Description

All $ figures are in $CAD unless otherwise noted.

TimberWest owns in fee simple 796k acres of timberland on Vancouver Island and its equity trades as a stapled unit on the TSX in Canada. The company's operating results have hit bottom and are likely to improve next year and beyond. TimberWest removed a major overhang to its units on Friday when the company announced the waiver of EBITDA debt covenants through 2011.

The potential was high for the company to violate these covenants in 1Q 2010 and this potential violation put pressure on the units. Although the units were up 10% on Friday, I believe this was an under-reaction and the units should be at least 50% higher. Looking out longer term, I think this equity is an easy double or triple in three years.

The units are out of favor with analysts, with an average rating of neutral and several underperform ratings and a median price target of $4. Most of these same analysts had price targets of $15 or more a few years ago. Yet, the strong long term earnings power of the company's timberland remains largely unchanged, and is perhaps even higher due to management's cost cutting.

The company's enterprise value per acre is $790 versus:

• Comparable timberland transactions of $US 1,400 to $US 4,000 per acre in the Pacific Northwest over the past few years
• NCREIF values of $US 2000 to $US 2220 from 1995 to present
• A discounted cash flow valuation of $10, or $1,690 per acre plus the value of HBU land

Timberland has very favorable long term investment characteristics, including inflation protection and high real cash flow growth.

TimberWest is an attractive acquisition target at its current valuation.

Insiders seem to agree the units are a buy. They have not sold one unit this year and have bought a significant amount. Insiders were net sellers in prior years.

Recent History

The company's units trade at $4 today and are down about 70% from $15 two years ago.

From two years ago, private timberland transaction prices are flat to down and U.S. public timberland REIT stock performance bracketed the S&P500's 28% decline: Rayonier -10%, Plum Creek -20% and Potlach -35%. (All of these figures exclude substantial dividends).

Why the difference in performance? Primarily because TimberWest was hit with a debt covenant violation at a very unlucky time: during the height of the financial crisis in 4Q08-1Q09. Creditors forced the company to raise capital after the debt covenant violation. This capital raise was February 11, 2009 in the form of $150m of 9% debt that is convertible into units at $3.50.

About $4 of TimberWest's move from $15 to $4 can be explained by the dilution from the convertible debt offering. In other words, the units would trade at $11 if the company had the same enterprise value per acre as two years ago. Adjusting for this dilution still leaves the stock down 60% from two years ago. I believe the potential for the company to violate a debt covenant in 1Q10 explains a lot of this 60%. The company announced on Friday a waiver of the covenant through 2011, removing this pressure from the stock.

Like other timberland companies, TimberWest's operating results have been poor in the last couple of years, due mostly to the downturn in U.S. and Japanese housing starts. However, from this low level it is likely results will improve.

• The company noted that recently "there is a bit of a saw log shortage in the domestic [Canadian] market"
• U.S. housing starts, a major source of log demand, are unlikely to deteriorate further. The current level of 600k is far below the 1.0-1.5m needed for new household formation and replacement according to economists. See http://www.voxeu.org/index.php?q=node/3782 and http://www.cbo.gov/ftpdocs/98xx/doc9885/11-17-HousingStarts.pdf.
• China and Korea are buying a rapidly increasing amount of logs from TimberWest. The Russian log export tax is driving part of this shift in demand to TimberWest. Russia has indicated in may raise the export tax yet again in 2010 or 2011.
• The mountain pine beetle could reduce the annual allowable cut in British Columbia by as much as 40% in 2012.
• Long term demand is likely to be greater than the supply of saw-logs. A snap back in log prices sometime in the next 2-3 years seems likely.

Strong Long Term Investment Backdrop for Timberland

The impact of the favorable factors below is critically dependent on the price one pays for timberland. With TimberWest's 15% free cash flow yield on normalized cash flows, you aren't paying for timberland's strong long term fundamentals, which include:

1.      According to GMO^ and other sources, Pacific Northwest timberland values should appreciate at 9-12% real (inflation adjusted) from 1) 2-3% real stumpage price growth and 2) 7-9% biological tree growth.

2.      Timberland returns tend to lead inflation by one year^^.  Binkley et al. (2005) showed that PNW timberland provided a strong inflation hedge from 1960-2004.

3.      "The supply of accessible natural timber has not kept pace with demand over the past few centuries."^

4.      Value can be added by deferring harvest. "Large-diameter trees have traditionally been worth more per unit of volume than smaller trees because they can be manufactured into higher valued products. When this happens, an investor benefits from two kinds of growth: biological growth in volume and economic upgrading from a lower-value commodity like pulpwood to a higher value commodity like saw timber (Zinkhan et al. 1992)."

^ Timber Investment Overview, GMO Renewable Resources LLC, October, 2005.

^^ From 1960 to 2006 the correlation coefficient of timberland returns and one year ahead inflation (CPI) was 0.6 per Forest Research Notes, Volume 4, Number 3.

^^^Capital Asset Pricing Model in Forestry: A Review of Methods and Applications, Binod Gyawali, October 2008.

Valuation

The units are clearly undervalued based on discounted cash flow, comparable transactions and history.

Capital structure today

Units outstanding: 78m

Plus units from convertible: 43m

Total units: 121m

Price per unit: $4

Market capitalization: $491m

Debt, end of 3Q09: $143m

Enterprise value: $627

Acres: 796k

EV/acre: $790

Discounted Cash Flow

*Excluding land sales

*"Risk and required return assessments of equity timberland investments in the United States", October 1, 2008, Forest Products Journal.

Sustainable Free Cash Flow from Timberland Harvest

Sustainable annual harvest: 2,400,000 m³

Price per m³: $105

Revenue: $252m

Royaties, etc: $4m

Total revenue: $256m

Variable costs (based on $60/m³): $145

Fixed costs: $26m

Timberland operating margin: $85

SG&A, excluding D&A: $11m

Capex: $4m

Unlevered free cash flow: $70

Notes

The average price per m³ was $105 from 1997-2007. Note that real saw-log prices grew 3.9% compounded annually from 1910-1997, so this will be a conservative price if you have a longer horizon.

TimberWest's average unlevered free cash flow excluding land sales from 1999-2008 was $68m and it was $78m from 1999-2007, which excludes 2008's -$18m.

HBU Land

A significant portion of TimberWest land is worth more than its timberland value.  In 2006 a study by Colliers identified 93,000 acres of TimberWest land with real estate potential and valued it "as is" at $300-450m, or about $4k per acre. I use a value of half of the midpoint of Colliers' $300-450, or $188m. In 2007 the company identified an additional 41k acres of real estate, for a total of 134k of land with real estate potential (aka higher and better use, or HBU, land); I exclude incremental value that could exist from this HBU acreage. Five years of HBU sales data are here:

* Leech Creek Conservation land sale totaled $64.7 million or $2,700 per acre reflecting primarily average timberland value.

History

According to NCREIF, the last time Pacific Northwest timberland was $700 was during the recession of 1990-1991. Adjusted for inflation using the CPI, $700 is $1,150 in today's dollars. Note that The Campbell Group in an April, 2009 presentation wrote that in 1990 "PNW timberland values were relatively low ($US1,300/acre)". This figure of $US 1,300 ($CAD 1,350) adjusted for inflation is $CAD 2,200 today.

Merely adjusting for inflation is likely too conservative. Over longer time periods timber prices, and timberland values, have outpaced inflation.

The compound annual rate of real price increase for saw-log stumpage was 3.9% from 1910-1997 according to an April 1999 paper by Richard Haynes, Chip Prices as a Proxy for Nonsawtimber Prices in the Pacific Northwest. Jeremy Grantham at GMO has cited a slightly lower figure of 3.3% real for the past 80 years.

Timberland prices have increased at an even faster rate than saw-log prices. Still, let us ignore the fact that timberland prices increase faster than saw log prices: assume 3% annual real growth plus 2% inflation for timberland. Applying that 5% nominal growth rate to a $700 per acre starting point in 1990 results in a per acre value of $1,800 today in the Pacific Northwest. This $1,800 value is a discount to the average PNW timberland value per acre from 1995 to today of around $US 2,000-2,500 according to NCREIF.

Comparables

TimberWest has much higher quality land at a cheaper per acre price than RYN, PCL, or PCH. TimberWest's lands are 100% on the Pacific Northwest coast, whereas RYN, PCL and PCH have only a fraction of their lands on the PNW coast. Note that coastal PNW timberland (e.g. TimberWest) is significantly more valuable than interior PNW timberland or timberland in the South or North East. This is primarily because the trees grow much faster on the Pacific Northwest coast than other regions.

August 13, 2009 Weyerhaeuser announced it has agreed to sell about 140,000 acres of timberland in northwestern Oregon for $US 300m, or about $US 2,140 per acre.

Brookfield Asset Management's (formerly Brascan) 2005 purchase of 639,000 acres of BC coastal timberland at $US 1,400 per acre. This could be the closest comparable transaction to TimberWest land since it was BC coastal land, a similar size to TimberWest and had a similar sustainable harvest per acre to TimberWest's land. I am unsure how the HBU potential of this land compares to TimberWest's HBU potential. The $US 1,400 per acre price excludes the value of sawmills and other assets. At $US 1,400 per acre TimberWest units are worth about $8.

From a December 10, 2007 Bloomberg article:

"Toronto-based Brookfield Asset Management Inc., whose Brookfield Properties Corp. is the largest landlord in lower Manhattan, bought Longview Fibre Co., a trust that owned 588,000 acres in Washington and Oregon, for the equivalent of $3,150 an acre [in February 2007], according to Merrill."

Campbell Group bought Menasha Forest Products Corp. and its 135,500 acres in Oregon and Washington in April [2007] for $4,000 an acre, according to RBC Capital Markets in Vancouver. The average value of Northwest timberland was $2,408 an acre in the previous four quarters, according to Chicago-based NCREIF.

From Pope Resources October 31, 2007 presentation:

• Longview Fibre (587,000 acres) acquired by Brookfield Asset Management for $US 2.15 billion (est. timberland value of $US 3,155/acre)
• Menasha (138,000 acres) acquired by The Campbell Group for $US 550 million (est. timberland value of $US 3,985/acre)
• Ohio STRS portfolio (430,000 acres) acquired by The Campbell Group for $US 780 million (est. western timberland value of $4,000/acre)
• MassPRIM portfolio (185,000 acres) to be acquired by Sierra Pacific and Rosboro for $US 660 million (est. timberland value of $US 3,565/acre)

Insider Buying

Insiders have bought a significant amount of stock this year, whereas in years past insiders were typically net sellers. The CEO and CFO each about doubled their unit ownership though open market purchases this year. In years past the CEO and CFO have been net sellers. A new director, whose appointment the company announced 3/6/09, bought shares in August. The company does not require directors to own shares.

Unit, Convertible Debt and Credit Line Details

Units consist of one common share, 100 preferred shares and approximately $8.98 face amount of Series A Subordinate Notes. These components are "stapled" together as a single unit and trade together on the Toronto Stock Exchange, under the symbol TWF.UN, as Stapled Units.

The company sold $100m of 9% convertible debt to British Columbia Investment Management Corporation (http://www.bcimc.com/) and $50m of 9% convertible debt through a rights offering to unit holders on February 11, 2009. The company would have rather sold land than the convertibles, but the market for timberland was frozen like most other markets. The convertibles convert into units at a strike price of $3.50 and pay 9% interest. The company will begin paying interest in kind starting October, 2009 to conserve cash until land can be sold in an orderly fashion or cash flows improve.

Credit line covenants (EBITDA covenants waived through 2011 as of last Friday):

(l) for each fiscal quarter permit:

(i) Consolidated Tangible Net Worth at the end of the quarter to be less than $700 million;

(ii) EBITDA for the then Current Period ending on the quarter year ends hereafter described, to be less than $8.3 million, $16.2 million, $24.1 million and $32 million, respectively, for the quarter year ends of

2010 and $40.7 million, $49.4 million, $58.1 million and $66.8 million, respectively, for the quarter year end of 2011;

(iii) Consolidated Debt to exceed 40% of Capitalization; and

(iv) Consolidated Debt to exceed 40% of the market value of Private Timberlands and Higher Use Properties. Market value will be determined in accordance with the valuation protocol set forth in

Section 17.7 (these covenants remain, but aren't an issue);

(m) permit:

(i) EBITDA for the period January 1, 2009 to June 30, 2009 to be less than negative $16 million; and

(ii) EBITDA for the period January 1, 2009 to December 31, 2009 to be less than negative $16 million;

Risks

If I didn't already address the points raised in this article, I'd be happy to in the message section: http://www.smartmoney.com/investing/economy/is-timber-an-overhyped-investment/?print=1

Regulatory. Canada already restricts log exports through 102. I suppose regulations could get worse for TimberWest, but it seems unlikely. Indeed, the odds seem better that 102 is overturned than more stringent regulations are enacted.

Catalyst

Improvement in operating results.

Company is acquired.