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Dear fellow unit holders; There is no getting around the fact that 2009 was a very challenging year. The numbers tell the story, with our revenues of $20 million, off 27% from 2008 and 69% lower than our high-water mark of 2006 just three years ago. We have to go back 20 years to find revenue levels this low. We also reported an annual net loss of $272,000, or $0.07 per diluted ownership unit, only our third time in our 24-year history we did not make a profit.

-2009 Letter to Unit Holders from Pope Resources (NASDAQ:POPE) President and CEO.

POPE is the smallest publically traded US timber company.

Why invest in timber? From a recent WSJ article:

Whipsawed by gyrating markets in recent years, some investors are taking root in a little-understood asset class that since 1987 has handily beaten stocks—timberland. A dollar invested in the National Council of Real Estate Investment Fiduciaries' Timberland Index then was worth nearly $21 at the end of 2009, a compounded annual return of more than 14%. That same dollar invested in the Standard & Poor's 500-stock index was, with dividends included, worth $7.83, a return of about 9.4% a year. Returns aren't the only attraction. Timber historically has tracked the consumer-price index, thus serving as an effective inflation hedge.

The timber business has been in a down cycle for the past 3 years. As the largest consumer of wood products is construction, the demise of the housing market brought some timber companies to their knees as well. Like all good cyclical industries, the housing market will recover and so will the fortunes of the timber business. By most accounts, this year should be a bottoming process with an anticipated stronger 2011.

Probably due to its small size and a lack of visibility, Pope Resources is the most overlooked company in the industry. The majority of investors stop at the big three: Plum Creek Timber (NYSE:PCL), Rayonier (NYSE:RYN), and Potlatch (NASDAQ:PCH). The timber fraternity will soon be the big four with the addition of Weyerhaeuser (NYSE:WY) after their pending REIT conversion.

With a unique history dating back 150 years, Pope Resources was spun off from forest products company Pope & Talbot in 1985. The 1980s was a period in the forest products industry when companies were separating their timber and land holdings as a means of realizing greater shareholder value.

Pope Resources is a mini-micro cap company. POPE has a current stock market capitalization of $129 million, has just 4.3 million units outstanding and total debt of $29 million as 12/09. The company owns and manages 152,000 acres of timberland around Puget Sound and the Pacific Northwest. With a very low float, it is important to understand the make-up of its shareholder base. The General Partners along with the Andrew and Pope Families own 21%, insiders and directors own 5%, institutional investors own 19%, and all others (retail investors) 55%.

There are several unique features of POPE that are worthy of a long-term investor’s consideration.

Pope’s management has an interesting perspective on its size and position in the marketplace. From the company’s 2009 Annual Report:

As a small company that is thinly traded and enjoys only a limited following, we are not beholden to meeting analysts’ earnings expectations. As such, we are able to behave more like a private company and make decisions with an eye towards adding long-term value rather than focusing on the short-term. This past year was a good example of this principle, where we made a number of decisions that pulled down current earnings, but were nonetheless the right thing to do from a long-term perspective.

Two such decisions taken by management were to cut unit holder distributions to the bone and to dramatically reduce harvest levels. To preserve cash, and reflecting lower revenues and earnings, unit distributions were slashed from $1.60 in ‘08 to $0.70 in ‘09 and an anticipated $0.40 this year. Harvest levels were reduced from 42 million board feet (MMBF) in 2008 to 32 MMBF in 2009, with a similarly reduced harvest anticipated this year. Lower revenues were the result of lower harvest levels and substantially weaker market prices.

More importantly, due to relatively small debt service requirements, management had the flexibility to reduce harvests in a low price environment without jeopardizing re-negotiated loan covenants or repayment.

Pope Resources calculates its “sustainable harvest” at 60 MMBF annually, with an annual merchantable timber volume growth rate of 4%. Harvests below this level extends the life cycle of the underlying timber assets while harvests above sustainable levels depletes the cycle. With harvest levels last year and projected this year at 32 MMBF, management has effectively banked an extra year’s harvest for when business improves. By sacrificing the current quarter’s revenues, management will be able to harvest substantially higher volumes when market prices are more attractive, without altering long-term asset sustainability.

Pope Resources is in the process of relocating its timber assets. One of their major land holdings is its 71,000 acre tree farm in the Hood Canal area of the Olympic Peninsula, squeezed between the Olympic National Park and Seattle’s western most metropolitan reaches. Since 2006, as real estate is sold for higher and better uses (HBU), the proceeds are being reinvested in timber assets more conducive to harvesting. POPE has identified timber assets in southwestern Washington and northwestern Oregon as replacements.

Fee Timber is one of three operating sections; the other two are Real Estate and Timber Management. POPE is continuing to develop several projects on its western Puget Sound land. Its biggest single contiguous holding is in the Hood Canal, and should be very attractive for future development. POPE is about ready to commence a 200 acre, 558 residential and 228 multi-family lot subdivision in Gig Harbor, a desirable suburb of Tacoma. POPE owns assets in and around Port Gamble, WA. Port Gamble is one of the last historic “company towns” in the U.S., built by Pope & Talbot in the 1850s.

In other parts of western Puget Sound, POPE has residential and commercial properties that are being offered or are in various stages of entitlement development. POPE has currently identified a minimum of 2,500 acres of HBU.

In 2009, POPE sold development rights to a conservation group for $3.3 mil, or $8,250 an acre, that allows for continued timber activity on 2,500 acres in the Hood Canal holdings. Selling conservation easements in a slow real estate market assists in maintaining ongoing cash flow while allowing long-term timber activity to continue.

The company provides timber management services for third parties and manages two timber funds, Olympic Resource Management Fund (ORM) I offered in 2006 and ORM II offered in 2009, also known as timber investment management organizations, or TIMOs. TIMOs allow individuals and institutions to own a pool of timber assets through a passive-type investment.

POPE’s TIMO is a bit different than its competitors. While others strictly manage the third-party owned assets for a fee, Pope Resources co-invests in these funds, and has taken a 20% equity stake in each of the two funds it manages. Pope looks at smaller opportunities in the $10 to $30 million range that are mostly passed over by its much larger competitors. Pope also specializes only in Pacific Northwest assets, allowing investors to target specific tree species and their related opportunities.

The two funds managed by Pope have combined assets of $146 million, with $50M remaining for capital investment. The current market downturn in timberland pricing has allowed POPE to analyze various offerings, and the funds should soon be fully invested.

Structure as a Master Limited Partnership, POPE becomes an even more intriguing investment. As a long-lived asset, timber is especially well-suited for the tax benefits offered by an MLP structure. While not offering tax advice, many investors seek out MLPs for income and tax advantages, and POPE is the only timber MLP.

A review of 5-year history of select financial information:

2005

2006

2007

2008

2009

Revenues, millions

$57

$66

$52

$28

$20

EPS

$2.88

$5.23

$3.22

$0.23

-$0.07

Distributions per share

$0.80

$1.06

$1.36

$1.60

$0.70

Harvest MMBF

74

55

55

37

32

Log Pricing MMBF

$576

$611

$607

$506

$410

Stock Price High/Low

$56 / $19

$36 / $30

$50 / $34

$43 / $15

$28 / $15


Investors seeking a very small cap timber company, with no Wall Street following and little institutional ownership, should review Pope Resources. While not especially undervalued at current levels, POPE should offer acceptable long-term appreciation. As a mid-cycle opportunity, POPE should return to the mid-$40s when markets improve. Distributions should also move back to a more normal level of around $1.00 per unit.

POPE trades a small number of shares a day. The illiquid nature of the stock almost demands buyers and sellers use limit orders. An investment in POPE should be viewed with a long-term horizon as it is not a stock that lends itself to excessive trading. Before starting a position, all investors should review the company presentation dated Feb 2010 and read the Letter to Unit Holders from the 2009 annual report, both available at the Investors section of their website: www.orm.com

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: Long POPE and have been a shareholder since 2003