As a general rule, a high dividend yield is often a warning sign that a company is experiencing significant trouble of some kind. The market sees signs of trouble, starts selling off the stock, and that conversely inflates the yield. If a company's business has deteriorated to the point that a dividend cut might be necessary, the stock price will begin to figure in the possibility.
These stocks with dividend yields that look too good to be true are often best avoided. Often, but not always. Take Weyerhaeuser (WY -0.60%), for instance. It has an unusual dividend policy that makes its yield look inflated, but all is not as it appears and the current inflationary environment is actually one in which the company is best set to compete. Let me explain.
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Inflation is good news for Weyerhaeuser
Weyerhaeuser is one of the biggest owners and operators of timberland in North America. It also manufactures wood products like plywood and structural lumber and is highly dependent on the state of the housing industry. It is structured as a real estate investment trust (REIT), which is required to distribute most of its earnings as dividends for tax purposes. REITs tend to be attractive stocks for income investors because they usually have pretty decent dividend yields. That said, as the main investment theme this year is inflation, commodity-driven REITs are benefiting.
In 2021, lumber prices more than doubled as COVID-19 supply chain issues created shortages across numerous sectors, including lumber. While lumber prices eventually fell back from mid-summer highs, they have remained elevated this year in anticipation of more homebuilding activity. Inflation has returned after a 40-year slumber, and this is supporting higher commodity prices. A company like Weyerhaeuser benefits from inflation because its costs do not rise in lockstep with the price of lumber, meaning profit margins are increasing at the moment.
Rising lumber prices increase profit margins
In 2021, lumber prices increased about 57%. This drove Weyerhaeuser's revenue from $7.5 billion in 2020 to $10.2 billion in 2021, about a 35% increase. Since costs did not increase at the same pace, Weyerhaeuser reported adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) increased 86% from $2.2 billion in 2020 to $4.1 billion the following year.
Weyerhaeuser has an unusual dividend policy. It pays a normal quarterly dividend that is meant to be stable throughout the entire homebuilding cycle. It then pays special dividends based on the earnings for the prior year. In 2021, Weyerhaeuser paid its quarterly dividend of $0.17 per share. It also paid a $0.50 per share special dividend in October and declared its special dividend for the full year of $1.45. Altogether, the company paid $2.63 per share in dividends, which works out to be 6.6% of the current stock price. If you look at a dividend reporting service, you might see a dividend yield that only looks at the quarterly dividend. Its yield is much higher than many sites might suggest.
At the end of the year, Weyerhaeuser had $1.9 billion in cash on the balance sheet, which is about 17.5% of its book value. The removal of Russian lumber from world markets will exacerbate an already tight market, which would help keep prices well supported. In inflationary environments, commodity producers tend to earn a lot of money. The tight lumber market, along with increased demand for homebuilding, should help Weyerhaeuser maintain its cash flow, which will be passed along to shareholders via its dividend policy.
All this suggests income investors holding or buying Weyerhaeuser stock right now will be getting a piece of dividend income that may look too good to be true but is really just a reflection of the company's ability to manage well in an economic climate that caters to its operational model, now and in the future.
