Investment Manager's Letter June 2004

For some time now, Jeremy Grantham has been listing timber as an undervalued sector. It sounded pretty boring so I, as investment manager, decided to do a little checking, and found that the US timber industry has been pretty much dead in the water for the last ten years. Normally this kind of long-term trend would be enough discourage any further investigation, but there are a couple of factors that lead me to look a little deeper. Over the past few years price pressure has lead to industry consolidation, and a great deal of capacity has been removed from the marketplace, and even better, timber is a good weak-dollar play. In the long run, the dollar has to get weaker and commodity prices are going to continue to inflate. I, as investment manager, have no idea of the short term direction of the dollar or timber prices, but over a period of ten to fifteen years the above trends seem inevitable to me. The trade deficit cannot expand forever, and with three billion people in Asia experiencing a rapid expansion of personal income, prices of the basic things like oil, gas, wood, and paper are likely to increase faster than they have for the last twenty or thirty years.

There are a couple of almost pure plays for timber in the United States: Plum Creek Timber Co. and Rayonier Inc. Both of these companies have recently converted REITs which gives them some tax advantages: 1) It eliminates the double taxation of dividends. 2) As qualified timber REITs, most of the dividend is considered a return on capital and is taxed at the same rate as long term gains. Rayonier owns about 2.1 million acres of timber land, and has a total market capitalization of $2.0 billion. Plum Creek is much bigger with 8 million acres of timber land and $5.6 billion in market cap. Much of the land now held by Plum Creek came with the 2001 reverse merger into The Timber Company. The Timber Company was the result of the spin off and merger of six timber-related subsidiaries of Georgia Pacific Corporation.

Weak Dollar

The domestic timber industry has been in a long period of stagnation and depression. The strong dollar during the late 1980s and all of the 1990s made Canadian timber cheap to import, and at the same time made the price of American timber very expensive in overseas markets. The impact of the weak dollar was apparent in this years first quarter at both Rayonier and Plum Creek. Rayonier's revenue was up 10% and their net increased from $2 million in 2003 to $26 million or $.51 per share. Plum Creeks timber revenue increased by 17% and their net income (helped by $102 million operating profit from the sale of real estate) was $155 million compared to $33 million in the same quarter of last year. The dollar has recovered a bit since its lows earlier in the year, and it will be interesting to see how this affects timber prices and industry profits in the second and third quarters of this year. But further dollar weakness is probably necessary if the business is to continue to gain traction.

Grantham's view on timber was quoted in a 2000 article in the Outstanding Investors Digest. He points out that during all the secular bear markets for equities of the twentieth century, timber prices have increased. (Timber is) one of my, as investment manager, favorite asset classes. We expect it to enjoy huge returns 1910 to the present real timber prices have compounded at 3% per year. That's greater than the 1.4% real increase in S&P earnings per share.

Total yield on timber today is — and always has been — about 6%, the yield on stocks is down from 4.5% to around 1.2% today. So you've got a price series that's won and a yield that's hugely higher. Now, I've, as investment manager, looked at the price of timber and the price of the S&P during this century's three great bear' markets. Remarkably, when you really, really needed help, timber provided it.

Emerging Market Timber

Emerging Markets are another area where projected ten-year returns are substantially in excess of large cap American and European equities. The problems with emerging markets are numerous, but they do offer one huge saving grace: they constantly offer a nice political or economic crisis in which their equity markets get reduced to rubble. A disciplined investor can "buy the crisis" and end up with very nice companies with huge margins of safety. Aracruz is Brazilian company, and while it is not big in the lumber business, it produces 31% of the world wide production of eucalyptus pulp which is used for making high grade papers. This is an interesting equity for several reasons. First is the recent political and economic problems which have impacted the company's earnings and stock price. Second, the Brazilian forestry industry offers competitive advantages provided by extremely favorable climatic conditions. Aracruz is about the same size as Both Plum Creek and Rayonier, with about $1 billion in revenue and earnings of $136 million.

All three of the companies pay a dividend of over 4%, and while they are not cheap at current prices, a market correction might make them tempting, especially considering the dividends. How secure these dividends are is a good question. Of the three, Rayonier, has the best cash flow to debt ratio so this may offer some down side protection. REITs are required to pay out cash earnings, so its likely that Plum Creek and Rayonier will increase their dividend in 2004 and 2005. This is my, as investment manager, guess in view of the fact that Rayonier earned more in the first quarter of 2004 than they did in all of 2003, and Plum Creek earned $.84 for the same quarter compared to $1.04 in all of 2003.

This is a commodity business so any moat would have be based on a company being the lowest cost producer. In this regard, Aracruz may gain because of lower labor costs and cheaper land prices. On the other hand Rayonier and Plum Creek are REITs so they do not pay any corporate income tax, whereas Aracruz paid over $130 million in tax in 2003. Aracruz does its business mainly in dollars, so all three companies will gain a cost advantage from any further weakness in the dollar.

  Rayonier Aracruz Plum Creek Timber
Revenue $1,101,000 $1,000,000 $1,196,000
2003 Income $50,000 $136,800 $192,000
Operating Cash Flow $208,000 276.000 $369,000
Market Cap $2,120,000 $3,160,000 $5,700,000
Forward PE 20.8 12.1 19.7
Acres of Timber 2.1 Million 8.0 million 1.1 million
Long Term Debt $620,000 $1,077,800 $1,439,000
Est. 2005 Earnings $2.01/Share $4.32/Share $1.58
First Qtr 2004 $1.49 $.46 $.84
Year 2003 $1.16 $1.33 $1.04
Debt to Cash Flow 2.95 3.90 5.96
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