Potlach Spinoff: Curb Your Enthusiasm

In April 2008, Potlatch (PCH) announced that it was evaluating a potential spin-off of its pulp-based businesses. After those businesses are divested, the residual company will be "essentially a pure-play timber REIT," exclaimed the company's CEO in a press release. Excited investors sent the stock soaring on the news.

Many investors and at least one Wall Street analyst are already referring to this residual company -- which I'll call Purelatch -- as a "pure play." However, Potlatch did not actually propose spinning off all of its non-timber businesses. Rather, it would retain the timber segment, as well as the wood products division (and six of its seven mills).

To quantify the impact of these proposed changes, I reviewed the company's 10-K filing. I determined only 45% of Purelatch's revenue in 2007 would have been timber-related. That figure rises to 49.6% if I conservatively exclude revenue (based on my estimates) from a recently closed mill. Hence, Purelatch is shaping up to be a half-play timber REIT. While that represents a big boost from its current timber exposure (a paltry 17% of revenue), it is far short of the 100% you'd expect from a "pure play," or even Plum Creek Timber's (PCL) current level of 71%.

I suspect this spin-off evaluation is management's reaction to persistent prodding from Wall Street; nonetheless, I do believe it would be a great business decision to divest any manufacturing assets. I'm skeptical that management can maximize the value of a timber business that is vertically integrated with low-margin manufacturing assets.

The current arrangement creates conflicts of interest that could impair timber returns. Potlatch may be tempted to prematurely harvest timber -- or sell trees at deflated prices -- in order to subsidize its mills.

Why is this significant? Well, the biggest buyer of Potlatch's timber is ... Potlatch. Because the firm transfers much of its timber directly from its forests to its mills, 58% of timber revenue (highest among timber REITs) is classified as intersegment sales. There's nothing nefarious about intersegment revenue -- these sales are supposed to be recorded at market prices and are excluded from total consolidated revenue. Nonetheless, it would certainly instill greater confidence if the company would put more of its timber on the open market to sell to the highest bidder. Spinning off manufacturing assets would be one way to realize this goal for shareholders.

Disclosure: The author holds no positions in any of the securities mentioned in this article.

Comments

[Aalan]

It would be helpful if you would supply the actual breakdown of what the business is now: 17% timber and 83%--what?
Of course, one must take into account the fact that the timber business is at the deep bottom of a multi-year cycle: growing, not cutting, trees, until demand comes back up. And having some numbers that would show how the use of forest resources is distributed over the cycle, so we can see how much of Potlatch's business is in timber over a more meaningful or representative period, would give a much better perspective.
So, thanks for the news, but the analysis falls short of being helpful.

[GeorgeNichols]

Aalan, as I noted, the revenue is primarily from manufacturing. In the space of my article, I didn't overwhelm readers with the full quantitative details, but here's the non-timberland revenue breakdown for you:

Pulp & Paperboard (35.3%), Wood Products (24.4%), Consumer Products (23.4%)

While of course timberland revenue % varies from year to year, the swings aren't dramatic. PCH's timberland-related revenue made up 17% of sales in the poor housing market of 2007, but a near-identical 18% in the strong housing market of 2005. Hence, at various stages of the economic cycle, PCH has primarily been a manufacturer rather than a timberlands manager.

In your response to my previous article, you said you're interested in (or even own) PCH as a timber play. My goal isn't to criticize PCH or encourage shareholders to sell the stock; rather, to give shareholders a better understanding of exactly what they own.