Plum Creek: If A Tree Falls In The Forest

| About: Plum Creek (PCL)

"If a tree falls in a forest and no one is around to hear it, does it make a sound?"

One of the most important philosophical thought experiments of all time; but it always just reminds me of the Far Side Gallery cartoon in which Gary Larson poses the equally weighty question, "if a tree falls in the woods, and nobody is around to hear it… and it hits a mime, does anyone care?"

That really gets to the heart of the matter. When no one is paying attention… whatever happens, really seems to make no difference. This thought leads me to a third philosophical question, "if a tree grows in the woods, silently and exactly as one would suppose, does anyone notice?" Based on the stock prices of the public timberland owners - I'd have to conclude, no.

While I'd like to revisit the long term investment thesis at some point-and I suspect I will since I'm also long the 2015 LEAPS-for right now, I am going to concentrate on the short term end of the story… primarily because I believe there is an opportunity to make money now. A chance to generate significant excess returns on the industry as a whole, and Plum Creek (NYSE:PCL) in particular, through the use of short term derivative call options. This would leverage the investment to the "improbable probable" scenario of a quick price convergence higher.

In terms of why I believe that scenario is in fact "improbably probable" - I'll break down the mosaic of my reasoning with seven confirmations of trends and events that have already taken place, as well as two potential catalysts that will unfold in the next few days.

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Confirmation #1.

The Housing Recovery & the Big Money Chasing It

Whether or not it is truly sustainable… and regardless of whether you believe it… there is a recovery going on in the housing sector. There is not a whole lot to prove here… the charts for new residential housing starts and new residential home sales tell just about the whole story.

And the market's perception is that this recovery has a long runway until it reaches the top. And whether that view turns out to be right or wrong, in the near term, perception always trump the facts-which is all that really matters to my "improbable probable" scenario.

So why not just buy the home builders? Because Wall Street prides itself on being forward looking. Since the following chart may not show up clearly for all readers, here is its key takeaway: the home builders have already moved. The average trailing 12-month performance is up 113%; more importantly, though, this great move up is not "in reaction to" something happening, but rather "in anticipation of" something that is now expected to happen in the future. We know this based on the aggressive out-year valuations on earnings and EBITDA. The group is fairly representative of traditional cyclical businesses… what they lack in hard assets, they tend to make up for in incremental operating leverage. The price move higher over the past year has become a lesson in the physics of momentum and the mathematics of herding. Wall Street is not just forward looking though, it's also forward thinking; and the thought that's likely forming in most money-managers' minds is what's the best way to cycle-out into the second and third derivatives.

It seems like the beautiful margin assumptions that always get built in for cyclical all-stars invariably end up being too aggressive. Commodity prices begin to rise as the raw material suppliers take their fair share of the excess profit pie. That is what happens in a commodity bottleneck. Supply is usually the factor that gets underestimated… and in the housing recovery's case, there is an increasing amount of deferred sawlog harvest combined with a secular decline in supply from British Columbia (~50%E of Canadian supply) that used to serve almost 35% of the US lumber market. Therefore it shouldn't come as a huge surprise that there is a vision forming of rising commodity prices coming down the pipe… and it isn't just a short term vision either. In the near term a bottleneck would likely happen faster than expected since it's always tough to turn the spigot back on; but if it does happen… it might be around for a long time. Longer term there are significant structural changes occurring in the dynamics of supply and demand for North American lumber that are likely to keep prices elevated for the foreseeable future. Luckily for us, PLC quantitatively spells out exactly what a price increase would do to its financial statements. Here is an excerpt from the company's 2011 Annual Report:

"As the largest independent seller of wood fiber in the country, we have a significant price-recovery upside for our products and valuable assets. For example, a $10 per ton improvement in sawlog price at today's harvest volumes represents a $73 million improvement in cash flow. A $5 per ton improvement in pulpwood prices equates to $43 million of additional cash flow."

That's a lot of extra cash flow. The price of the timber stocks is implying that investors believe there will be time to jump back in before a move higher… but as that vision of price increases gets clearer and clearer… the idea isn't likely to wait around, especially not with all the big money clamoring for an "undiscovered" way to get in on the housing recovery.

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Confirmation #2.

Timber: Growing as an Asset Class

Beyond just the investors looking to play housing, there are indications that timber could see an increasing share of institutional managers' capital allocation-a key factor to the dynamics of supply and demand for the stock as a financial instrument. Why might this be the case?

The management and ownership of timberlands is a nuanced industry... one in which I do not profess to be an expert. One thing I do understand about the industry, though, is that it does not "screen" well. Investors who subscribe to the Ben Graham School of Value Investing often lament that after running various screening criteria, nary a stock fits the mold. This is because golden opportunities rarely present themselves as golden opportunities; value is only found if it has not already turned up on someone else's screen.

This self-reinforcing principle of not being exactly as one appears reminds me of the motto for the Green Machine flavor of Naked juice: "Looks weird. Tastes great."

The first thought an investor should have when looking at valuation of the timberland REITS is "looks weird." Or in other words, the companies look expensive. And on most traditional metrics, indeed they would be… as a multiple of the ongoing businesses. As a silly corollary, imagine an industrial business generating 'x' profit from good 'ole widget making. Imagine it makes those widgets, though, using machinery that costs a large multiple of 'x'; or better yet that its corporate headquarters is located on top of a huge oil field. That critical detail is obviously going to factor in greatly to the overall valuation a prospective buyer would place on the entire business. And depending on whether it utilized debt, that factor will significantly alter the residual equity value; and make it appear as though the buyer is paying a wildly high multiple of ongoing earnings. So too for the timber industry…

We cannot forget the land; that irreplaceable asset that has represented a tremendous store of value throughout the history of human existence. Forgetting its existing businesses for just a moment, let this thought settle in… Plum Creek is the largest private land owner in the United States of America. Oh yeah, that land. So perhaps a more rational way to form a valuation is to include the price of the land: the enterprise value (EV) of the company on a per acre basis.

So how does that measure stack up? PCL trades at an EV of approximately $1,500 per acre. Fifteen measly Ben Franklins per acre and you can throw in the current businesses of harvesting and selling valuable (not to mention regenerative) sawlog, recycling land into higher value uses, and collecting royalties on all the good stuff underneath like oil, natural gas, aggregate and various metals… for free. Hmm… doesn't sound so expensive anymore.

This is not meant to be a political statement, but our National debt (not counting all those hip unfunded liabilities) has increased by roughly $5 trillion since President Obama took office. Maybe, just maybe… there are some people out there who would want to trade a few dollars for something this country hasn't been producing any more of since the beginning of time. Or maybe not… it's not like interest rates are low or we're approaching an important election or a fiscal cliff or anything…

According to a lengthy 2006 report from the Department of Agriculture's (USDA) Economic Research Service, the United States has a total land area of nearly 2.3 billion acres; of which 394 million acres are classified as non-Federal forest-use "timberland." For less than the market value of Facebook (NYSE:FB)-which I think is a good value, mind you-a group of investors could own 16.3mm acres outright. Not to mention millions more through land leases and license agreements. That's over 4% of all non-Federal timberland… and all the resource rights that go with it.

Oh hey, China! I forgot you only own an estimated $1.2 trillion of U.S. Treasury Debt! Swap out 3% of your holdings and it could buy you 1% of the entire landmass of our country. Or forget China, 'cause we're Am'urican! Maybe Buffett says the time is right to reload his "elephant gun." The timber industry has cost and environmental advantages - just like what Berkshire looks for, according to his 2010 Letter to Shareholders. It has asset value protection and consistent earnings power; and it literally has organic growth opportunities, while figuratively maintaining a "deep moat" with irreplaceable assets and numerous competitive advantages over other materials. Not to mention that in Plum Creek's case it comes from great stock; its predecessor is the same Burlington Northern that Buffett plunked down $44bn for in 2009.

And all it's going to take is one big investor to tip the scales and make the entire world revisit its valuation of timberland. Intrinsic "worth" is just equal to the highest price someone else is willing to pay for it.

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Confirmation #3.

PCL: Best-of-Breed

Even within the timberland asset class, I believe investors are likely to cycle out of other names and into Plum Creek. Simply put, PCL appears to have the best assets, combined with the best management, combined with the best dividend, combined with the best long term opportunity as a pure play commodity owner... and yet it still has only 240 "likes" on Facebook?! Come on!

Speaking of the dividend, let's take a quick look at the distribution yields:

Food for thought: if PCL's distribution yield converged to the level WY is trading, it would be a $70 stock. As in 60% higher than the level it is trading at today; and that's assuming of course that it doesn't raise its dividend when it next reports from a growing reserve of cash available for distribution.

Achieving that lower yield should be commensurate with growth… and judging by the numbers most investors seem to think WY has it. Weyerhaeuser (NYSE:WY) is actually my least favorite of the "big four" REITs. I understand the appeal-it's got more juice to confirmation numero uno, the recovery in residential housing starts. That leverage, though, is not leverage I personally want to own. I believe timber, as an asset class, is poised for fundamental long term growth with the potential of an "improbable probable" short term recovery. If I wanted exposure to a cyclical home builder, I'd buy one-just like everyone else already did. In fact, I think investors could still get better exposure to a hybrid timber-slash-homebuilder combo by cycling into 1 share of PCL and 3 shares of HOV for every 2 shares of WY. Not only would this lever an investor to the single-family home recovery, but it would leave the timber side of the equation with a best-in-breed, pure play that owns superior assets and currently pays out a larger dividend. That's right… an investor spending $44 on PCL for its $1.68 annual distribution ends up receiving nearly 20% more than the owner of 2 shares of WY, receiving $1.36 distribution on a $56 investment-which leaves the $12 left over for shares of "high-beta" Hovnanian (NYSE:HOV). Besides, WY has already moved. Benefiting from this homebuilder halo-effect, it has shot up more than 65% over the past 12-months vs. an average of about 25% for its timberland brethren. The money has already been made and investors will figure out it's time to move on… perhaps to PCL.

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Confirmation #4.

An Insider Tip?

Here is a piece of non-material public information… the land is still there. Here is a second one… the trees are still growing. Here's a third… insiders have been buying stock. Almost every senior executive and Board member has added to their holdings since May.

… and while trying to navigate through the complex web of form-4's and proxy statements can be a daunting task (and it does appear as though most of the additions were through various restricted stock and options), two members of the compensation committee added stock through open market purchases as recently as three weeks ago. The additions may not be the strongest sign of confidence, but it's certainly better than seeing the entire management team lighten up heading into the quarter.

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Confirmation #5.

PCH: First Out of the Gate

Potlatch (PCH:NYSE) was the first of the timberland REITs to go, reporting FY'12 Q3 results on Monday before the open. Its release provided an key read-through to the rest of the industry… but more importantly, PCH's planned harvest deferral held back headline results and did not disturb the setup for a potential "beat" from WY and PCL later in earnings season. In fact, thanks to instant headline-analysis by sources like flyonthewall, the stock actually traded slightly down until it got closer to its noon conference call.

So what did the company actually say? Here are a few excerpts from management's prepared remarks:

  • "In our Resource business, we again realized higher sawlog prices compared to the previous quarter."
  • "Over the long term, we believe a variety of factors could work in concert to create very favorable market conditions for both our Wood Products and our Resource segments."
  • "Though both near and long-term market conditions appear promising, we have not altered our near-term harvest plans"
  • "…intentional decision to defer a portion of our timber harvest activities"
  • "…most beneficial to our shareholders to exercise patience and preserve our timber value directly on the stump, allowing our trees to grow and further increase in value while awaiting even better market conditions."
  • "…already begun to see higher lumber prices translate into higher sawlog prices, particularly in our northern region."
  • "Undoubtedly, pronounced continued improvements in the Wood Products Industry, capacity utilization and profitability will ultimately lead to higher sawlog prices."

All sounds pretty good to me…

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Confirmation #6.

LL: Let's Get Silly

Lumber Liquidators (NYSE:LL) was up next, shooting up over 12% after reporting earnings Wednesday morning. What happened? Well it was your stereotypical, pre-recession style "beat and raise". Gangnam! The company topped consensus and raised its full year earnings guidance.

So what did management actually say?

  • "…delivery of a terrific quarter with exceptional financial results."
  • "Average ticket for the third quarter was the highest it has been since the fourth quarter of 2008."

How many companies have been able to say that this earnings season? The confident outlook confirms two things… lumber prices are going higher and valuations are getting silly. The company, a traditional brick-and-mortar retailer of lumber, is now trading over 35x current year earnings. All we would need is for a hint of that unbridled optimism to spill over into the timber market and it could be off to the races.

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Confirmation #7.

RYN: Small Beat Ain't Gonna Cut It

After that we had Rayonier (NYSE:RYN) report. Thanks for blowing it Ray! On the surface, headline numbers were down yr-yr and it looked like an in line quarter; and of course like any good west coast company, they then made investors wait until 2pm to glean all the details on the earnings call.

And so what did management finally say… before the stock started trading straight down in the late afternoon. Well for one thing:

  • "We anticipate cash available for distribution to range from $295 million to $310 million, substantially above our recently increased dividend."

That doesn't sound so bad. The company had just raised its distribution in late July and traded straight up for about a month afterwards. I think the lesson to take away from the release is as follows: in line isn't going to cut mustard when investors are looking for growth.

Management also put a small wrinkle in the story which I promise I'll get back to in a minute.

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Catalyst #1.

WY: Final Push?

On tap this morning is Weyerhaeuser. The "good times" may already be priced-in to valuation… but that doesn't mean there aren't "good times" to come. The fundamentals are still levered to the housing recovery; so while its "mo" may be slowing, it can certainly still deliver a solid earnings beat… and perhaps a rising tide lifts all boats.

Consensus stands at $0.18. That doesn't look unachievable for a company that put up over $4.00 of earnings back in 2005.

And maybe this is just me being crazy, but I'd tend to think the company's CEO would not be out making headlines on U.S. tax reform, asking to pay higher taxes, unless his business was humming along. Ok, fine… "broadening the base" may not be exactly the same thing as paying higher taxes, but still… the thought process is the same.

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Catalyst #2.

PCL: In Store for Its Own Surprise?

Finally we get to Plum Creek. In this "improbable probable" scenario… to play against time, you need to play the game of quarterly earnings. It's when the lights flash on and investors determine if they were right or wrong, and adjust accordingly. So if it turns out right… and the company "beats"… what exactly is that even worth? Well in this day and age, if it's the right combination of factors, it sure seems to be worth a lot.

To be able to exceed expectations, though, we first need to understand where those expectations are set. Consensus is at $0.36. This is in part because management provided quarterly financial guidance of $0.32-$0.37 at the end of July-a time when the market was exceedingly jittery.

I have this weird philosophy that any CFO, who can't set an earnings bar appropriately in a market where investors are worried about the Eurozone fracturing on a geopolitical level, deserves to be taken out to the woodshed and shot. Perhaps congress would endorse it as a jobs creator because judging by the number of companies missing earnings these days there would be a lot of those elusive "high paying" job positions opening up. But I gotta keep the faith… PCL is best of breed. And it has a recovery working in its favor. I've got to believe the bar was set right.

And maybe, just maybe, it was set really right. Maybe it finally comes time for the company to recognize all that extra cash available for distribution and raise the dividend. We know it's coming as pricing begins to improve… its laid right out there in the Letter to Shareholders. So how about a "beat and raise"… what might that be worth?

Ahhh the wrinkle. I'd told you I'd get back to this. The only real hiccup in this plan is the pesky export market. On RYN's call, its management commented that the company has seen the resource market in the Pacific Northwest (that exports to China) remain soft. The export trade has represented a significant portion of that regional market in recent years… so to the extent it has yet to bounce, it could hold back leverage… but we'll just have to wait for Monday to find out.

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So that's it. My basilica on why PCL and the rest of the timbers might see a short term move higher.

Of course the one other thing to bear in mind is I am biased. I am not writing this article as an academic exercise. I'm writing it because I believe it's a trade with potential to make a lot of money. I am long a whole slew of PCL call options at various points in the chain. I'm also long some PCH calls. (I'm also short a few FB puts).

So do I really think this whole chain of events is likely to happen in the very short term? Likely, no. It is not science… and there are a million other variables at work. I do think, however, that I've laid out a pretty reasonable scenario in which it could happen… one that seems much more "improbably probable" than the options appear to be pricing in. Perhaps some will take notice and the growth going forward won't be so silent after all.

Disclosure: I am long PCL, PCH. 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.

Additional disclosure: I am long PCL calls, PCH calls. I am short FB puts. I have no positions in HOV, LL, RYN, WY and no plans to initiate any position within the next 72 hours.

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