Bury your head in the sand

Focusing on the wrong key performance metric may lead to unintended results

August 11, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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Timber REITs grow, harvest trees and convert them to lumber. A typical timber REIT manages millions of private acres, but there are only three main categories of business: timber, wood products, and cellulose. In the timberland segment, the company grows, harvests trees and, at times, manufactures and sells products from what have grown and harvested. The wood products segment includes structural lumber, engineered wood products, structural panels (such as OSB) and softwood plywood, mainly used for residential construction. In the third segment, cellulose fibers are designed for absorbent products, such as diapers.   

It is a remarkably innovative industry. Cellulose fibers are not only used in sanitary disposable products; they are also used in printing and writing paper. Wood products, such as structural lumber, are designed for framing residential and commercial real estate. Engineered wood products, such as solid section and I-joists, are used in real estate for flooring, roof joists, headers and beams. And timberland products, such as logs, are made into lumber and building products, and pulp and paper products. 

Yet Timber REITs sell a commodity product. Firms compete on price, and then on quality and service. Further downward pressure looms on the prices of timber and lumber because of the Softwood Lumber Agreement expiration on October 2015. Because non-fiber based alternatives are plentiful, an attempt to increase the price of timber results in lower demand. 

Substitution to timber is not the only risk. The timber industry is dependent on the homebuilding and credit markets. Residential housing is the most important end-use market for timber. About two thirds of the total US softwood harvest is used by the housing industry. The sensitivity to capital markets relates to home purchase affordability. If home affordability declines due to an increase in interest rates, home demand declines along with the demand for timber.

Overall return has been moderate at best. The four timber REITs included in the NAREIT Index offered a pittance for an average return of 4 percent. The best performer was Weyerhaurser Company (NYSE:WY) that exhibited a total return of 13 percent since 2011. But a $100 in  Catchmark Timber Trust (NYSE:CTT) in 2011 would be worth $91 at the end of 2015, a negative return of 4.5 percent. Lucky for the NAREIT passive investor, over 80 percent of the exposure to timber REITs rested on the hands of Weyerhaurser.

Perhaps it is time to be leery of valuing Timber REITs using EBITDA multiples. The metric does not take into account any expenses such as depreciation and depletion, capital expenditures and working capital, notes Rob Powell of Cardinal Capital, a consultancy company. And since over 60 percent of the operating costs for a typical timber REIT compose of depreciation and depletion expenses, ignoring the expense is comparable to the description of the Beat of Traal, a character in the novel Hitchhiker’s Guide to the Galaxy. An animal’s behavior is described as “so mind-bogglingly stupid that it assumes that if you can’t see it, then it can’t see you.”