VNQ - PotlatchDeltic: Great Point To Exit

2023-12-23 00:18:31 ET

Summary

• We gave you three reasons last time to hold an optimistic outlook on PotlatchDeltic.
• Those have played out and the stock has done well.
• We tell you why we are now shifting to a Sell rating.

On our last piece on PotlatchDeltic Corporation ( PCH ) we gave investors a few reasons to be relatively optimistic. In " 3 Reasons To Get A Little More Optimistic On This REIT " we laid a case for a counterrally, and we even upgraded the stock from a "7" on our pain scale, all the way to a "5". The thesis played out, despite some pressures from the macro side. PCH managed a double-digit total return since then and edged out SPDR S&P ETF ( SPY ) in a photo finish.

Of course, you would have been better off owning Vanguard Real Estate ETF ( VNQ ) during this timeframe, but PCH's bounce was still sweet. We now go over three reasons why you should consider exiting as we enter into 2024.

1) Commercial Traders Negative

A key facet of our argument for a rebound in PCH was the way the commercial traders were set up on Lumber. The commercial traders are those that uses these futures positions to hedge. So a lumber/timber supplier may short futures to lock-in an attractive price. A lumber/timber consumer, like Home Depot ( HD ) may buy futures to lock-in that price. Their cumulative thoughts are more important than that of speculators. It has been our observation that extreme setups by commercial traders tend to precede reversal points. So when the commercial traders were heavily net long Lumber, as they were in our last update, we felt the odds of a rebound in lumber prices and by extension PCH, were high. The setup back then was with long positions outnumbering short positions 2:1. Of course in futures, every long has a short, so the other side of that was that speculators (non-commercial category) were short.

You can see where Lumber prices were at the time.

We have had an impressive rally (about 20%) off those lows, and the positioning has changed quite substantially. The same commercial traders are now net short. Speculators are net long at almost a 3:1 ratio.

This does not mean the rally ends today. It just means that the setup is radically different than what we saw 3 months back. It takes away one key reason we were suggesting a long.

2) Seasonality Winding Down

Lumber prices are also seasonal and housing starts, among other factors play a role. Late September was a great time to add a touch of optimism for Lumber and PCH. We are actually close to the final peak of seasonal boost. Yep, it played out so perfectly this year that even we were surprised. Trough to peak we are up 21% in this rally and that is almost exactly as much as the seasonal chart predicts for an average year for Lumber.

Very late December and till middle of January is a weak period and then we could get another bounce. We will see how point number one (Commercial Trader longs) develop into January to see if this move may have more strength. But for now this a headwind.

3) Valuation Still Extreme

Ok, so the primary commodity that PCH is exposed to has some challenges ahead and the rally may be behind us. That normally just gets us cautious, not negative. But for PCH the biggest issue is that its break-evens are right around the current commodity prices. If you look at estimates for earnings, they will show you exactly what we mean.

Investors may quibble that earnings per share is not exactly applicable for PCH and funds from operations (FFO) is more relevant. We agree, but the EPS shown above are actually the adjusted versions that correspond closely with FFO for PCH. PCH is trading at close to a 100X multiple and even assuming a modest rebound in Lumber prices, we are looking at a 31X multiple for 2025

Verdict

While we like the idea of using real estate and timberland as inflation hedges, the pricing has to be right. Here a lot can go wrong, especially at these multiples. We took the contrarian side when the stock was selling off earlier in the year. But we think all that has played out. If you want inflation hedges, there are other forms that are quite cheap today. For example shorter term inflation adjusted bonds, like the ones offered in Vanguard Short-Term Inflation-Protected Securities Index Fund ETF Shares ( VTIP ) offer solid real yields and have virtually no risk of losing money if held for the next few years. PCH remains a problematic investment as the cash flows look rather weak. We get that even the low NAV estimate is around $55 per share so a material downside is unlikely. But we see now issues with it trading at a 30-40% discount to NAV, especially if longer term interest rates rise in 2024 as we expect. The stock that traded that far below the lowest NAV estimate even during relatively benign economic conditions in 2016, when risk-free rates were pinned to zero.

So we would not get too euphoric here and consider exiting PCH. We are downgrading this to a Sell. In our earlier article, we had earlier suggested the $45 Covered Calls for May 2024.

That trade looks relatively safe (with a net cost basis of $40.92) and we had initiated that, we would hold that till option expiration.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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