Thursday, March 26, 2009
Sunday, March 15, 2009
The issue in today’s post concerns why the transaction price of timberland has shown little or no decline in value but the stock price of the publicly traded companies that own timberland has declined dramatically. I will also look at what I think is happening in the timberland market today and how I see the market for timberland investment. But first, let’s set the stage.
In January, I did a post that included some graphs developed from my timberland transaction file. I was looking to see if the data supported a wide-spread belief that timberland values had dropped. The thinking was that housing starts declined, which caused a drop in lumber prices, which caused a drop in stumpage prices (all true), which caused a drop in timberland prices. You can read that post here How Much Did Timberland Values Fall in 2008? The data did not support the logic and did not show any evidence of a significant decline in timberland values. (For those that sent emails saying my opinion was wrong – that was not my opinion, it was just the data). I also wondered what the NCREIF Timberland Index would look like when it was released. The publicly accessible portion of the NCREIF website showed quarterly returns that compound to a 9.5% total return for the timberland in its index in 2008 but the components of the return are not broken out. A recent report by Brookfield Timberlands Management, distributed by Forestweb, shows the NCREIF return broken down by earnings and capital appreciation.
NCREIF TIMBERLAND INDEX
The significant decline in the blue portion of the graph reflects the decline in housing/lumber/stumpage/earnings. The green portion, Capital Appreciation, can be viewed somewhat (not perfect) as a surrogate of the change in timberland value as determined from tract sales and appraisals of tracts – all of which are a part of the index. Note the green from 2000 to 2002. This data certainly contains no indication of a 2008 decline in the price of timberland either.
Below is another graph that I found interesting. It is from the Timberland Report VOL. 10, NO. 2; by the James W. Sewall Company, a highly respected firm with a very long record in the timberland investment community.
From my perspective, the important take-a-way from this graph is that the old correlation between timberland values and housing starts fell apart. We can speculate as to why and we can speculate as to whether the correlation will return but it’s pretty clear that the conventional wisdom has not prevailed during this economic downturn. Another graph in the report reinforces the historical correlations between housing starts and stumpage prices. That correlation did hold as all timber owners know only too well. You can read the entire Sewall report here(recommended).
Now, let’s take a look at the price of common stock in some of the publicly traded companies that have timberland holdings that represent a significant share of the companies’ assets and see how share prices were impacted last year. Ownership structures of these companies include timber REITs, “C” corporations and limited partnerships but for my purposes today, I will refer to them collectively as “timberland companies”. Let’s look at this chart I made from Google.
It’s hard to see but the blue line just above Weyerhaeuser (green line) is the S&P 500. Weyerhaeuser took an early hit because it has such a major direct investment in housing. I read somewhere that it is the 17th largest home builder. The rest of the timber companies fell about the same amount as, and in synch with, the general market. My conclusion is that the timber companies stock price tracks the stock market rather than with the timberland market. Not a “pure play” in the bunch. Down about 50% when timberland prices held pretty steady.
I have long been a skeptic of the “pure play” concept of acquiring timberland companies (or an ETF) as a surrogate for timberland ownership. Even if 100% of the assets owned by the company were timberland, I would still be a skeptic and here is why.
Timberland investors use metrics based on a time horizon of 10 to 50 or more years. The key metrics are based on a discounted cash flow (DCF) analyses over that time horizon. If you would like to read more about timber valuation than you really want to know, you can do that here. The metrics used by those that analyze stock value are usually based on very short term future cash flows of a year or two (no need to discount those!). The inherent assumption is that the stock price will respond to very short term (a few quarters or few years at most) cash flows and that the stock will be bought or sold in that time frame. Some of the most referenced metrics are based on what happened last year rather than what is expected to happen in the future (current P/E for example). The Warren Buffets in the crowd that actually do take a long term view of stock investing are a clear minority today and I’m sure that DCF is an integral part of their valuation. Don’t misunderstand me. I’m not saying that one way is right and that the other way is wrong, only that they produce different results and that creates a dichotomy in value and an opportunity for long term investors. Given all this, is it any wonder that the stock of the timberland companies has fallen dramatically with the general market decline? The value of their timberland portfolio is based upon the very depressed earnings reflecting current stumpage prices rather than the DCF of future stumpage prices!
At this point, I reach two conclusions (and I know that some will not agree)
- Timberland values have fallen little if any, and
- The timberland value component of the timberland companies’ stock price has fallen dramatically
And therein is the opportunity.
Here is another stock chart just like the one above except Forestar Group has been added. If ever there was a pure play for timberland/HBU, this is it. Other than some OGM, that is its only asset!
In spite of that, the stock price of Forestar dropped over 80% - the worst of the group. So much for the “pure play” concept. If you want to invest in timberland, you need to own timberland, not stock!
Think about this. Is it possible that the assets of Forestar were worth five times as much in June as they were in November? Some folks sure didn’t think so. To name a couple, Holland Ware and Carl Icahn. Both recognize the dichotomy in valuation methodology between timberland and the valuation of the stock in timberland companies! Both made some serious money with that little bit of information and a lot of cash. Buy at $3 - $4/share, offer $15.00 (still undervalued), sell at $12 or so. Not bad. And the $15/share offer? Even that was well under the underlying value of the timberland/HBU asset.
Okay. We understand what happened in 2008. What is happening to timberland prices now and what will happen in the future? I still have seen no significant decline in transaction prices regardless of the emails I get claiming dramatic declines in prices (no transaction details attached). There is a slowing of transactions, at least one announced major transaction (St. Joe) did not close and several tracts that were put on the market were pulled off. What does this mean for the future?
It may mean that prices will fall. It may mean that buyers are holding their cash until this economic downturn, recession, depression, or crisis begins to resolve itself. I don’t know what the future holds but I do know that there is a lot of pension fund and other cash out there that will be invested somewhere. Today it is going into money market accounts and just kind of sitting there. Barron’s reported about a week ago that there was $4 trillion in money market funds which is about one-half the market cap of the entire U. S. stock market. That is a lot of money and I doubt that it will all stay in cash. At some point, some will go back into the market, some to commodities, some elsewhere and some to timberland.
Long term, I remain bullish on timberland but, in the short-term, I think that stock in the timberland companies is a better investment. The downside is less than timberland and the upside is much, much greater. If you follow Holland Ware, you won’t starve. --Brian
Visit my website at Timberland Strategies
Monday, March 9, 2009
The “discount rate” is essentially the same thing as the interest rate used in any financial calculation. We have to get the series of future cash flows “discounted” back to the present so we pick the appropriate interest rate to do that. As an example, say you wanted to buy a tract of land and your credit union would lend you the money for 6%. You know there is some risk associated with this so you assign another 2% for risk. You would use a discount rate of 8%. Sounds simple to me.
Let me start off by saying “I don’t know what discount rate to use”! This question is argued by investors, economists and corporate finance types. But understand this, selection of the discount rate is the most important decision made during the valuation process. Let me illustrate.
Many years ago (I was working as a Land Acquisition Forester at the time) I decided to reread Thoreau’s “Walden” which led me to “In the Maine Woods”, “A Week on the Concord and Merrimack Rivers” and “Cape Cod”. Considering my job, Thoreau really got my attention with the following words from “Cape Cod”.
“Between the Pond and East Harbor Village there was an interesting plantation of pitch-pines, twenty or thirty acres in extent, like those which we had already seen from the stage. One who lived near said that the land was purchased by two men for a shilling or twenty-five cents an acre. Some is not considered worth writing a deed for.”
Thoreau had traveled across the Cape in the 1850’s and I had noticed and made mental note of these same pitch pine plantations while visiting there. So what would a Land Acquisition Forester think… “Man, what a buy that would have been!”
What if an investor knew what the values on the Cape would be like in 2008? Would he have bought some of that timberland for $0.25 acre? Maybe, maybe not. Let’s consider the opportunity and create a simple analysis. Let’s say that the investor could foresee all that wonderful HBU land on the Cape and actually KNEW what 2009 land prices would be like. Keeping it simple (so we can isolate the impact of discount rate selection), assume he leased the land out “for taxes” so he had no cash flows (positive or negative) other than the purchase and sale of the land. The data below shows the value of a $0.25/acre investment compounded forward for 150 years.
So…, would the investor have bought the land (for his descendents!!). It very clearly depends on the discount rate that the investor used. I don’t think that there is an acre of scraggly pine plantation on the Cape that could be bought for $1,562/acre and I doubt that you could sell an acre for over $300 million per acre either – not even the Kennedy compound. The value determined clearly depends on the discount rate used. So what discount rate would you have used? Think about that seriously. If the rate is too high (nice to get but will you get it!) you may never have the opportunity to make an investment EXCEPT one that is very risky.
When I was in forestry school (back in the 60’s) we normally used 6% in our forest economics courses. When I was an MBA student (in the late 70’s), we used the company’s marginal cost of capital with an appropriate adjustment for risk. Early in the timberland shift to TIMOs, it was pretty freely discussed that TIMOs were using real rates in the 6% to 8% which was based on the “risk free” rate of return (10 year T-bills at 4%) plus risk adjustment. At the same time, integrated forest products companies with large timberland acreages were using investment hurdle rates significantly above the average or even marginal cost of capital for the firm (a mistake – it should have been based on the marginal cost of capital and risk associated with purchasing and owning more timberland not riskier investments!). The result of this is that high-risk capital investments were subsidized by low-risk timberland ownership. As a general rule, discount rates used by the C corporations were much higher than that used by the TIMOs (rates in the range of 12% - 15% or more). Remember the decision you reached above with the Thoreau example. The C corporations also had to include taxes in the cash flow analyses (reducing cash flow and, subsequently, value) whereas most of the TIMO clients were pension funds and tax exempt. Between the tax payments and high discount rates used by the corporations, it is pretty clear why the TIMOs valued timberland higher than the forest industry.
Note two things from the above discussion. The “appraised value” of a particular tract of timberland, based on comparable sales, was the same for the TIMO buyer and the forest industry seller yet the real valuation for the buyer and seller were very different. As I pointed out in an earlier post; timberland valuation and fair market value are two different things!! The second point: the difference in discount rates used, combined with tax policy, has dramatically changed the face of timberland ownership and forestry practice in this country.
How do inflation and taxes affect the selection of the discount rate? We discussed that somewhat in the post on cash flows. Here are a couple of quotes, also from the Forest Landowners Guide to the Federal Income Tax, Ag. Handbook No. 718.
“it is imperative that the discount (interest) rate used for the analysis include a similar expectation factor for inflation. In summary, both elements of the analysis—cash flow and discount rate—must be kept in comparable terms (with or without inflation and before or after-tax) for reliable results.”
“Forestry investments are very sensitive to the discount rate used because of the long time period between planting and harvest. For after-tax analyses, the correct discount rate is the after-tax rate based on your alternative rate of return. If the next best alternative is a tax-free investment, such as a municipal bond, then the interest rate is used without adjustment, as shown in Table 2-3 for the 10-percent discount rate. If your next best alternative is an investment, such as a corporate bond, that yields 10 percent annually with taxes subtracted before compounding, the correct discount rate is 7.2 percent, after-tax [10 percent x (1 - 0.28 assumed tax rate)]. Alternatively, if the next best alternative is an investment such as an individual retirement account (IRA), certain saving bonds, or an alternative timber investment, where taxes are deferred until the end of the period rather than being subtracted before compounding, then the correct discount rate depends on the length of the investment period and when the costs are incurred and revenues received. Assuming an initial investment, 10 percent interest, and a 28-percent tax subtracted at the end of 34 years, the appropriate discount rate would be 8.94 percent.
Now, if you feel that you still need more info on how to select the right discount rate for a timberland purchase, let me give you a couple more references.
- “Timberland Investments” by Christian Zinkhan, et. al.
- “Discount Rates and Timberland Investments” by Brooks C Mendell in the Timberland Report published by James W. Sewall Company
Finally, it may be worthwhile to speculate a little bit (actually that is what the selection of the discount rate is). Timberland investors have watched as discount rates rose early in this decade followed by decreasing discount rates which resulted in a steady increase in timberland transaction prices (and corresponding values from comparable sale based appraisals). Some TIMOs have left the market so they clearly believe discount rates got too low and pushed prices too high (potential returns too low). Other TIMOs have tried to sell large blocks but pulled them off the market. Perhaps they think discount rates are too high but prices are too low to justify selling?? Or maybe there is less money chasing timberland. This concludes the Timberland Valuation series.
Oh, I almost forgot. Nobody is going to tell you what discount rate to use. That's your call. Comments welcome. --Brian
Monday, March 2, 2009
International Paper (NYSE: IP) announced today that it plans to divest approximately 143,000 acres of properties located in the southeastern United States in a transaction with American Timberlands Fund I, LP (the "Partnership").
The transaction value is approximately $275 million. International Paper will sell approximately 114,000 acres to the Partnership for $220 million in cash and will contribute 29,000 acres, with a value of $55 million, in exchange for a 20 percent interest in the Partnership.
The transaction value is subject to various adjustments at closing and is contingent upon the Partnership raising $220 million to finance the transaction. The transaction is expected to close in mid-June.
A couple of observations:
1. American Timberlands Company, out of Columbia, SC, also bought 20,000 acres from I-P last year. The Registered Agent for them is Mark W. Buyck III from Florence SC. Other than that, I don't know anything about them but it looks like they could use some money.
2. It also looks like somebody thinks the value of timberland has not dropped. The reported value is $1,923/acre. --Brian
Visit my web site at Timberland Strategies