Plum Creek (UNKNOWN:PCL.DL) is one the largest names in the U.S. timber industry, especially in the northwest where it has planted its Seattle headquarters. Despite a strong brand name, Plum Creek, as well as other timber REITs, are facing considerable hurdles in the near future.
One of the main issues facing the timber industry is a lack of newly available and harvestable timberland. While most timberland is already earmarked as wildlife preserves or commercially utilized territories, there are still available lands; however, a relatively new surge in non-commercial competition has made these lands poor investments. According to the CEO of Potlatch (NASDAQ:PCH), major universities continue to increase funding for forestry programs and as a result are able to consistently outbid commercial cutters like Plum Creek in order to use those lands for the private use of the university. Conclusions similar to this are also supported by studies from the USDA and local forestry agencies.
In addition, companies like Rayonier (NYSE:RYN) have attempted to fuel growth by better utilizing their existing timberland. Rayonier began utilizing the pulpwood from its lands to produce pellets for use in stoves acting as alternatives to traditional wood stoves. While popular in Europe, the growth of these pellet stoves appears to be idling and with Rayonier already the primary U.S. competitor in that market the cost of developing an influence in the area is likely to keep competitors away from entering the region. In a recent note, Deutsche Bank's Mark Wilde stated "recent contract negotiations suggest a drop in 2014 cellulose specialties (CS) and slower transition to CS."
A natural inclination among financial managers faced with the prospect of essentially no remaining positive net present value projects may be to bid for competitors. The timber industry is already largely consolidated, however, with only four major publicly traded timberland REITs including Plum Creek, Rayonier, Weyerhaeuser (NYSE:WY), and Potlatch. These four companies have seen stable appreciation in their stock price since 2008 as the U.S. housing industry has recovered; however, with minimal growth prospects and P/E ratios around 29, 15, 27, and 24 times, respectively (remember that Rayonier at 15 times also earns much of its revenue from pulpwood pellets that are in declining demand), it appears that the entire industry is poised for declining share prices.
As REITs, all four of these companies pay 90% of funds from operations to shareholders in the form of dividends as mandated by the IRS. In order to help boost these dividend payouts in recent years the timberland REITs have turned to selling what are known as higher-and-better-use (HBU) properties. These properties are generally classified as those that could generate more revenue if used for non-logging purposes (imagine felling timber around a hot spring that could instead be surrounded by a hotel, restaurant, and its very own gift shop). As the REITs continue to sell HBU properties their supply is certain to run out eventually and along with those HBU properties may go a substantial portion of recently boosted dividends.
Avoid the timberland REITs
The timber industry faces a number of challenges including increased activity among non-commercial timberland purchasers and limited investment in new or innovative timber-based technologies. While typically an industry more concerned with the stability of the housing market than the potential for growth opportunities, the timberland REITs recent reliance on HBU sales doesn't bode well for the future of the company's dividends. Additionally, high valuations could lead owners of the shares into more trouble as prices decline. For now, it appears that the timber industry has gotten ahead of itself and may be poised for a correction.
Zach Carvalho 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.