Trouble In The Forest
By Andrew Bary
U.S. TIMBERLAND MAY BE ONE OF THE WORLD'S most overvalued asset classes.
Timberland is a rarity because prices have risen steadily since the mid-1990s, with Southern timber properties more than doubling to around $1,700 an acre, even as the price of logs, lumber and other forest products scrapes multiyear lows. Last year, when almost all investment categories declined in value and the U.S. stock market fell about 35%, timberland prices rose 9%, atop a 17% gain in 2007. In the first half of 2009, prices are down 0.5%, according to the National Council of Real Estate Investment Fiduciaries, or NCREIF, which tracks the timber market.
Timber prices could be vulnerable to a decline of as much as 50% in coming years. That likely would sting a group of real-estate investment trusts focused on timber, including Plum Creek Timber (ticker: PCL) and Potlatch (PCH), as well as Weyerhaeuser (WY), the forest-products company whose most valuable asset is two million acres of prime forest in the Pacific Northwest. Plum Creek, whose shares are flat this year, at 34, is expected to generate most of its 2009 profits from land sales, prompting analysts at Off Wall Street Consulting to write in a recent report that the company "increasingly looks like a self-liquidating entity rather than an ongoing business concern."
Plum Creek currently pays a dividend of $1.68 a share, and Potlatch, $2.04. Both dividends could be vulnerable because they're not generated from operations. Rayonier (RYN), another timber REIT, is in better shape because it has a more diversified business mix.
Credit Suisse analyst Chip Dillon downgraded Weyerhaeuser last week to Underperform from Neutral, citing its ongoing losses, a low dividend yield of less than 1% and potential tax and other hurdles if it tries to convert into a tax-advantaged REIT in the next two years. Weyerhaeuser, whose shares have moved up to 37 from 28 amid a rally in commodity stocks, is expected to lose about $2 a share this year. Dillon pegs "peak earnings" at about $4.45 a share in 2013.
If timber prices crash, the biggest losers could be university endowments and other institutional investors that plowed an estimated $40 billion into timber investments in the past decade as part of a major shift toward so-called alternative investments. The private market for timber is even more inflated than the timber values embedded in public REITs. Plum Creek, for instance, is valued at about $1,100 an acre, versus an average national private-market price of $1,800 an acre, according to NCREIF.
"If you look at income per acre, you're earning about a 1% return. A bank will pay you 2% or 3%," says Dillon. "The price of timberland is up two times in 10 years, while the income stream has gone down."
Dillon thinks timberland prices may decline as timber-investment-management organizations, or TIMOs, which hold millions of timber acres on behalf of institutional investors, begin to sell holdings in the next several years. Their funds hit predetermined liquidation dates, often eight to 10 years after inception.
It's tough to assess the state of the U.S. timber market because it is illiquid. It has gotten even harder to gauge the market lately because there have been no significant transactions since the global financial crisis erupted last fall. It is rumored that some sizable deals were shopped in late 2008 but were pulled from the market because of big gaps between what sellers wanted and what buyers would pay. On Plum Creek's earnings conference call in late July, CEO Rick Holley ventured that timber prices were down 10% from their peak. That could be an optimistic assessment.
Some small sales have been made at what Dillon considers inflated prices as TIMOs bought timberland from Plum Creek and other sellers. His view, in a recent note: TIMOs are "hustling to 'put money to work' in funds they created just before the financial crisis in order to avoid refunding these monies to fund investors" and thus getting lower management fees. Small sales at inflated prices also help maintain the value of existing timber holdings, but do a disservice to investors in the timber funds.
In the past decade, timber has migrated from the hands of long-time corporate holders such as International Paper (IP) and Boise Cascade to TIMOs, as forest-products companies sought to rid themselves of low-return assets, bolster their balance sheets and showcase hidden assets. Forest-products stocks generally have been terrible performers in the stock market for two decades. International Paper has rallied to 19 from 4 but remains below where it traded in 1989. Despite its impressive land holdings, Weyerhaeuser, at 37, is only slightly higher than it was 20 years ago.
Corporate owners found ready buyers in the TIMOs as timber became a hot asset class. Early investors such as the Harvard University endowment racked up big returns. Yet Harvard sold its U.S. timber holdings four years ago to Hancock Timber Resource Group, the largest of the TIMOs, with about $8 billion of timber assets under management. Hancock Timber executives weren't available to comment.
Timber has been hailed as an ideal investment for university endowments and other institutions because of strong historical returns, a low correlation with stocks and bonds, its renewable nature and supposed benefit as an inflation hedge. Bulls like to say timber "grows while you sleep" and isn't a depleting resource, unlike oil wells or copper mines.
Oscar Schafer, managing partner at O.S.S. Capital Management in New York and a member of the Barron's Roundtable, outlined the bear case for timber in our Midyear Roundtable in June ("Too Far, Too Fast," June 15). He said timber's "seductive investment pitch" doesn't make sense today. "The reality is the underlying cash flow is highly dependent on cyclical industries like housing, paper and newspapers," he said. "It is also tough to hedge inflation when you are buying at an inflated price. This is the greater-fool theory at work."
Compared with the outlook for key commodities such as oil, copper or aluminum, the outlook for most forest products isn't strong. Demand could weaken as the world goes digital and uses less paper.
One of timber's great selling points, its renewable nature, also means wood is less likely ever to be in tight supply. "With many of the trees maturing in recent years 'remaining on the stump,' we certainly do not see an immediate log-price jump when lumber markets heat up, as there will be a 'pent up' supply of logs for several years," Dillon wrote.
Part of the bull case for timber is that some land near expanding urban areas can be sold to real-estate developers. That argument, however, is less compelling now, given the weak state of the housing market.
"If timber is an inflation hedge, why are log prices at a 25-year low?" Dillon asks. Log prices are around $50 a ton, while lumber recently went for $222 per thousand board feet, half the 2004 high. North American newsprint is near a 20-year low at $450 a ton.
In outlining the bear case for Plum Creek in the Midyear Roundtable, Schafer noted it was valued at about 30 times estimated 2010 earnings and nearly 20 times projected pre-tax cash flow. Plum Creek's seven million acres of timberland are now valued at more than $1,100 an acre. He said $600 an acre is a more realistic value, which would translate into a stock price of $15 a share or less.
Timberland's tiny yields compare with 7% to 8% yields on commercial real estate for an all-cash buyer and similar returns on real-estate investment trusts. Why should timberland return so much less? Most of the reported returns on timberland in recent years came from appreciation, not log sales.
In the future, the timber market could see a shift in assets toward REITs and away from TIMOs. "We do not see sufficient benefits of having a private and illiquid interest in a multiyear timber fund versus having a highly liquid investment in a diversified timber portfolio owned through shares in a publicly traded timber REIT," Dillon wrote. He thinks the TIMO model also is in trouble because endowments and other institutions increasingly prize liquidity.
Dillon thinks Plum Creek, in particular, ought to consider cutting its dividend, both to husband cash for potential acquisitions in coming years and deal with debt maturities in 2011 and 2012. Plum Creek CEO Holley said on the recent conference call that the current dividend is "important" to both the company and shareholders and could be increased in the future.
Timber is one of those overhyped investments whose supposed virtues don't hold up well under closer scrutiny. It is hard to find an asset that has appreciated so much, even as the products created from it are so weak. This doesn't bode well for private holders of timber and investors in timber REITs. For those seeking commodity investments and inflation hedges, look elsewhere.
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