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PotlatchDeltic Corporation (NASDAQ:PCH) is a timber real estate investment trust (“REIT”) with a market capitalization of around $4 billion. Accounting for dividends, the shares are down about 17% over the last 12 months compared to a loss of 21% and 17% for the Vanguard Real Estate ETF (VNQ) and the S&P 500 (SP500), respectively. The near-term headwinds provide an attractive entry point when considering the longer-term prospects based on lumber demand forecasts and other factors.
Operations
PotlatchDeltic Corporation has an interesting structure. Potlatch does not only own timberlands for logging. Instead it operates in three segments: timberlands, wood products and real estate. The Timberlands segment manages 1.8 million acres of timberland in Idaho and the southern U.S. The wood products segment produces lumber. PCH owns six sawmills and an industrial plywood mill. The company is a top-ten lumber producer in the U.S. with a capacity of 1.1 billion board feet. Finally, the real estate segment identifies when land can be sold because it offers a higher value for uses other than timberland. Some of these land sales are for conservation or recreational use. There has also been a recent land sale for building a solar farm with similar opportunities expected given the growing focus on renewable energy. Per the latest 10-K, in 2021 the timberland, wood products, and real estate segments accounted for 37%, 56%, and 7% of EBITDA, respectively.
Rising Rates
The increasing interest rate environment hurts PotlatchDeltic Corporation in several ways. Rising rates have resulted in a national average 30-year mortgage rate of around 6.5%, per bankrate.com. The housing market has cooled and the Federal Reserve is not finished raising rates. Per the company’s own investor presentation, they have higher direct leverage to lumber prices compared to competitors like Weyerhaeuser (WY) and Rayonier (RYN). This is due to their lumber production in addition to the Idaho sawlog prices being indexed on a four-week lag to lumber prices per the latest 10-K.
On a broader level, higher interest rates make the yields from REITs less attractive compared to low-risk government bonds that finally offer decent returns. Higher rates tend to decrease the value for properties as borrowing costs increase. Despite these impacts, a study by S&P Global notes that REITs actually performed well in past rising rate environments. While the possible explanations cited may not apply this time around or even be applicable to Potlatch, it is worth noting that the impact of rising rates on REITs is not as clearcut as it may initially seem.
Positive Housing Demand Characteristics
Home affordability is clearly under pressure with the increase in mortgage rates described above. However, population growth and the increasing average age of available houses will support lumber prices going forward. Due to limited supply and high demand, the median sales price of houses in the United States reached a record of $454,900 in Q3 of 2022.
Median Sales Price of Houses Sold for the United States (St. Louis Fed)
The next graph shows us that homeownership in the U.S. has been declining. As a result, we can see that the rental vacancy rate also declined in a similar manner. Rental property construction has not kept pace with demand.
Valuation & Financials
The company produces reliable free cash flow and has a manageable debt load. The property plant and equipment number used in the cash flow table below also incorporates timberland reforestation and road costs.
A simple discounted cash flow (“DCF”) model shows PCH as highly undervalued if you started off with the last 12 months EPS of 5.29 and assumed a 5% average annual growth rate and a P/E in year five of 25. However, EPS is expected to drop substantially per average analyst estimates for next year. If we use the average EPS of the last three years as a starting point, 3.19, the model indicates PCH is trading at around 63% of fair value. The company also seems cheap based on its historical multiples and in comparison to peers.
Morningstar
Final Thoughts
Although PCH falls in the REIT category, one can also consider it as part of one’s commodity allocation given that it is a timberland REIT. Hard assets tend to do well in periods of high interest rates and offer the benefit of not being as correlated to the general stock market. Given the longer term housing demand characteristics and the associated impact on lumber prices, having an allocation to timberland makes sense.
PotlatchDeltic offers an attractive way to achieve exposure to timber, and is currently trading at an attractive valuation. Near-term volatility and a cooling housing market may provide opportunities to add to the PotlatchDeltic Corporation position throughout the year and collect the 4% dividend while interest rates stabilize.