Never Ending Change and Tough Markets Hallmarks of 2006

A number of major events rocked the US South forest products world in 2006. International Paper sold its timberlands, changing the way timberland is sold forever; Canadian companies gobbled up US assets, the Canadian Lumber Dispute was settled (at least for now), TIMOs changing their business model in light of new economic realities and the solid wood bull run ended with a thunderous crash.

I predict a flood of changes in 2007 as poor economic conditions put pressure on the few remaining public companies that own timberland to shed their assets; Canadian firms settle in the US South and everyone holds their breath for a lumber recovery, allowing new private equity players to enter at the bottom of the market or existing players to consolidate assets.

2006 was indeed an interesting year. Arguably the most interesting event was the disposition of 60% of International Paper’s assets—one by one. First the timberlands, then the solid wood mills and other peripheral assets. There is irony everywhere you turn. It took John Dillon (IP’s former CEO) 20 years to build the largest forest products company in the world and John Faraci (IP’s current CEO) only two years to dismantle it. However, I am not criticizing John Faraci, actually quite the contrary. It took some guts to make the decisions he did—not to mention great personal risk if the sales process was unsuccessful. However, fortunately for Mr. Faraci, the sales were largely a success. IP raised about 11 billion from the sale proceeds and received good (IP solid wood business) to outstanding (IP – timberlands) sales values.

The asset sales were the culmination of years of IP taking a whipping from Wall Street over poor returns. IP finally took action to get more focused on their uncoated paper and packaging businesses, selling other “non-core” assets in hopes of improving returns. Obviously the verdict is still out on whether IP’s new strategy will result in better returns and a higher stock price. But as we have noted many times in the past, it is very unclear whether a smaller (leaner and meaner) company without timberlands is more profitable. It’s also very unclear whether Wall Street has ever really responded to these new more focused strategies in the forest products industry. So far, IP’s stock price has not responded. We’ll see in 2007.

A couple new Timberland Investment Management Organizations (TIMO) rose to the occasion to acquire the IP timberlands and become major timberland owners in 2006. Namely, Resource Management Services (RMS) and TimberSTAR. Strangely enough, both are operating more as a timber supplier than a traditional TIMO. That is to say they are managing the entire raw material supply chain, from growing the trees to harvesting and delivering the logs. This is a much expanded role from the traditional stumpage sellers of old and follows the trend by forest products companies to offload wood procurement responsibilities, as well as financial risk to others in the supply chain. F2M believes that this expanded role for the TIMOs is much more efficient than having the investment function separate from the property management function—currently the most prevalent business model. Commercial real estate managers have performed both roles for many years very successfully. F2M believes we will see more of TIMOs performing property management in 2007 and converting to a delivered log sales program.

Last year at this time, I expected the remaining integrated forest products companies (principally, Weyerhaeuser, Temple and MeadWestvaco) to sell or announce the sale of their timberland in 2006. Well, I was a bit premature. However, Weyerhaeuser is looking at “strategic options” and one option is to convert to a Real Estate Investment Trust. Other more dramatic moves are certainly on the table. The senior management at MeadWestvaco told its investors in December to expect a plan in early 2007 to “extract value” from the company’s assets—I’ll give you two guesses on what that means.

Anyway, the trend of integrated forest products companies selling timberland or converting to a REIT continues in 2007.

In my third quarter letter, I spoke of the “internationalization” of the US South forest products business. Particularly, with the Canadian firms aggressively seeking assets in the US South. As evidenced by Canfor buying three mills from New South and West Fraser announcing the purchase of 13 sawmills from IP—dramatically increasing their presence in the US south from only 2 mills.

However, expect this trend to be stymied in 2007. Not for lack of interest, but for lack of available assets. Weyerhaeuser has good facilities and seems to be content to hold on to them. The new Georgia Pacific seems to be more interested in shutting down unprofitable sawmills than selling. Rayonier and MeadWestVaco may be coaxed into selling mills, but Temple-Inland seems unlikely from a purely cultural standpoint.

As everyone is painfully aware, the lumber and panel markets are abysmal. The slide started in early 2006 and appears to have bottomed only recently. This carried sawlog prices downward and wiped out the usual wintertime price bounce. On the bright side, there is some indication that housing starts are on the rebound. I personally believe that the fundamentals of the economy—a dequate GDP growth, rising incomes, affordable interest rates and strong demographics—don’t support a long downturn. Many economists—even my own—argue with me. I still expect a turn around in early summer, ahead of most economists’ predictions.

As seems to be the case…when the solid wood business is infirmed, the pulp business is healthy. As 2006 wore on, lumber and panel prices slid, but pulp and paper prices strengthened. Prices strengthened to a point that most pulp and paper mills are actually earning their cost of capital—a modern day miracle! Demand for most paper and pulp grades is strong, pulp and paper stocks are low, energy prices have abated and 2007 looks like it will be a fine year for the pulp and paper business. In 2007, the only negative impact on mill profitability will be wood costs. Forest2Market’s pulpwood prices—on the stump and delivered—have been on the rise since mid 2006 and are expected to strengthen slightly through 2007. Still only one negative factor is very manageable — and even welcomed compared to the multiple negative impacts of the recent past including low end product prices, high energy cost and weak product demand.

F2M expects the following major trends to continue in 2007:

• The remaining integrated companies sell timberland or convert to a more efficient tax structure
• Canadian firms (other foreign firms) search for US South assets
• Privatization of the US South industry

F2M also expects:

• A solid wood recovery earlier than expected, but poor sawtimber pricing throughout the year
• A roaring pulp and paper business, driving pulpwood prices up

And an industry that continues to run smoothly and profitably, but largely in obscurity.