Rayonier (RYN +1.04%) dropped nearly 20% overnight in late October after missing its earnings forecast by $0.02 and on the unwelcome news it would be scaling back second quarter projected production increases. While revenue guidance was not given, we should expect decreases in 2014. Its next report will be released on January 27.
The secret of Rayonier's historically profitable and successful business has been its occupancy of the sweet spot in the timber REIT universe with its business squarely in specialty cellulose pulp rather than dimensional and engineered lumber. Two competitors, Weyerhauser (WY +0.94%) and Plum Creek Timber (PCL +0.00%) are primarily in the lumber business. Both manufacture dimensional boards and engineered products including plywood and opposite strand board. All three companies sell logs and real estate, but that's only around 32% of Rayonier's revenue.
Rayonier has less exposure to housing and weathered the 2008-2009 recession relatively well since dissolving pulp has been on a bull run for over a decade and demand is predicted to keep rising.
Rayonier's steady earnings
Source: YCharts.
Relatively low P/E ratio may indicate better value
Source: YCharts.
Pulp non-fiction
Trees can be turned into boards and plywood, but wood has a softer side: dissolving pulp and fluff pulp. Wood fiber is turned into fluff pulp to make absorbent materials and dissolving pulp makes, fabrics, filters, cosmetics, LCDs and other very unwoodlike products. Dissolving pulp is marketed as commodity cellulose and specialty cellulose.
Commodity cellulose is lower quality and used in rayon, other textiles, and cellophane. It's easy to make and barriers to entry are low. Specialty cellulose is a more technically demanding process and there are fewer competitors. The per-ton price is higher than commodity cellulose making it worthwhile if the company has the expertise and is willing to make the investment in specialized production lines.
The spread between the two is usually around $500 per ton with high enough prices to keep commodity production profitable and those manufacturers happy. All of this came crashing down in 2013 and is the back-story behind the Rayonier fall from grace in October.
The fiber business unravels
Because commodity cellulose producers can't and don't make specialty cellulose on the same lines, they are at high risk for substantial loss of revenue when the commodity market plunges as it has in 2013. The price differential between specialty and commodity is now more than $1,000 as commodity prices dropped to around $800 per ton.
That has had the effect of pushing swing producers who have the capability to make both into specialty only and has spurred overhaul of commodity plants to specialty production lines. There is now more specialty cellulose than the market can absorb. Prices will drop and Rayonier has responded by cutting production projections and warning that existing customers may be difficult to negotiate with in 2014.
Exquisitely bad timing
The decreased demand for commodity cellulose and the almost doubling in market capacity for specialty cellulose could not have come at a worse time for Rayonier. The company just finished a massive line expansion at its Jessup plant that will bring an additional 190,000 tons of specialty to market. The modifications took down all of the fluff line production that was used to make absorbents and accounted for 200,000 tons of product that will now no longer be shipped.
Rayonier's absorbent product has been selling for between $700 to $900 per ton with an average $1,000 price spread between specialty (up to $1,900/ton) and absorbent over two years, specialty is more profitable. If all had gone according to plan, Rayonier would be sitting in the catbird seat with increased production of high-priced specialty cellulose replacing the much lower absorbent revenue stream.
Before accusing Rayonier of doing something stupid, just three years ago customers were begging it to expand the specialty business because demand was outstripping supply. It's one of those ideas that was an excellent business move at the time, but adverse commodity pricing wrecked the plan.
Rayonier makes deep cuts
Instead of being able to place an additional 90,000 tons into the market in 2014, it is now scaling back expectations to 25,000 to 40,000 tons of incremental production from the new line. Production will only include commodity cellulose initially, but will eventually turn out 190,000 tons per year of high-dollar specialty cellulose.
In the near-term, it looks like much of the capacity will be idle due to the saturated market. The retooling of the plant is an expense that can't be fully offset for years. It also loses the volume and revenue from absorbent products. The cost of the expansion was around $390 million and returns on that investment will be delayed until 2017 or 2018.
Why bother with Rayonier at all?
Rayonier is interesting for its dividend and growth potential. The weakness in the stock has raised the yield to 4.6% compared to 2.9% for Weyerhauser and 3.8% for Plum Creek Timber. Plum Creek has paid $1.68 for the last five years with no raises, and Weyerhauser, as a new REIT in 2010, increased its dividend in 2012 by only $0.02 to $0.62. Both Weyerhauser and Plum Creek are more diversified, but that doesn't prevent their businesses from setbacks when housing starts slow. Rayonier's focus on fibers has been a great strategy over the last decade and may still serve them well.
Rayonier has a better track record and longer history of consistently raising dividend payments and the 2013 dividend looks secure with sufficient cash flow through the first three quarters. The 2014 payout may be in jeopardy -- if the dividend is cut, expect a better buying opportunity.
Jettisoning the absorbent business and making a big expensive bet on high-priced specialty cellulose may look like folly now, but demand is expected to continue increasing. The excess will be absorbed, and by 2018 Rayonier could be a great investment if we manage to catch it at the moment of greatest pessimism.
