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| 8-K - POPE RESOURCES LTD PARTNERSHIP | v181093_8k.htm |
Exhibit
99.1
President's
Letter furnished with the December 31, 2009 Annual Report
Dear
Fellow Unitholders:
There is
no way of getting around the fact that 2009 was an extraordinarily challenging
year. The numbers tell the story, with our total revenue of $20 million off 27%
from 2008 and 69% lower than our high-water mark just three years ago in 2006.
We have to go back 20 years to find the company’s revenue levels this low. We
also reported an annual net loss of $272,000, or $0.07 per diluted ownership
unit, only the third time in our 24-year history we have failed to generate a
profit.
There is
a definite temptation to bemoan the difficult economic climate we have been
operating in over the past year, and to focus on all the macroeconomic
indicators responsible for the great recession that we seem to have just come
through. Rather than rehash the origins of this recession and the resulting
market conditions it created, I will focus instead on the proactive steps we
have taken to add value to the company’s assets and prepare for what we believe
is a bright future.
As a
small company that is thinly traded and enjoys only a limited following, we are
not beholden to meeting analysts’ earnings expectations. As such, we are able to
behave more like a private company and make many decisions with an eye towards
adding long-term value rather than focusing on short-term results. This past
year was a good example of this principle, where we made a number of decisions
that pulled down current earnings, but were nonetheless the right thing to do
from a long-term perspective.
Foremost
among these decisions was a move to conserve cash by cutting our quarterly
distribution. Given how far log markets had declined and the uncertainty
associated with the length of the housing downturn, we opted to cut our
quarterly distribution twice during the year. We cut it from $0.40/unit in the
fourth quarter of 2008 to $0.20/unit in the first quarter of 2009 and to
$0.10/unit in the fourth quarter of 2009. Relative to 2008, this conserved $4.2
million of cash in 2009 and, at the current quarterly distribution level of
$0.10/unit, $5.5 million on an annualized basis.
The
reductions in our quarterly distribution, in concert with our relatively low
level of debt, also afforded us greater flexibility to cut back our log harvest
volume and thereby avoid pushing logs into a depressed market. As was the case
in 2008, we decided to reduce our harvest to below our long-term sustainable
level. We went into 2009 with the intention of harvesting 37 million board feet
(MMBF), a reduction of nearly 30% from our sustainable harvest of 52 MMBF. As we
moved into the year, log markets proved to be so weak that we dropped the target
harvest by an additional 5 MMBF to 32 MMBF. These harvest deferrals of 2008 and
2009 will add value by allowing the trees to continue to grow while we wait for
markets to improve. The mature merchantable timber on our tree farms grows by
almost 4% per year, so it will not take much of a log price recovery for this
deferral decision to make sense from a discounted cash flow standpoint.
Including growth, we have deferred 37 MMBF of volume over the past two years.
When markets recover, we plan to harvest this deferred volume as an increment to
our sustainable harvest level.
With the
collapse of the housing market and the uncertainty associated with how long the
recovery will take, we recognized the need early in the year to tighten our
belts. We moved to contain costs by letting go of some talented individuals,
freezing salaries, and slashing discretionary spending across our operations.
These measures led to a 25% reduction in our operating expenses across our three
business segments and a 59% decline in discretionary capital spending relative
to 2008, all of which helped to mitigate the impact of declining log prices and
lower harvest levels. While this cost cutting effort entailed some difficult
decisions, it left intact core competencies and will serve us well in 2010 and
beyond as we foresee a slow recovery in our markets.
An
additional response to the poor state of log markets in 2009 might have been to
increase the harvest of higher valued logs to help compensate for declining log
prices. Instead, we mirrored our 2008 log sort mix by emphasizing the harvest of
lower valued stands with a higher component of pulpwood volume. We did this for
two reasons. First, while all log grades declined in price during the year,
pulpwood logs experienced the lowest percentage decline. In addition, weighting
our harvest mix towards stands with a heavier component of pulpwood volume
allowed stands with a higher proportion of more valuable logs to continue to
grow. Accordingly, pulpwood volume, as a percent of our total mix, swelled to
23% and 21%, respectively, in 2009 and 2008. By comparison, pulpwood timber
comprises only 14% of our total merchantable timber inventory. This bias towards
more pulpwood in our harvest mix contributed to the 2009 decline in our total
weighted average log price to $410 per thousand board feet (MBF), a drop of 19%
from the average 2008 price of $506/MBF and 32% from the average 2007 price of
$607/MBF. So again, while this decision to cut lower valued stands in 2009
served to further depress revenue and earnings, we believe it will add value to
our remaining asset base.
Lastly,
in 2009 we decided to refinance one of our two timber mortgages that, while
improving downstream cash flows, reduced near-term earnings. Going into 2009,
both our mortgages carried interest rates that were high relative to the current
interest rate environment and also represented refinancing risk with both coming
due in April 2011. To mitigate this refinancing risk and reduce future interest
expense, we refinanced one of these mortgages and entered into a new 10-year,
$9.8 million mortgage due in September 2019. The proceeds were used to retire
the old mortgage and pay a $1.1 million make-whole premium, which was recognized
as a one-time debt extinguishment cost. The interest rate on the new mortgage is
fixed at 6.4% versus 9.65% for the refinanced mortgage.
In
addition to some of the defensive moves described above, we also had the chance
to play some offense during the year. Early in the year, we closed ORM Timber
Fund II (Fund II), an $84 million fund focused on acquiring Pacific Northwest
timberland properties. As with our first fund, Pope Resources has a 20%
co-investment stake in Fund II. Early in the fourth quarter of 2009, Fund II
invested $34 million in two separate properties in northwest Oregon totaling
12,000 acres. We are actively seeking attractive timberland acquisitions to fill
out this fund’s remaining $50 million of committed capital. Over time, as we are
able to grow the size of this timber fund business, we expect that our
unitholders will enjoy increased economies of scale, fee income from managing
both the properties and the funds, and future carried interest participation
fees for each fund that delivers returns to investors above pre-determined
thresholds. We are excited to have fund capital available to put to work in the
current timberland market, where indications suggest that prices may be
moderating.
We have
had to make some painful decisions during 2009 including reducing headcount,
discretionary expenses, and unitholder distributions in order to conserve
capital. These decisions, while difficult, heighten our resolve to not just
survive the market downturn, but to continue making the forward-looking
decisions that will position our portfolio to capitalize on an economic recovery
that is still probably more than a year away. The balance of this letter will
examine, in more detail, our capital allocation strategies as well as the
actions we are taking in each of our segments to add long-term value to our
asset base.
CAPITAL
ALLOCATION
In last
year’s letter, we detailed the “harvest” of free cash flow from 2004 to 2007
totaling $65 million. Two years ago, at the beginning of 2008, we had cash and
short-term investments on our balance sheet totaling $32 million. By the end of
2009, this total, excluding cash from our two timber funds, had declined to
approximately $6 million. The table below details the most significant cash
outflows during this two-year period and highlights our capital allocation
priorities:
|
($
millions)
|
2008–09 | |||
|
Distributions
to POPE unitholders
|
$ | 10.7 | ||
|
Timber
fund co-investment
|
6.9 | |||
|
Unit
repurchases
|
5.8 | |||
|
Non-discretionary
Real Estate project expenditures
|
2.7 | |||
|
Discretionary
Real Estate project expenditures
|
2.4 | |||
|
Direct
timberland purchases for Pope Resources
|
0.9 | |||
|
Total
|
$ | 29.4 |
While the
above table details the cash outflow over the past two years, it is not
necessarily a prologue to the next few years. To a great extent, the aggregate
amount directed toward these categories in the future will be a function of the
strength of our desire to conserve cash as well as the characteristics of the
economic recovery.
As
described earlier, we reduced our quarterly distribution by 75% in conjunction
with our curtailment in log harvest volume. Going forward, our distribution
level will be heavily influenced by our harvest level, as that is our primary
vehicle for cash flow generation. The amount we will spend to fulfill our timber
fund co-investment commitments is difficult to predict as it is dependent on
timberland deal flow matching up with attractive acquisition pricing. We have a
$10 million co-investment obligation remaining for Fund II, which we anticipate
fulfilling during the two-year drawdown period ending in March 2011. However,
the drawdown period may be extended upon approval by Fund II’s investors at that
time if the fund is not fully invested. If we are able to place all the capital
in Fund II during 2010, we anticipate having to tap our $35 million line of
credit for a portion of this co-investment obligation. With our current emphasis
on preserving cash, we have constrained our unit repurchase program since the
middle of 2009. We have also ratcheted back our discretionary Real Estate
project expenditures to align with lower anticipated sales velocity over the
next few years.
BUSINESS
SEGMENT STRATEGIES
Fee
Timber
Our Fee
Timber segment is the beneficiary of Pope Resources’ strong balance sheet and
relatively low level of debt. By cutting our quarterly distribution by 75%,
refinancing one of our two timberland mortgages, and obtaining covenant relief
during these depressed markets, we were able to do what many other timber
companies could not “afford,” namely to reduce both harvest volume and current
cash flow during down markets. We have seen many companies being forced to sell
into depressed markets due either to high absolute levels of debt or concerns
over failing cash flow debt covenants. As described earlier, with our
merchantable timber volume growing by almost 4%, it will not take much of a log
price recovery for this deferral decision to make sense from a strictly
financial standpoint. As markets begin to recover, we anticipate that we will be
recouping this 37 MMBF of “banked” timber volume through stepped-up harvest
beginning in the next year or two.
When log
markets are as depressed as they were in 2009, we observe considerable price
compression across both species and log sorts. To manage through this
phenomenon, we work hard to retain harvest unit flexibility by maintaining a
considerable volume of permitted harvest units. This allows our foresters
maximum flexibility to switch harvest units to either capitalize on strong spot
pricing or, as in a year like 2009, to sell harvest units that have a heavier
mix of log sorts that have experienced a lower relative price decline. We
believe this helps us to not only manage through these difficult times, but also
positions us to emerge even stronger in the future as markets begin to
recover.
We are
also continuing work on maintaining our timber inventory system through the
annual cruising of between 15% and 20% of our stands aged 20 and older. This
statistical sampling effort measures not only volume, but species mix, site
index, defect, and log grade. This helps us in three important ways. First, it
improves our short-term forest and financial planning efforts by giving us
greater confidence in accurately predicting realized harvest volumes. As a part
of this process, we compare all harvest unit cutouts (the actual results of our
harvest) to the volume estimates developed through our inventory system. Over
the past five years, our cutout on 254 MMBF of actual harvests has exceeded our
timber inventory by 2.25%. These annual cutout analyses help us to fine tune our
growth and yield models, which gives us greater confidence in predicting
long-term sustainable harvest levels. Finally, the extensive experience and
expertise we have developed using our own personnel to conduct internal timber
cruises helps us in assessing acquisition targets for our timber fund business,
as we use those same personnel in our acquisition due diligence
process.
Our
long-term timberland ownership strategy is to diversify away from our
traditional holdings in the Hood Canal region of Puget Sound that date from
our 1985 formation in a spin-off by Pope & Talbot. Over the past decade, we
have grown our timberland base from 72,000 acres to over 121,000 acres when
including our 20% interest in ORM Timber Funds I and II. We’ve also diversified
into other sub-regional logs markets by expanding into southwest Washington and
northwest Oregon. In conjunction with both our timber fund and real estate
strategies, we expect this trend to continue over time. We continue to see
co-investments in our timber fund offerings as a means of converting a portion
of our free cash flow into growing our land base over time. In addition to the
fee income stream that will accrue to our Timberland Management & Consulting
segment, we see our co-investments as a means of being in the timberland market
on a continuous basis and managing this growth through dollar cost averaging.
Our real estate strategies will help to fund this growth by capturing the value
we have added to our 2,500-acre Real Estate portfolio and leveraging the
relatively high timberland values of our Fee Timber portfolio associated with
encroaching development pressures. Over time, we expect to continue to shrink
our footprint in the Hood Canal region of Puget Sound while continuing to grow
in southwest Washington and western Oregon.
Timberland
Management & Consulting
When we
launched our Olympic Resource Management (ORM) subsidiary in 1997, it signaled a
new strategic intent to leverage our expertise in managing our own timberlands
into providing that service to third parties. ORM’s first decade was
characterized by a succession of three large-scale timberland management
contracts for clients that owned large blocks of Pacific Northwest timberland.
During this period, we provided comprehensive management services on over 1.5
million acres of timberland stretching from British Columbia to California. Over
time, we also recognized market demand for commingled timberland investment
funds where outside investors could invest alongside Pope
Resources.
In 1985,
when Pope Resources was spun off from Pope & Talbot, most timberland was
owned by forest product companies that saw the primary value of the land as a
source of logs for their mills. At that time, timberland was just beginning to
be “discovered” as an alternative investment with attractive return
characteristics for institutional investors. As major integrated forest products
companies gradually divested of their timberland holdings over the past 25
years, most were sold to large institutional investors through timberland
investment management organizations (TIMOs). As we watched this TIMO market
evolve over time, we saw four areas where we could offer a differentiated
timberland investment fund while leveraging our timberland management expertise.
Few, if any, TIMOs were co-investing alongside their third-party investors. We
saw an opportunity for Pope Resources to invest its own capital alongside
third-party investors while at the same time improving alignment with investors.
We also saw a need to provide regional specialization in the Pacific Northwest
rather than trying to be in all markets as is the case with many TIMOs. In terms
of transaction sizes, we saw an opportunity to focus on middle-market
transactions in the $10–$30 million range that were deemed too small for many
large TIMOs to pursue. Finally, we observed that most large TIMOs were managing
a mixture of large separate accounts and commingled funds, thus creating issues
with acquisition queues for investors trying to get into the asset
class.
These
observations helped to shape our strategy for a differentiated timber fund
offering. In 2005, we closed our first timber fund with a total capital
commitment of $62 million, 20% of which came from Pope Resources. In late 2006,
we placed $58 million of this capital through the purchase of 24,000 acres of
western Washington timberland in two transactions. We closed our second fund in
early 2009 with a total of $84 million of committed capital, with Pope Resources
again providing 20% of the total. As mentioned earlier, we acquired two
properties totaling 12,000 acres in northwest Oregon in the fourth quarter of
2009. This leaves another $50 million of committed capital to place sometime in
the next year or two before the capital commitment expires. As cash flow
generated from timberland investments declined during this current downturn in
the housing market, we noted an increase in attractively priced acquisition
opportunities. We believe we will be able to capitalize on these investment
opportunities as a result of our timber fund business in a way that would not
have been possible using only our own capital without significantly increasing
leverage and corresponding risk.
There are
a multitude of benefits to Pope Resources from being in the fund business that I
have trumpeted in prior versions of this letter, including: the attraction and
retention of talent to meet the service demands of a third-party business that
also benefits Pope Resources’ timberland; diversification of Pope Resources’
core holdings; constant engagement with the market for timberland that keeps our
timberland acquisition and disposition skills sharp; and, finally, the addition
of a stable stream of fee income to augment the revenue generated from our
timberland and real estate holdings.
Real
Estate
Following
the 2001 sale of our resort assets in Port Ludlow, we shifted the focus of our
Real Estate segment away from resort operations and homebuilding to securing
entitlements that will add value to our land. After years of operating as a
vertically integrated real estate development company, we believe this is the
part of the value chain where we can add the most value. This strategy is of
particular importance to us as a large portion of the 71,000-acre Hood Canal
tree farm is clearly in the path of development. The Pacific Northwest continues
to be a desirable place for in-migration from other parts of the U.S. and we
believe that is a trend that will continue to put upward pressure on demand for
land for decades to come. During the recession of 2001–2002, we focused on
developing a pipeline of product we could sell during the next cyclic upturn in
the market. This strategy paid off handsomely at the top of the cycle in
2006–2007 when we generated total segment revenues of $40 million from the sale
of an array of urban and rural residential lots as well as some very valuable
commercial land in our Gig Harbor project.
While
this current downturn in the housing market is far more severe than anyone
projected and it will likely take a number of years to absorb excess supply of
lot inventory, the recovery will eventually happen. In addition to the
in-migration referenced earlier, there are strong underlying demographic
characteristics that should translate to good long-term demand fundamentals for
land in our regional market. We also recognize that many developers have cut
staff in the area of lot development. When the market does come back, we believe
this will translate to a constrained supply of permitted lots. So while we have
cut back on a significant amount of our Real Estate discretionary capital
spending, we continue to fund the long-term entitlement efforts that will
translate to a supply of lots two to four years from now.
Foremost
among these efforts are our residential plats in Gig Harbor and Kingston.
In December 2008, we submitted a residential plat application for the 200-acre
residential portion of our Gig Harbor project, which is located in a desirable
suburb of Tacoma. This plat application, for which we expect to gain approval in
2010, calls for 558 single-family lots and 265 multi-family lots. Once approved,
we will incur road infrastructure costs before we have finished lots ready to
sell. However, most of the more capital-intensive infrastructure investments
have already been completed in conjunction with the Costco sale in 2006. Our
356-acre Kingston project, which is one mile from the Kingston ferry terminal
(providing service to the Seattle suburb of Edmonds), finally received plat
approval in late 2009 after many years of delay. In February 2010, Kitsap County
approved a 15-year development agreement for this project, which calls for 663
single-family lots and 88 multi-family lots. We expect both the Gig Harbor and
Kingston projects to have product ready to sell in the next two to three years
and we believe this timing should coincide with at least the beginnings of a
recovery in the local housing market.
While we
are encouraged by the future revenue generating capacity of our Real Estate
assets, 2009 was a very slow year. We sold only 50 acres of raw land and rural
residential real estate this past year, an all-time low for the company.
Although we were satisfied with the $10,420 per acre average price of these
sales, we did not see fit to push land sales in a soft market. In this sense,
our actions in the Real Estate segment were similar to our decision to defer log
harvest volume in our Fee Timber segment. To generate some revenue and cash
during this period, we began providing consulting services to banks that now own
developable land as a result of non-performing land loans. These consulting
services provide a creative way of keeping our Real Estate team largely intact
while continuing to work with our properties and still generate some revenue and
cash during this time of weak land markets.
Although
outright land sales activity has been slow during this market downturn, we have
had notable success selling conservation easements over the past few years.
These agreements, which typically preserve all our rights to intensively
practice silviculture and harvest timber, allow us to monetize the real estate
development rights. Nearly 65% of the Real Estate segment’s 2009 revenue was
generated by a $3.3 million conservation easement sale on 2,290 acres of our
Hood Canal tree farm. Conservation easements such as this are structured to
provide benefits to multiple constituencies. Conservation groups work to raise
money to retire these development rights and in the process, preserve working
forests that help protect soils, streams, and wildlife. We see these agreements
as an important tool for extracting real estate value that would otherwise take
many years to realize. While these agreements typically take several years to
complete, the $6.6 million of conservation easement sales in the past three
years have helped us during an otherwise slow period for land
sales.
One of
the central tenets of our Real Estate segment’s efforts to add value to our
lands is to look for win-win solutions with local communities. Since obtaining
land entitlements is fundamentally a political process, we believe that seeking
such win-win solutions is a key to success. Two of our long-term entitlement
efforts are good examples of this principle, the “String of Pearls” strategy for
our 8,000 acres of north Kitsap County lands and our “Ring of Fire” initiative
for our 24,000 acres of Skamania County lands. In Kitsap County, we are
exploring a partnership with the County to increase development densities on
1,000 acres near our historic mill town of Port Gamble in exchange for selling
other portions of our 8,000-acre ownership to the public. We believe this will
help create the necessary scale to make the re-development of Port Gamble
economically viable, while at the same time providing the County with an
increased tax revenue base. By allowing for public ownership on the balance of
our lands, the broader community will benefit through the development of a
regional trail system connecting many of the waterfront towns, or “pearls,” in
north Kitsap County. Our Skamania County initiative is based on selling a series
of conservation easements over a number of years on 85% of our ownership in that
county in exchange for obtaining entitlements on the remaining 15% to provide
development opportunities for active recreation and services to support a
regional tourism loop around Mt. St. Helens.
To
provide for some downside protection should our entitlement efforts not be
successful and to protect against the potential for down-zoning on both projects
while we are working on each of these initiatives, we deployed a defensive
strategy over the past two years of recording 20-acre legal parcels in
conformance with current zoning in Kitsap and Skamania counties. We view this as
a form of insurance to have saleable lots and lock in our existing rights while
we continue to work with both counties and a number of conservation
organizations on each of these initiatives. We still have considerable work to
do on both projects, but feel the potential long-term return is worth the added
effort.
LOOKING
FORWARD
As the
recession appears to be coming to an end, many economists report that the
housing market has finally bottomed out and will begin to recover, albeit
slowly. We are hopeful that the housing market will begin to improve this year,
but are not counting on it. We remain concerned about the overhang of
foreclosures and the impact that high unemployment and tight credit will have on
this recovery. Accordingly, we are adopting a cautious operating posture and
once more are holding back on our planned log harvest level. As previously
announced, we intend to harvest 32 MMBF in 2010, a level similar to 2009 and 47%
below our current sustainable harvest of 60 MMBF. If markets do improve faster
than anticipated, our deferred harvest volume and large supply of permitted
harvest units will allow us to capitalize on that situation.
In the
meantime, we are not merely hunkered down in a totally defensive posture. We are
growing our timber fund business, investing in our Real Estate portfolio, and
actively positioning our land and timber assets to be ready for an expected
recovery across our various markets. I am very proud of the fine work our Board,
management team, and employees have done in staying focused on executing our
strategies and managing through these challenging times. The steps we have taken
leading up to and during this recession have maintained the strength of our
balance sheet and our ability to raise debt capital if needed while still
preserving our ability to capitalize on an economic recovery. I would like to
thank our unitholders for your continued support of our strategies and team and,
as always, I welcome your feedback.
David
L. Nunes
President
and CEO
March
15, 2010