Despite the feeble state of housing starts in the United States, Pacific Northwest log prices have performed fairly well post crisis, particularly when set against the uninspiring price performance of logs from the South. Access to hungry export markets (China) explains much of the strong performance. In the coming years, we expect Pacific Northwest log prices will continue to perform well as looming log supply deficits in neighboring British Columbia (a traditional source of U.S. wood supply) wrought by the mountain pine beetle promise a tight supply situation in the markets the Pacific Northwest serves. Continued growth in export opportunities to China and other developing Asian nations, while less of a sure thing than the British Columbia supply deficits, also bodes well for Pacific Northwest log prices.
Among the timberland companies Morningstar covers, Weyerhaeuser (WY) remains a top pick, thanks in part to an outsized exposure to the Pacific Northwest region in its timberland portfolio. In contrast to timberland peers Plum Creek (PCL) and Rayonier (RYN), Weyerhaeuser also has a massive wood products business (lumber and panel manufacturing), so the firm is more leveraged to an eventual recovery in housing starts. Investors looking to place a bet on a housing turnaround (as opposed to a housing turnaround accompanied by significant home price appreciation) would do well to consider Weyerhaeuser. Importantly, Weyerhaeuser sits on an ample cash balance and has limited debt maturities in the coming years, a favorable liquidity profile that should mitigate the downside risk associated with continued housing start weakness.
Chinese Demand Buoys Pacific Northwest Log Prices, Southern Prices Weak
Pacific Northwest log prices have performed remarkably well post crisis: Douglas fir log prices tracked by the Oregon Department of Forestry are up 65% from crisis lows and down only 14% from their 2003-06 average. Pacific Northwest hemlock prices are up 71% from trough levels and up 8% from their 2003-06 average.
The post crisis surge in Pacific Northwest log prices is particularly impressive given the all-too-depressing trajectory housing starts have taken over the same period. The most recent reading from the U.S. Census Bureau put June starts (single family and multifamily homes) at 629,000 units on a seasonally adjusted annual rate (SAAR), not far removed from 2009's multi-decade low of 554,000 units and a distant cry from the 2.1 million unit peak of 2005. Needless to say, the story of log price recovery in the Pacific Northwest has owed little to the U.S. housing market.
Yet while underlying domestic demand has been moribund, overseas demand -- namely China -- has fared remarkably well. Year-to-date through April, total U.S. log overseas exports are up 79% from same period in 2010, with Chinese export volumes surging 322% (China now accounts for 52% of U.S. overseas log exports, up from 19% in 2010). U.S. lumber exports reveal a similar story: up 62% in aggregate, 416% to China. Canadian lumber exports from British Columbia also have fared well (up 45% in aggregate, excluding exports to the U.S., 100% to China), further benefiting log price conditions in the Pacific Northwest.
In contrast to the strong post crisis performance we've seen from Pacific Northwest log prices, timberland owners in the southern U.S. -- the country's other major commercial softwood timber-growing region -- have had very little to get excited about. Southern yellow pine prices in Georgia are up a mere 2% from crisis lows and stand 27% below the boom-era average of 2003-06. The post crisis log price trajectory in the South, which lacks access to Asian markets, seems to confirm the centrality of the export story in the price behavior we've seen in Pacific Northwest logs.
Looking ahead, continued wood products demand growth in China (and other emerging Asian economies) bodes well for Pacific Northwest log prices. Interestingly, most of the wood imported by China (be it logs or lumber) isn't destined for the wood frames of new residential construction, but for pallets, concrete forms, and scaffolding. Effectively, this ties Chinese wood demand to fixed-asset investment rather than housing activity.
Of course, continued breakneck demand growth isn't a given. In the event Chinese demand for wood products were to weaken or China were to return increasingly to its traditional sources of wood supply (neighboring Russia tops the list, but an export tax on log exports has damped Chinese purchases in recent years), Pacific Northwest log prices would have further to fall than Southern prices.
The Looming Supply Shortfall in British Columbia
Even if the upward march of export demand were to stall, there's still ample reason for optimism about Pacific Northwest log prices in the coming years. That's because wood supply from British Columbia, which historically has served the same markets as the Pacific Northwest, is set to trend dramatically lower in the coming years as a consequence of the devastation wrought by mountain pine beetle infestation on the province's lodge pole pine forests.
According to the British Columbia Ministry of Forests, Mines, and Land, roughly 45% of merchantable pine volume in the province's interior had died by 2008 and roughly 70% is expected to be dead by 2017. Harvest volumes, without a doubt, will be pared significantly from historical levels. Put in perspective, British Columbia traditionally has accounted for roughly one quarter of North American lumber output (a reasonable proxy for sawlog harvest volumes), so the ramifications for the continent's supply picture will be dramatic. One estimate, from timberland owner Plum Creek, puts the total hit to North American supply at 7% to 15%, a material deficit which will persist for several decades.
When considering the implications of the mountain pine beetle disaster for the North American wood market, it's important to note that beetle-killed trees can still be used for lumber in the years immediately following their demise. A recent study conducted by Forest Economic Advisors (FEA) estimated dead timber in moist regions of British Columbia has a 5-10 year usable span before it is rendered uneconomic. In drier regions, life spans might exceed 10 years.
Since the onset of the infestation in the early 2000s (the "kill rate" peaked in 2005), British Columbia producers have been working hard to salvage whatever value they can before the clock runs out on the dead wood's economic life span. Because producers are still working through ample quantities of beetle-killed timber, the market hasn't yet felt the consequences of the mountain pine beetle. The research paper put forth by the FEA estimates the effects of the kill won't manifest in log prices until 2013-14. We therefore see ample room for Pacific Northwest log price appreciation in the coming years, even if U.S. residential construction activity fails to rebound in a material way. A return to normal levels of annual housing starts (in our view, about 1.7 million including single and multifamily homes) by that time would create a perfect storm for Pacific Northwest log prices.
Weyerhaeuser Is Our Top Pick Among Timberland Owners
We cover three large timber REITs: Plum Creek, Rayonier, and the newest member of Morningstar's Club REIT, Weyerhaeuser. We view Weyerhaeuser as the best way to play the favorable outlook for Pacific Northwest log prices, as it boasts far and away the highest exposure to the region (not to mention no exposure to low-value Rocky Mountain and Northern acreage). Our fair value estimate for Weyerhaeuser is $28 per share, a 32% premium to the $21.28 price as of July 25. More aggressive, but not Herculean, modeling assumptions suggest a fair value of $37 per share.
We use a sum-of-the-parts method to value Weyerhaeuser because we believe this approach best allows us to capture the option value inherent to timberland that may have its highest and best use in a function other than wood production (such as development, recreation, or conservation). Our base-case estimate of Weyerhaeuser's enterprise value includes three components: (1) core timberland value ($11.2 billion), as estimated by calculating the perpetuity value of the cash flows associated with what we consider to be a sustainable harvest; (2) HBU timberland value ($1.5 billion), estimated for each state as a function of current population density and future population growth; and (3) the value of other businesses ($6.5 billion), including wood products, cellulose fibers, and real estate. We then subtract "double-counted" HBU acreage and net debt to arrive at our equity valuation. A brief description of our build-up approach for Weyerhaeuser follows:
Timberland: $18 Per Share
On a per-acre basis, Weyerhaeuser's timberland is exceptionally productive and profitable. We estimate average EBITDA of $83 per acre during the last seven years, much higher than peers Plum Creek ($38 per acre) and Rayonier ($57 per acre).
Geographical distinctions explain the disparities among the three. While southern U.S. acreage comprises the majority of each firm's portfolio (67% at Weyerhaeuser, 51% at Plum Creek, and 75% at Rayonier), there are big differences elsewhere. For starters, Weyerhaeuser has no exposure to the low-productivity Northern and Rocky Mountain regions. Plum Creek's 41% allocation to these regions explains its underwhelming per-acre profits. Another factor driving Weyerhaeuser's strong per-acre results is its large position in the Pacific Northwest (33% of the total), by far the most productive tree-growing region in the country. Pacific Northwest exposure is more modest at Plum Creek (8%) and Rayonier (19%).
We estimate midcycle EBITDA per acre at $125 in 2011 dollars, slightly lower than levels achieved in 2006 on an inflation-adjusted basis. We believe 2006 profitability represents a reasonable midcycle proxy since housing starts for the year were roughly in line with our estimate of long-term sustainable starts. Capitalizing this sum at a 6.9% real discount rate, we estimate Weyerhaeuser's timberland is worth $1,816 per acre or about $11.2 billion. Including net HBU upside adds another $738 million.
Wood Products: About $3 Per Share
This is a battleship of a business that has proved very hard for management to turn around. We'll probably have to wait for a housing rebound before we see significant profit from the wood products segment.
We value wood products using a 6 times multiple on $330 million midcycle EBITDA (modestly lower than 2006 EBITDA). This could be a very conservative modeling assumption: The business averaged roughly $1 billion EBITDA from 2003-05. Capitalizing the latter sum at 6 times would add another $7 per share to our $28 per share fair value estimate.
Cellulose Fibers: About $3 Per Share
Weyerhaeuser's cellulose fibers business, which makes mostly "fluff pulp" destined for diapers and other products that require absorbent properties, has been the company's strongest performer as of late. We value the business using a 6.5 times multiple on $350 million midcycle EBITDA. Again, this might be conservative. The business generated $542 million in EBITDA in 2010, benefiting from strong global demand and supply constraints. For our part, we expect realized prices to weaken as heady prevailing prices prompt significant capacity additions around the globe. But if we were to capitalize 2010 EBITDA at 6.5 times, this would add another $2 to our fair value estimate.
Real Estate: $3 Per Share
We value Weyerhaeuser's homebuilding business using a book asset multiple of 1 times, in line with the average multiple of our homebuilder coverage universe. We have some doubts as to the business' strategic fit, but given the depressed state of housing starts and the uncertain trajectory of housing prices, we believe it is extremely unlikely the company would move to sell the operation in the near term. Fortunately, given its substantial cash pile, Weyerhaeuser is under no pressure to undertake such a distressed sale in an effort to bolster liquidity.