PotlatchDeltic Corporation (PCH) Earnings Call Transcript & Summary

Good morning, and welcome to the 9:00 session at Citi's 2022 Global Property CEO Conference. I'm Anthony Pettinari with Citi Research, and we're very pleased to have with us Eric Cremers, CEO; and Jerry Richards, CFO of PotlatchDeltic. This session is for Citi clients only. So if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. And for those joining us here in person, if you have any questions, please use 1 of the mics in the center aisle here or if you're joining us remotely, simply type the question into the portal, and I'll do my best to ask it during the session. So Eric, with that, I'll turn it over to you to introduce PotlatchDeltic and then we'll move into Q&A.

Yes. Great. Thanks, Anthony, and good morning, everybody. I'm Eric Cremers. I'm the CEO. I've been with the company about 15 years. Joining me here is Jerry Richards. He's our CFO, and he's been with the company about 8 years. So PotlatchDeltic is -- it's a timber REIT. We have an enterprise value of around $4 billion. We operate 3 different business segments. The first 1 is our Timberlands segment. We have 1.8 million acres of timberland. About 600,000 of those acres are in Idaho and 1.2 million acres are in the U.S. South, really Arkansas, Mississippi, Alabama, and a little bit in Louisiana. We harvest sustainably about 6 million tons per year. And after harvesting, we'll turn around and plant about 22 million seedlings per year. And last year, our Timberlands business on those 6 million tons that we harvested, we generated about $260 million of EBITDA. The next business segment is our Wood Products segment. We have 7 converting mills across the United States. Six of those are lumber mills. One of those is an industrial-grade plywood mill. With those 6 lumber mills, we produced a little over 1 billion board feet of lumber per year. And last year, we generated nearly $400 million of EBITDA in our Wood Products segment. And the last segment that we have is a Real Estate segment. Our Real Estate segment really has got 2 different product lines. One is the sale of rural real estate. So think about the 1.8 million acres that we have, we stratify each and every 1 of those acres every year. In some of those acres, they're going to have more value as a sale to somebody else, HBU perhaps, higher and better use property, than if we kept that land and operate it as timber going forward. An example might be a solar operator wanting to put in a solar farm somewhere, will pay us a big premium for our land. That's 1 segment of our real estate business. And then the second segment is we own a master plan community just outside Little Rock, Arkansas. It came to us from the Deltic merger that we completed back in 2018. And really with this business segment, we create residential lots for sale. We don't do any vertical development. Costs us $40,000 to $50,000 to create a lot, and we sell it for $80,000 to $100,000. So a very high-margin business for us. We sell about 160 lots per year, more or less. We also sell some commercial acreage out of that master plan community. In total, we have about $50 million per EBITDA out of our Real Estate business per year. So 3 final things I want to mention about the company before we move into the Q&A. The first is that our claim to fame is that we are the timber REIT most leveraged to the price of lumber. So that is, if you look back, say, the past 5 years and you look at our EBITDA, how much of that has come from -- or been associated with lumber pricing, it's roughly 2/3 of our EBITDA is attached to lumber pricing, both from the lumber mills, but also to a very unique indexed log pricing arrangement that we have in Idaho. So we sell our sawlogs in Idaho indexed to the price of lumber. So as lumber prices have gone up, so have our log prices in Idaho. That's the first thing that makes us very unique is that we have got a very high percentage of EBITDA attached to the price of lumber. The second thing that I would say is that we are the lowest levered of all the timber REITs. Our leverage today is about 11% relative to our enterprise value. And we like having low leverage. It helps our credit metrics, keeps our borrowing costs down. And it also gives us incredible optionality to take advantage of M&A opportunities or perhaps pay a large special dividend like we did last year. We paid a $4 special dividend in December. And the last thing I'd mention is that as a timber REIT, we are a net carbon sequesterer. So a lot of companies are trying to figure out how to get to net zero, well guess what, we're already way net negative as trees through photosynthesis consume a lot of CO2 as they grow. So with that, Anthony, I'll pause there and turn it back to you.

Great. Thank you, Eric. Given your leverage to lumber, can you talk about lumber demand in the market here in the kind of the heart of the spring building season?

Yes. So lumber demand has been very robust of late. Housing starts are strong. I'm sure you've all been reading about the housing market. And even though mortgage rates have moved up a little bit off the bottom, housing is still pretty affordable in the United States. That's 1 segment of lumber demand. So that's been pretty firm. And the other segment is what we call the R&R market, repair and remodel. That really consists of do-it-yourselfers kind of doing their home repair projects, but it also consists of the remodelers, the professional remodelers that are out there, contractors. And we've seen continued strength in that market segment as well. So I guess the best way to characterize it, Anthony, is that we've seen really strong demand from both of those 2 key market segments.

And how would you characterize inventories of lumber across the chain? And have folks been able to rebuild any inventory since the pandemic began? Or just how do you characterize that?

Yes. I think the way I'd characterize it is inventories are at very low levels. They have been for some time. People tend to want to operate with low levels of inventory, operate on a just-in-time basis. And as industry capacity utilization has creeped higher over the years, it's created a lot of volatility in lumber pricing, because of this just-in-time nature. And when you start factoring in supply chain and transportation issues, it's really continued to make it even more volatile, those lumber prices. But our general feeling is that inventories are pretty low levels across the system.

Do you have any view on where maybe cash costs are for high-cost lumber producers?

Yes, that's a really, really important question. There are really 4 key growing -- 4 key lumber-producing regions in North America. So you have the U.S. Southeast. You have the Pacific Northwest. You have British Columbia. And then you have the Eastern provinces of Canada. Canada provides about 30% of the U.S.' lumber. And of that 30%, roughly 15% comes from British Columbia. British Columbia, for many different reasons, has gotten itself in a bind with a relatively high cost structure. First, it's the mountain pine beetle that decimated the forest up in British Columbia. The second thing is there's a lot of environmental concerns about the harvesting of old growth forests. You've also got roughly 20% duties on Canadian logs flowing or lumber flowing into United States. A whole host of factors have caused British Columbia to be what's considered the high-cost region in North America. Most pundits estimate cost of producing lumber in British Columbia to be up around $500 to $600 per thousand board feet. And as prices drop below, which they do from time to time over the past several years, as the prices drop below those levels, you'll see no closures. And we've seen several billion board feet of lumber capacity come out of British Columbia over the past several years, and there are forecasts that show an additional 2 billion board feet of lumber coming out of British Columbia over the next several years.

Can you talk about your capacity actions or your projects to debottleneck or add supply over the last few years?

Yes. So 1 of the best uses for capital in our company is to improve our manufacturing operations. These projects tend to have IRRs in the 20% to 40% kind of range. There is a limit as to how many of these projects we can identify and complete in any given year. But over time, we generally have capacity creep in our business of 2% to 4% per year, debottlenecking through -- each mill's got its capacity limitation. And we're always trying to work our way around that capacity limitation, but our historical track record is roughly 2% to 4% capacity creep over time.

And you talked about the supply constraints in Canada. From a lumber perspective, can you talk about supply additions in the U.S. South? Have those progressed faster than expected, slower than expected, is it sort of offsetting the declines in Canada? Do you think about North American total capacity as being sort of flattish? Just wondering if you can talk about the South and sawmill capacity expansions there.

Yes. So there -- Anthony, it is right. There have been a lot of capacity additions, whether it's an expansion of an existing mill or the building out of a new greenfield mill in the U.S. South. The U.S. South outside of Russia, has got the cheapest sawlogs that you can buy in the world today. So the U.S. South is a great place to build a new sawmill. But if you look at what's happened over the past 5 years, demand for lumber in the U.S. has gone up roughly 8 billion board feet, but net capacity. And by net, I mean, excess new capacity offset by closed capacity, that capacity has only gone up 2 billion board feet. So capacity utilization has been increasing in the industry, and it's making industry conditions ever more tighter. There's still strong economics for building a mill in the South. But what I'd tell you is it's getting harder and harder to get that mill built. And let me give you a couple of examples. So the cost to build a new mill, a couple of hundred million dollars, number one. Number two, it takes 2 to 3 years to get that mill constructed and up and running. And then lastly, you have to find the people to run that mill. And I can't overemphasize enough how hard it is to find skilled labor in these small rural towns in the U.S. South. So there's a lot of impediments that get in the way from the industry of looking at building a new greenfield mill. Certainly, we do, certainly our competitors do, and we always think about it. But those constraints are -- they're very real. And the backdrop, the cause of why it's so challenging to build a mill is think about the great financial crisis. I know it was a long time ago, 14 years ago, what have you. But in the great financial crisis, the demand for housing dropped and the demand for housing dropped, the demand for lumber dropped. And with the demand for lumber dropped, capacity utilization in the industry collapsed. So virtually no pricing power to be found by lumber producers. People were not earning a return on their capital. So how much investment went into sawmilling at the time? Very little. So what does that mean for the equipment vendors to the industry? It means their business dried up. So after the great financial crisis, all the equipment vendors, they consolidated. So now we're down really to just 2 big suppliers of capacity of equipment to the industry. And they only have the ability to produce so much equipment. So consequently, the time line for taking delivery for new equipment has been really pushed out 2 to 3 years. And that's a big issue the industry faces.

And you talked about supply chain constraints and labor availability issues in terms of how you handle that within PotlatchDeltic and maybe the impact in '21 and what you're seeing early this year, kind of any view or detail on that?

Yes. So the good news is, if you've had a mill and it's been running for quite some time, you've had a workforce already established. And so it's much easier to keep an existing mill running, going and have employees than it is to build the new mill. And I mean that's just -- it's really more simpler than that. And so we've been successful at hanging on to our people. And we've been trying to be innovative in finding ways to keep them. But no doubt, it's a challenge.

I guess, can you talk a little bit more about Idaho, because I think your public peers have a lot of exposure to the Southeast and they have a lot of exposure to Washington State, Oregon state. You have kind of a unique exposure in Idaho. Can you just talk a little bit more about that?

Yes, Jerry, do you want to take that one?

No, absolutely. So I would start by saying, Anthony, that's probably the most misunderstood part of our story. It starts with, we are the largest private landowner in Idaho by a wide margin. We own just over 600,000 acres. The next industrial timberland owner is a TIMO. There's a couple of TIMOs around 100,000 acres to put that in context. It's a tight wood basket. It's a really attractive place to do business from a regulatory standpoint. It's a very business-friendly state, which is a bit different when you go to the west side, Oregon and Washington. In terms of what makes us unique beyond the land size and the ownership position is, Eric touched on this in his opening comments, which is we indexed the price of our sawlogs in Idaho, about 75% of that volume to the price of lumber on a 1-month lag. I'm not aware of anybody else in the industry that has that kind of a pricing arrangement in place. And when you think about the real strength behind lumber pricing and that's translated into a really strong log pricing as well. Some other key parameters, so often, we're asked by investors is there a chance that agreement goes away anytime soon. And I will tell you, it's a 5-year evergreen agreement. So every year, before it rolls off, the 2 parties going to look at each other, because we have a key outside party, that we sell under this arrangement. And we continuously add that year back on. So it's an evergreen 5-year arrangement. So people often ask, well, why is -- why are they willing to pay high log prices? Well, effectively, what it does allows them to go get bank financing in a tight wood basket -- so -- guarantees supply, but also in some respects, it operates as a toll manufacturing arrangement where -- when there invariably at times lumber pricing is weaker, there's still a margin in the business for them. So it's been a very -- it's been a mutually good arrangement for both parties. And certainly, it's created a ton of cash and a ton of value for shareholders from our perspective.

And then maybe just switching over to the Timberland side. There's a lot of transactions in the Southeast or a relatively large number of transactions. Can you talk about where you've seen Idaho lands trade to the extent that there are kind of public comps out there? And then maybe more broadly, could you talk about Southern Timberland values versus maybe what you were seeing pre-pandemic, any trends?

Yes. So what I would say is we love Idaho. It's been a great business, but there's not a lot of transaction activity. So again, we're the largest private land owner. It's the family jewels in terms of core asset. So there's very few market comps out there. I will tell you on an EBITDA per acre basis, which would be 1 way to think about assigning a value to that land, you go back over the last 5 or 6 years, we've actually generated more EBITDA per acre than competitors have in Western Oregon and Western Washington. And you might say what's the significance of that? Well, the significance is Western Oregon and Western Washington are widely viewed as the most productive industrial timberlands in the world. So that will just show you the power of this indexing arrangement that we have in place. Sell-side generally has our acres sub-2,000 in Idaho per acre. I will tell you that's way off the mark, especially when you look at the EBITDA and the profitability of that land. You move to the south. A few years ago, we kind of hit a new norm of about $2,000 an acre. Now I will tell you, the devil is always in the details with real estate. It's all about the specific asset that you're talking about. And there's times when timberlands in the South will trade in the mid-teens, call it, $1,500 to $1,800 an acre. There's times when it trades above the $2,000. It really boils down to how -- what is the stocking level? In other words, what's the volume of timber, how close is it to harvest, because when we -- as a strategic buyer, for us, it's a discounted cash flow analysis, we apply an appropriate discount rate, but it all is about that volume and how close to proximity that cash flow is. So that usually drives the valuation. I'd say more recently, Anthony, we've seen valuations increase. There's obviously -- there's a high desire to add hard assets, a search for yield and you're certainly seeing the timberland asset class benefit from that. And we're seeing not necessarily discount rates that we're willing to underwrite deals at, but they're down in that 4% to 4.5% range, whereas more recent memory is more like 5%, 5.5%. So we're certainly seeing a compression there.

And can you talk about the potential for log price appreciation in the South? I mean you're indexed or kind of hedged in Idaho, I guess, not so much in the South. Like what are you seeing in log prices? What are you anticipating log prices in the South?

Yes. So we do enjoy a terrific pricing agreement in Idaho. It's very good for both parties with this lumber index arrangement that we've got. In the South, you don't find those kinds of arrangements. Certainly, we don't have them in place. Our competitors don't either, to my knowledge. There's been an overhang of excess timber supply in the U.S. South. We call it growth to drain. How much volume is being added to the forest every year compared to how much harvest there is, that's the drain. That's taken off the ground every year. So growth to drain ever since the great financial crisis has been relatively high. That forest was growing faster than what was being harvested. That's created a timber glut for a lack of a better word. So log pricing has been depressed for much of the past decade, and it's disconnected from the price of lumber. Historically, there is a correlation, as lumber went up, lumber prices went up, log prices tended to go up, particularly in the U.S. South. And that has not been true for the past 10 to 15 years, as lumber demand collapse with a great financial crisis. Well, over time, capacity has been added in the U.S. South. We talked about the U.S. South has got the cheapest logs in the world. And as that capacity has been added in the U.S. South, that timber glut, the growth-to-drain ratio, is coming more and more into balance. It's not perfectly in balance today. There's still excess timber growing out there in the forest compared to what's being harvested, but it is getting more imbalanced. And certainly, at the end of the day, logs can really only travel roughly 100 miles is a rule of thumb, beyond 100 miles, it's not economical to move a log, because the log is 50% water, and that water has to come out of the lumber as you move through the manufacturing process. So you don't want to truck water around very far, I guess, is the moral of a story. So every wood basket is a little bit different. But in general, there's been an overhang of timber in the South and that's kept prices low. We're starting to see a little bit of tensioning in some of the log markets in the South. We're nowhere near getting back to that lumber price trend that I spoke about earlier. I think eventually, we will get back on track, but it's going to take many years for that to happen.

When you referenced tension in some markets, are you talking about maybe some areas within Arkansas, Mississippi, Alabama, where you're located? Or are you talking more about sort of Northern Florida, Georgia or...

Yes. So I think it's fair to say that the coastal regions tend to have better log markets today. Those baskets tend to be more tensioned, simply because you're near the ocean and you don't grow trees in the ocean, obviously. The further inland you get in the Arkansas, Mississippi, East Texas, those markets are not as tensioned as the Gulf Coast markets tend to be, but that's also where the new capacity is going to go. It's where those logs are the cheapest. So we're going to see new mills go up in Mississippi, we're going to see them in Arkansas. So in some ways, those more depressed markets have got more upside, if you will, because that's where the new capacity is likely to go.

And should we think of you as a net buyer, net seller of Timberlands? And what kind of acquisitions could be attractive? And maybe what returns, what financial hurdles do you typically target with Timberland acquisitions?