PCH - PotlatchDeltic: Hold For Short Run Buy For Long Term

2023-04-10 09:00:00 ET

Summary

• PotlatchDeltic is a bona fide FROG that is outperforming its Timber REIT peers.
• Timber REITs are riding significant tailwinds, but face falling lumber prices.
• This article examines growth, balance sheet, dividend, and valuation metrics for this up-and-coming mid-cap REIT.

Timber REITs are off to a decent start this year, with YTD total return of 0.41%, exceeding the Equity REIT Index, which is in slightly negative territory.

Among Timber REITs, there are currently two FROGs , PotlatchDeltic ( PCH ) and Weyerhaeuser ( WY ). Over the past 12 months, both have outperformed the REIT average as represented by the Vanguard Real Estate ETF ( VNQ ), but PCH has outperformed WY by 1666 basis points, as shown in the chart below.

Shares in PCH are up 7.9% since RBC upgraded it to Outperform on October 18. How is PCH likely to fare, in the coming 2 - 5 years?

Meet the company

The smallest of the Timber REITs, founded in 2005 and headquartered in Spokane, PotlatchDeltic currently has a market cap of $3.9 billion. The company owns 2.2 million acres of timberland across 7 U.S. states, and 7 manufacturing facilities that produce lumber and plywood. PCH generated $574 million in EBITDA in 2022, down (-12.1)% YoY (year over year).

PotlatchDeltic operates in 3 segments:

PCH sustainably manages 2.2 million acres of forest, and sells sawlogs and pulpwood harvested from those lands, providing customers with a consistent and reliable supply of high-quality logs at competitive prices. According to the company's most recent 10-K , the timberlands segment produced 43.5% of the company's 2022 EBITDA ($249 million).

Internal log sales to their own mills comprised approximately 33% of PCH's Timberlands revenues in 2022. No third-party customer represented more than 10% of consolidated revenues for the year.

Nearly half (44%) of PCH timberland is located in Arkansas, while another 29% is in Idaho. The remaining 27% is all in the Deep South.

In their all-stock 2022 merger with CatchMark Timber, PCH acquired nearly 400,000 acres, including approximately 348,000 acres of superior site indexed timberlands in Alabama, Georgia and South Carolina. The company's timberlands carry an estimated fair market value of $4.85 billion.

About 58% of the company's sawlog harvest in 2022 came from the Southern states, along with 98% of its pulpwood.

In the majority of the U.S. South, there is an oversupply of ready-to-cut standing timber, due to:

• years of low and deferred harvesting following the 2009 housing market crash,
• the conversion of southern row crop land to timberland through federal government incentives of 30 years standing, and
• increased productivity of southern acres due to improved forestry practices.

This weighs on the company's margins, as PCH produces ever more product in the South, while revenues per ton in that region remain at or below the 40-year average.

PCH produces lumber, plywood, and residual products with a capacity of 1.1 billion board feet, and has plywood mill capacity of 150 million square feet, placing them in the top 10 for U.S. softwood lumber production. The company then sells the finished products to end users, retailers, or wholesalers for nationwide distribution, primarily for use in:

• home building,
• repair and remodeling,
• industrial products, and
• other construction activity.

The Wood Products segment accounted for just over half of the company's 2022 EBITDA ($291 million).

Three of the company's 7 sawmills are in Arkansas, with two in Idaho.

Internal log sales to their own mills represented approximately 49% of PCH's Wood Products fiber costs.

The company seeks opportunities to expand its wood products capabilities through capital expenditures, typically targeting returns exceeding 15%.

The Real Estate segment contributed about 7% to the company's total 2022 EBITDA. PCH monetizes its non-core acreage through higher and better use, such as:

• recreation,
• conservation,
• alternative energy facilities (such as new solar farms), and
• residential or commercial development.

PCH currently has identified approximately 90,000 acres of timberland they intend to sell over time, having sold 20,451 acres in 2022, at an average price of $2349 per acre. PCH also has a 4800-acre master-planned community in Little Rock, acquired when they bought out Deltic Timber in 2018.

Which way is the wind blowing?

The company has some significant tailwinds at its back:

• Millennials, the largest age cohort in the U.S. population, have reached the prime homebuying age of 30 - 35 years, which boosts demand for lumber.

• Over the past 12 years, housing supply has not kept up with population growth, so there is a shortage.

• As a result, the age of the existing home inventory continues to climb.

• The total amount homeowners are spending to remodel and improve their homes has climbed sharply since the pandemic, and is forecast to stay at or near its all-time high through 2025.

• Due to environmental efficiencies, wood construction of tall commercial buildings is on the increase.
• Total timber demand is expected to at least triple over the next 12 years.

• Timber REITs have significant opportunities before them, in the form of carbon credits, carbon capture, green energy, and conservation, as global greenhouse gas management becomes more and more crucial to human life.

Growth metrics

Here are the 3-year growth figures for FFO (funds from operations), and TCFO (total cash from operations).

Source: TD Ameritrade, Hoya Capital Income Builder, and author calculations

The pace of revenue and cash flow growth was so phenomenal in 2020 and 2021 that despite a major step back in 2022, the 3-year growth rates for PCH are double digits.

Meanwhile, here is how the stock price has done over the past 3 twelve-month periods, compared to the REIT average as represented by the Vanguard Real Estate ETF ( VNQ ).

Source: MarketWatch.com and author calculations

PCH has lost money for the past two years, although its loss of (-6.9)% in the trailing twelve month period was much better than the VNQ's loss of (-25.2)%. Thanks to the mammoth gains of 2021, however, PCH investors are up 23% per annum over the past 36 months, compared to just 8% for the average REIT.

Balance sheet metrics

PCH has a very strong, investment-grade balance sheet, with outstanding liquidity and ultra-low debt/EBITDA.

Source: Hoya Capital Income Builder, TD Ameritrade, and author calculations

As of December 31, PCH was carrying $1.03 billion in debt, over against $344 million in cash. The interest coverage ratio is a whopping 21.4x, and the weighted average cost of debt after tax is a microscopic 2.4%.

The company faces only $40 million in maturities this year, and $28 million in 2026, with a combined $276 million due in 2024 and 2025.

In August, PCH bought back $200 million worth of shares.

Dividend metrics

PCH pays a slightly sub-par 3.7% dividend that is still the highest among the Timber REITs. With a payout ratio of 60%, low debt, and strong revenue growth prospects, Seeking Alpha Premium awards PCH a too-safe dividend safety rating of A. The company could comfortably be more aggressive with its dividend, and in 3 of the last 5 years, PCH has paid large special dividends that considerably raised the yield.

Source: Hoya Capital Income Builder, TD Ameritrade, Seeking Alpha Premium

Dividend Score projects the Yield three years from now, on shares bought today, assuming the Dividend Growth rate remains unchanged.

Valuation metrics

PCH sells for a slightly lower Price/FFO than the average REIT, and a slightly steeper discount to NAV.

Source: Hoya Capital Income Builder, TD Ameritrade, and author calculations

What could go wrong?

Stock prices of Timber REITs tend to rise and fall with lumber prices, naturally enough. The chart below shows this clearly, with Potlatch stock price in green and lumber price in blue.

Of the three Timber REITs, PCH is the most directly levered to lumber prices, as the chart below shows.

PCH management is optimistic about lumber prices, as shown in the company's graphic below, projecting prices to remain above $400 per thousand board feet for the foreseeable future.

However, more objective sources don't see it that way. According to Trading Economics ,

Lumber is expected to trade at $337.81 USD/1000 board feet by the end of this quarter, according to Trading Economics global macro models and analysts expectations. Looking forward, we expect it to trade at $288.61 in twelve months time.

Similarly, housing starts have a strong impact on demand for Timber REIT products. PCH management expects housing starts to continue declining this year, but pick up sharply in 2024.

More objective sources agree on the 2023 decline. After that, there is some chance that interest rates will drift higher, tamping down any increase.

According to Rocket Mortgage ,

Battling higher interest rates, homebuilders expect [housing starts] to be down even further next year, according to HousingWire. Fannie Mae puts the housing starts number at 1.137 million , 26.4% below their final forecast for 2022. Meanwhile, the MBA sees housing starts coming in at 1.472 million, falling 6.06%.

PCH also faces the risk of forest fires, which is heightened by global warming.

Investor's bottom line

Timber REITs are an integral part of the solution to the climate crisis, and the macro environment contains significant tailwinds for these companies. PCH is well positioned to profit in the coming years. In the near-term, the falling price of lumber is likely to pressure PCH share prices downward slightly, so a better price seems likely to present itself. When lumber prices stabilize, this company will be a strong buy. For now, I rate it a Buy for a 2-to-5 year horizon, but a Hold for the next 6 months.

TipRanks rates PCH Underperform and Zacks rates it a Strong Sell, but The Street says Buy and Seeking Alpha Quant Ratings system says Strong Buy. Of the 8 Wall Street analysts covering the firm, 5 rate the company Buy or Strong Buy, and the other 3 say Hold. The average price target is $53.75, implying 10.8% upside.

As usual, opinions vary, and as always, the opinion that matters most is yours.

For further details see:

PotlatchDeltic: Hold For Short Run, Buy For Long Term