Potlatch Corporation (NASDAQ:PCH)
Bank of America Merrill Lynch US Basic Materials Conference
December 10, 2013; 03:35 p.m. ET
Michael Covey - Chairman & CEO
Michael Roxland - Bank of America Merrill Lynch
Michael Roxland - Bank of America Merrill Lynch
Michael Roxland, Senior Home Building analyst for BOA/Merrill. We are pleased to have Michael Covey, Chairman and CEO of Potlatch who is here with us today and with that I’ll turn it over to Mike.
Thank you, Mike. Welcome everyone. In the back of the room our presentations will follow what’s on the screen if you’d like to follow along, on the table in the rear.
I draw your attention to the forward-looking statement in the presentation, also our website, as well if you’re following on a webcast.
Potlatch is the fourth larger of the four Timber REITs. I’d like to think of ourselves not as the smallest, but I guess the math dictates that. Nevertheless Potlatch has got a successful run as a Timber REIT and our business outlook going forward is very favorable. A market cap of just $2 billion today, a little less than 1.5 million acre platform in three distinct geographic regions of the country.
We converted to a REIT in 2006 to provide our tax sensitive investors with a very efficient level of, single level of taxation and the dividend is capped at a capital gains tax rate, another attractive advantage of owning a Timber REIT.
And regarding the dividend we are very pleased to announce that on Friday of last week we increased our dividend by 13%, the first increase that we made in quite some time. The dividend now stands at a $1.40 per share with a yield of about 3.5% and we hope to continue to drill that going forward on a sustainable basis.
Business is organized under the Timberlands business, which we think was our resource business and then we operate our wood products manufacturing business and our real-estate business under the taxable REIT subsidiary as you can see on the chart.
Switching to our Timberland business to begin with, to outline the platform of ownership that we have, the largest landowner in the state of Idaho with over 800,000 acres of large landowner in the lake states, primarily in the state of Minnesota. There’s a very small amount of acreage left in Wisconsin and then on the South Central Arkansas where we own a little over 400,000 acres of Timberland.
Our wood products manufacturing business produces just under a billion units of products in aggregate, including 650 million board feet of lumber that we produced in four saw mills; two in the lake states, one in Bemidji, Minnesota, one in Gwinn, Michigan and then a saw mill in South Central Arkansas and Warren, Arkansas and another one in Idaho.
As well as an industrial plywood plant in Idaho, where we manufacture plywood for the industrial segment of the country. We don’t make residential plywood. It all goes into industrial end uses and applications such as boats, RVs, motor homes; rider trucks applications such as that.
And our wood products business has performed very well recently. The distinguishing feature of Potlatch compared to several of the other Timber REITs is we have a lot of leverage to the wood products manufacturing business and the business has performed very well, particularly in the last two years.
You can see that on the next slide, on page six, the breakout of the revenue segments for each of the three businesses, as well as the EBITDA contributions of those. I would like to points you to the bottom of the slide, early through the great financial recession and since the time of the company’s conversion to the REIT in mid 2006 we got fairly stable revenues and a fairly stable generation of EBITDA, despite the mix of businesses that have been up and down during that period, which really demonstrates the flexibility of the timberland asset class through all the wood products businesses.
The Potlatch story is largely about housing and the improving demand for housing in the country. It drives the price of wood products, which in turn drives value back to the trees, which we own and which we think of in terms of the value of the sawlogs and it starts with the housing recovery.
We’re in what we think are the early stages of improvement in that, so you all know housing starts are on their way up, a little under a million starts this year. We look for slightly over a million starts next year, but I think importantly for Potlatch as we look two and three and four years out, we think the second half of the decade is going to have very robust housing starts and a continued improvement in the demand for wood products and which would cause pressure on the price of both lumber and plywood entries.
You can see that that’s already started to take place in the Pacific Northwest with the price of logs on this graph. A green line depicts the price of Pacific Northwest sawlogs, which are back to levels that are very close to the pre-recession high excluding the big bubble that occurred in the mid 90’s from the listing of the Northern spotted owl.
So pricing in that market is high and why. Lots of tension in the market due to demand from the Chinese and Japanese log markets, the Chinese lumber market as well and strong demand from the US saw mills that are in the business and plywood plants that are in the business of buying logs in the Northwest.
Contrast that with the picture that’s depicted on the red line in the south. Southern log prices have gone in exactly the opposite direction. They are as week as they’ve been in some time and continue to languish, whereas the Pacific Northwest is quite strong. The distinguishing different, the absence of Chinese demand in the U.S. south and an overhang of supply, as many of the Timber REITs and timber investment management organizations that manage and own Timberland in the south deferred harvest during the great recession. That overhang of supply still exists in the market and southern log prices are quite low.
Potlatch has an attractive inventory of timber inventory and a harvest profile going forward. Well we think it’s going to give us a lot of leverage as the U.S. southern market improves. We deferred harvest from our peak of about 4.4 million tons back in 2008, down to about 3.6 million to 3.7 million tons in the last couple of years and much of that deferral is taken place in the U.S. south, as I mentioned due to the weak pricing. We have increased our harvest levels in the Northwest to take advantage of strong pricing, but the opportunity going forward is really to pick up harvest levels in the south as markets improve over the next two to three years.
You can see that on slide 10 the price of logs for the company, sawlogs for the company has moved up nicely $6 a ton in the last year alone, which added $16 million of incremental cash flow to the bottom line of the company, and in that nice trend that you see the yellow line in sawlog pricing is really a reflection of an improved mix and a richer mix out of the pacific northwest, while sawlog harvest levels in the south remain quite flat.
So against that, what are the other demands, supply and demand fundamentals that are going to drive the business going forward and lead the higher cash flows for Potlatch in the years ahead?
In addition to an improving housing market which we think will continue, we also got supply factors which are well known in the industry that acquired in the British Columbia forest products industry due to the mountain Pine Beetle, approximately half of the log supply in British Columbia has now been killed by the Mountain Pine Beetle and all of the logs are being salvaged and used going forward over the next two to three years.
That its going to have a supply impact, somewhere in the order of 5% to 10% of North American supply will go away because of what’s happening in Canada; that’s point number one.
Point number two is China. I just saw in the press this last week, record exports from North America of lumbar to China on a year-to-date basis. The 2013 numbers will likely be higher than what we’ve even forecast here, which I think bodes for the strength of that market. The accessibility of lumbar and eventually from logs from North America and what we see is solid and increasing demand there, which will keep tension on the markets, especially in the specific North West.
And finally the emerging demand for biomass throughout the country, primarily due to pellet plants focused mostly in the U.S south. These are the facilities that compete for pulpwood with paper mills and OSB plants to purchase pulpwood to grind into industrial wood pellets, which have been exported largely to the UK and to Europe -- the European continent for use in co-firing with coal and other energy sources to meet the renewable energy mandate of Europe with 20% renewables by 2020. So we think that puts continuing pressure on pulpwood as well. All three of these factors coupled with strengthening lumbar markets really help accelerate Potlatch’s ability to generate cash flow going forward.
We’re seeing a nice trend here in lumbar and plywood pricing on page 14 and while this market continues to have bubbles in it and peaks typically during spring building seasons, I think you have to look through those bubbles and look more at the longer term and the lumbar and plywood prices are generally on an upturn and we think they will be despite weather aberrations and other things which are facing the industry today in this month and as the weather across the country its very difficult, no doubt lumbar prices will come under pressure. But we look through that and think about 2014, ’15 and ’16 and beyond. As housing improves, these prices should improve as well.
The foundation for our optimism is centered on residential construction. You can see on the blue bars here on the graph on page 15, we have a strong belief that new home construction is going to continue to gain steam throughout the middle part and second half of this decade with stable demand for repair in any model and other sectors along the way.
So what does that translate to for kind of forwards looking basis for pricing? We plotted on the graph on page 16 its historical relationship between North American demand capacity ratios for the lumbar business against on the y-axis, the price of SPF 2x4. The wobbled line that’s depicted here is not a best fit; it’s an approximation of the relationship between demand, capacity and price.
As you can see with demand capacity ratios in the North America between 75% and 80%, you can see on that graph on the red dot where we expect 2013 to finish, perhaps a little bit ahead of the trend line, but that’s not surprising given the large spike in lumbar that we saw in the spring of this year since we traded a little bit, but still strong and as we look into 2014 with an additional 4 billion board feet of lumbar needed to build the houses that we forecasted, that will be constructed in 2014 without a lot of additional capacity are being installed by the competitors in North America.
We think that the operating ratios are going to move 80% and with that we should see stronger pricing in 2014 than we are going to see in ’13 just like 2013 was better than 2012. Again, under our favorable outlook for our businesses – and you can see that in the cash flows from our wood products business, which I mentioned at the outset.
Potlatch has a lot of leverage to wood products pricing into our production of lumber and plywood. Our wood products businesses on an LTM basis generated $70 million in cash flow this year. In 2012 I think the number was $58 million, so its much stronger this year than last and with stronger pricing in 2014, we expect it to even be better, so a favorable trend in our wood products business.
Let us shift gears and talk about our last business segment, the real-estate business and like all Timber REITs we have property throughout the country that’s better suited to recreational uses than to grow trees. We’ve identified a little over 200,000 acres of that property. We’ve mentioned several times we plan to sell about 20,000 acres a year. We’ve got about a 10-year runway here.
On property sales the business is lumpy and it goes up and down with demand, but demand for us has been quite steady, somewhere between 40 and 50 transactions a quarter, primarily in the State of Minnesota, where we sell rural recreational land with just a few hours from the Twin Cities.
Over time we expect that real-estate demand to shift to central Idaho, where we own a real gem of property just two hours north of Boise, Idaho. In the McCall area there is a large ski resort there that’s working its way through bankruptcy. We think that will eventually come out of that and be successful and as the second home market gains traction. We think the second half of the this decade will see a better real-estate market in Central Idaho, which kind of takes the place of what we’ve been doing in Minnesota.
Skip to slide 20, you can see the historical pattern of revenue and prices per acre. It’s a pretty stable business. Prices per acre are high and better used land. The better quality real estate that we have, have been drifting up a little bit. Prices for the bulk of our work, which is depicted in the rust color here, have been pretty steady at around $1,200 to $1,500 per acre.
The transactions depicted in the yellow are largely complete and over with. This was the sale of non-strategic timberland that we pretty much executed during 2009 through ’11, that’s mostly been complete, and going forward most of the acreage that we’ll sell again, about 20,000 acres a year more of less will be HBU and rural recreational land that’s depicted here.
Finally we get questions about well, if you’re selling real estate you must be diluting the asset base of the company and while that certainly can be true, we hope to grow the asset base, but you can see what’s happened here over a long period of time. Starting in 2007 at the time of the re-conversion we purchased a couple of 100,000 acres of timberland, mostly the land in Central Idaho. We since sold a couple of 100,000 acres of land over the last seven years as our structure as a REIT and we are back to about 1.4 million acres where we started in 2006 at the time of the REIT conversion.
The acres that we own today are more valuable than the ones we held seven years ago and I think have a lot more cash flow generation potential going forward and our aim certainly is to grow the company and add to the acreage base over time.
Let me change gears and talk about the balance sheet and a few financial metrics for a minute and then we’ll take questions. Potlatch has a strong balance sheet today. I think the best way to look at the business is a net-debt to enterprise value, because the timberland on our books has been there for – in some cases nearly 100 years. The book value, the timberland traditional way that you think about debt to book value doesn’t make much sense.
Our net debt to enterprise value, its about 13.8% today. We think we have ample room to grow debt in the company for the right kinds of acquisitions. We have an un-drawn $250 million revolver. Investment grade rated by Moody's was split rated with a DD+ rating from S&P. They recently put us on positive credit watch and we are hopeful to move through investment grade rating from S&P and B, investment grade rated by both rating agencies shortly after the first of the year, not before.
In the last year we paid down $37 million in debt. Most of that we prepaid just about all that we can to make sense with the mix now of about 85% fixed rate debt and 15% floating. You can see on the next slide the maturity profile. We got one big bullet 2019 of a $150 million bond issuance we did in 2009, but other than that very modest debt maturities and very manageable over the next several years.
Looking at this cash flow generation from each of the business segments on slide 24, we’ve seen a nice improvement in every one of Potlatch’s business this last year on an LTM basis. Our resource business is better because of stronger pricing in North West. Our Idaho business where most of that activity takes place is performing very well with stronger cash flow generation.
Our real-estate business is kind of staying the same year-over-year. As we mentioned we sell about 20,000 acres a year, so there is so surprise there and a nice steady improvement in the cash flows from our wood products manufacturing business on an LTM basis to about $70 million.
So how does this translate? We try to focus on for shareholders as funds available for distribution, what can we generate at the end of the day to give back to shareholders. On an LTM basis FAD was about $77 million of dividend prior to our increase of $50 million annually. That’s stepped up now by a little over $6 million with the increase that we announced on Friday, but still gives us a fair amount of headway going forward to use the proceeds not only for capital expenditures where we need to, but hopefully a little more room to see future dividend growth on the horizon.
So as we look forward we are optimistic about all of our businesses. We think specific Northwest is going to continue to have strong markets. We look for the southern log market to turn and improve as housing continues to recover in the industry. Our wood products business is solid and generating strong cash flow at each of our facilities and attractive dividend with the yield of about 3.5% that we just increased in a balance sheet that we think is poised for growth and can certainly stand a little more leverage as we look at acquisition opportunities on the horizon.
With that Mike, I’ll pause and take questions from the audience.
Michael Roxland - Bank of America Merrill Lynch
Thanks Mike. I guess I’ll kick it off first. As you had noted here, you raised the dividend 13% to $0.35 a share quarterly from $0.31. Is there a particular ratio, lets say a percentage of FAD that we should be thinking about on a go forward basis as the company target.
Well we’ve. The philosophy with which we’ve approached this is we are going to grow the dividend on a sustainable basis. We have not set metrics to distribute a certain percentage of cash flow or FAD to shareholders, while some have given guidance, some of our competitors give guidance in that regard.
I think with the lumpiness of our business, wood products are still a cyclical business. We have a real estate, which is fairly steady, but we can really be wood sawed by changes in sawlog prices. We set our goals as to grow it on our sustainable basis in a measured way and that’s as definitive as we are going to be.
Michael Roxland - Bank of America Merrill Lynch
And just as a quick follow-up, you know historically you had mentioning growing the dividend based on an improvement in your timber cash flows. It seems like you’ve become a little more comfortable with wood products and the early generation out of that business, such that you are able to raise dividend with slow improvement in resources and slow improvement in wood.
What’s the logic behind this you are thinking in terms of reasons that have been based on really significant improvement that we see the wood products business over the last 12 months.
Well, your observation is right and we are more confident about our wood products business than we have been. As you look at the slide earlier in the deck, it came trough a very difficult period where it generated almost no cash flow, but I think if you look at mid-cycle earnings for our wood products business, that’s how we try to think about what’s sustainable in the dividend.
We are probably a little bit ahead of the mid-cycle earnings in the woods products business today. It’s doing very, very well and our mid-cycle earnings are probably a bit less than they are today. So that came into consideration.
But I think importantly for us, at some point southern log prices are going to turn and I think as the housing recovery takes shape over the next two to three years and we don’t think about it quarter to quarter, we think about it in years here. As southern log markets improve and they will as the harvest backlog gets worked off, even if wood products comes off a little bit in terms of its earnings stream in the next couple of years, we think our southern log prices are going to move up and that’s what it gave us comfort and the board comfort that a meaningful increase to the dividend of 13% made sense now and we’ll approach it year to year from here, and hopefully be able to grow it some more.
Again what gets lost for Potlatch a little bit that’s worth noting is while we saw a significant impact from the decline in southern sawlog prices and the volume deferral that we took, specially following the closure of one of our customers large plywood facilities. If you look at the cash flow that we’ve lost in our southern log business, it’s been more than made up by the performance of our southern saw mill. Log prices in the south are low, product prices are high and the cash flow generation from our southern saw mill has really been exceptional.
Thanks Mike. I had a couple of questions for you. If we go back five years ago, others in the industry used to talk about the Pine Beetle having a 10%, 15% impact on overall lumber production and I don’t recall what your forecast was or whether it has changed or not. But it seems that over the years the expected impact, the expected reduction in ultimate lumber production from Canada into the U.S. has diminished. Would you agree with that premise as the impact that people are expecting changed and declined somewhat and if so, what’s driven that? That is question number one.
Question number two is, and maybe you may have mentioned it but I missed it. Do you expect southern log process to more or less follow SPF or will the continued increase in merchantable inventory retard that improvement, that inflection point in log prices relative to what we are seeing in the product market?
Thanks George. Let me tackle the Canada question first. Just doing the math of the supply that comes from British Colombia and that that’s going to be affected by the Pine Beetle, I think you can still get to the 10% kind of number that you referenced and that many of us have talked about in the past, which is roughly on the same order of magnitude is what happened when the spotted owl was listed in the mid-70s and you have the price response from the impact, into the market from the impact of the decline in the Canadian forest products industry is nowhere near as great as what happened during the spotted owl. I guess that’s one frame of reference.
I think the reasons for that is taken longer. The woods been able to be utilized for longer period of time. Some of its found markets in China. The Canadians have shifted their harvest to other species that are green and by green I mean not been killed by other species that are not susceptible to the damage from the mountain Pine Beetle. So I don’t think that the Canadian situation is going to play out as robustly as probably we thought it was two to three years ago. In terms of the supply shock there has been a couple of announced mill closures, but in many cases the Canadians has shifted production to other facilities.
I think the other thing that’s going on, and don’t forget under all that has been a softwood lumber agreement between the two countries, which I think is generally operated pretty favorably for both. The percentage of the Canadian zone of the U.S. market is gone from the mid-30% range to the mid-20% range and so I think those things have all been slow to take shape and I don’t think that we are going to see a big supply shock from Canada. It’s a long-term favorable impact for the industry, but it’s not something we are going to wake up one morning and say gee, Canada is out of business. Isn’t this wonderful for wood product pricing. It just isn’t going to happen.
Second part of your question, southern log prices and what are they going to bench market to. I don’t think it’s probably fair to say they are going to follow an SPF pattern, but I don’t have any reason to say they are still correlated with that. They are certainly not substitutable, southern pine lumber doesn’t get used in the same way that SPF does. But I think as the overhang of backlog or supply gets worked off over the next two to three years and it will, I think you will see southern log prices trend up to the trend line that I showed in the earlier graph which was on page, maybe 10 or something like that, I don’t have the book right in front of me.
But I think southern log prices will trend back up to the trend line where they have been in the past. Roughly speaking, southern log prices today are around $40 a ton delivered to a facility and I think that if you went back in three or four years time you would have seen those same logs at $50 to $55 a ton and I think that’s the kind of magnitude that we expect to get back in shape as the industry heals itself over time.
Just curious on the product side what you would distribute the long-term real decline in product prices to. If you look at lumber listed like a 20-year period, real prices are down pretty significantly. I’m just curious what your thoughts are on what drives that.
Well there’s been a long term belief that over time lumber or logs are an inflation hedge over time, but I think it’s a fair observation in the last 20 years the real price of the products that we manufacture from logs has not gone up as fast as it did probably in the 20 or 30 years prior to the mid-80s.
A lot of that has to do with the spotted owl crises that I mentioned, which caused log prices to life way up. If you translate from logs to the product prices that you are referring to, I think the industry’s become more productive. The cost of the wood products manufacturing has been more or less flat over that period of time. There has been intense pressure in the industry, especially during the downturn where those were competing for every sale that they could and I think that drilled down.
Lumber pricing reached its lowest levels since World War II, I think three years ago and it just hasn’t picked up from there. It’s gone up, but on a inflation adjusted basis it’s not up as much.
Canada is a terrific producer. We see imports coming from around the world. This is a global business now. The U.S. now gets lumber from Europe, which didn’t happen 20 or 25 years ago. So I think all those forces, like lots of prices and lots of different commodities have been pretty darn flat or gone down in real terms. I don’t think lumber is immune for that. As much as we’d like to think its special and great, the fact of the matter is it’s a commodity and we build houses with it.
Mike I have one question on biomass. Biomass has been discussed as a big opportunity for a number of years now, and you even highlighted that as in the presentation as well. With the amount of natural gas availability and given where the price of natural gas is, do you think that biomass has the same potential as it had five to seven years ago. How should we think overall the benefits of biomass to the wood products industry and to the log industry?
Well, I think in North America, if your considering the price of natural gas in its current state, I think the biomass industry will be dead if that was its only competitor or the only market force. I don’t think there will be any appetite for it. There is no possible way that you can build a biomass plant out of the wood products stream that we deal with that makes sense compared to natural gas alternatives. But that’s not the playing field we are in.
Europe in the market and the renewals energy credits that I talked about and the demand for renewable energy to go into the coal fired power plants and European comment in the UK are what’s driving the increase in biomass capacity in the pellet business in the United States, not the power plant construction in the United States, but the end use manufacturing products in terms of an industrial pellet.
So if Europe were to or the UK were to back away from their 20/20 objective, 20% renewables by 20/20 and tax subsidies and other things that are in place for those supply chain fundamentals would go away, I think you’d see the pellet and biomass industry collapse here in the United States. It’s driven by the UK currently.
Michael Roxland - Bank of America Merrill Lynch
Any final questions from the Potlatch. If not, please join me in thanking Mike for a great presentation.
Thank you, Mike.
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