PotlatchDeltic REIT: External and internal challenges on the horizon (NASDAQ:PCH)
Timber land and timber production REITs could be a great way to hedge against inflation, as land holdings steadily appreciate over time. However, the appreciation will probably be slower next year than the actual CPI figures and it will only catch up later. Potlatch Deltic Corporation (NASDAQ: PCH) could be one of the choices for Timberland REIT investors; however, the next 12 to 15 months will not be easy for the company. I believe there is a lot of value under the surface and long term PCH is a good choice, but I am currently neutral on the stock. That’s because the valuation is just maybe a bit above fair value, I don’t see the shareholder-friendly CAD outcome from the recent merger yet, and the external trends are unfavorable to the company in the near term.
PCH is a leading timberland real estate investment firm that owns over 1.8 million acres of land at the time of the completion of the acquisition of CatchMark Timber Trust Inc. (CTT). The company also operates sawmills to capitalize on lumber’s higher profit margin. The company operates with large net profit margins which have increased over the last 2-3 years. PCH’s revenues come from 3 main sources. About four-tenths of the company’s revenue comes from the forest land itself, real estate and land sales, but the lion’s share comes from wood products.
To get a better understanding of PCH and its future, we need to take a look at the external trends in woodlots and lumber. What can we expect in the next 12-15 months? The past 2 years have been great for forestry companies, especially with high lumber prices and strong demand for housing. The new “normal” won’t be that simple: Wood and lumber prices are at 52-week lows and there’s a reason behind that. The the housing market is gradually slowing down, new construction projects face supply chain issues and high labor costs, leading to lower demand for lumber. This should remain so for the rest of 2022 and possibly the first half of 2023 as well.
At a time, sawmill costs are also rising, which will hurt Potlatch’s CAD over the next 12 months. A tight labor supply and inflation are expected to drive up labor costs by 5-10% in 2022 and, in addition, energy prices could remain high. Electricity accounts for 2% of sawmill turnover. This could increase by 2%, 3% or even 5% depending on the agreement that PCH factories could reach with suppliers. This means that the overall cost structure could change and energy costs could exceed labor costs. Additionally, high costs combined with lower lumber demand and prices mean less money flowing into PCH. This situation is coupled with a very overvalued acquisition of CatchMark.
This may sound scary for PCH investors, but the good news is that the company is stable and remains a good long-term choice. Next year will not be great for the company, but after the consolidation of the newly acquired forestry company and the renewal of demand from the housing market will work in their favor in the long term. Timber prices may seem low at the moment, but investors should be aware that these prices are very choppy. It is not uncommon that in the space of 2 to 3 months, prices jump or fall by 30 to 40%. Analysts indicate that lumber prices will range between $550 and $1,500 over the next 12 months, which is good news for PCH.
Considering all of the trends mentioned above, the CatchMark merger and PCH’s current valuation, we can safely say that the company is anything but cheap despite the -22% year-to-date decline. . Short interest of 1.16% rose to almost 5% at the end of August 2022, suggesting that large hedge funds also see the risks associated with PCH in the short term. Unfortunately, the dividend yield is still not good enough for income investors, but above 4-4.2% I would buy the stock for income purposes. However, PCH still has the highest forward dividend yield among its peers, but the valuation is fair or even a bit overvalued at the moment.
The price-to-book ratio of 1.72x might seem very overvalued among REITs, but forestland and farmland REITs generally trade well above their book value. Compared to its peers, the company is relatively well valued, but we can only have a vague idea of how that might change after the acquisition closes by the end of the third quarter.
Company specific risks
Surprisingly, I see only one major risk factor for PCH. This is because they cannot alter external trends in timber or lumber prices, and management cannot alter housing market demand. The only part they can improve or spoil is the CTT consolidation. PCH management overpays for land owned by CTT by approximately 25%. PCH pays approximately $2,600 per acre owned by CTT. This figure is 25 to 30 percent higher than deals of around $1,900 to $2,100 per acre of southeastern forest land. If management can consolidate the newly created company and use the local leverage of CatchMark to drive sales and production in the next 12-15 months, I would say that management has made a fair decision to acquire the company. But if the consolidation fails or does not produce real CAD results for shareholders, then it will just be an overpaid transaction and misallocated capital.
My take on the PCH dividend
PotlatchDeltic is a reliable, dividend-paying Timberland REIT. It has been paying dividends consecutively since 2006 and has a 2-year streak of consecutive dividend increases. In addition, the management pays special dividends from time to time which are usually 2 to 3 times the annual dividend. The company’s payout ratio is in the safe zone and the AFFO payout ratio is good at the moment. Analysts estimate a 2.2% dividend increase for 2023. Management typically announces dividend increases in the fourth quarter and I expect them to increase the dividend to around $0.45 per share from 0, $44 currently. That’s a far cry from current US inflation numbers, but the 2021 special dividend has made up for that for shareholders.
There is no doubt in my mind that PCH is a good company with a decent management team. I’m also confident that over the long term, the company is a fair choice for income investors who want exposure to forest or farmland REITs. My concerns relate to the next 12 to 15 months where external trends go against the business while management must also consolidate the newly purchased business. That’s why I’m neutral on PCH at the moment.