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Potlatch Corporation (NASDAQ:PCH)

Q3 2009 Earnings Call

October 27, 2009 8:00 am ET

Executives

Eric Cremers - VP and CFO

Michael Covey - Chairman, President and CEO

Analysts

Gail Glazerman - UBS

Mike Roxland - Banc of America/Merrill Lynch

Steve Chercover - D.A. Davidson

Mark Weintraub - Buckingham Research

Mike Marburg – Ramsey Asset Management

Joshua Zaret – Longbow Research

Operator

Welcome everyone to the Potlatch third quarter 2009 earnings conference call, featuring Eric Cremers, Vice President of Finance and Chief Financial Officer; and, Michael Covey, Chairman, President, and Chief Executive Officer for Potlatch Corporation. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator instructions) Thank you.

I would now like to turn the call over to Mr. Eric Cremers for opening remarks. Sir, you may proceed.

Eric Cremers

Thank you, and good morning. Welcome to Potlatch’s investor teleconference covering our third quarter 2009 earnings. Before we begin, let me remind you that this call may contain certain forward-looking statements within the meaning of US Securities Laws. These statements include statements about the company’s future business prospects, anticipated performance in upcoming quarters, harvest levels, and future dividends. These statements are not guarantees of future performance, and the company undertakes no duty to update them. Although these statements reflect management’s expectations today, they are subject to a number of business risks and uncertainties. Actual results may differ materially from those expressed or implied in this call.

For a discussion of certain factors that may cause actual results to differ from the results anticipated, please refer to Potlatch’s recent filings with the SEC. Also, please note that segment information as well as a reconciliation of non-GAAP measures, can be found in the supplemental materials on our Web site, www.potlatchcorp.com, as part of the webcast for this call. I would now like to discuss our third quarter results.

Despite a difficult economy in the third quarter we continued to make progress in several areas. First, we closed the previously announced timber deed transaction in the third quarter and used the nearly $49 million of cash proceeds to pay down drawings we had on our revolver. As I will discuss later, our balance sheet continues to strengthen and we have more than ample liquidity.

Second, our wood products division had positive EBITDA in the third quarter overcoming the very challenging conditions facing virtually all wood products manufacturers.

Finally, saw log and pulpwood prices appear to have bottomed and we continue to be optimistic about future log prices as we are forecasting significantly higher housing starts over the next several years.

Now let’s turn to the numbers. As shown on slide three of the slides accompanying this presentation, we reported third quarter 2009 earnings from continuing operations of $46 million or $1.15 per fully diluted share. This compares to earnings from continuing operations of $24.9 million or $0.62 per fully diluted share in the third quarter of last year. As a reminder, our comparative 2008 financial results have Clearwater Paper operations moved to discontinued operations including corporate administrative costs directly associated with Clearwater and interest expense for the debt retained by Clearwater.

I would now like to review our third quarter results broken down by segment. Our resource segment results for the third quarter of 2009 were significantly better than the third quarter of 2008. Operating income in the third quarter totaled $55.4 million compared to $30.7 million in the third quarter of last year. Of course the primary driver behind the positive earnings variance was the timber deed transaction which provided almost $42 million of operating earnings for our resource segment.

Slide four highlights harvest volume and pricing trends for the Northern region. Saw log feet volumes were down 24% comparing Q3 2009 to Q3 2008 as we continued to defer harvest levels to match the lower demand caused by sawmill curtailments. Saw log pricing in the Northern Region was down 29% year-over-year but actually increased 8% sequentially. Pulpwood volumes in the Northern region were down 20% year-over-year and pricing was lower by 10%. Sequentially pulpwood pricing in the Northern Region was up 1% as compared to the second quarter of this year.

Slide five highlights harvest volume and pricing trends in the Southern Region. Saw log feet volumes in the third quarter of 2009 decreased 16% from the third quarter of 2008 but increased nearly 2% sequentially. Saw log pricing in the Southern Region is holding up better than the Northern Region with prices down 7% year-over-year and flat sequentially. Pulpwood volumes in the Southern Region were up 7% year-over-year and up 11% sequentially. Pulpwood pricing in the Southern Region fell 12% year-over-year but was flat sequentially. As Mike will discuss in a moment, we are cautiously optimistic that log prices in both the Northern and Southern regions have reached a bottom.

Next, I would like to review our real estate business. As shown on slide six, our real estate segment closed sales totaling $5.6 million during the third quarter resulting in segment operating earnings of $1.5 million. This is down from $3.2 million in operating earnings in Q3 2008 due to a higher cost basis for land sold in 2009 versus 2008. In total we had 38 real estate transactions in the quarter. Coincidentally, the same as in Q1 and in Q2. Slide seven highlights our real estate sales by product type and as you can see we sold over 2,100 acres of rural recreational real estate in the quarter down from the 2,900 acres we sold in Q2 but consistent with the 2,000 acres we sold in Q1.

We also sold over 800 acres of HBU land and 2,600 of non-strategic timberland, both ahead of 2Q sales volumes. Slide eight highlights price trends for our real estate business broken down by product type. As you can see, rural recreational land pricing is stable and continues to sell for just over $1,100 per acre. HBU land pricing is also stable at around $2,300 per acre. We had one non-strategic timberland sale in the third quarter which included over 2,600 acres at an average price of $500 an acre. This non-strategic timberland was located in central Wisconsin. While our HBU land sale program continues to be relatively soft, our rural recreational segment continues to product solid results and interest in non-strategic timberland remains relatively firm.

Our wood products business continued to make solid progress in the third quarter with an operating loss of just $1.5 million compared to a $3 million loss in the second quarter and an $11.2 million operating loss in the first quarter. Importantly, EBITDA improved over $1.4 million when comparing Q3 to Q2 and it has now improved three consecutive quarters in a row. Slide nine highlights pricing volume trends in the lumber part of our wood products business and as you can see both lumber prices and volumes improved quarter-over-quarter. Some of our improvement in the quarter is no doubt seasonal in nature but also helping our wood products business is the fact that the U.S. dollar continued to depreciate relative to the Canadian Dollar increasing the competitiveness of our wood products business. We continued to carefully monitor key input costs in our wood products business.

Returning to slide three of the presentation, corporate administration including interest expense totaled $14.8 million for the third quarter compared to $11.6 million for the second quarter and $12.9 million in last year’s third quarter. Interest expense net of interest income totaled $5.1 million in the third quarter compared to $4.9 million last quarter and $4.8 million in last year’s third quarter. The increase in our third quarter corporate administration expense was driven primarily by higher retiree healthcare expenses, otherwise referred to as OPEB expense. We are planning to modify our OPEB programs to lower the liability and expense and we will discuss this in more detail when we discuss and release fourth quarter earnings next year.

We booked a $6.3 million tax benefit in the quarter largely due to losses in our taxable REIT subsidiary. EBITDA totaled $63 million in the third quarter versus $35.5 million in last year’s third quarter and $7.2 million in the second quarter of 2009. Funds from continuing operations in the third quarter totaled $64.3 million versus $36.4 million a year ago and $10.3 million in the second quarter. The company paid cash distribution of $0.51 per share during the third quarter for a total of $20.3 million.

Next I would like to make a few comments about our balance sheet and liquidity. As I indicated earlier we used the proceeds from the timber deed sale to pay down some of our revolver and that balance now stands at $72.5 million. Per the terms of our revolving credit agreement our last 12 months interest coverage ratio, or EBITDA divided by interest expense, now stands at 6.4 times, significantly higher than the covenant requirement of 2.5 times. Further, our debt to capital ratio for our credit agreement now stands at just 46%, also well below the covenant requirement which now stands at 55%.

Finally, we announced yesterday we are pursuing a $150 million offering of senior notes to be used to refinance our existing revolver debt and for other general corporate purposes. Because the offering is a 144-A Private Placement of Securities we are restricted on making any comments or answering any questions regarding the offering.

I would now like to turn the discussion over to Mike to provide some additional comments about our outlook.

Michael Covey

Thank you Eric and good morning. As we mentioned last quarter we are cautiously optimistic that log prices reached a low point during the second quarter and have since flattened out with slight improvements in demand and price in some regional markets. Over the next few months we don’t see a meaningful catalyst that will cause saw log prices to rise in either the fourth quarter or the first quarter of next year.

However, the returns for the biomass crop assistance program (OTCPK:BCAP) may enhance the value of pulpwood and biomass going forward. We are working with a number of our pulpwood customers who may qualify for BCAP. It is too early to estimate returns from this renewable energy revenue source but it may be meaningful for land owners and our customers next year.

As we move towards spring we expect to see stronger annualized housing starts which may be the catalyst for stronger wood products processing, stronger demand for logs and modest price increases off the cyclical low prices we have seen the last few months. Accordingly, we plan to continue the harvest deferral of 500,000 tons of saw logs through the balance of 2009 and at least through the first quarter of 2010. We expect our 2009 total harvest to be approximately 3.7 million tons compared to 4.3 million tons in 2008. We will provide information on our 2010 harvest plans on the next conference call in February.

As Eric discussed we have been able to manage our wood products business to cash breakeven for the last few months. As we enter the winter months we expect weaker demand and lower wood product prices despite significant industry wide curtailments and shutdowns. Offsetting this is the weak U.S. dollar which makes our wood products business more competitive and should provide a little tailwind. Because we expect weaker prices for lumber during the next few quarters we don’t expect stronger log prices from our customers who primarily manufacture framing lumber for home construction.

While we don’t expect to see the losses in wood products we experienced in either the first quarter of 2008 or the first quarter of this year, we do expect to operate modestly below cash breakeven for the next two quarters. We will provide more information in February about our 2010 outlook for our wood products business but we do expect it to be cash flow positive over the course of next year.

Our real estate business continues on a remarkably steady pace as we closed almost 40 transactions in each of the last three quarters. We don’t expect that trend to change nor do we see a material weakness in the demand or price of our rural recreational real estate or HBU. The very small number of acres that we sell in any quarter we can see large variations in average prices due to the quality of a particular tract or two. For this reason it is difficult to provide an outlook for prices on a per acre basis.

As we indicated last quarter interest in our non-strategic timberland remains relatively firm and setting aside large transactions such as the sale of 24,0000 acres in Arkansas earlier this year for $43 million our real estate segment should have revenue between $20 million and $25 million in 2009 which is very similar to our 2008 performance.

Although there has been no fundamental change in our overall business outlook over the last quarter we need to see improvement in log prices if we are going to reach our potential harvest level of approximately 5 million tons a year. We have been fortunate to execute a couple of large transactions during 2009 at attractive prices that have helped boost cash flow. The Timber Asset Class is still attractive to many investor groups although there is no question that return expectations have crept up slightly from previous levels.

Although our FFO and FAD metrics will likely fall short of covering the $20 million quarterly dividend over the next few quarters, we have ample liquidity to pay our dividend over the near-term. As we have stated before our board is comfortable leaving the dividend at its current level of $0.51 per share per quarter with the expectation we can support the dividend from operating cash flows as markets improve and harvest levels rise in late 2010 and 2011.

We will now take questions from participants on the call.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Gail Glazerman – UBS.

Gail Glazerman - UBS

Can you talk a little bit about the southern pulpwood markets? We have heard a lot of talk about the stress caused by the wet weather. Has that impacted your land and your customer base?

Michael Covey

As you know our operations are concentrated in Southern South/Central Arkansas. The rain has had an impact on the supply chain. Certainly it has restricted our ability to harvest log supplies and pulpwood supplies to many of our customers. There is no question that I think pricing is under stress due to that. Our ability to capture better pricing is limited by our ability to access the forest and operate in wet weather conditions. So far we have not seen a meaningful improvement due to the rain. We will see how things shake out in the fourth quarter.

Gail Glazerman - UBS

Looking at the North are you comfortable that the recent improvements in saw log pricing is something that is sustainable that have curtailed enough to kind of match demand?

Michael Covey

Absent another leg down in the economy, if that were to happen clearly that would change our outlook. Given the current state of housing starts and where we see things slightly improving as we go into next year we are confident that log pricing will hold.

Gail Glazerman - UBS

In terms of log transactions, could you envision doing another deal like you did in Arkansas and other timber deed deals? Have you been receiving interest in transactions that size or is that kind of out of the question at this point?

Michael Covey

Well the transaction that we did I think we viewed as fairly creative. It was certainly very tax efficient and we have received a number of inquiries about it. I think that is as much as we will say about that.

Operator

The next question comes from the line of Mike Roxland - Banc of America/Merrill Lynch.

Mike Roxland - Banc of America/Merrill Lynch

Regarding the balance sheet, can you remind what the maturity schedule looks like over the next few years?

Eric Cremers

It is very limited. Virtually nothing is coming due next year. Then I think it is $5 million a year after. I think total over the next five years is just over $50 million so very limited amount of near-term maturities.

Mike Roxland - Banc of America/Merrill Lynch

The $150 million you are looking to raise, as you mentioned in the press release $73 million would be targeted towards paying down your senior secured credit facility. Any specifics or any more color you could provide us with when you said general corporate purposes would that be something you would consider using possibly to fund your dividend if markets remain weak?

Eric Cremers

Well the cash what is left over after the offering will go cash onto the balance sheet. As we stated it will be used for just general corporate purposes.

Mike Wakelin [ph] -Banc of America

Wondering if you could provide some color on the energy policy and the BCAP program. How are you thinking about all of that with respect to your pulpwood harvest?

Michael Covey

As we have said the BCAP program is in the very early innings. The funding for the program in 2009 appears to be quite small. It is very uncertain as to the level of funding in 2010 but I think it is fair to say whatever is there should benefit our customers, the ones that qualify, and certainly should benefit the land owner. Our expectation is there will have to be some sharing of the BCAP benefit between the land owner and the customer. Those negotiations are underway with a variety of customers. I think the most important thing is this asset class over time has transitioned to a number of revenue streams and I think we are in the early stages of renewable energy whether it is for electricity production, ethanol production or other things. Just beginning to get traction and I think we will in 2010 and beyond begin to see more money from it.

Operator

The next question comes from the line of Steve Chercover - D.A. Davidson.

Steve Chercover - D.A. Davidson

I just wanted to discuss your housing outlook a little bit more. I don’t want to quibble with you. I certainly hope you are right but there are those who say that there is still a lot of foreclosures and mortgages that are not being serviced and things will get worse before they get better. How confident are you in that perspective?

Eric Cremers

When I talked about significantly higher housing starts, we are in the real low bottom right now, down to 500,000 or 600,000 unit level. Our view is it could move up to 700 to 800 next year and then up over a million starts in 2011. I think that is pretty consistent from most forecasting firms. Everybody has a different point of view of course, but most people point to those kinds of numbers. There are going to be a lot of additional foreclosures coming. Fortunately there is not a lot of new starts now helping to keep inventories down. At Harvard University their Joint Center for Housing Studies just released a report a few months ago. It talked about household formation over the coming decade in the 10-15 million range. Dividing that over the ten-year period you get to a million to 1.4 million starts a year required to support that household formation. We are optimistic. The industry goes through ups and downs like it always has and will continue to do so. We are cautiously optimistic we have hit a bottom here.

Steve Chercover - D.A. Davidson

So we are referring back to the [RECE] and Harvard type data.

Operator

The next question comes from the line of Mark Weintraub - Buckingham Research.

Mark Weintraub - Buckingham Research

Two questions related to the comment you made on the OPEB. Can you just remind us where the OPEB funding status is at this juncture and I recognize you don’t want to get overly specific I’m sure, but is it possible there could be a fairly significant change to that number or is it kind of more a minor change and it changes how the trajectory of the OPEB would be going forward?

Eric Cremers

Our OPEB plan is an unfunded plan and that liability to date sits on our balance sheet at $120 million. We are making considerable changes to the plan likely to be implemented in the fourth quarter and it could significantly lower that liability.

Mark Weintraub - Buckingham Research

I will ask it, can you give us a sense as to where you think that possibly would go to at this juncture?

Eric Cremers

We will give guidance as we get into next year with the fourth quarter results.

Mark Weintraub - Buckingham Research

On the corporate expense, you mentioned that had picked up for the reasons enumerated. Do you think that could go back to the $6-6.5 million range and this is a kind of one-time thing? What should we look on a go forward basis for corporate?

Eric Cremers

We aren’t done with our budgets for next year but I do anticipate that will come back down.

Operator

The next question comes from the line of Mike Marburg – Ramsey Asset Management.

Mike Marburg – Ramsey Asset Management

First, I understand that the private land owners now under TEMOS have constrained their harvest by 60-80% versus a lot of the public companies more around the 25-35% range. How concerned are you that a flood of new supply will push prices back down and demand incrementally recovers next year?

Michael Covey

Well certainly that is a risk but I think you have to think of it more of TEMOS and public landowners like ourselves don’t own land everywhere and so regional markets matter and help move 100-150 miles economically in distance. So the behavior of a TEMO in one part of Arkansas may have deferred harvest may be different than another area of Arkansas or Idaho or wherever the case may be. I don’t think it is possible to broadly answer the question. There can be certain markets where there is a factor. Just a certain saw mill and plywood plants and pulpwood plants have curtailed operations in some places. They may start back up much stronger than we anticipated to absorb that harvest so we are just going to have to see how it plays out.

Mike Marburg – Ramsey Asset Management

Is the competitive set in Idaho primarily one segment? Is it primarily TEMOS? Is it primarily independent landowners? I know there are not a lot of public players there.

Michael Covey

It is primarily Potlatch. We are the largest landowner by a factor of three or four.

Mike Marburg – Ramsey Asset Management

Secondly, on the BCAP program you mentioned earlier this might be apples and oranges but we have an expectation that the black liquor tax loophole won’t move forward and pass this year. Maybe you have a different view on this but the demand that has created on the pulp side is the BCAP program enough to offset that or am I not understanding it?

Michael Covey

Well I don’t know if the black liquor tax credits will be extended. It certainly can have an impact on the profitability of our customers that are in the paper business. I think BCAP to a lesser extent may provide similar kinds of benefits depending upon if the program is funded and that remains very unclear at this point.

Operator

The next question comes from the line of Joshua Zaret – Longbow Research.

Joshua Zaret – Longbow Research

First, in terms of wood products prices, plywood particle board, can you just tell us where prices are relative to 3Q average? Then also taking a little discussion on what is going on in the particle board market over the last couple of weeks?

Michael Covey

I can’t speak specifically to trends in the particle board market. We are a very small player and I am just not aware of any trends that may have happened in the last couple of weeks. In the lumber question, could you repeat your question again?

Joshua Zaret – Longbow Research

I just wanted to know in your products where your prices are today relative to the third quarter average.

Michael Covey

I guess off the top of my head without doing some calculations I couldn’t say. My intuition would be they are slightly below the third quarter average. Prices have dipped down just a little bit in the last 3-5 weeks. We would have seen stronger pricing in July and August than what we have today.

Joshua Zaret – Longbow Research

On the balance sheet, why is the restricted cash and the current installment on the long-term debt, why is that still on the balance sheet? Does that come off next quarter?

Eric Cremers

Yes it does. Those credits aren’t [some] debentures. They mature December 1st so this will thankfully be the last time we talk about the debentures again.

Joshua Zaret – Longbow Research

I am curious on this one, and maybe it isn’t a great question but in the South why is it you don’t have land you hold in reserve that you can access in wet weather to take advantage of spike that are created by harvest constraints? Or do you?

Michael Covey

Well the answer to that is solely dependent on topography and having land that is of an appropriate slope type or elevation that allows it to drain quickly and provides wet weather access. We have some of that in the western portion of Arkansas over near Prescott and Hope, Arkansas but that is too far from markets that are in the southeastern side near Crawford, Arkansas which is too far away so the opportunities are just very limited by topography and soil type.

Operator

At this time there are no questions in queue.

Michael Covey

Thank you for your participation. We look forward to talking to you in 2010.

Operator

This concludes today’s conference call. You may now disconnect.

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