- Timber prices are near a cycle low and have a lot of upside.
- This will lead to bull markets in many timber resource companies.
- I think the midcap Deltic Timber Corporation is the best play.
I invest in commodities and commodity-related equities. My analysis always starts with the commodity, and my analysis is always long term. I look for commodities that are deeply undervalued, and then try to find companies that will survive the bad times to see the upside.
I believe that the timber market is such an undervalued situation. In this report I will first give my bullish analysis of timber. Then I will describe why I am long Deltic Timber Corporation to play it. The structure of this analysis is similar to my piece on Alcoa late last year. Readers unfamiliar with me may want to check out that report for additional perspective.
The US housing market remains depressed. Even after their recent trend up, US housing starts are still less than 60% of the average of the last 30 years. Although exports of timber and lumber are very strong, this is not enough to offset the domestic housing depression.
The result of this is that timber and lumber prices have fallen to very low levels. The next chart is a 35 year series for Canadian softwood logs. Because of the length of the series, I deflated it to 2014 dollars and adjusted for the change in the value of the $US against major trading partners. Current prices are about as low as they have been after accounting for inflation.
In many markets low prices inevitably lead to a reduced production, higher consumption and a turn in the cobweb cycle. This shows up well in the timber/lumber data. The next graph shows the above deflated price plotted against forward ten-year returns. So for example, on Jan 1995 the deflated price of softwood timber was $375. The graph forecasted that the ten-year price would only be about 60% of that, a 40% loss. In fact the price in 2005 turned out to be 64% of 1995's level, a 36% loss.
The red line on the graph is the current price. This model is forecasting a real ten-year price of $260. If inflation is 2% per year, this would work out to $315. Timber companies can make a lot of money at those prices.
How to Play it
This analysis is very long term. It makes no sense to trade this in the lumber futures market and have to pay the contango, the rolling costs and the commissions. It also makes little sense to invest in a highly levered timber company. This process may well take several years to work itself out. It is entirely possible that an over levered company will not survive to fight another day.
To decide which timber companies (I include REITs) are best, I look for two things. First, I want a company that can earn returns as high as possible in a low timber price environment. Second, I want a company that is conservatively financed, i.e. has low debt. I am not too concerned with current dividends and buybacks. The value here will be realized when the assets are worth more. This is primarily a balance sheet rather than a capital return play.
US tax law lets timber companies deduct for timber depletion, much the same as oil producers do. There are also tax breaks to encourage reforestation, which all timber companies do. For this reason I believe that GAAP earnings understate the economic profits of timber companies. To account for this, I am using cash flow from operation (OCF) rather than P/E to rank timber companies. I do make adjustments to OCF for one-time factors like increases in payables, but these turn out to be minor.
The following table has the data for six timber companies I have looked at:
Deltic is the clear winner here, beating on both metrics. However, Deltic is an Arkansas company, and it receives southern pine prices, not Pacific NW. Of course timber is a world market so one would expect southern and Pacific prices to have a strong relationship. Just to be sure, I checked the prices Deltic actually received vs. the Canadian prices used above. The two series tracked together beautifully.
For a relatively small company, DEL is rather complicated. DEL has four separate businesses, all tied to its timberland holdings. It harvests timber from its lands; it owns mills that produce lumber and products; it develops its real estate to higher valued uses (mostly McMansion-type planned communities in AK); and it leases its land to oil and gas producers. DEL's land is located in the Fayetteville shale play, mostly in the Lower Smackover formation. The distribution of the segments is as follows:
Oil and Gas Leasing
DEL's mills are located near the center of its landholdings. I believe the company is quite cost-efficient even with its smaller size. Note that the split between the Woodlands and Manufacturing segments depends on the transfer prices used. In the future, the Oil & Gas and real estate segments may have huge upsides. I consider them something of an option. Even more speculative is the possibility of large scale conversion of timber byproducts into fuel sources via cellulosic ethanol.
I haven't been able to talk to DEL's management, although I hope to at the next meeting. Their bios make them out to be experienced administrators, with long records in the timber and associated industries.
In keeping with the spirit of this site, here is a graph of the alpha of DEL vs. SPY since 2007:
I know. It's a really ugly chart. But that's what you look for when you are a value investor. Note that the chart may be making a bottom in the past year or so.
Since this is primarily a sector play, probably most of the major timber companies would be good bets. I would stay away from the heavily indebted ones, PCL and PCH (both REITs). Also note that there are some proposals in congress that would negatively affect REITs. The timber REITs are not in any jeopardy to my knowledge, but it is something to keep in mind. I have a position in DEL and will add to it if the sector behaves as I expect.
Disclosure: I am long DEL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.