Is Barron's Roundtable Wrong on Plum Creek?

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This morning, an article in Barron's featured a roundtable discussion with professional investors giving their favorite picks both on the long and short side of the market, including thoughts on such diverse investments as Microsoft (Nasdaq: MSFT), Legg Mason (NYSE: LM), Verizon (NYSE: VZ), and SPDR Gold Shares ETF (NYSE: GLD). One panelist was hedge fund managing partner Oscar Schafer, who offered up Plum Creek Timber (NYSE: PCL) as his favorite short idea. Everyone's entitled to their opinion, of course, but I found his argument to be full of flaws.

His argument began (Mr. Schafer's comments in italics):

Plum Creek Timber is overpriced. This REIT [real-estate investment trust] is the largest private owner of timberland in the U.S., with about 7.4 million acres in 19 states. The stock is trading for around 30 times consensus 2010 earnings estimates and nearly 20 times estimated Ebitda.

When looking at REITs like Plum Creek, you shouldn't focus on earnings due to the massive depreciation expenses that come with owning real estate. In other words, don't rely on the price-to-earnings ratio. A better measure is funds from operations (FFO), which is simply net income plus depreciation and amortization.

Even so, before today's decline Plum Creek only trades at 12.8 times estimated 2010 EBITDA -- not "nearly 20" as Mr. Schafer contends. Using the more appropriate valuations of funds from operations, PCL presently trades for 11.9 times FFO for the last twelve months. Not exactly cheap, but still worth researching (more on that in a moment).

The core business of harvesting timber has been operating at break-even levels, while all the free cash flow is generated by selling assets.

Real estate sales did contribute a lot of cash flow last year, but harvesting timber is definitely not a "break-even" business as Mr. Schafer claims. In 2008, Plum Creek's "Northern Resources" segment had a pre-tax profit margin of roughly 12% while the "Southern Resources" segment was nearly 28%. Plus, 2008 was a weak year for harvesting. In 2006, those figures were 25% and 37%, respectively. Unless you think housing and construction won't recover in the next few years, you have to expect the profit margins to improve for the harvesting business, particularly after the various cost-cutting measures the company put in place over the last twelve-months.

Liquidating your productive asset isn't a sustainable strategy.

It can be if you prudently liquidate less productive assets and focus on developing and managing the more productive ones. Plum Creek routinely sells off non-strategic assets and develops others for sale. At the company's most recent investor presentation at June's NAREIT conference, Plum Creek still has 5.6 million acres of "Core" lands that it plans to manage, with the rest of the land available for joint ventures, conservation sales, and rural land sales.

In six of the past seven years, Plum Creek paid out more cash in dividends and share buybacks than it has generated. Management achieved this in part by adding leverage. This isn't a sustainable strategy, either.

While I agree that the current economic approach is probably unsustainable, there is good news. Going back to each fiscal year since 2002, Plum Creek has actually paid out less in dividends than it generated in funds from operations. Therefore, I expect the company to continue with its strong dividend performance. Now, it's true that long-term debt also increased over this period, but most of that debt is under very favorable terms -- Plum Creek's weighted average cost of debt is just 4.78%. Plum Creek also has $355 million in cash and equivalents on top of $530 million available under a line of credit to meet short-term demands. Finally, it's important to point out that Plum Creek has taken steps to pay down its debt -- in the last reported quarter it retired some $125 million.

At 35 a share, the market is valuing Plum Creek at more than $1,100 per acre. The company has tremendous assets and a high-quality management team, but investors are mispricing timberland as an asset class and Plum Creek as a stock. Our target price is $10 to $15 per share, or $600 an acre.

It seems perfectly rational for the market to value Plum Creek at $1,100 per acre when recent transactions have been in the $1,200 to $1,900 per acre range. Obviously not all of Plum Creek's lands are worth this much, but others are much more valuable, particularly in the Pacific Northwest where transactions in the region have been in the $2,100 to $4,000 per acre range.

As Mr. Schafer aptly notes, Plum Creek is led by strong management. The team has a knack for knowing when to increase or decrease harvesting ahead of market conditions. They're also solid capital allocators, having repurchased 3.3 million shares at an average price of $26.60 in the first quarter 2009.

Foolish bottom line
As I write this, Plum Creek shares have fallen more than 6% in today's trading, some of that action possibly stemming from the Barron's article. Granted, the markets and especially commodities are down across the board, but investors would be wise to take Mr. Schafer's argument with skepticism and do their own research before making a hasty decision to buy or sell.

At our Motley Fool Pro service, where we own and recommended Plum Creek in December, we have a fair value of $36-$40 on the shares. At their current price of $32, they aren't a deep value, but they are still undervalued, in our opinion. To capitalize on this opportunity, in February we wrote August 2009 covered calls with a $40 strike. Later, in March, we also wrote August $22.50 puts. In other words, if the shares don't get called away from us at $40 in August, we're happy to hold, but if they do get called away, we would still consider it a good investment. And if by chance Plum Creek shares are put to us at $22.50, we'd be thrilled to buy them at that price.

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