By RelPolEco :" If a tree falls in a forest and no one is around to hear
it, does it make a sound ?"
One of the most important philosophical thought experiments of
all time; but it always just reminds me of the Far Side Gallery
cartoon in which Gary Larson poses the equally weighty question, "
if a tree falls in the woods, and nobody is around to hear it…
and it hits a mime, does anyone care? "
That really gets to the heart of the matter. When no one is
paying attention… whatever happens, really seems to make no
difference. This thought leads me to a third philosophical
question, " if a tree grows in the woods, silently and exactly
as one would suppose, does anyone care? " Based on the stock
prices of the public timberland owners - I'd have to conclude,
no.
While I'd like to revisit the long term investment thesis at
some point-and I suspect I will since I'm also long the 2015
LEAPS-for right now, I am going to concentrate on the short term
end of the story… primarily because I believe there is an
opportunity to make money now . A chance to generate
significant excess returns on the industry as a whole, and
Plum Creek (NYSE:[[PCL]]) in particular, through
the use of short term derivative call options. This would leverage
the investment to the "improbable probable" scenario of a quick
price convergence higher.
In terms of why I believe that scenario is in fact "improbably
probable" - I'll breakdown the mosaic of my reasoning with seven
confirmations of trends and events that have already taken place as
well as two potential catalysts that will unfold in the next few
days.
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Confirmation #1.
The Housing Recovery & the Big Money Chasing
It
Whether or not it is truly sustainable… and regardless of
whether you believe it… there is a recovery going
on in the housing sector. There is not a whole lot to prove here…
the charts for new residential housing starts and new residential
home sales tell just about the whole story.
And the market's perception is that this recovery has a
long runway until it reaches the top. And whether that view turns
out to be right or wrong, in the near term, perception always trump
the facts-which is all that really matters to my "improbable
probable" scenario.
So why not just buy the home builders? Because Wall Street
prides itself on being forward looking. Since the following chart
may not show up clearly for all readers, here is its key takeaway:
the home builders have already moved . The
average trailing 12-month performance is up 113%; more
importantly, though, this great move up is not "in reaction to"
something happening, but rather "in anticipation of" something that
is now expected to happen in the future. We know this based on the
aggressive out-year valuations on earnings and EBITDA. The group is
fairly representative of traditional cyclical businesses… what they
lack in hard assets; they tend to make up for in incremental
operating leverage. The price move higher over the past year has
become a lesson in the physics of momentum and the mathematics of
herding. Wall Street is not just forward looking though, it's also
forward thinking; and the thought that's likely forming in most
money-managers' minds is what's the best way to cycle-out into the
second and third derivatives.
It seems like the beautiful margin assumptions that always get
built in for cyclical all-stars invariably end up being too
aggressive. Commodity prices begin to rise as the raw material
suppliers take their fair share of the excess profit pie.
That is what happens in a commodity bottleneck .
Supply is usually the factor that gets underestimated… and in the
housing recovery's case, there is an increasing amount of deferred
sawlog harvest combined with a secular decline in supply from
British Columbia (~50%E of Canadian supply) that used to serve
almost 35% of the US lumber market. Therefore it shouldn't come as
a huge surprise that there is a vision forming of rising commodity
prices coming down the pipe… and it isn't just a short term vision
either. In the near term a bottleneck would likely happen faster
than expected since it's always tough to turn the spigot back on;
but if it does happen… it might be around for a long time. Longer
term there are significant structural changes occurring in the
dynamics of supply and demand for North American lumber that are
likely to keep prices elevated for the foreseeable future.
Luckily for us, PLC quantitatively spells out exactly what
a price increase would do to its financial statements .
Here is an excerpt from the company's 2011 Annual Report:
" As the largest independent seller of wood fiber in the
country, we have a significant price-recovery upside for our
products and valuable assets. For example, a $10 per ton
improvement in sawlog price at today's harvest volumes represents a
$73 million improvement in cash flow. A $5 per ton improvement in
pulpwood prices equates to $43 million of additional cash flow
."
That's a lot of extra cash flow. The price of the timber stocks
is implying that investors believe there will be time to jump back
in before a move higher… but as that vision of price increases gets
clearer and clearer… the idea isn't likely to wait around,
especially not with all the big money clamoring for an
"undiscovered" way to get in on the housing recovery.
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Confirmation #2.
Timber: Growing as an Asset Class
Beyond just the investors looking to play housing, there are
indications that timber could see an increasing share of
institutional managers' capital allocation-a key factor to the
dynamics of supply and demand for the stock as a financial
instrument . Why might this be the case?
The management and ownership of timberlands is a nuanced
industry... one in which I do not profess to be an expert. One
thing I do understand about the industry, though, is that it does
not "screen" well. Investors who subscribe to the Ben Graham School
of Value Investing often lament that after running various
screening criteria, nary a stock fits the mold. This is because
golden opportunities rarely present themselves as golden
opportunities; value is only found if it has not already turned up
on someone else's screen.
This self-reinforcing principle of not being exactly as one
appears reminds me of the motto for the Green Machine
flavor of Naked juice: " Looks weird. Tastes
great ."
The first thought an investor should have when looking
at valuation of the timberland REITS is " looks weird ."
Or in other words, the companies look expensive. And on most
traditional metrics, indeed they would be… as a multiple of the
ongoing businesses. As a silly corollary, imagine an industrial
business generating ' x ' profit from good 'ole widget
making. Imagine it makes those widgets, though, using machinery
that costs a large multiple of 'x' ; or better yet that
its corporate headquarters is located on top of a huge oil field.
That critical detail is obviously going to factor in greatly to the
overall valuation a prospective buyer would place on the entire
business. And depending on whether it utilized debt, that factor
will significantly alter the residual equity value; and
make it appear as though the buyer is paying a wildly high multiple
of ongoing earnings. So too for the timber industry…
We cannot forget the land; that irreplaceable asset that has
represented a tremendous store of value throughout the history of
human existence. Forgetting its existing businesses for
just a moment, let this thought settle in… Plum Creek is
the largest private land owner in the United States of
America . Oh yeah, that land. So perhaps a more rational
way to form a valuation is to include the price of the land:
the enterprise value ( EV ) of the company on a
per acre basis .
So how does that measure stack up? PCL trades at an EV of
approximately $1,500 per acre. Fifteen measly Ben Franklins per
acre and you can throw in the current businesses of
harvesting and selling valuable (not to mention regenerative)
sawlog, recycling land into higher value uses, and collecting
royalties on all the good stuff underneath like oil, natural gas,
aggregate and various metals… for free. Hmm… doesn't sound so
expensive anymore.
This is not meant to be a political statement, but our National
debt (not counting all those hip unfunded liabilities) has
increased by roughly $5 trillion dollars since President
Obama took office. Maybe, just maybe… there are some people out
there who would want to trade a few dollars for something this
country hasn't been producing any more of since the beginning of
time. Or maybe not… it's not like interest rates are low or we're
approaching an important election or a fiscal cliff or
anything…
According to a lengthy 2006 report from the Department of
Agriculture's (USDA) Economic Research Service, the United States
has a total land area of nearly 2.3 billion acres; of which 394
million acres are classified as non-Federal forest-use
"timberland." For less than the market value of Facebook
(NYSE:[[FB]])-which I think is a good value, mind you-a group of
investors could own 16.3mm acres outright. Not to mention millions
more through land leases and license agreements. That's over 4% of
all non-Federal timberland… and all the resource rights that go
with it.
Oh hey, China! I forgot you only own an estimated $1.2
trillion of U.S. Treasury Debt! Swap out 3% of your
holdings and it could buy you 1% of the entire landmass of our
country. Or forget China, 'cause we're Am'urican! Maybe Buffett
says the time is right to reload his "elephant gun." The timber
industry has cost and environmental advantages - just like what
Berkshire looks for, according to his 2010 Letter to Shareholders.
It has asset value protection and consistent earnings power; and it
literally has organic growth opportunities, while figuratively
maintaining a "deep moat" with irreplaceable assets and numerous
competitive advantages over other materials. Not to mention that in
Plum Creek's case it comes from great stock; its predecessor is the
same Burlington Northern that Buffett plunked down $44bn for in
2009.
And all its going to take is one big investor to tip the scales
and make the entire world revisit its valuation of timberland.
Intrinsic "worth" is just equal to the highest price someone else
is willing to pay for it.
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Confirmation #3.
PCL: Best-of-Breed
Even within the timberland asset class, I believe
investors are likely to cycle out of other names and into Plum
Creek. Simply put, PCL appears to have the best assets, combined
with the best management, combined with the best dividend, combined
with the best long term opportunity as a pure play commodity
owner... and yet it still has only 240 "likes" on Facebook?!
Come on !
Speaking of the dividend, let's take a quick look at the
distribution yields:
Food for thought: if PLC's distribution yield
converged to the level WY is trading, it would be a $70
stock . As in 60% higher than the level it is trading
at today; and that's assuming of course that it doesn't
raise its dividend when it next reports from a growing
reserve of cash available for distribution.
Achieving that lower yield should be commensurate with growth…
and judging by the numbers most investors seem to think WY has it.
Weyerhaeuser (NYSE:[[WY]]) is actually my least
favorite of the "big four" REITs. I understand the appeal-it's got
more juice to confirmation numero uno , the recovery in
residential housing starts. That leverage, though, is not leverage
I personally want to own. I believe timber, as an asset
class , is poised for fundamental long term growth with the
potential of an "improbable probable" short term recovery. If I
wanted exposure to a cyclical home builder, I'd buy one-just like
everyone else already did. In fact, I think investors could
still get better exposure to a hybrid
timber-slash-homebuilder combo by cycling into 1 share of PCL and 3
shares of HOV for every 2 shares of WY. Not only would this lever
an investor to the single-family home recovery, but it would leave
the timber side of the equation with a best-in-breed, pure play
that owns superior assets and currently pays out a larger dividend.
That's right… an investor spending $44 on PCL for its $1.68 annual
distribution ends up receiving nearly 20% more than the owner of 2
shares of WY, receiving $1.36 distribution on a $56
investment-which leaves the $12 left over for shares of "high-beta"
Hovnanian (NYSE:[[HOV]]). Besides, WY has already moved. Benefiting
from this homebuilder halo-effect, it has shot up more than 65%
over the past 12-months vs. an average of about 25% for its
timberland brethren. The money has already been made and investors
will figure out its time to move on… perhaps to PCL.
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Confirmation #4.
An Insider Tip?
Here is a piece of non-material public information… the land is
still there. Here is a second one… the trees are still growing.
Here's a third… insiders have been buying stock .
Almost every senior executive and Board member has added to their
holdings since May.
… and while trying to navigate through the complex web of
form-4's and proxy statements can be a daunting task (and it
does appear as though most of the additions were through
various restricted stock and options), two members of the
compensation committee added stock through open market
purchases as recently as three weeks ago. The additions may not be
the strongest sign of confidence, but it's certainly better than
seeing the entire management team lighten up heading into the
quarter.
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Confirmation #5.
PCH: First Out of the Gate
Potlatch (PCH:NYSE) was the first of the timberland REITs to go,
reporting FY'12 Q3 results on Monday before the open. Its release
provided an key read-through to the rest of the industry… but more
importantly, PCH's planned harvest deferral held back
headline results and did not disturb the setup for a potential
"beat" from WY and PCL later in earnings season. In fact, thanks to
instant headline-analysis by sources like flyonthewall, the stock
actually traded slightly down until it got closer to its
noon conference call.
So what did the company actually say? Here are a few excerpts
from management's prepared remarks:
- " In our Resource business, we again realized higher sawlog
prices compared to the previous quarter. "
- " Over the long term, we believe a variety of factors could
work in concert to create very favorable market conditions for both
our Wood Products and our Resource segments."
- " Though both near and long-term market conditions appear
promising, we have not altered our near-term harvest
plans"
- "…intentional decision to defer a portion of our timber
harvest activities"
- "…most beneficial to our shareholders to exercise patience
and preserve our timber value directly on the stump, allowing our
trees to grow and further increase in value while awaiting even
better market conditions."
- "…already begun to see higher lumber prices translate into
higher sawlog prices, particularly in our northern
region."
- "Undoubtedly, pronounced continued improvements in the Wood
Products Industry, capacity utilization and profitability will
ultimately lead to higher sawlog prices."
All sounds pretty good to me…
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Confirmation #6.
LL: Let's Get Silly
Lumber Liquidators (NYSE:[[LL]]) was up next, shooting up over
12% after reporting earnings Wednesday morning. What happened? Well
it was your stereotypical, pre-recession style "beat and raise".
Gangnam! The company topped consensus and raised its full year
earnings guidance.
So what did management actually say?
- "…delivery of a terrific quarter with exceptional financial
results ."
- " Average ticket for the third quarter was the highest it
has been since the fourth quarter of 2008 ."
How many companies have been able to say that this earnings
season? The confident outlook confirms two things… lumber prices
are going higher and valuations are getting silly. The company, a
traditional brick-and-mortar retailer of lumber, is now trading
over 35x current year earnings. All we would need is for a
hint of that unbridled optimism to spill over into the
timber market and it could be off to the races.
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Confirmation #7.
RYN: Small Beat Ain't Gonna Cut It
After that we had Rayonier (NYSE:[[RYN]]) report yesterday
morning. Thanks for blowing it Ray! On the surface, headline
numbers were down yr-yr and it looked like an in line quarter; and
of course like any good west coast company, they then made
investors wait until 2pm to glean all the details on the earnings
call.
And so what did management finally say… before the stock started
trading straight down in the late afternoon. Well for one
thing:
- "We anticipate cash available for distribution to range
from $295 million to $310 million, substantially above our recently
increased dividend."
That doesn't sound so bad. The company had just raised its
distribution in late July and traded straight up for about a month
afterwards. I think the lesson to take away from the release is as
follows: in line isn't going to cut mustard when investors are
looking for growth .
Management also put a small wrinkle in the story which I promise
I'll get back to in a minute.
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Catalyst #1.
WY: Final Push?
On tap tomorrow morning is Weyerhaeuser. The "good times" may
already be priced-in to valuation… but that doesn't mean there
aren't "good times" to come. The fundamentals are still levered to
the housing recovery; so while its "mo" may be slowing, it can
certainly still deliver a solid earnings beat… and perhaps a rising
tide lifts all boats.
Consensus stands at $0.18. That doesn't look unachievable for a
company that put up over $4.00 of earnings back in 2005.
And maybe this is just me being crazy, but I'd tend to think the
company's CEO would not be out making headlines on U.S. tax reform,
asking to pay higher taxes, unless his business was
humming along. Ok, fine… "broadening the base" may not be
exactly the same thing as paying higher taxes, but still…
the thought process is the same.
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Catalyst #2.
PCL: In Store for Its Own Surprise?
Finally we get to Plum Creek. In this "improbable probable"
scenario… to play against time, you need to play the game of
quarterly earnings. It's when the lights flash on and investors
determine if they were right or wrong, and adjust accordingly. So
if it turns out right… and the company "beats"… what exactly is
that even worth? Well in this day and age, if it's the right
combination of factors, it sure seems to be worth a
lot.
To be able to exceed expectations, though, we first need to
understand where those expectations are set. Consensus is at $0.36.
This is in part because management provided quarterly financial
guidance of $0.32-$0.37 at the end of July-a time when the market
was exceedingly jittery.
I have this weird philosophy that any CFO, who can't set an
earnings bar appropriately in a market where investors are worried
about the Eurozone fracturing on a geopolitical level, deserves to
be taken out to the woodshed and shot. Perhaps congress would
endorse it as a jobs creator because judging by the number of
companies missing earnings these days there would be a lot of those
elusive "high paying" job positions opening up. But I gotta keep
the faith… PCL is best of breed. And it has a recovery working in
its favor. I've got to believe the bar was set right.
And maybe, just maybe, it was set really right. Maybe
it finally comes time for the company to recognize all that extra
cash available for distribution and raise the dividend. We know
it's coming as pricing begins to improve… its laid right out there
in the Letter to Shareholders. So how about a "beat and raise"…
what might that be worth?
Ahhh the wrinkle. I'd told you I'd get back to this. The only
real hiccup in this plan is the pesky export market. On RYN's call,
its management commented that the company has seen the resource
market in the Pacific Northwest (that exports to China) remain
soft. The export trade has represented a significant portion of
that regional market in recent years… so to the extent it has yet
to bounce, it could hold back leverage… but we'll just have to wait
for Monday to find out.
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So that's it. My basilica on why PCL and the rest of the timbers
might see a short term move higher.
Of course the one other thing to bear in mind is I am biased. I
am not writing this article as an academic exercise. I'm writing it
because I believe it's a trade with potential to make a lot of
money. I am long a whole slew of PCL call options at various points
in the chain. I'm also long some PCH calls. (I'm also short a few
FB puts).
So do I really think this whole chain of events is
likely to happen in the very short term? Likely ,
no. It is not science… and there are a million other variables at
work. I do think, however, that I've laid out a pretty reasonable
scenario in which it could happen… one that seems much
more "improbably probable" than the options appear to be pricing
in. Perhaps some will take notice and the growth going forward
won't be so silent after all.
Disclosure: I am long [[PCL]], [[PCH]]. I wrote
this article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Additional disclosure: I am long PCL calls, PCH
calls. I am short FB puts. I have no positions in HOV, LL, RYN, WY
and no plans to initiate any position within the next 72 hours.
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