December 9, 2003 – Sacramento, CA – Richard N. Smith, president of Forest Systems, Inc., delivered the opening keynote address today at the Western Forestry Conference at the Doubletree Hotel.
The theme of the conference was: “The New Environmentalism and Forest Resource Sustainability.” Smith's remarks, which focused on changing private forest ownership patterns and their implications, follow.
Thank you for the introduction, and thanks to the WFCA for inviting me to be with you this morning.
I always enjoy participating in forums like this because it is very important for us to share our views on the future of forestry and conservation, regardless of whether we agree or disagree. A willingness to listen, to ponder, to challenge our assumptions and perceptions and to ultimately seek solutions that are good for both the forest and humankind is what will allow of us to shape how change occurs in the days ahead…
That brings me to the subject of my remarks this morning.
I'm sure some of you were scratching your heads when you saw the title of my speech… But let me explain about the pony and hopefully you'll see how it is germane to the subject at hand.
When I was a kid growing up in Maine, we used to have a saying: “There must be a pony in here somewhere.” It was a cheerful reference that was meant to take the drudgery out of a chore every country kid hated – mucking out the stalls in the barn. It meant that even when you're trudging around up to your knees in the manure life dumps on you, you have to maintain a positive outlook because, otherwise, you may not recognize the benefits and opportunities being presented to you by that situation.
Now, I never found a pony in that barn, but I sure learned a lot about hard work. If it weren't for that, I probably wouldn't have gone off to college, become a forester and become involved in the forest investment business. If none of that had happened, I wouldn't be standing here today… I owe it all to manure.
Any way, I'm sharing this story because when I look at the turmoil and upheaval we're experiencing in forest management today, I often think of my experience in the barn. It takes a lot of courage, faith and perseverance, to keep looking for the pony, but I believe we have to do it because that is what will sustain us and allow us, as foresters and conservationists, to grow in stature and influence. In that context, my overriding purpose this morning is to share a view of where our pony might be…
It doesn't matter whether you have been working in forestry or conservation for ten years, fifteen years, 20 years or longer. Our world is a very different place today than it was when we got started.
If you work in conservation, there has never been more opportunity to protect sensitive lands, but the competition for securing such lands has never been more acute, or the process and mechanisms for doing so more complex and sophisticated.
If you work in the public domain, there has never been a more challenging time to be a government forester or land manager. You've faced increased regulatory enforcement pressure; difficult legal challenges from groups opposed to active management of forest resources; budgetary constraints that have zapped your capacity to serve the public's interest; and perhaps most importantly, mission creep caused by the inability of our elected officials to build a strong consensus around the extent of your role and responsibilities for being stewards of our public forests.
If you are a forester working in industry or private land management, the issues you face, because of global consolidation and increased manufacturing pressures from abroad, has had a seismic impact on your day-to-day job responsibilities as well as your long-term career path options.
This is the context within which I would like to focus my remarks this morning. I want to begin by sharing some of my own experience.
When I left the University of Maine with my forestry degree more than 20 years ago, the major landowners in my state were Georgia-Pacific, Scott Paper, International Paper, Diamond International, St. Regis Paper and Great Northern Nekoosa. Just about everyone who graduated from U Maine’s School of Forestry had a decent shot of getting a job at one of those companies, and a realistic expectation that we might spend our entire careers working on their lands. Today, only one of those companies still owns forests in Maine… one no longer owns forests anywhere… and five others don’t even exist at all – having been bought and absorbed by competitors.
Nationwide, the trend is no different. The list of major industry players that fall into these categories is staggering: Champion International… Willamette Industries… Union Camp… Chesapeake … Crown Zellerbach… James River… Louisiana Pacific… MacMillan-Bloedel… and, the list goes on and on and on…
The question I'm often asked is ‘why?’ Why has this transformation occurred… what are the implications… and where do we go from here? There are many facets to the issue, but here's what I see when I step back and examine how and why our world is evolving.
I think the change in forest ownership has occurred for one, primary reason. In the past, the forest industry, and most of us in this room, thought of timberland as a production asset. However, that perspective has been changing since the mid-1980s, when big pension funds first began investing in forests and generating very attractive returns with them.
Today, forest industry and investors increasingly view forests, first and foremost, as financial assets. As this has happened, forest ownership by integrated forest products companies, particularly those that are publicly traded, is gradually, but inexorably, becoming a vestige of a bygone era. The reason is simple: Once management and shareholders begin to think of their forests as financial assets, forest management is no longer considered a core business to a forest products company. It is a non-core business that has the potential to suck up enormous amounts of capital that could be used elsewhere to improve manufacturing efficiency and product distribution capabilities – the critical business dimensions upon which companies in this sector must concentrate to compete effectively in a challenging global market.
I realize that's a radical statement, but I believe it… Here's an analogy…
I think you could argue that forest ownership and management is no more a core business for a forest products company than owning a sugar cane operation is to a candy company. As long as its raw material needs can be met at competitive prices, Hershey doesn't need to have a single cane field on its balance sheet.
As more and more forestland gets bought up by financially-oriented landowners, forest products companies no longer need to own vast amounts of forestland to gain reliable access to quality wood fiber. The people who want to buy their lands and continue managing them as working forests for investment purposes have a huge economic incentive to treat forest products companies as valued customers and to sell them all the wood they need at market-based prices.
Companies like Packaging Corporation of America, Smurfit Stone Container, Georgia-Pacific and Louisiana Pacific have come to realize this and that's why they've gotten out of the forest ownership business.
The focus of management within an integrated forest products company must be on manufacturing because that is where its capital is most heavily invested. The machinery produces the products… that generate the revenue… that produce the profits… and ultimately create shareholder value. I believe this focus often causes a company to sub-optimize the financial potential of its forestlands, which is another way of saying it is not delivering as strong a return as it could on its invested capital. I'll get into that in more detail later, but suffice is to say, when push comes to shove, keeping that machinery humming along takes precedent over increasing the number of trees it is growing per acre on its land.
The emergence of forestland as an investment class has brought this issue into starker relief. In the past, selling non-strategic land to competitors was the only option forest products companies had to monetize forest holdings. Today, cash-rich institutional and high net worth investors are providing a safe and attractive place for industry to migrate both non-strategic assets as well as the forests upon which they depend for critical fiber supplies.
Paul Stecko, the well-respected CEO of Packaging Corporation of America, told me this when he sold my company, Forest Systems, 250,000 acres in the U.S. South in 1999. Paul said he couldn't manage PCA's land to its peak productivity because he had to devote scarce capital to improving his mills. He also recognized that he could reduce his debt levels considerably by getting out of the tree-growing business, and still have access to quality wood fiber through a supply agreement with us. I think he was ahead of his time with this kind of thinking, and others like LP and GP have followed the lead.
Now, I've mentioned the concept of forest industry “sub-optimizng” its forest assets a couple of times today. I realize that may have an offensive ring to some of you, so for the sake of clarity, let me give you a couple of examples of what I mean. One is dated, but the other is very recent.
About 20 years ago I worked as a field forester in the woods of Maine. I saw first-hand that companies regularly pushed large diameter sawtimber harvested from their lands into their paper mills alongside pulp logs. This never made any sense to me because we could have sold that wood to a nearby sawmill for nearly three times the price. However, it made a lot of sense to procurement managers because their jobs were to “wood” the mill and keep it running no matter what. In short, those companies had a lot of money invested in the land, but they were “sub-optimizing” that investment by turning a high quality, high value commodity – saw logs – into a low quality, low-priced consumer product – paper.
I had a similar revelation last year when I was speaking with a senior forest industry executive and his head of woodland operations. The senior person, who is well known and well respected, insisted that his company was fully optimizing the value of its timberland assets – despite the fact that it was consuming most of the wood that it was growing. When I asked his woodlands manager if he could do better from a pricing standpoint on the open market than he was doing as a captive supplier to his own company, he responded without hesitation, “Absolutely! I could sell our wood for a premium over what the company pays for it.” That wasn't the answer his boss was expecting, and I guarantee that it wouldn't have been welcome news to that company's shareholders, either. It was their money that was invested in that company's forests and they had a right to expect the best possible return on that investment.
Any way, in both of these cases, I would argue the companies in question were using their forest assets to subsidize the manufacturing sides of their businesses. In the process, they were “sub-optimizing” the financial potential of their forests. By continuing to own them, they also were keeping capital tied up in a non-core business – capital that might have been more effectively re-deployed to improve their manufacturing and distribution capacity.
These are not isolated examples and as more and more forest industry shareholders begin to understand the financial dynamics at play, the pressure they are bringing to bear on the industry to divest of forest assets is increasing. In fact, with publicly traded, vertically integrated companies, it is an issue that comes up every time there is a quarterly earnings call with Wall Street stock analysts. Companies that still own vast amounts of forestland are consistently being asked to explain and justify their decision to do so, and in many cases, it appears the value of their stock is suffering as a consequence.
This pressure is being ratcheted up as global competition, and the need to grow and consolidate increases. The takeover activity we have seen in the industry has caused corporate debt levels to skyrocket at companies that are in the acquiring mode – including Weyerhaeuser, International Paper and MeadWestvaco. As this has happened, the investment community's conviction has deepened that many such companies should divest of some, or all, of their forestland assets to clean up their balance sheets. This pressure will continue to wreak havoc on our historical concept of land base stability – that of large integrated companies owning vast tracts of land forever. Furthermore, I don't think it will subside until the consolidation of the forest products industry is complete and most of the forest industry's lands have been transferred to the ownership of investment-oriented landowners.
Another reason publicly-traded, vertically-integrated forest products companies face pressure to sell or divest of their forest assets is the tax inefficiencies associated with holding their lands within the traditional c-corporation structure.
Without getting into all of the details, companies that own timberland assets within c-corporations are taxed on earnings from those assets at an effective rate of more than 50 percent. Conversely, forests held in more tax-efficient structures, like REITs, are taxed at a rate of 15 percent.
Clearly, from a financial standpoint, when your cost of holding a capital asset is higher than that of others who own the same asset, it makes it very hard to be competitive. The forest industry has responded to this by lobbying Congress to reduce its tax burden, but I think the chances of that happening are slim and none because there's no compelling public interest for Congress to go down that path.
This isn't an issue for privately held, vertically integrated forest products companies like Sierra-Pacific and Roseburg , because their forests are held in tax-efficient s-corporations. Obviously, as private companies they also don't face the pressures from Wall Street I referenced above. However, through time, I believe the issue of tying up lots of their capital in forest ownership in the face of growing global competition will become a bigger concern for them. Likewise, given the excellent quality of some of their forest holdings, they may find it highly beneficial, at some point, to place their lands in REIT structures to capitalize on the public market's appetite for investing in forests through that mechanism.
So those are some of the major reasons I believe the private forest ownership landscape is changing. But the other questions we want to explore today are: How is it changing and what are the implications for forestry and forest conservation?
As forests move from being considered production resources to financial assets, a new type of land manager has emerged. Just as St. Regis, Diamond International and Willamette have disappeared from the landscape, organizations like Plum Creek, the Hancock Timber Resource Group and The Campbell Group have emerged as major forces in that arena. Groups like these have two things in common. First, they operate forests within the type of tax-advantaged structures I discussed earlier – including REITs; insurance company separate accounts; private partnerships; and, limited liability companies. Second, rather than managing forests primarily, if not exclusively, to keep associated milling assets operating, they manage lands on behalf of their shareholders and clients almost exclusively for the purpose of maximizing and optimizing their financial performance.
I would argue that the emergence of groups like these has both positive and negative impacts on our world.
From a positive perspective, they have helped push the increased emphasis on intensive silviculture by rationalizing productivity gains in a stronger cost-benefit context. They also have had an impact on the types and sophistication of the forest level technologies we employ because their decision-making processes are information and data driven. Finally, in companies that practice investment driven forestry, foresters are expected to manage each operating unit as a standalone business with its own profit and loss accountability. They also are expected to market their wood products aggressively and creatively. I believe all of this has brought a higher level of business sophistication to the practice of forestry.
Every week, I get at least one resume from some young man, and encouragingly from some young woman, who is graduating from one of our forestry schools with a dual degree in forestry and finance, or forestry and technology. That didn't happen 10 or 15 years ago… and I think it is a positive development because what it means is that the forestry profession is gradually building the technical capacity to influence how capital markets think about forests. Because of this, in the future, it won't be accountants, corporate raiders, engineers or land speculators who are making the important decisions about the future of our private forests. More often than not, I believe it will be foresters who understand the financial underpinnings of forests as capital assets – as well as the environmental and biological attributes that are the real source of their value.
Now let's look at the impact financially oriented ownership of forest assets has had on forest conservation.
I think financial ownership of forests has provided the environmental community with more opportunities to buy land. I also think it has helped legitimize and popularize the use of conservation easements as land protection and preservation tools.
Financial owners want to optimize value per acre on every acre – even those that are better suited for purposes other than timber production. Consequently, they have more incentive to work with conservation groups to sell, or otherwise protect, sensitive areas. Again, among other things, I believe this has helped fuel the explosion we have seen nationwide in the use of conservation easements in working forests. That's a very positive development because while easements can be a challenging to negotiate and manage, they are valuable tools that will be an important part of our forest management and protection strategies for many years to come.
The final positive development I want to mention with regard to financial ownership of forests is that it has raised the profile of the asset class on Wall Street. I believe this is increasing the level of appreciation investors of all sizes and orientations have for forestland's attractive investment characteristics. Eventually, I believe this notoriety and appreciation could pave the way for enhanced understanding of the principles and objectives of forestry among the general public – something we all care about.
Twenty-years from now, I believe efforts like President Bush's Healthy Forest Initiative will be more widely and easily embraced because as the public obtains a more direct economic interest in our private forests through ownership of forest REITs and other mechanisms, it will have more of an incentive to understand why active management is important.
Now, I'd like to talk about a few of the challenges we face as more and more forestland is bought, held and managed directly by the investment community. Right now there are really three things that concern me – greed, greed and greed…
A few years ago, the TIMO world consisted of five or six major players. Today, there are almost 20 groups hocking timberland investment management services – primarily to big institutional investors. Because each of these firms gets compensated on the basis of how much land they manage and how many transactions they complete, they have a real interest in buying and selling land… and buying and selling more land so they can keep their management fees flowing.
As competition increases in the TIMO marketplace, not only from new firms, but also from land speculators who see the timberland market as an attractive playground, buying land is getting harder to do. Because of this, we see forestland transactions occurring in the marketplace today that do not appear to be well or fairly priced. In my judgment, nothing will damage the forest asset class more than TIMOs doing bad deals just because they have clients' money to spend and an economic incentive to make investments on their behalf.
I believe there needs to be better alignment of financial interests between TIMOs and their clients – a better sharing of risks and rewards, if you will, to encourage sound investment decision-making. In short, TIMOs need to exercise an extremely high degree fiduciary responsibility when investing their clients' capital because if they don't, the end result will be declining investor confidence and, perhaps, a market collapse similar to one that occurred in the commercial real estate sector in the 1990s.
The second concern relates to how TIMOs and forest REITs are conditioning the investment marketplace to think about the performance characteristics of forest investments. Forests are what they are – value oriented investments that will return 6 to 12 percent, per year over long-holding periods if they are well-managed and if markets perform as they have historically. Unfortunately, the increased competition I referenced earlier, and the unsustainable high returns during the last 15 years, has caused some in the TIMO community to promote the idea that forestland investments can consistently generate returns in the mid-to-high teens – or even higher... I don't believe that is possible unless another spotted owl situation comes along, or the forest industry decides to sell its remaining forest assets at ten cents on a dollar. Those who are providing investors with access to the forestland investment market need to set realistic expectations about its future performance potential because if they don't, their credibility, and more importantly, the credibility of the asset class, will suffer.
The problem is somewhat different in the forest REIT market. I believe we need more publicly traded forest REITs to foster a better understanding of the unique investment characteristics of forests – especially among traditional REIT investors. Right now, Plum Creek is the only show in town – with Rayonier soon to join them. However, until some additional forest REITs emerge, those two companies will continue to see their management and performance reviewed and critiqued by investors and Wall Street analysts in the broader context of commercial property REITs. That's a problem because office buildings, shopping malls, apartment complexes and warehouses have underlying financial characteristics that are very different from those of forests. Those markets are more diverse, more complex and far more volatile, which means those who invest in REITs that hold such properties are likely to have higher return expectations than may be reasonable to expect from an investment in a forest REIT.
In short, the forest REIT market needs more depth and variety to become more firmly established. The alternative, I fear, is more churning of land; more rapacious harvesting; and, more active HBU land sale activity by forest REIT management companies to meet what are clearly unrealistic yield and return expectations among their shareholders.
That brings me to the final concern I have with the move toward more financially oriented ownership of forest assets. The issue is forest fragmentation.
Just as TIMOs are providing new opportunities for conservation groups to buy and protect lands that may have been inaccessible for such purposes in the past, their portfolio rationalization activities, and those of forest REITs concerned with maintaining their dividends, are also a threat to further fragment the forested landscape. Plum Creek has announced that as much as 1.4 million of its 7 million acres has higher and better use potential and it is actively marketing such property nationwide to public agencies and conservation groups as well developers and organizations that represent private recreation interests. In New England , where I live, I'm told a prominent TIMO has sold almost half a million acres in the last two years to nearly 30 different groups and individuals. All of these properties were bought by the TIMO within the last ten years from two or three, large industrial landowners. The new owners include conservation organizations, state agencies and other investment groups – but I'm also told they include developers, land speculators and timber liquidators. The point is, in about a decade, those original two or three large ownerships have been scattered to the wind because of the need to provide institutional timberland investors with liquidity. That has to be of concern to the conservation community and the forest industry as well.
During the next 20 years, I believe this issue, forest fragmentation, will be as big for the forestry community, and for the forest investment community, in particular, as clear-cutting has been during the last two decades. Furthermore, I would argue that, a forest management company's position on the issue will be even more important to its public identity than its forest certification status. People can visualize and relate to forest loss because most of us experience it. Places we have walked, hunted and fished as kids and with our families and friends are now occupied by Wal-Marts, strip-malls and mini-mansions. As a result, forest loss is far more real to us and the public at large than some of the more esoteric and scientific aspects of forest management that seem to occupy such focus in the world of forest certification.
So those are some of the trends and my thoughts about them. But, the question remains: “Where's the pony?” I would argue that depends on your perspective…
If you're a conservationist, the trend toward financial ownership of forests may allow you to acquire more land and stewardship rights. It also will give you more opportunities to innovate – to pioneer new financing strategies, like tax-exempt bonds, and transaction structures, like the debt service assumption agreement TNC has undertaken in Maine . Ultimately, I'm confident this will enable you to protect more sensitive and unique areas that are of interest to the public.
If you're a forest industry executive, the growing interest in forest ownership for investment purposes may be providing an opportunity for your company to become stronger by disposing of an asset, forestland, that may not be core to your business and that is becoming increasingly valued for its compelling financial characteristics.
If you're an investor with a long-time horizon – perhaps saving for retirement or a kid's college education – you want investment opportunities that offer stable performance, moderate risk, diversification attributes and capital preservation potential. Forestland offers all of these and it is becoming increasingly accessible to you with the expansion of the forest REIT market.
Finally, if you're a forester, I believe the current turmoil in our world poses near-term challenges. However, it also is creating unprecedented opportunity for our profession to grow and evolve and thus shape the direction forestry and forest management takes in the decades to come.
In closing, I'm guardedly optimistic that shifting forest ownership trends will strengthen the North American forest products industry and make it more competitive on a global scale. I'm also optimistic that the goals of forest conservation and responsible forest management will be more easily pursued and attained because change will create more opportunities and spur more creative thinking.
Finally, I'm optimistic that the role and responsibilities of foresters will expand and become more valued because we have a perspective and the professional expertise to help facilitate these changes in ways that will benefit society.
Keep looking for that pony. Trust me, it is out there somewhere… Thank you for your attention and for inviting me to be with you this morning.
Rick Smith can be reached at 508 230-0402 or at rsmith@forestsystems.com