Description

Plum Creek Timber is a very highly valued stock trading at over 40X 2008 consensus EPS & over 33X FCF.  Plum Creek Timber has cut estimates twice in the last 9 months.  The commodities PCL sells (timber & rural land) are under pressure and the commodities they use (diesel & fertilizer) have risen dramatically.  PCL’s main resource, timber, is closely related to housing.  Housing accounts for 40% of timber volume and 64% of the timber value (in dollars), with half of that volume being for new homes and half for remodeling.   PCL’s stock has defied conventional wisdom and trades near an all-time high.

Business Description:

Plum Creek Timber Co., Inc. is a REIT that owns and manages timberlands in the United States.  PCL has 8 million acres of land. This can be further segmented into 2 million acres of rural land which includes 70,000 acres in development and 130,000 in joint ventures.  The remaining 6.1 million is classified as timber land.  PCL has highlighted the value of portions of its land that can be more valuable if sold as rural land, rather than harvested.  In fact, the company has begun this process.  PCL also has a small manufacturing (lumber) business.

We believe that 6 myths regarding the company and asset class exist that are keeping the stock price high: 

Myth # 1:  The private market value of PCL’s assets are between $50 (company estimate) and as high as $62 (street estimate) a share. 

This is untrue for the simple fact that the company could not be sold or liquidated at that price.  Much of PCL’s underlying asset value (40%-50%) is in rural land.  Rural land is usually used as somebody’s trophy property; consequently it can’t be sold all at once but rather piece by piece to maximize value.  PCL admits that it should take 15 years to sell their current rural land holdings.  If you were to discount these land sales back to today, you would get a discount of 30%-45% to get actual private market value.

Myth #2:  Timber producers are not vulnerable to falling log prices.

Timber companies have the option of letting trees grow instead of cutting them, if prices are not satisfactory.  Essentially every business has that same option, it’s called building inventory.  Eventually this build up in inventories has to have an effect on prices.  The decrease in harvest in part explains the lag in log prices vs. housing, but also indicates that the downturn may last longer than housing.  One Caveat- a pine beetle infestation of Canadian timber is forcing them to cut, putting pressure on current prices, but should also decrease their harvests in later years (potentially increasing prices in future years). 

Myth #3:  Rural land has a correlation to farm land.

With the spike in farm land prices, bulls decided to mine some data. There does seem to be some historical correlation between rural land and farm land, although rural land has lagged recently.  Unfortunately, any correlation between rural land and farm land is spurious.  In the 1Q call, PCL’s CEO said “I think mother nature decided that trees grow good in some places, and corn grows good in some places and vice versa.”

Myth #4:  PCL can arbitrage by selling land in the private market and buying back stock.

This may be true in the short run (PCL is selling 300,000 acres of land to be used for conservation in what appears to be a very attractive deal).  We would point out that PCL is a fairly levered (4.3X TTM EBITDA) REIT, this would be a very efficient and highly valued capital structure, plus PCL is the largest land owner on the planet, giving them scale advantages.  The fact that they can currently sell land at higher prices than their market valuation is more likely indicative of excessive private market values for timber land than a cheap stock market valuation. 

Myth #5:  Timber is a renewable asset, which gives Plum Creek a continuous stream of income.

For the most part, this statement is true.  However, the return on growing trees can change over time.  On PCL’s last call they said that with the spike in fertilizer prices that the IRR of fertilizer application has gone from 15%-18% to 8% to 12%.

Myth #6:  Over time Timber land becomes rural land, increasing its value.

This may be true but the process may take decades and even centuries.  A recent and bullish Merrill estimate puts PCL’s timber at $1,292 per acre vs. $2,492 for rural land so not even double, not much of a big score considering you may be waiting 100 years for it. 

Potential Downside Catalysts:

A drop in timber or rural land prices:

Earnings keep dropping for timber properties, as log prices go down and costs go up, which should put pressure on private market values.  For an idea of how over valued timber land is we take Merrill Lynch’s estimates for timber earnings and valuation.  If we then assume that a buyer would use 25% debt paying 5% interest, they would get negative earnings and a Price to free cash flow of over 136.  We would note that though PCL has been able to sell timber properties for very high prices overall, some of their properties have been sold for the lowest prices in years.  The company has said these low prices were due to the properties being lower grade. 

Rural land is correlated to housing; the bursting of the housing bubble is starting to take its toll on rural land.  In a recent conference, PCL’s CEO Rick Holley noted “The real high value markets like Montana, where lands, higher and better use lands, can sell for $5,000 to $7,000 an acre.  You know that market’s a bit slow right now.  A lot of those high net worth individuals are staying home.” And from the 1Q call “you get into the higher value HBU properties, into the $5, $7, $8 or $10,000 an acre, which are much more high net individual interest, that market is really slow and the inquiries have come down there.”  We would note that HBU properties make up approximately 60% of the value of PCL’s rural land holdings. 

While some investors may be worried that you will be shorting against a bubble, we would point out that we do not know of any bubble or asset class that has been able to sustain itself in a period of deteriorating earnings.  Once again Plum Creek’s CEO says it best, during the June 5^th NARET conference in reference to timber lands “I think this will be a buyer’s market some time in the future”. 

Declining earnings:

Earnings continue to be under pressure for Plum Creek.  PCL has cut guidance twice in the last 9 months, but we do not think they have cut enough.  Log prices are clearly under pressure, of note is that PCL has suffered what looks like under a 10% drop in log prices while the industry is down over 20%.  The relative strength is due to location, but that could change as the housing crisis spreads. 

Rising diesel fuel is also a big problem for PCL.  For every dollar change in diesel prices, we estimate a $36 million hit to PCL’s earnings.  We do not believe that current, guidance or consensus incorporates diesels recent parabolic run (see exhibit 1 below). 

Catalyst