Think Twice Before Diving for Dividends

"Psst! Hey, kid! You want $5.6 billion?"

The obvious answer is "yes," right? But what if you had to give up $5.6 billion to get the payout? While I don't know any kids with that kind of dough, even Richie Rich would know to leave that deal alone.

Weyerhaeuser (NYSE: WY  ) announced a $5.6 billion special dividend earlier this week as a prerequisite for converting to a Real Estate Investment Trust (REIT). After briefly discussing the move, I will take this timely opportunity to make sure Fools understand the nature of dividends and the complex tax implications before contemplating a dive for dividends.

Running the road to REIT
Analysts and major investors have been pressuring Weyerhaeuser to convert to REIT status for years. The $5.6 billion transaction represents the tallest hurdle the company had to clear in order to join competitors Rayonier (NYSE: RYN  ) , Potlatch (NYSE: PCH  ) , and Plum Creek Timber (NYSE: PCL  ) within the income-friendly crew of timberland REITs.

Given the horrendously weak environment for forestry products and real estate, Weyerhaeuser's steady stream of losses in recent quarters actually served to reduce the burden of a REIT conversion. After accumulating losses totaling $1.77 billion over the past six quarters (through the first quarter of 2010), the size of the required distribution -- representing all accrued earnings and profits over the company's full century in existence -- has been materially reduced by the wait. While construction material producers USG (NYSE: USG  ) take their lumps from this protracted downturn, at least Weyerhaeuser can enjoy this modest consolation prize.

Little will change with respect to the company's non-core operations like homebuilding and finished wood products, which will operate under a taxable subsidiary. Starting next year, though, Weyerhaeuser's earnings from timber (and any future extraction of the energy and mineral resources that lie beneath) will be distributed to investors without incurring corporate income tax. As long as investors understand the implications for their own tax reporting, the long-term advantage to the REIT tax structure is easy to see.

Dividend divers swoop in
In the days since Weyerhaeuser announced the special dividend, unfortunately, I have encountered multiple indications that some investors out there may be piling into Weyerhaeuser shares with dreams of turning a quick and tidy profit on this apparent windfall.

It probably didn't help matters that Jim Cramer recommended Weyerhaeuser shares back in May -- when the shares traded 17% higher than they do today. Emboldening potential dividend divers, Cramer stated: "I think you want to be in front of this Weyerhaeuser conversion, and own the stock ahead of the news."

In one financial forum, an investor claimed to have purchased 100 shares of Weyerhaeuser after the dividend announcement, with intentions to sell the stake right after the distribution for a quick 50% net return on investment (after taxes).

If only investing were that easy!

Hey, where's my $5.6 billion?
The $5.6 billion special dividend makes a terrific headline, but rest assured there is no get-rich-quick opportunity hiding in this distribution that no one else has figured out but you.

To wash away any misconceptions you may have about dividends, I recommend this excellent two-part series (Part 1, Part 2) penned by our own Jim Mueller a few years ago. You may not realize it, but even those coveted quarterly cash distributions from your favorite income stock is effectively canceled out by a commensurate downward share-price adjustment conducted by the exchanges. Those share adjustments are normally quite small, so many investors may not even realize they occur.

When we get into multi-billion-dollar special dividends, it's hard not to notice the repricing. Microsoft (Nasdaq: MSFT  ) afficionados may recall a sudden dip in the share price when the company's $3-per-share dividend went ex-dividend. Anyone who missed the announcement of TD Ameritrade's (Nasdaq: AMTD  ) $6-per-share dividend would have been in for quite a momentary panic (on Jan. 25, 2006) to find the share price massively lower. Wither big, small, or special, dividends are not to be confused with sudden windfalls of pennies from heaven. Rather, they are transfers of capital that only long-term investors are likely to perceive as well-earned windfall.

To illustrate the point, let's dive back into Weyerhaeuser's special dividend.

For starters, 90% of the distribution will come in the form of a share offering that will increase the company's share count by more than 250%. Of course this is because Weyerhaeuser is only sitting on a little over $2 billion in cash, not even enough to cover half the required payment. Effectively, this portion of the payout is similar to a stock split: investors will receive new shares, but the share price will be adjusted downward accordingly.

Even considering the 10% cash portion of the dividend, as confirmed by Weyerhaeuser directly, shareholders will receive no tangible net gain in the transaction whatsoever!

In other words, utilizing Weyerhaeuser's own hypothetical ex-dividend and forma share prices (and indicated share counts), a shareholder's cash received and pro forma stock value, combined, will theoretically be identical to that shareholder's investment value at the pre-ex-dividend share price. Since share prices are adjusted downward to account for the exchange of cash and shares from the company to shareholders, dividends are essentially a zero-sum game.

But wait, it gets worse. We still have complex tax implications to work through. In a conference call, Weyerhaeuser indicated that some portion of the distribution may come in the form of a "return of capital," which would lower an investor's cost basis and impact capital gains exposure when the shares are sold. The remainder will be treated for tax purposes the same way one records normal dividends, which varies by investor. Once the distribution occurs, some of these tax implications will be easier to interpret.

Dividend diving doesn't pay
So there you have it, Fools. The next time you overhear a fellow investor hatching a plan to strike a quick fortune by gaming a juicy dividend, you will be equipped to explain in no uncertain terms why such a strategy will only end in humbling disappointment. You will recall the adage, "if it sounds too good to be true, it probably is" … and you will notch yet another valuable lesson learned since joining the ranks of the Motley Fools.

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly in the CAPS community under the user name TMFSinchiruna. He tweets. He owns no shares in the companies mentioned. Microsoft and USG are Motley Fool Inside Value picks. The Fool has created a covered strangle position on Plum Creek Timber. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool lives inside a single-family disclosure policy.


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  • Report this Comment On July 19, 2010, at 12:39 PM, CPACAPitalist wrote:

    It kills me that Jim Cramer was essentially advocating a dividend timing strategy. I am no expert investor but I know enough about life in general to see that if something looks like its going to be quick and easy money, then I don't have the whole story. Dividends are essentially an efficient way to dollar cost average into companies I want to hold for the long term, so that one day when my accounts are large enough I can live of interest and dividends alone and not worry about stock price fluxuations.

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