Potlatch Could Be The Pot Of Gold Inflation Hedge – Potlatch Corporation (Holding Company) (NASDAQ:PCH)
In January we published an article addressing the impact of inflation on Timber REITs and which ones, specifically, have benefited most historically from inflationary pressures. Our thesis was predicated on the ability for Timber REITs to leverage their manufacturing segments to boost their top line. Our analysis concluded that Weyerhaeuser (WY) had the largest portion of its business related to manufacturing and the quantitative analysis we completed confirmed that, at least historically, it’s stock price was most sensitive to increases in prices – especially to lumber prices.
However, Potlatch Corporation (PCH) also has a substantial portion of its business coming from its manufacturing segment. According to the PCH Investor presentation, it has a greater exposure to manufacturing than WY. (WY’s presentation has it the other way around) In any case, Potlatch also showed a strong correlation to prices – which makes sense given its manufacturing segment.
Another driver that helps Potlatch benefit from rising prices, however, is that its Idaho production is indexed to inland lumber prices. And it’s Idaho production is a substantial portion of its manufacturing output. Inflation hedge!
Recent results confirm strong momentum in pricing, production, and cash flow generation. 4Q results were not indicative of a very strong year, however the full year numbers were considerably higher than last year and additional price increases expected in early 2018 could help the momentum continue. For example, while the Resource segment had a decline in operating income of $12MM in the quarter, it was up $25MM on a YTD basis. The same conclusion could be drawn on net income, which was down from $0.94 per share to $0.62 per share for the quarter but up from $1.18 to $2.51 YTD. Margins also declined quarter to quarter but were up on a year over year basis and continue to be on an upward trend. The chart below shows the Resource business metrics.
While the chart below shows the Wood Products business. The increase in adjusted operating income from Q1 2017 to Q2 2017 is striking, with margins more than doubling from 9% to 19%.
Source: PCH Investor Presentation
Other good reasons to invest
While the dividend yield on Potlatch isn’t as attractive as Weyerhaeuser, it still pays a decent 3.1% dividend yield and recently increased its dividend. Analysts on the call questioned why management didn’t increase it even more considering its hefty cash position and strong cash flow. Management responded that there will be considerable outflows this year: $20MM of merger costs; a Special distribution to be paid in 4Q 2018 of $250MM of which $50MM is cash; and $14MM of debt maturing in February. So, much of the cash on hand of $120 is earmarked for certain items already.
While the company has a strong balance sheet and ample cash on hand, there are looming debt maturities in 2019. On a positive note, however, Moodys placed the company’s rating under review in October for a possible upgrade after it reported that the merger with Deltic was a credit positive. Its current rating is Ba1.
Source: PCH Investor Presentation
Why we continue to like Timber REITs
US Housing starts have been steady, even if choppy from month to month and have remained above the 1MM mark since October 2014. We continue to believe that the shift from multi-family construction to single-family construction will continue and will drive further increases in lumber demand and prices.
And while the previous chart on housing starts indicates slow and steady growth over the last year, the chart below reveals how much further housing starts must recover to reach previous highs reached in the early to mid-2000s. If housing starts reach those levels again (we’re not predicting that they will), the demand for lumber could potentially double from current levels. That would certainly be bullish for lumber prices.
Since our Timber REIT vs. Inflation analysis, lumber and wood prices have continued to accelerate, reaching a year over year increase of 5.2% in December and the PPI Index for Lumber and Wood products has now reached a record high, despite housing starts being nowhere near their pre-recession levels.
Prices should remain strong for other reasons too: Canadian production looks like its peaked with the pine beetle issue; capacity utilization is getting higher; and supply disruption due to fires and other factors. One compensating factor is the increased level of imports from Europe but that is still very small – almost immaterial. The factors for further price increases outweigh the factors that would cause priced to drop.
From a valuation perspective, the stock looks slightly undervalued on a trailing 12 month P/E multiple. But analysts are forecasting EPS of $2.87 for 2018, which would result in considerable price appreciation even with no multiple expansion. If we assume mean reversion on the multiple as well, we could be looking at a price target of $80 by the end of 2018.
That said, analyst price targets are in the low $50’s which doesn’t jive with the EPS estimates. We believe there are imminent price target adjustments and would suggest investors take a hard look. Zacks recently upped its EPS estimates and upgraded the stock to a Strong Buy. We believe others will follow suit.
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Disclosure: I am/we are long WY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Looking to buy PCH.