"The housing market is softer than people think," (Jeffery) Gundlach said, pointing to a slowdown in mortgage refinancing, the time it's taking to liquidate defaulted loans and shares of homebuilders that have dropped 16 percent since reaching a high in May. (Bloomberg, January 24th)
Pope Resources (POPE) is a publicly traded Master Limited Partnership (MLP) owning and managing land and timber in the Pacific Northwest, created as a spin-off in 1985. Assets include 113,000 acres of productive fee timberland and a 15% co-investment in 90,000 timberland acres. Essentially, all Pope's revenues are timber-related or land sales.
Pope has paid a trailing past-year distribution of $2.00, which equates to a sub-3% yield. This is far too low for an MLP, especially one whose earnings swing violently from profit to loss. A Seeking Alpha article seven months ago just about perfectly called the top and "time to take profits". At present, given evidence that a slowdown in housing is appearing, lumber prices are seemingly rolling over, and other income products pay yields more than double Pope's, we believe aggressive investors can profit handsomely on the short side.
We have seen plenty of China growth and "looming shortage" stories before in such resources as uranium, rare earths and fertilizer, and think the timber premium is also vulnerable over the intermediate term. Other MLPs such as Kinder Morgan (KMP), which pays a 6.8% distribution (annualized), significantly higher than Pope's - and that is for a pipeline MLP, something we believe as vastly safer. The JPMorgan Alerian MLP Index ETN (AMJ) currently pays 4.72%.
First, thinly-traded Pope was no refuge during the past 2 downturns, falling around 70% each time:
Chart source: Yahoo
In 2009, with shares sub-$20, Pope was undoubtedly a bargain. The shares' performance over the past few years, however, has outpaced distribution growth. We agree there is real value in the timberland, the growth in Asian sales is impressive, and agree the land near Seattle is a big plus. All this is wonderful if the growth story continues. If not, we point out that timber gets walloped in any type of slowdown, which happened even during a brief blip of lessened Chinese demand in 2012. As nice as the long-term thesis for timber may be, the simple fact is the shares are vulnerable to a 33%-50% correction, which would simply return distribution yields to a more competitive MLP peer yield.
We agree with the argument that value exists within. We believe the value of Pope's Real Estate will only increase over time and will certainly be worth much more twenty-five years on. Pope likes to point out the Company's long history of over 150 years of wise stewardship, so our point to investors is that expecting faster sales/earnings and distributions overnight seems unrealistic.
Secondly, Pope has help up this past year, while other timber-related REITs (Plum Creek and Potlatch) have been dropping, suggesting a 20% downside just to "catch up":
Chart source: Yahoo
Third, lumber prices appear to be topping:
Jeffery Gundlach is, in our opinion, one of the smartest investors working today. He is now very bearish on the associated sub-prime mortgage bonds which have under-written much of the housing recovery. As quoted in a recent conference call by Bloomberg, "You see Case-Shiller price data showing strong markets, and you expect in a certain logical way that these loss severities should be coming down as home values are increasing," said Gundlach, who started Los Angeles-based DoubleLine Capital in December 2009 and built it into the fastest growing mutual-fund firm ever in its first year. "Unfortunately, that's being trumped or neutralized by this rotting away problem."
We cannot see how any housing or economy "hiccup" would not also carry into lumber prices.
Fourth, costs are rising.
From 10K: "We rely on contract loggers and truckers who are in short supply and seeking consistent work at increasing rates". Recent booms in oil and commodities have raised production costs throughout the entire sector, as high paying oil-related jobs have reduced the supply of blue collar workers. We do not see any change to this trend; only lower commodity prices will free up labor. Of course, lower commodity prices would mean lower earnings.
Back in 2003, we bought heavily into the whole "China story" and commodity boom, investing in many legacy producers across multiple market segments. We wish to point out that while most commodity prices have risen dramatically over the past 10 years, the legacy land owners' earnings have not kept pace due to the rapid rise in production costs. We wrote recently, for example, on the legacy Oilsands producers who made a profit (not too many years ago) at $26 oil, but now production costs have risen to $80 per barrel. That's men and machinery. Back in 2009, Pope fell to a loss and reduced the quarterly dividend to $.20, so we believe any notion of value-based security by "hiding" in Pope is ill-advised.
We are sympathetic with those who do the "real work", especially in a high-risk business like timber, and would prefer they earn a decent living instead of some Wall Street charlatan twisting paper for billions. Pope's patient, long-term strategy is the right one, which is what makes the near-term price/yield ratio unsustainable.
Fifth, we like our gravy "lumpy", not our MLP income
Pope has a historic real estate portfolio near Seattle, which certainly is undervalued on the balance sheet and has been a help in providing income for the MLP, yet by the Company's own words, the "timing of sales will be 'lumpy'". Fair enough, that is how real estate works, but we believe investors should be paid higher yields for "lumps", yields of between 6%-9% in this market. Furthermore, although Pope has managed resources well during downturns by reducing lumber "harvest", commodity price and production volume reductions have directly impacted earnings. Investors are paying a huge premium for a growth story and may be already trapped.
One-time charges (or gains) aside, our biggest concern is operating income going forward, which was at a loss when prices volume dipped in 4Q 2012:
Pope Resources, A Delaware Limited Partnership
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(all amounts in $000's, except per unit amounts)
Three months ended December 31,
Twelve months ended December 30,
Costs and expenses:
Cost of sales
Real estate environmental remediation
Operating income (loss)
Anyone remember Enron?
We are not accusing Pope of any misdeeds, however, we believe investors should realize, and also discount, the fact that insiders manage private timber funds, which also involve Pope as a minority partner. From Jan. 29, 2014 NR: "December 2013 our third private equity timber fund closed on a purchase of nearly 10,700 acres of timberland in southwest Washington for $43 million. The property was purchased with a combination of $18 million of debt and the balance with the fund's equity. The Partnership contributed $1.3 million, or 5%, of the equity as part of its co-investment in this fund." We have typically avoided Companies with insider "deals", and at least suggest investors pay extra attention.
"Risk happens fast", as Doug Kass points out. We do believe the distribution due next month will be good, based on trailing earnings, but investors' perceptions are more important and we believe the shares are overdue to correct. Pope is very thinly traded, so a more practical positioning and scale-in or out, is prudent. If the "goldilocks" economy continues, stops can be placed above the recent highs, but given the already low yield, we believe Pope is not going to run away anytime soon. The main risk, as we see it, is a buy-out, but since insiders are big sellers we doubt they are interested.
Some premium in lumber-related stocks may be due to Canada's problems with the mountain pine beetle, but even so, this does not necessarily mean a near-term rise in lumber prices. Often harvesting is accelerated to beat the beetle or reduce its food supply, which actually pressures prices. This is similar to cattle prices in a drought, when prices first drop as ranchers reduce herd supply.
Plus, we note that another beetle wiped out the pine trees around our vacation home near Sedona, Arizona, and there are beetle problems in California - so there is no guarantee a beetle won't wander, they have, and that is a huge, longer-term risk to the Pope story.
We see any sustained market correction leading to a rather sizable sell-off.
One reason for the shares' rapid rise over the past 2 years may be the accumulation of one investor, philanthropist James Dahl, who now has a 10%+ position. Records show him as a heavy buyer in 2012 and '13, but with no purchases since September 2013. This idea makes some sense since while the earnings have been swinging wildly, the shares have not. Mr. Dahl is not listed as a manager or director of the Company and we do not know his intentions.
In addition, while insiders frequently sell shares for various reasons, we always take note when the CFO has been a recent, heavy seller.
For investors seeking to manage market risk in addition to profiting on any sort of housing slow-down, we believe Pope Resources is vulnerable to a correction and, in the event of another recession, a 50%+ share reduction. If a 50% share reduction happened tomorrow, it would only mean a trailing distribution yield of 6%, and perhaps up to 7%, if the distribution increases to $0.60 quarterly average. That would only serve to make Pope comparable with other single-ticket, volatile MLPs.
Yes, other timber REITs also pay low distributions, but this does not make us feel better about Pope or the industry. We believe Pope should be trading at a discount to its larger, more diversified peers. Thus, as an MLP who generally pays higher distributions due to "return of capital" (and a tax bill often upon a share sale) Pope should be valued primarily on its bottom-line distribution yield, given the earnings risks and close association with housing… and better, safer MLP yields are numerous.
With virtually no existing short position to worry about, we believe investors will come to recognize this discrepancy and appropriately re-rate Pope significantly lower.