A timber company fits well in many investors' portfolios, Potlatch Corp. told investors at the REITWeek Conference, in Chicago, last month, and its presentation provided insights into how the Spokane company's conversion into a real estate investment trust is working.

Timber is a hard asset, Michael Covey, Potlatch's chairman, president, and CEO, said. Generally, hard assets become more desirable when paper assets such as stocks and bonds are in decline.

Timber is a hedge against inflation, and the value of timberland historically has been "uncorrelated" to that of stocks and bonds as it moves up and down independently from their prices, Covey says.

During the business downturn, Potlatch has been able to hold its revenue and EBITDDA, or earnings before interest, taxes, depreciation, depletion, and amortization, "fairly constant, which I think further points out the liquidity and the divisibility of the timberland asset" from other types of business assets, Covey says. That achievement, he says, also points out "how we're able to manage it through an economic downturn."

Meanwhile, in the past year or so, Potlatch's real estate business, which the company launched as it converted into a real estate investment trust (REIT), has completed a number of sales, Covey says.

Potlatch owns a huge amount of land, with 835,000 acres in Idaho, 439,000 acres in Arkansas, 244,000 acres in Minnesota, and 65,000 acres in Wisconsin, and its desire to derive value from those lands, other than by harvesting them to feed logs to its own mills, was a key factor in its decision to become a REIT. Last year, the company's resource segment, or timber business, derived just 17 percent of its revenue by selling logs to the company's own mills, Potlatch's annual report says.

The company's resource business now is its most important business and is the driver of its cash flow, Covey says. Between 2003 and 2008, the company increased the harvest of logs from its lands to 4.4 million tons from 3 million tons.

"An increasing harvest profile allows us to generate more volume, which in turn generates more cash flow for the company," Covey says. "The company used to have a very large manufacturing business in pulp and paper, which was spun off in December 2008. Future cash flows from our timber business should carry a higher EBITDDA multiple," or contribute more to earnings, "than they have in the past."

Potlatch is in a position to harvest 5.1 million tons of timber a year on a sustained basis for many years, because when the company was a C corporation and primarily a paper and forest products manufacturer, its timber business was "overlooked and conservatively managed," Covey says. "Timber was not treated as a financial asset that could really be optimized, so we have an 'overmature' timber base, meaning the trees are older than they should be, which allows us to increase the harvest level for some period of time, generating incremental volume and incremental cash flow as we do that."

Still, he says, housing starts have fallen to an extent that's almost unprecedented since the 1930s and 1940s, and recent improvements in lumber prices stem more from the industry's "destocking" of inventory than from any improvement in business fundamentals.

As a timberland REIT, Potlatch enjoys the advantages of being able to vary its log harvest as economic conditions change, Covey says.

While owners of other types of real estate, such as office buildings and apartments, lose money when their property is vacant, "the nice thing about the timber asset class is that if we elect not to cut a tree, we haven't lost the income; it's just been deferred for another day," he says.

Because log prices weakened as the lumber market fell, over the last 18 months Potlatch reduced its harvest of timber, and it cut only 3.8 million tons of logs last year, Covey says.

"There's no reason to sell timber in a weak market," he says. "We said, 'We ought to let it grow, stay in the forest to get bigger. It gets more valuable as time goes by, and then bring it to market at a more attractive time as housing prices begin to recover.'" He says, though, that Potlatch will begin to raise its harvest level this year to 4 million to 4.4 million tons, and over the next two or three years the company is likely to reach its long-term sustainable-harvest level of 5.1 million tons.

Steve Chercover, an analyst in Lake Oswego, Ore., with D.A. Davidson & Co., the Great Falls, Mont.-based regional brokerage firm, says, "I think Potlatch and their peers have done a very good job of managing through the downturn. They're doing the right thing in not maximizing the harvest during a weak period."

The idea is to maximize the value of the company's assets over the long term rather than the short term, and the company also has done a good job of maintaining liquidity, paying its dividend, and raising cash during the current period of weak demand for wood by selling some land, Chercover says.

Covey also told the REITWeek Conference that as generators of renewable energy seek biofuels such as wood, a new business line is beginning to emerge for timberland companies.

"While this is an emerging opportunity, and we don't have a lot of applications to point to today, we have inquiries from every operating area of the country (from) people who want to build biomass plants and haul wood waste, leftover logging residue, and slash to these facilities to generate energy," he says. Potlatch also is receiving inquiries from those who are interested in making ethanol from wood, and while neither opportunity has jelled yet, they might later, Covey says.

Potlatch now has just five mills and only enough production capacity to put it in the top 20 lumber producers, but its plants are attractively located next to the company's timberlands, and still make up one of its three business segments, with its resource and real estate segments as the others, Covey says.

In the last four or five quarters, the company's real estate business has grown sharply as the value of some of the timberlands Potlatch owns has risen because of their potential use as recreational property, Covey says.

In each of those quarters, the company has sold about 40 blocks, each of about 100 to 200 acres in size, of its Minnesota timberland to people from Minneapolis and St. Paul who want to build cabins on the parcels, cross-country ski there, hunt on the property, or recreate on the parcels in other ways, Covey says.

"It's worth two times to three times what it's worth as timberland," Covey says. He adds, "This is a new business for the company."

Sales of recreational properties brought in $65 million in revenue for Potlatch last year, up from $24 million in 2006, when the company first got into the real estate business, Covey says. He makes it clear, however, that "we're not in the development business."

Non-timber revenue from the company's lands, from leases for hunting rights, buildings, easements, and grazing, has grown to $4.9 million annually from $2.3 million over the last six years, the company says. It regards 1.2 million acres of its holdings as core timberland, and says it frequently assesses its acreage as it seeks to realize maximum value through the sale of non-core timberland. It says its lands include more than 3,000 miles of "desirable water frontage."

Also, Potlatch now is selling land to a new type of buyer, the institutional investor, Covey says. In one such transaction, a division of a bank paid $1,200 an acre for 24,000 acres of timberland it bought on behalf of an Arkansas teachers retirement fund, he says.

"We're optimistic we're going to continue to sell into that market," Covey says.

Potlatch now projects that it will sell up to 20 percent of its lands over the next decade, although eventually such sales would reduce the company's long-term sustainable annual harvest level to about 4.5 million tons, he says.

Covey told the investment conference that the company's $2.04 annual dividend would have yielded an annual return of 5.9 percent if an investor had bought its stock at recent price levels. In February 2009, when the stock market hit a low ebb, the company's dividend would have yielded an annual return of 11 percent.

Eric Cremers, Potlatch's vice president of finance and chief financial officer, says that the company sold $150 million of 10-year, 7.5 percent notes in the fourth quarter last year and now has $364 million in long-term debt, but its debt-to-capital ratio, at 52.6 percent, is well within the 60 percent level required by its loan covenants. The company also has renewed its $250 million revolving line of credit, on which it has yet to draw, and secured that credit line and another $70 million in debt by putting up as collateral 660,000 acres of core timberland from its holdings in Idaho, Cremers says.

"The appraisal on that collateral is about $1.1 billion," he says.

Cremers called Potlatch "a pure-play timber REIT" for investors, and said that such companies "are typically valued at 15 to 20 times EBITDDA" by the stock market, and as the company's harvest levels improve, it hopes to reach such values.

"We're optimistic that as the housing market continues to recover, and our harvest levels continue to improve, we'll generate a lot more cash, hopefully have a higher dividend, and hopefully have a higher stock price," he says.

Covey points out a further advantage of having owned timber for a long time.

"The company is 107 years old this year," Covey says. "Much of the timber has been on the books for almost that long. So when we cut a tree, it has a very low (cost) basis, and generates significant cash flow."