Free Cash Flow 50
can trace its roots back to 1903 when it was then the Potlatch
Timber company and as a publicly-traded company since the 1950's
when it first traded over-the-counter before moving to the Pacific
Coast exchange and finally the NYSE in 1969. Despite often being
labeled a timber pure play, Potlatch is an integrated forest
products company structured as a REIT that operates a real estate
business and five manufacturing facilities. The investment thesis
however rests on the underlying value of Potlatch's 1.45 million
acres of timberland the company owns in Wisconsin, Arkansas, Idaho,
and Minnesota. Potlatch is in fact the largest private landowner in
Idaho and Minnesota and the third largest private landowner in
The company (like all timber REITs) consist of both attractive
economics in the harvesting and selling of timber as well as raw
land coupled with operating the low margin production/mill
Potlatch divides itself into three segments: Resource, Real estate,
and Wood products. These segments accounted for 38.5%, 14.5%, and
48%, of 2010 revenue.
The Resource segment
manages the company's 1.45 million acres of timberlands, which
consists of planting and harvesting trees and recreation lease
management. A key in managing timberlands is maintaining a rational
focus with respect to harvesting timberland when prices are high
and deferring harvests when prices are low. An example of this was
during 2006 when Potlatch deferred 200,000 tons of their planned
timber harvest in Arkansas due to weak markets. A year later prices
rebounded and the initial harvest was increased offsetting the 2006
deferred harvest. For 2010, the overall harvest from the company's
timberlands was 4.2 million tons compared to 3.8 million in 2009.
In 2009 the company deferred about 0.6 million tons or around 14%
of their originally planned harvest for the year due to weak
prices. Harvest levels in 2011 are estimated be at about 2010
levels of 4.2 million tons.
Breakdown of timberlands:
More than 9 million people live within the four states of the
company's timberland ownership. Every acre that is harvested is
reforested, either through replanting or through natural
regeneration. Since 2000, the company has planted more than 120
The Real Estate segment
consists of the sale of non-core real estate, timberland,
acquisitions, and development activities. Generally, revenue from
this segment varies from quarter to quarter and year to year
depending on relative values.
The sale of non-core timberland real estate is divided into
- Higher and better use or HBU
- Rural recreational properties and
- Other non-strategic.
Higher and better use or HBU land has development potential and
generally a much higher value than timberlands. Rural recreational
properties also have a higher value than timberlands, but do not
have the same qualities of HBU land. Rural recreational land may be
good for hunting or conservation. Other non-strategic properties
are usually on the fringe of ownership areas. Potlatch has stated
that between 16%-18% of their timberlands have value that is more
valuable for development or recreational purposes than it is for
growing timber. For 2011, this segment accounted for about 14.5% of
The Wood Products segment
manufactures and markets lumber, plywood, and particleboard at five
mills in Arkansas, Idaho, Michigan and Minnesota. This is basically
the home building segment and has been in the doldrums for some
time as the housing industry remains in dire shape. Revenues for
2010 however came in at $274 million representing about 47% of
total revenue and an increase from $216 million in 2009. The
increase was due to average lumber prices increasing 16% combined
with a 14% increase in sales volumes.
Profitability of the wood products segment depends on mills
operating at or near full capacity. At times of low lumber prices,
one can expect mills to be operating at reduced capacity (perhaps
substantially) as in 2009 when mills were running at 50-75% of
capacity further compounding the problem.
In March of 2010 they sold their Idaho particleboard
manufacturing facility's building and equipment. In November they
sold their Arkansas lumber mill which had ceased operations in 2008
due to poor market conditions.
The forest products industry in general was hit quite hard in
2008 by the national decline in home building. The effect on
Potlatch was a permanent closing of a lumber mill in Arkansas as
well as a significant reduction in production at the remaining five
mills. The slowdown ran well into 2009 and although lumber prices
rebounded in 2010, this industry remains a permanent low margin
The brief numbers below reveal the tough economics of the wood
products industry coupled with the strength of the resource and
real estate segments:
(Figures in millions)
Economics of timber
As a quick disclaimer, timber REITs are not timber pure plays and
this must be understood. As noted at the beginning, timber REITs
combine the excellent economics of growing and harvesting timber
with the low margin production facilities.
According to The Campbell Group, the U.S. contains about 490
million acres of potentially productive timberland, more than
two-thirds of which is private. Over 80% of the private land is
controlled by small, non-industrial landowners with integrated
forest products companies such as Potlatch and private timberland
investors accounting for the remaining 20%.
While land has always been a well-known place to put money over
the long-term, timber has provided better returns coupled with less
risk but has only come to mainstream investors in the last 20 years
or so. Much like water, timber has been one of the best performing
asset classes since asset classes have been tracked delivering
market beating returns coupled with safety of principle and low
Historically, timber has shown little correlation to the stock
market and generally been insulated from all the vagaries of the
economy. Regardless of market, economic, or political conditions,
trees continue to grow and increase in value. When the housing
market is at a standstill and timber prices are down as is the
current situation, timber companies can simply choose to forego
harvesting and wait for prices to rebound.
According to an article from
, author George Nichols cites an academic study that found
biological growth drives more than 60% of total returns while
timber price changes and land appreciation account for the
Timberland value changes
Changes in timber valuations are driven by the increase in quality
of the trees as they grow and overall supply and demand. This is
certainly an area where having good management in place that
acquire high quality timberlands at a good price becomes important
as well as employing forest management practices such as thinning
and fertilization with the goal of increasing biological growth
Raw timber sales
generate current income and cash flow.
The rate of growth depends on a number of factors including age,
species, and productivity of the site. On average, a tree grows
around 2% to 8% a year.
Timber distinctly different from real estate
The correlation between timberland returns and real estate has been
quite small due to the fundamental economic differences between the
two. Although timberland is typically included in real estate as an
asset class, it is a different animal marching to the beat of its
own drummer. Although both use physical land to generate income,
there are very few other shared economic similarities. Listed below
are a few key differences:
- Timberland is a growing asset generally requiring low capital
investment over time relative to total asset value.
- Prices for timberland are less volatile than real estate as
the economic life cycle for timberland is much longer.
- Timberland cannot be over-built as it is a finite resource.
The current housing market provides a good example of this. The
ability to increase the timber supply can only happen over long
investment cycles. Further, Federal government restrictions on
harvests from national forests affect the supply available from
federal lands. This constraint on supply has resulted in price
and value increases in privately owned timberland.
The supply and demand equation is equally dynamic. Timber
harvests from the U.S. National Forest System have been reduced
dramatically under public pressure starting in the 1990's when
heavy restrictions on harvesting from public lands were imposed.
This is principally why over the past decade net growth in U.S.
federally managed forests has exceeded harvest by 55% or more.
The reduction of cutting on public lands however has led to
increased dependence on international sources. The United States
has been a net importer of wood for over 30 years with per capita
consumption of forest products about 25% higher today than in 1970
according to Evergreen Magazine.
What's it worth?
It gets a little sticky when trying to get an estimate for the
value of the company's shares as there is some hard data that we
can look at for some accurate pricing with respect to their
timberland but the brunt of the company's acres are not appraised
by a third party. Potlatch owns roughly 1.45 million acres
scattered across 3 states as listed below:
Of this amount, the company has identified 235,000 acres as
having values that are potentially worth more than the timberland
itself. I have been unable to get an answer from the company as to
where these acres lie however. For simplicity's sake with respect
to the valuation, this figure was just divided into three and
backed out from the acreage in each respective state.
Backing out these higher value acres leaves around 1.21 million
acres. The company has what it calls "secured" timberland of
352,000 acres in Idaho which is used as collateral to secure the
company's revolver on its $216 million in debt. Potlatch has stated
that this has been appraised by a third party and currently has a
value of $707 million or just over $2,000 an acre. This leaves
388,000 "unsecured" acres in Idaho after backing out the estimate
for the higher value acreage. A presentation listed on the
company's website from February showed that the total acreage used
to secure the revolver on its debt used to consist of 641,000 acres
of its Idaho timberland (price per acre of $1,716) opposed to the
352,000 acres they now use. Based on these figures we can get a
pretty good estimate that the value of the Idaho timberland falls
between $1,716 and $2,000 an acre. To be on the safe side $1,700
per acre is used to value the unsecured timberland.
With respect to the higher value timber acres, the price per
acre for the past few years is listed below:
For the chart below, the average price per acre was used for
valuing the higher value acreage:
|Core Idaho timberland
|Rural real estate
The big question that remains though is what is a ballpark
figure to use for valuing Potlatch's remaining 480,000 acres in
Minnesota and Arkansas? For some very rough estimates, looking back
at past land sales lends a bit of clarity.
In 2008 Potlatch sold 42,00 acres in Minnesota for $16.1 million
or $376 an acre. In 2009 the company sold 49,500 acres for $49
million or $990 an acre in Arkansas. Another sale in Arkansas
during 2009 netted them $43.5 million for 24,500 acres or $1,775
As a very rough estimate, values of $500 and $1000 per acre were
used in gauging the remaining 480,000 acres in Minnesota and
Arkansas. We do know that this is not swamp land so I don't believe
these figures over inflate the value.
This is certainly far from perfect but the these two figures
hopefully fall in the ball park of reality.
Value of Minnesota and Arkansas acreage at $500 per
|Non-core Idaho est.
|Core timberland+higher value
|Non-core & remaining timber @ $500/acre
Value at $1,000 per acre average:
|Non-core Idaho est.
|Core timberland+higher value
|Non-core & remaining timber @ $1,000/acre
As of writing, the stock closed at $32.48. All told, perhaps an
estimate of fair valuation is between $33-$39 dollars per
The company's debt maturity extends fairly far into the future
with the brunt of it coming due after 2015 with roughly $22 million
coming due in 2012. A perhaps bigger issue is that the company has
underfunded its pension plan for the past 3 years. For 2010, this
came in at ($66 million) and ($81 million) in 2009. For 2012
pension obligations are estimated to come in at $29 million.
With respect to the payout ratio, the company uses Funds Available
for Distribution ((
)) calculated as earnings from continuing operations, plus
depreciation, depletion and amortization plus basis of real estate
sold, and minus capital expenditures. So basically owner earnings
or structural free cash flow. The FAD is listed below:
Even though the wood products division accounted for roughly 47%
of revenue during 2010, it accounted for only 1.7% of the FAD. The
dividend is basically entirely dependent on the real estate and
timber business accounting for 91% of the FAD during the year.
Is it sustianable? It appears so, at least in the short term but
a future dividend cut wouldn't be surprising. I think a lot of
folks know that they fund their dividend through the real estate
and timber business and believe that it is not sustainable. Well,
it has been for several years as the company continues to manage
harvesting levels and sell attractive real estate properties. Are
they selling off attractive properties on the cheap in order to
keep up the payout? Tough to say as it would require intimate
knowledge of each property sold.
An interesting aspect is that while Potlatch is a REIT and
requires that they derive the brunt of their income from selling
timber, the company restructured creating Potlatch TRS which
enables them to operate several subsidiaries which include their
manufacturing facilities and other non-timerbland assets. This
corporation is taxed as a C corporation and enables them to
continue operating these businesses without violating REIT
requirements. While normal REITs require that 90% of taxable income
is distributed, Potlatch is able to get around this by having the
structure mentioned above and are not required to distribute 90% of
their income. Potlatch's REIT income is mainly capital gains from
payments they receive under timber cutting contracts with Potlatch
TRS and others rather than ordinary taxable income. They are thus
not required to distribute material amounts of cash to remain
qualified as a REIT. This, in effect, enables them to do whatever
they wish with the dividend and not put their REIT status at risk.
This is certainly a caveat if you are buying because they are a
REIT and required to distribute 90% of their income in the form of
dividends. They are not and this could potentially burn dividend
seekers if the company ever cuts its payout.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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