Description

SEEING THE PROFITS THROUGH THE TREES

Investment Thesis

We view Potlatch as an attractive long idea at today’s levels.  Potlatch is an asset rich timber REIT trading at a significant discount to its private market value.  We think Potlatch offers substantial upside if timber prices recover, and little downside (due to real estate value and dividend support).  We believe that Potlatch will be able to monetize non-core timber real estate at substantially higher prices than are embedded in Potlatch’s current stock price.  We view the stock at $30 as a safe way to earn a 5% dividend yield, with potential upside of 30% as Potlatch trades closer to its underlying NAV of north of $40 per share.

Background

Potlatch is the 4th largest timber REIT owning approximately 1.6mn acres of timberlands.  The company derives income from its timberland investments in real estate, including the sale of standing timber.  Potlatch also generates revenues through monetizing its non-core real estate and through sales of wood products, specifically lumber and plywood.

The table below shows Potlatch’s regional real estate ownership.

Note:  Trees are classified as either softwood or hardwood, Softwood- widely used as dimensional lumber for construction,  Hardwood- typically used for flooring, cabinets, trim, and furniture

Potlatch had a very poor year in 2015 as lumber prices fell dramatically causing weakness in its wood products business.  Notably, its core Resource Segment has been relatively stable.

Lumber prices were hurt by a strengthening US dollar (and weakening Canadian loonie), and to a lesser extent weaker demand from China.  The strength of the US dollar has been a severe headwind as it has made log exports from the West Coast less competitive and played a role in increasing lumber shipments to the US from Canada.  As a result Potlatch’s average lumber price realization per thousand board feet dropped by $56 in 2015 relative to 2014.  This led to significant drop in Potlatch’s wood products EBITDDA.  Interesting prices have been to recover, and, more recently, futures markets show lumber rising off the lows.  Below we show the trailing two year chart of lumber prices.

We think Potlatch’s fundamental outlook will improve meaningfully in 2016 and beyond as the supply/demand dynamics of lumber in North America become more favorable for US timber companies.  While Asian (Chinese) demand is expected to continue to be volatile, the supply outlook is beginning to turn increasingly favorable for US timber companies.  Unfortunately for Canada timberland owners, the mountain pine beetle infestation will drastically lower lumber production from Canada.  Approximately 57% of the total susceptible pine volume in British Columbia is projected to be killed by 2017.  This is important because British Columbia has historically produced 20-25% of North America’s lumber.  It is expected to take decades before BC forests recover.  Ultimately, US timberland producers will have to absorb the demand in the US.

Potlatch maintains a clear long-term harvest profile of the next several years and expects to harvest between 4.0 and 4.8 million tons of timber annually for the next decade.  Potlatch has the highest leverage to timber prices of all the timber REITs, so any fluctuation in price impacts the bottom line.  Historically, timber prices have been highly correlated to overall US housing demand (both housing starts and remodels/renovations).  We believe there is significant pent up demand and household formations have a long tailwind over the next several years.  This should lead to increased demand for lumber.  In the event lumber prices recover, Potlatch will benefit more than its peers.  For each $10 per ton change in sawlog prices, Potlatch would realize $20mn in incremental annual EBITDDA (the second ‘D’ is for depletion) in its Northern regions and $10mn more in annual EBITDDA in its Southern regions.

The sensitivity to lumber prices is more dramatic in its Wood Products segment.  Besides harvesting its timberlands, Potlatch operates four sawmills that produce about 650 million board feet of lumber annually.  Potlatch also operates a plywood mill that produces 160 million square feet of higher grade panels.   A $30/mbf change in lumber prices would equate to $17mn in annual EBITDDA.

ARBITRAGE OPPORTUNITY

With PCH stock at $30, the market is implying that the real estate value is roughly $1,000 per acre.  Yet, over the last couple of years there have been multiple transactions of similar timberland real estate (see table below); those transactions show that a significant portion of Potlatch’s timberland would be valued at closer to $2,000 per acre.

Interestingly, on December 31, 2015 Potlatch celebrated its 10th anniversary as a Timber REIT.  This is significant as PCH can now sell land without triggering a built in gains tax.  We view the anniversary as important as Potlatch can now monetize the disparity between the implied value the public market is giving Potlatch for its timber acres and the value in the private marketplace.  Potlatch management is very aware of the disparity and has publicly stated that they intend to monetize non-core timberland real estate.  We think that if Potlatch announces any non-core sales they will use the capital to buyback shares at a meaningful discount to net asset value.

“… we are actively pursuing opportunities to take advantage of the arbitrage between high private market timberland values and a steep discount at which our stock currently trades in the public equity market.  Hence, we have shifted from being a buyer of timberland to a seller with the intent of using sale proceeds, if we’re successful, to repurchase our shares and reduce our debt.”

Our built-in-gains tax required by tax rules for 10 years after a REIT election expired at the end of 2015.  This greatly increases our flexibility because we can now sell timberlands out of the REIT without paying income taxes.”

                                               -CEO Michael Covey 1/26/2016 earnings call

Valuation

At $30 per share, Potlatch trades maintains a $1.2B market capitalization and a $1.8B enterprise value.  The company has $626mn in net debt comprised of $322mn in term loans (due 2019-2024), $150mn in senior notes (7.5% due in 2019), $108mn in Revenue bonds (due 2024 and 2026) and $27mn in medium term notes (2016-2022).

We estimate the Net Asset Value (NAV) of the timberland real estate at close to $1,600 per acre on average which equates to an NAV of close to $42-$44 per share.  Historically, Potlatch and other timber REITs have traded at roughly 5-10% discount to NAV versus the 30%+ discount today.

Conclusion

Potlatch is an asset rich company that suffered from temporary issues in 2015.    We believe fundamentals are poised to improve after troughing in 2015.  Lumber prices have begun to recover and should be a nice tailwind for the company.  Additionally, there is significant downside protection as the real estate value would be worth much more than the current valuation in the private market.

Risks

• Housing recession drives lumber prices lower

• Strong US dollar/weak Canadian dollar

• Timberland values decline meaningfully

Catalyst

Non-core asseet monitizations at attractive valuations, recovery in timber prices