REIT's: Once the Darlings, Now the Dogs?

Stephen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'm sick and tired with the daily fluctuations in the market driven by fear and speculation over when the Federal Reserve's bond buying program known as Quantitative Easing will be slowed and eventually stopped. 

Actually, check that.  Daily fluctuations don't bother me at all; it's the 24/7 financial news organizations fanning the flames that really grinds my gears.  The upside to all the consternation is that quality businesses with strong long-term value can go on sale when the masses overreact. 

Recent comments from the Federal Reserve regarding the timing of the end of Quantitative Easing caused investors to flee the very same high yielding investments they clamored for two years ago.  In a single week in late June investors pulled $4.5 Billion out of municipal bond funds.  Utility stocks, typically popular dividend payers, have tanked relative to the S&P over the last 3 months. 

Real Estate Investment Trusts (REITs) have suffered the same fate.   

Two REIT's I have my eye on after this recent drop are  Plum Creek Timber Company (NYSE: PCL) and Potlatch Corporation (NASDAQ: PCH).  Both companies manage timberlands across the United States.  They make money by selling logs, selling land, and selling manufactured wood products.  Plum Creek is the larger of the two with 6.4 Million acres of timberland across 19 states and a $7.6 Billion market cap.  By comparison, Potlatch owns 1.4 Million acres in only 3 states and sits at $1.6 Billion in market cap.  Both stock charts look amazingly similar:

I believe these companies have been unfairly punished by the market over the last few months despite positive future prospects, but before I get into why their future is so bright I want to look a little closer at the companies themselves.

Plum Creek Timber

Plum Creek is the largest private land owner in the United States.  The company generates roughly 50% of sales from logs: sawlogs used for lumber and wood products and pulplogs used for pulp, paper, and wood pellets.  The remaining sales are evenly split between real estate and manufactured wood products.  The real estate segment deals with land that the company deems as more valuable to be sold to commercial or residential real estate interests as opposed to wood production.  Revenues dipped during the recession from $1.6 Billion in 2008 to $1.2 Billion in 2010 and $1.34 Billion in 2012.  The CEO has been in the position since 1994 and has been with the company since 1989. 

REIT's are often sought for their dividend, and Plum Creek fits the bill with a 3.8% yield.  The cash flow situation looks good with $353 Million in operating cash flow in 2012 and $272 Million paid in dividends.  The debt situation looks a little scary at $1.8 Billion with only $1.2 Billion in equity, but the interest expense is consistently sitting around 50% of operating income so I'm not overly concerned. 

Potlatch

Potlatch can be thought of as a mini Plum Creek.  Its business segments are basically the same, although the distribution of sales is different.   Potlatch earns 60% of its revenues through manufactured wood products, 35% from timber sales, and only 5% from real estate.  Their sales didn't suffer much at all through the recession. 

Revenues in 2008 were $440 Million, increased to $540 Million in 2010, and slumped a bit to $525 Million in 2012.  The dividend picture is similarly attractive with a 3.1% yield.  In 2012 the company earned $80 Million in operating cash and paid $50 Million in dividends.  The debt situations are even alike - Potlatch has $320 Million in long term debt making for a scary debt to equity ratio above 200%, but interest payments are around 30% of operating income so again I'm not worried.  The CEO has been with the company since 2006 and was previously employed by Plum Creek, for 23 years.

The future

These companies look solid enough and have simple business models that even I can understand.  Even better, I believe there are significant long-term trends that bode well for Plum Creek's and Potlatch's futures. 

Residential construction is the major force that drives demand in this industry, and while new home starts have been increasing consistently over the last year they still have a very long way to go.  The Census Bureau's report on housing starts in May showed an annual rate of nearly 1 Million homes.  This is great considering in May of 2012 it was around 600,000.  However, the historical annual average of new home starts is around 1.5 Million.  This indicates to me that demand for wood is going to increase. 

Prices are already beginning to reflect this trend.  According to Timber Mart-South, southern sawlog prices are increasing after bottoming out around $24 per ton after dropping from nearly $40 a ton in 2007.  A second driver of future demand is the effect of a pine beetle in British Columbia that has destroyed over 50% of the pine trees in that region.  British Columbia has produced around 25% of the lumber used in the United States, and it's estimated it will take up to 60 years for these forests to fully recover. 

The drastic reduction in supply from Canada will increase prices and generate more business for Plum Creek and Potlatch.  This should also open up new timber export opportunities to China.  In 2012 British Columbia exported over 3 Billion board feet (bbf) to China compared to only 0.5 bbf from the United States.  Plum Creek estimates that the demand opportunity in the United States and China as a result of the pine beetle in Canada could be the equivalent of 600,000 housing starts.  

A final driver of growth is biomass energy demand in the European Union.  Biomass energy is a broad term that includes burning wood pellets, and since it's defined as a renewable energy source it has become a popular option for countries that have committed themselves to renewable energy.  Instead of making significant investments in windmills or solar energy, relatively cheap modifications can be made to coal plants to burn biomass or even a mixture of coal and biomass.  Reuters UK reported in January that European biomass demand was expected to triple by 2020 and that Europe would need to import 66% of its biomass from abroad.  That sounds like a slam dunk for Plum Creek and Potlatch.

Dogs no more

These companies look like great opportunities to pick up, especially on days when the market collectively shudders anytime someone mentions interest rates.  All of that noise has nothing to do with their businesses and the opportunities that lay ahead.  It's times like these when well run companies go on sale for those investors who focus on the fundamentals of the business and assess the growth prospects ahead.  These two fit the bill perfectly.

 


Stephen Benz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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