The Rising Influence of Rising Affluence

[DewDiligence]

Rebuttal of Barron’s piece on PCL:

The crux of the bear argument presented in Barron’s stems from PCL’s valuation based on GAAP EPS:

Plum Creek shares appear particularly vulnerable because of their lofty valuation, especially compared with rivals'. The stock trades at 34 times 2013's estimated earnings of $1.36 a share and more than 29 times 2014's consensus estimates of $1.59 a share, pricey in light of earnings' projected 17% rise.

Silly stuff! For PCL, GAAP EPS is close to meaningless because of the large non-cash depreciation charge on PCL’s forests, which are actually appreciating in value by 5-6% per year from natural growth.

To its credit, Barron’s also mentions PCL’s valuation based on Funds From Operations (FFO), defined as GAAP earnings plus depreciation:

Measured on a funds-from-operation basis , [PCL shares] also look dear: 19 times this year's estimates of $2.40 a share. Funds from operations are expected to rise by less than 12%.

The clear implication here is that PCL’s price/FFO ratio (19x) is unduly high because it exceeds the projected growth rate of FFO/sh (<12%), but this is a mathematical non-sequitur insofar as it compares two metrics measured in different units. This is tantamount to comparing apples to bananas!

As a PCL investor, I’m more than satisfied with a growth rate of around 12% in FFO/sh; if this rate can be sustained for several years, as I think it can be, it will almost certainly ensure a substantially higher stock price. A double-digit growth rate in FFO/sh ought to be sustainable for several years based on the US housing recovery (see details below), increasing wood exports to China, and the crimped supply of North American timber caused by infestation of the mountain pine beetle—see #msg-47898395 and #msg-80952209.

(That the Barron’s article does not even mention the supply squeeze from the mountain pine beetle shows a lack of thoroughness in the author’s due diligence.)

The Barron’s article whiffs again in discussing PCL’s break-up value:

"Our target is $36 a share," says Chip Dillon, timber analyst at Vertical Research Partners in New York, who has a Sell rating on the stock based on his assessment of industry conditions as well as his calculations of Plum Creek's break-up value and discounted cash flow.

I’ve performed an analysis of the break-up value of PCL’s timberlands based on the actual selling prices per acre PCL has obtained from various kinds of land holdings in recent years, and I (conservatively) arrived at an estimate of $53/sh. PCL’s CEO, Rick Holley, said in an investor presentation that the fair value of PCL’s timberlands is “well north of $60/sh.” (Both my $53 and PCL’s “well north of $60” are “all in” calculations that take into account PCL’s net debt.)

Another premise of the Barron’s article is that PCL can’t afford the dividend payout:

Wall Street gives [Rick] Holley high marks for finding ways to generate cash to pay its roughly $280 million annual dividend. But investors worry about quality of coverage. From 2006 through 2012, Plum Creek has been relying more on real-estate sales to raise cash.

Yes, PCL relied more on land sales during the period in question because this period coincided with a housing recession that saw US housing starts drop from 1.5M per year to 0.5M starts per year at the low point. We’re now back to about 1.0M housing starts per year, so there’s still a lot of headroom if housing starts merely return to the 1.5M annual rate that demographers say is compatible with the expected long-term growth rate of US households.

In any event, selling selected timberlands to conservationists and developers is a core part of PCL’s business, not a sideshow, so insinuating that PCL will have trouble funding the dividend is misguided.

Perhaps the strongest point in the Barron’s write-up is that long-term interest rates are almost certain to rise in the coming years, and REITs and other high-dividend stocks tend to react badly when interest rates rise. This already occurred in May 2013: when the Fed broached the start of its tapering program and the interest rate on the 10-year T-bond rose by about 1%, PCL’s stock price fell from the low 50s to the mid 40s. Thus, I would argue that much of the damage to PCL from interest-rate sensitivity has already occurred, which diminishes the chance of further interest-rate damage in a rising-rate environment. Moreover, contrary to the Barron’s author, I expect PCL to boost the dividend payout substantially during the next 3-5 years, which should more than offset the effect of higher interest rates.

All told, my assessment of PCL is the polar opposite of the description in the Barron’s write-up. If I were required to put 100% of my asset portfolio into one stock, PCL would be that stock and I would make the selection without hesitation.

p.s. This is not the first time I’ve responded to a bearish Barron’s article on PCL; it happened in 2009—see #msg-40570222. In the 2009 article, Barron’s predicted a dividend cut that never happened.