Description
Plum Creek Timber (PCL):
Plum Creek Timber is the largest REIT timber producer in the US with approximately eight million acres of land. Over the course of the past decade, timber became a must own asset class for large pensions endowments, etc. looking to chase stable cash flows and yield. Ironically, timber does not provide stable cash flows nor does investing at the current valuation provide any real yield. I believe Plum Creek to be an overvalued stock that over time will gravitate towards its fair market value some 40% lower.
I am of the opinion an asset is only as good as the cash flow it produces over time. The company trades at 20x EBITDA & 36x earnings, but is supported by a 4% dividend yield. The bull thesis is based on the following points: 1) Owning timber has been a great investment historically (Harvard, Yale, etc. made great returns over the past two decades), 2) Timber is a natural resource that grows organically, meaning if you decide not to harvest one year, you will end up with ~5% more the next year. 3) Housing is currently well below normalized levels, meaning an investment in timber today provides meaningful leverage to an improving housing market, and 4) The stock pays a 4% dividend while you wait, an attractive yield for volumes and pricing near the trough. While I do agree with some of the above mentioned points, there is a fundamental misunderstanding of the cash flows and normalized earnings power of this business that is not well understood.
Current Business Burns Cash:
While the company is expected to earn (Based on consensus) $1.14/share in 2012 & pay a 4% dividend yield , the core business is actually burning cash (see below). Plum Creek sells off land to fund the dividend and manage towards earnings expectations. Given these land sales are run through the income statement and are one-time in nature, it is more appropriate to look at the business on a normalized earnings basis, excluding land sales. In the last twelve months, 70% of the company’s EBITDA has come from one time land sales. When backing this out, Plum Creek generates $76mm of EBIT & carries ~$84mm of annual interest expense, thereby burning cash in today’s market. While we acknowledge that the business may see an improvement from a US housing recovery, we believe normalized earnings for the timber business is under ~$.85/share. Even under an environment such as 2005 when margins were approximately 100% higher and volumes 30% higher, PCL’s core operations would earn $1.39/share.
| |
|
TMT |
05 Peak |
| EBIT |
|
256 |
448 |
| Less Land Sales |
(180) |
(140) |
| Core EBIT |
|
76 |
308 |
| |
|
|
|
| Net Int Expense |
84 |
84 |
| Net Income |
|
(8) |
224 |
| EPS (Total) |
|
$ 1.09 |
$2.25 |
| EPS (Ex Land Sales) |
$ (0.05) |
$1.39 |
Dividend is Not Sustainable: If you look at the business over time, the company cannot continue to sell land to fund the dividend. The company pays out ~$275mm in dividends each year and pays out well above EPS under a “mid-cycle” scenario. I estimate $100mm of normalized FCF burn to fill via land sales & clearly substantially more under today’s run rate. While it is inherently a long term thesis, I believe the eventual catalyst is a cut to the dividend, which would send the stock materially lower. I believe they are currently selling off the highest value land and as time goes by, will find it more and more difficult to fund the dividend through asset sales.
Price/Book is Increasing: Book value per share has steadily declined over the past several years as management has focused on liquidating its book to maintain its dividend. This not only allows the company to attract yield oriented investors, but also allows the company to inflate earnings (as it flows through EBIT under the real estate division). The drawback to such a policy is that the Shareholder’s Equity declines annually. From 2006 to 2012, Shareholder’s Equity has declined from $2.1B to $1.2B and as a result, Plum Creek now trades at 5.2x book value v 3.5x previously. Book value today currently stands at less than $8.00/share.
| |
2007 |
2008 |
2009 |
2010 |
2011 |
2012 |
| Book Value |
1,901 |
1,572 |
1,466 |
1,374 |
1,263 |
1,202 |
| BV/Share |
$11.77 |
$9.73 |
$9.08 |
$8.51 |
$7.82 |
$7.44 |
Lousy Returns: If you look at any metric, you will see their timber business is poorly positioned. Return on Invested Capital is a lousy 2%, which is actually an untaxed number given the REIT structure.
Trees Organically Grow is Analogous to Building Inventory: While timber bulls believe that even if you do not harvest this year, you will benefit from greater volumes down the road conceptually makes sense, I believe a harvest deferral is analogous to building inventory. Because industry demand dropped significantly from the 2005-2006 peak, the industry has been under-harvesting for years. This has led to a structural oversupply in the market that will inherently limit any material price appreciation over time. This is evident from the increase in demand seen earlier this year. As housing picked up in January, the entire industry jumped at the chance to increase volumes and dump supply on the market. To use the Northern Sawlog part of the business as an example, Plum Creek experienced a 34% increase in volumes in the second quarter, but pricing declined steadily through the months of April to June such that the ending price in the quarter was 4% below the average. I am of the view that it will take years to eat through the backlog of effective inventory that has been built from reduced harvest levels. If you assume volumes have average 10% below average for 6 years & we are 20% below normalized levels, then it would take three years to effectively eat off this inventory overhand (clearly theoretical). While less relevant for the purpose of this write-up, it also worth noting that there is a significant amount of hidden inventory/supply in the hands of government acreage and family trusts. Decisions to sell or monetize acreage can have a severe negative impact on the industry that is not well understood and could limit any material price improvement in the industry.
Land Value Play:
A significant portion of the thesis has rests on the fact that the company has approximately two million acres of Higher Better Use (HBU) land that could be worth a significant premium to the average value of its timber. During the real-estate bubble, the company sold off certain acreage to land developers at large valuations, thereby convincing the market that the remaining acreage is worth a comparable value. Assigning $1,500/acre to the HBU acres remaining would suggest a value of approximately $18/share. That said, I am of the view that the company has been selling the highest valued land first, thereby implying a lower valuation than the remaining acreage. I believe this is done to 1) drive higher earnings on the income statement and 2) to continue to support the theoretical value of real estate. While this could continue to many years, it is of note that the margin on real estate sold has been steadily declining over the past several quarters, thereby implying to me that the high value big earnings driven land sales may be coming to a close.
What is the Market Valuing The Business:
Most sell side firms have target prices equal to that of the current stock price, suggesting little fundamental upside even under the relatively bullish scenario. I estimate this is generally broken down in value as follows:
Timber: $7.5B
HBU Land: $1.7B
Other/Corp/Manufacturing: 0
Net Debt: $1.9B
Equity Value: $7.2B ($44/share)
Summary:
I think it makes more sense to step back and look at what this business could look like in a housing upturn. Given we have actual data on the volumes and pricing historically, it is a good reference point. If you go back to 2005 during the last peak in pricing, Plum Creek did $308mm in EBIT and what would translate today to ~$1.39 in earnings per share. Assuming a 5% cap rate on peak earnings and + $18/share in land value (property development, HBU land, etc.) you have a stock that is fairly valued today. This would suggest a profit/ton improvement of ~100% higher v current and volume improvement of 30% current levels. What I believe is more appropriate is to assume a more normalized EPS number of $.85/share, a 5.5% cap rate and rural land value of ~$10/share. Overall, I believe the stock to be worth ~$25/share, which takes into account the normalized level of housing starts plus an estimated value of the remaining acreage to be sold.
(The above commentary is solely the authors' opinion)
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