connecticut, Rayonier has increased its dividend and bought back stock each year since it was spun off from the former ITT in 1994. At the same time, the company has met its promise of two years ago to cut its debt. What's more, last year, the company realigned its businesses to focus on its two most important segments, performance fibers and timberland management, in an effort to boost return on capital and its share price.

"Stockholders are paying us always to see what we can do to improve returns," the blunt, straight-talking 57-year-old Nutter tells Barron's.

Still, Rayonier's business is beholden to swings in the commodity cycle and like the rest of the forest-products industry, it tends to be penalized during periods of overcapacity and weak prices, such as during the past five years. Rayonier's third-quarter earnings attest to that vulnerability: down by half to $6 million, or 22 cents a share, on sales of $275 million versus $12.1 million, or 44 cents a share on sales of $270 million in the year ago period.

But the steadiness of its timber management business has helped shore up Rayonier's share price. Sales were higher in the most recent quarter partly because of land sales. The company predicted fourth-quarter results would likely resemble those of the previous quarter, "although land sales currently in negotiations could provide some upside."

Offsetting the cyclical softness in the pulp business has been a push to boost Rayonier's high-end specialty cellulose fiber sales (which represent 60% of the performance-fiber segment of the company) where pricing is stronger and more stable. Rayonier currently commands about 50% of the specialty market in which its cellulose fibers are used in products ranging from toothpaste to explosives to cigarette filters to high-performance racing tires.

At 46, Rayonier shares trade at 21 times the $2.17 consensus 2002 earnings forecast from Thomson Financial/First Call, which would be up from an estimated $2.00 this year, a slight premium to other forest products companies. A 3.1% dividend yield also helps bolster the stock price.

The thinly traded shares have gained 17% this year as investors have become more optimistic about the outlook for forest-product companies in particular. Pulp prices appear to have touched bottom, and a turn in the cycle seems under way. That should translate into better operating industry earnings in the next few years. U.S. plant closings and consolidation have permanently reduced industry capacity, so any increased demand should lead to strong gains in prices.

Already a dominant player in the specialty cellulose-fiber market, Rayonier is seeing additional strength in that business because of uncertainty surrounding other players, says Nutter, referring to a cellulose fiber mill that International Paper has on the shopping block. (Rayonier is prevented from buying it because of antitrust concerns.) A weaker U.S. dollar also would benefit Rayonier because about half its sales are from overseas.

Nutter won't make predictions about the economy or Rayonier's business prospects, but says, "there's more upside than downside" on the horizon. Right now, there's no plan to raise prices, though "as the general industry improves, that's a prospect." Instead, Rayonier has focused on adding customers that represent bigger volumes and lower delivery costs.

But it's the company's trees in the Northwest, the Southeast and New Zealand that get people really interested in Rayonier. Investors took notice two years ago when it snagged a million acres of timber properties from Smurfit-Stone Container (SSCC) at what was seen as a bargain price of $750 million. While Rayonier's 2.4 million acres rank it sixth in terms of overall landholdings among forest products companies, it is considered the second-largest pure play on timber because timber represents such a big portion of its overall business mix.

The leader is Plum Creek Timber (PCL) with its vast 7.9 million acres. And using cash flow as a barometer of value -- a method preferred by investors -- Rayonier looks like a steal. Plum Creek Timber trades at 12.6 times cash flow and paid 9-to-10 times cash flow when it bought Timber Co., which was spun out of Georgia-Pacific in 1997 in a move to realize the value of its timber assets. By contrast, Rayonier trades at five times cash flow.

Lately, timber as an asset class has attracted renewed investor interest because over the long haul it has delivered returns in excess of the S&P 500. Those returns have been negatively correlated to equities, making timber an attractive portfolio diversifier. The price of timber, a steadily appreciating natural resource, has risen in the past three great bear markets.

Veteran money manager Jean-Marie Eveillard of Arnhold and S. Bleichroeder is a believer in timber and in Rayonier. Funds he steers for Bleichroeder are the second biggest shareholder of Rayonier. Southeastern Asset Management, a Memphis firm led by Mason Hawkins, another redoubtable investor partial to timber assets and a stickler for buying good businesses on the cheap, is the biggest holder. As Eveillard sees it, "you're getting an attractive commodity at a 40% discount." Based on the value of its timber, he figures Rayonier is worth $70-$75 a share.
0
Looked at another way, if Rayonier sold its 2.4 million acres for an average $1,000 an acre, it would just about match the enterprise value (market value plus net debt) of the entire company, notes Chris Gillespie, an analyst at Schneider Capital Management in Wayne, Pennsylvania. By his reckoning, investors are getting Rayonier's underlying business free.

Rayonier has often expressed frustration that its timber value isn't reflected in its share price. In the chairman's letter to shareholders this year, the company's 75th anniversary, Nutter griped about that and said the company values it at about $2.4 billion, or $33 a share, after taxes and debt.

What's piqued investor interest in Rayonier recently is a series of Internal Revenue Service decisions this year that related to Plum Creek's acquisition of Timber Co. that cleared the way for the deal to be completed in late October, more than a year after it was announced.

As some investors see it, those decisions could allow Rayonier (as well as other forest products companies) to unlock the value of its land holdings. The IRS actions might also have a profound impact on the way all corporations with major real-estate holdings structure those holdings, though that is a hotly debated topic among tax experts and real- estate investment trust specialists.

"What Plum Creek and Timber Co. did was blaze a trail for Rayonier to become a real-estate investment trust," says Richard Holohan, a forest products analyst at Salomon Smith Barney. "The trail blazed is a good one. They [Rayonier] have to look at it more closely. It's too compelling."

It is compelling from a tax standpoint. Under a REIT structure, virtually all earnings are passed through directly to investors as dividends without being taxed. From a competitive standpoint, Plum Creek Timber, because it is a REIT and shielded from corporate taxes, will have an advantage when it comes to bidding on properties.

Indeed, it's a compelling enough strategy that Rayonier has already considered it. It explored forming a timberland REIT a year ago but a weak stock market and high interest rates discouraged further pursuit of such a plan because the company worried the gains wouldn't offset the economic penalties associated with the restructuring. Management suggested then that it would reexamine the idea should conditions change.

In the meantime, Rayonier adopted a program in which it sells 2%-4% of its land holdings a year on the open market to the highest bidder to capture some of the value imbedded in its timber operations. And it sells all the timber it harvests on the open market.

Now, however, not only have economic conditions changed, but Plum Creek's acquisition of Timber Co. seems to have settled some of the regulatory sticking points surrounding such a move; that alone might inspire others to take the same route.

"We've taken some hard looks at it and will continue to do so," says Nutter, about converting its timberland operations to a REIT, but adds "there are still some very major issues" that remain.

Chief among those concerns are tax considerations, but also high on the list is the balance-sheet issue of where to place the debt that might be associated with such a restructuring. There's also the question of whether the performance-fiber operation is big enough to operate on a stand-alone basis. Expanding it through acquisitions would be desirable but difficult because it already is a dominant player in many of its markets. Its leading market share also could complicate a possible sale of the business.

While not convinced the Plum Creek Timber deal is the trailblazer some are making it out to be, Nutter admits that "the ideal situation, if we can work our way through the tax and financial entanglements, is to go to a REIT." Above all, he says, "you have to convince yourself you've added value to your shareholders." At the moment, Rayonier is working "to reduce debt to a level that puts us in a position to look at major alternatives," Nutter adds.

The difference this year in the discussion of converting timberland operations into a REIT format was Plum Creek and Timber Co.'s decision in June to move forward boldly with merger plans announced in 2000, despite failing to obtain a customary "private-letter ruling" from the IRS that would have sanctioned the tax-free status of the transaction. The companies took the advice of tax counsel provided by the law firms of Skadden, Arps, Slate, Meagher & Flom and McDermott, Will & Emery. They also bought $500 million of tax-liability insurance, paying a $25 million premium, as protection in the event their decision was challenged.

Their transaction was complicated because of its "spin-and-merger" nature: Georgia-Pacific spun off Timber Co. as a standard operating company, which was then merged into a REIT, which receives very different tax treatment from that of a standard company. The companies met most of the criteria required by the IRS for approval, yet they failed to convince the agency that the conversion was necessary for the business purpose of acquiring Timber Co. Instead, the IRS held the view that the primary purpose of the deal was tax avoidance and declined to issue a ruling.

Nonetheless, other rulings issued by the IRS in association with the case were seen as critically important and very favorable for future cases seeking tax-free treatment of a spinoff.

One ruling in particular resolved a longstanding ambiguity about the way REITs were treated. IRS rules dating to 1973 determined REITs were not active businesses but rather passive sources of income. Under the Tax Reform Act of 1986, the rules were relaxed so that REITs could be seen as actively engaged in conducting businesses. In order for a spinoff to receive tax-free treatment, companies must qualify as active businesses. Finally, 15 years after the 1986 Tax Reform Act, as a result of Plum Creek Timber's application, the IRS concluded that REITs qualify as active businesses and so may qualify for tax-free status under the spinoff rules.

Another tricky question arising out of the transaction -- one almost equally important as the "active-business requirement" -- was whether the cutting of timber constituted a disposal of assets, which would then force Plum Creek to pay a corporate tax on the built-in gains associated with the disposition of assets, even though as a REIT it would normally be exempt from corporate taxes.

Again, a favorable decision was reached and Plum Creek was not required to pay such a tax. (As a result, too, Plum Creek's purchase of Timber Co. looks even more attractive because the deal was priced on the assumption that the tax would have to be paid.)

"The combination of the two rulings makes Rayonier a compelling story," says Robert Willens, a tax accounting specialist at Lehman Brothers.

Compelling though it may be, the fact the IRS didn't give its full blessing to the Plum Creek Timber pact injects some uncertainty into the outlook for future such deals. Yet, some point to the low insurance premium Plum Creek paid to protect it against any tax liabilities that might stem from its decision to move ahead with the Timber Co. acquisition as a reason to be encouraged that other such transactions will transpire.

Knock on wood, Rayonier will do what's right for shareholders.

The REIT Way to Cut Corporate Taxes

Despite a wall of skepticism surrounding the issue, one of Wall Street's best-known tax authorities, Robert Willens of Lehman Brothers, can barely contain his enthusiasm for decisions related to the merger of Plum Creek and Timber Co., and the precedent they might set for for a new wave of corporate restructuring.

"I feel they are critically important rulings that open the door for a lot of corporate financing activity," he exhorts, referring to decisions by the Internal Revenue Service in connection with Georgia-Pacific's spin-off of Timber Co. and Timber Co.'s subsequent conversion to a real-estate investment trust and merger with Plum Creek, also a REIT. "For anybody with a lot of real estate, this is the thing to do."

While the IRS didn't completely sanction the tax-free status of the transaction, because it didn't accept the deal was done for an authentic business purpose and viewed the motivation for Timber Co.'s conversion to a REIT as merely one of tax avoidance, it did however revise a former ruling under which it now accepts REITs as active businesses for purposes of a spinoff. In good news specifically for timber companies that may be contemplating a similar move to that of the Timber Co., the IRS also ruled the cutting of timber isn't a disposition of assets and so isn't subject to a built-in gains tax.

Willens argues that not only would companies with extensive timber operations, such as Rayonier, Weyerhaeuser (WY) and International Paper (IP), benefit from converting their land holdings into a REIT format , but retailers such as Sears, Roebuck, Wal-Mart Stores, J.C. Penney and even McDonald's would unlock a tremendous storehouse of value for their shareholders. "They'd be converting tax payments to Uncle Sam into dividends for shareholders," he says. By leasing properties it used to own from a newly established REIT, the corporation could deduct the lease payment from its taxes and the REIT pays out the income it receives from the lease directly to its shareholders without the IRS taking its cut. (The REIT shareholders still would be liable for taxes.)

Moreover, corporations would see their financial profiles enhanced by converting real-estate holdings to a REIT structure. In an extensive report on the subject written this past summer, Willens notes: "The separation, from a corporation's operating business, of its real estate, will dramatically improve the corporation's financial profile: The corporation's asset base will be drastically reduced and, as a result, certain key financial ratios, such as return on equity and return on assets, will be correspondingly enhanced. This, in turn, should enable the parent to trade at a higher multiple of earnings (its P/E ratio should benefit) and, as a result, an equity offering, for the purpose of expanding the business, would be facilitated. In addition, because real estate is generally debt-financed, and such real estate will now, along with the accompanying indebtedness, be lodged in a separate entity, the operating company's 'leverage ratios' will improve and, therefore, new borrowings it seeks to undertake, again for the purpose of financing expansion, should be more readily available."

It's along these lines that Willens believes other companies can make a persuasive case to the IRS that there are sound business motives for pursuing a REIT format, a case that Plum Creek failed to make. He points to the agency's own regulations in which it lists any number of business purposes that should generally result in a favorable ruling. Among those purposes are facilitating an equity offering or a borrowing.

The biggest challenge corporations will face in pursuing this strategy, he believes, is in satisfying the requirement that a converting company must purge itself of all retained earnings accumulated in its non-REIT years by paying a special dividend. But that is not as daunting as it appears, and there are numerous ways to defray the distribution, Willens insists.

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.....Jen

-- posted by JenL_2

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