Description

I believe Rayonier (NYSE: RYN) presents an attractive risk/reward investment. This is a $2bn mkt cap asset-rich company with substantial downside protection, a near-term catalyst that drives a 20-30% total return, and potentially much greater returns over a longer horizon.

This is not a micro-cap, absurdly cheap, 2x potential return idea often found on this site, but rather a reasonably liquid, special situation/catalyst-driven idea with adequate upside and far less risk (size positions accordingly). RYN should be particularly attractive to those who think that stock market valuations are a bit rich and are looking for investments with defensive characteristics (Jeremy Grantham fans take note).

Full disclosure: I currently have a long position in RYN.


BUSINESS DESCRIPTION:

RYN is a forest products company that a) owns 1.8m acres of timber land (plus long-term leases on 0.3m acres) and b) owns two performance fiber mills.

Owned timber land:
1,397k acres in the Southeast US
375k acres in the Northwest US
77k acres in New Zealand

In addition, it has long-term leases (with rights to grow and harvest timber) on:
260k acres in the Southeast US
42k acres in New Zealand

RYN grows and harvests timber on these lands and sells to lumber and pulp mills. I believe timber lands are attractive, defensive assets that historically have shown steady price appreciation due to their scarcity and regenerative nature. Since 1987, returns on managed timber assets (income plus capital appreciation) have averaged 15% per year. For more thoughts on timberland returns, here’s a couple links:

http://www.ncreif.com/indices/timberland.phtml?type=total
http://www.smartmoney.com/barrons/index.cfm?story=20031103


The performance fibers division consists of two product lines:

a) Cellulose specialties – these can be broadly described as specialty chemicals made with wood/pulp feedstocks. End uses vary, but include textiles, packaging, plastics, cigarette filters. Cellulose specialties are pretty high value-added products with pretty stable selling prices ($850-950/ton over a cycle).

b) Absorbent materials – this are “fluff” fibers used for diapers, feminine hygiene products, etc. Absorbent materials are more of a commodity vs the cellulose specialties and thus have more cyclical characteristics ($525-700/ton).

In addition, RYN has a MDF facility and log-trading operations, but since these operations are small relative to the overall company and operate at a small loss, I will ignore them for this write-up.


ASSET VALUE / DOWNSIDE PROTECTION

I believe a “break-up” analysis supports a share price of $45. I do not expect this to happen, and is not the basis of the investment thesis, but am showing this to illustrate the asset value and downside protection inherent in this investment. Per/acre prices are based on transaction comps for timber land purchases from 1990-2003.

Southeast US timberlands (1.397m acres @ $1,000) = $1,397 mm
Northeast US timberlands (0.375m acres @ $1,600) = $600 mm
New Zealand timberlands (0.077m acres @ $1,000) = $77 mm
Leased timberlands (0.302m acres @ $200) = $60 mm
Higher and better use land (266 acres @ $500) = $133 mm
Specialty pulp mills (avg cycle EBITDA of $80m x 6x) = $480 mm

Total Asset Value = $2,747 mm
Less: net debt ($534)

Equity Value = $2,213 = $45 per share


REIT CONVERSION

The value creating catalyst was the August announcement that they are converting to a REIT. The conversion is expected to be completed by 1/1/04. In connection with the conversion, the company is disgorging its cumulative earnings and profits of $305m in a special dividend to be paid on 12/19. Pro forma for this distribution, the company will have 48.9m shares outstanding.

The REIT structure is a highly efficient structure for the company as it will reduce their corporate tax rate from the high 20%s to close to 5% by my estimate. The company is converting into a REIT structure and placing its non-qualifying manufacturing assets into a taxable REIT subsidiary (TRS). Based on some assumptions of how they allocate the interest and corporate expenses to the taxable and non-taxable entities, I derive a roughly 5% effective tax rate for the combined entity.

The company has indicated that the estimated first year dividend is $110, or $2.25 per share. At its current price, the implied yield is 6%, in-line with where REITs generally yield in today’s market. However, RYN should trade at a tighter yield than property REITs given the tax-efficiency of dividends from timber REITs vs property REITs. There is only one publicly traded timber REIT currently – Plumb Creek Timber (NYSE: PCL). PCL currently trades at $29 and has an indicated dividend $1.40, or a 4.8% yield.

Dividends from property REITs did not get any relief from recent changes in dividend taxation and thus are taxed at ordinary income (35% rate). However, timber REIT dividends are more tax efficient as cash generated from harvest of timberlands are treated as capital gains (15% rate) and distributions in excess of earnings are treated as a return of basis (no current taxation, but reduce basis when stock is eventually sold). I expect that 50% of the dividend will be treated as capital gains and 50% will be treated as a return of basis, so the effective tax rate on RYN’s dividend will be about 8%. By comparison, the effective tax rate on PCL’s dividend is about 12% (80% capital gains, 20% return of capital). So although timber REITs trade “tighter” than property REITs on a pre-tax basis, their after-tax yields are roughly equivalent.

P-tax Yield Tax Rate A-tax Yield
“Typical” Prop. REIT 6.0% 35% 3.9%
PCL 4.8% 12% 4.2%



TARGET PRICE

Assuming RYN will demand a yield premium given PCL’s longer history as a REIT and its larger market cap, I use a 5.0% pre-tax yield (4.6% after-tax), to get to a target price of $45 ($2.25 / 5%).

If you assume RYN trades to the same 4.2% after-tax yield as PCL, RYN would yield 4.5% on a pre-tax basis, and the price target would be $50.

Adding in a 6% dividend yield results in a total return of 22-35%, depending on where RYN trades compared to PCL.

One reason why I think RYN’s yield should converge with PCL’s is the different ownership bases that companies currently have. Given the tax-efficient dividends, timber REITs are particularly attractive for taxable retail investors. PCL’s ownership is 56% retail. RYN’s ownership today is only 16% retail.


UPSIDE (LONGER TERM)

I believe RYN management team has set the initial dividend yield at a conservative level and would expect it to increase over time.

Looking at historical cash flows, the company more than covers its indicated dividend level of $110m.

2000 2001 2002 LTM 9/03
Operating CF $287 $231 $253 $222
Maint CapEx $66 $61 $66 $63
Free Cash Flow $221 $170 $187 $158
+est REIT tax savings $26 $21 $10 $7
Pro Forma FCF $246 $191 $197 $165
Dividend cover ($110m) 2.2x 1.7x 1.8x 1.5x

Recent operations have been depressed (note decreasing FCF and dividend coverage ratios). However, I believe these issues are cyclical and “normalized” annual cash flows are north of $200m per year, implying a roughly 2x dividend coverage.

The cellulose specialties business generated about $35m in EBIT in 2002, far below peak levels ($103m in 1995 and $83m in 2000) and below the 1991-2002 average EBIT of $49m. Near-term prospects for this business look reasonably positive as Int’l Paper closed a competing mill during the summer and the company should see improved pricing in 2004 as contracts are re-priced.

In addition, timber prices are currently being impacted by weak timber prices – partly due to a on-going trade dispute that has resulting in excess lumber supply coming from Canada. Thus, the last couple years of earnings from timber harvests are also below long-term averages (2000 appears to be close to an average year).

I believe management has intentionally set the initial dividend level low as it wants to increase it over time, and wants to make sure it is at a sustainable level even in poor environments (as we’re seeing today). Note that PCL was forced to cut its dividend in mid-2002 due to the weak environment and RYN management seems to have learned this lesson.

Assuming an improving environment and/or greater comfort level from management, it is quite possible to see the dividend increasing to $2.70 over the next two years. At a $2.70 dividend the company would still have >1.5x dividend coverage based on normalized earnings. Assuming a 5% pre-tax yield results in a target price of $54. Adding in 6% annualized dividends results in a 51% total return or 23% annualized returns over two years.

Catalyst

Completion of REIT conversion 1/1/04, convergence of dividend yield to PCL, dividend increases (longer-term)