Glenn Rogers writes:
A few months ago I wrote a column suggesting that the housing market had bottomed here in the U.S. I continue to believe that is the case and number of leading indicators back that up. Inventories are gradually shrinking and sales have been quite brisk in individual markets around the country. The latest statistics show that sales of previously-owned homes jumped 7.8% in August compared to July. The median price was up almost 10% from the year before. New home starts in August were 29% higher than for the same period in 2011. We still have a long way to go and it will be a number of years before we return to levels that even approach the bubble days but it certainly appears that the healing process has begun.
The housing stocks and their related ETFs, such as iShares Dow Jones Home Construction Fund (ITB), have been on a tear. So have a number of related stocks like Home Depot (HD) and Whirlpool (WHR), which closed on Friday at $85.22 and has gained 10.9% since my last update in March at $76.84 (prices in U.S. dollars). In fact, as of the close of trading on Sept. 18, the S&P Supercomposite Homebuilding Sub Industry Index had risen 77% for 2012 against only a 16% rise for the S&P 500. The performance has been so good that I am worried that they may be getting overextended here.
So this month, I thought I'd introduce a related sector that is also showing strong evidence of recovery: lumber and building supplies. Barron's recently wrote a very positive article on the sector and on Weyerhaeuser (WY) in particular even though the stock has risen 79% from its 12-month low of $14.82. However, that appreciation was against historic lows so doesn't necessarily mean you missed the entire party if you have not had a position.
A number of analysts believe that the stock could rise from where it is currently at $26.53 to over $30 within the next 12 months. This call is really based on housing starts ramping up over the next couple of years from the low, by historical standards, where we are now in the 600,000 to 700,000 range, to somewhere closer to one million. Even then we would still be significantly below the peak when the U.S. was producing 1.6 million houses a year.
This does not seem far-fetched since the U.S. needs to produce around one million housing starts just to replace and maintain the number of new houses needed for immigrants and family creation along with replacement of destroyed homes from wildfires, tornadoes, etc.
If you agree that a slow, steady recovery is in the cards then it should have a positive effect on lumber prices. Given the cost-cutting most of the timber companies have done the last two years, any price boost should fall directly to the bottom line. There are indications that lumber dealers do not have adequate supply to meet the increasing demand - orders for British Columbia softwood lumber are on the upswing and this should also help prices firm.
Weyerhaeuser converted to a REIT in 2010, as did most of the timber asset companies, which makes them good dividend play. Currently, Weyerhaeuser is yielding 2.3% but if the positive improvement in demand pricing unfolds they will be able increase that over time. Converting to a REIT dropped the level of taxation on earnings to 15% from the 35% rate applied to corporations. This should set up well for income investors over the long haul assuming that Congress does not do something crazy as the fiscal cliff approaches. Personally, when I think it gets right down to the crunch, whoever wins the White House will end up cutting some kind of deal with the House and the Senate, which will enable us to dodge financial Armageddon.
Weyerhaeuser has been slowly divesting itself of underperforming assets including spinning off their fine paper business to Domtar back 2006. Later it sold its packaging business to International Paper for $6 billion. The result is that they are even more heavily leveraged to the housing market which, as Barron's pointed out, is not a bad thing at this moment in time.
Another operation I like in the same sector is Plum Creek Timber Company Inc. (PCL). It pays out an even higher dividend than Weyerhaeuser at $1.68 a year and is yielding 3.8%. Plum Creek trades at a slightly less lofty p/e ratio then does Weyerhaeuser although both companies look pricey by that measure because their profits have been so squeezed in recent years.
Plum Creek owns over 6.6 million acres of timberlands across 19 states. This makes it the largest and most geographically diverse private landowner in the nation. In addition to simply selling timber the company also has some high-value products like plywood and fiberboard, which will benefit from increased housing construction.
The company recently announced quarterly results. Second-quarter earnings were $36 million, or $0.22 per diluted share, on revenues of $294 million. These results fell short of the second-quarter profits in 2011, which came in at $44 million ($0.27 per share) on revenues of $284 million. The outlook the company provided was in line with what economists are predicting, which is a gradual recovery in domestic demand over the course of the year with slowly improving fundamental performance of the various business segments within the company.
I think with improving housing sales and a generally improving economy, and with very little exposure to international markets, these companies offer good income-producing plays over the next couple of years.
Finally, a quick note on the taxation of U.S. REITs in Canadian accounts. Dividends paid to a non-registered account will be subject to a withholding tax of 15%, which may be recovered by claiming a foreign tax credit. They will not qualify for the dividend tax credit. Capital gains distributions will also face a 15% withholding tax and do not qualify for the 50% exclusion. Both dividends and capital gains distributions will be treated as foreign income and taxed at your marginal rate. Therefore, it is better to hold these securities in a registered plan.
Action now: Buy Weyerhaeuser at $26.53 with a target of $33 and/or buy Plum Creek Timber at $44.76 with a target of $46.