A small cap pure timber play, Keweenaw Land Association

Keweenaw Land Association (KEWL.Pink Sheets)

Price: $76 (12/13/2011) - note this is an extremely illiquid stock, small trades can really move the stock price.

A bit back I did a post on investing in Timber and got some great emails from readers regarding other companies that are more pure timber plays.  One of the companies mentioned was Keweenaw Land Association a smaller company traded on the pink sheets.  In my last post on Queen City Investments I mentioned pink sheet stocks often having a story that follows them, Kewneenaw doesn't disappoint in this regard.

Keweenaw doesn't report to the SEC but they do offer quarterly reports on their website along with their audited annual report.  The company isn't "dark" by any means, they are transparent with shareholders and tout the cost savings from non reporting as an investment advantage.  There are actually a few presentations on their site showing the potential cost of becoming a REIT and filing.

Company Background

Keweenaw has a long history, it began as a land grant after the Civil War.  The company owns 159,831 acres of land of which 153,074 is timberland in the Upper Peninsula of Michigan and northern Wisconsin along with 405,985 acres of mineral rights.

For much of it's history Keweenaw made money on mineral royalties and timber harvests.  For years the company harvested more timber than they grew.  In the 1960s the company made a decision to manage the woodland in a more sustainable manner, and began this aggressively in the early 1990s.  Now the company grows more timber than they harvest and focus on increasing the asset value of the timber holdings.

Activist Story

As I mentioned above almost no pink sheet stock escapes without having some sort of story to tell, Keweenaw is no different.  The story here is a bit unique, there are two shareholders Ron Gutstein and Scott Frisoli who for the past few years have been offering shareholder proposals and director nominations at each election.

The shareholder proposals seem to change each year, in the beginning there was a laundry list of suggestions to unlock value including the following, a snowmobile theme park, wind power generation, a REIT conversion, elimination of the dividend, and a buyback.

The proposals haven't been for naught, the company has put together some great presentations explaining why it isn't in the best interest of shareholders to convert to a REIT.  They also commenced buyback and eliminated the dividend.  The dividend was eliminated with the purpose of channeling the money back into growing the business.

Here is a letter from Ron Gutstein with some of his proposals back in 2009: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDbpkM.zuib8

For each letter and proposal Mr Gutstein submitted David Ayers wrote a rebuttal and posted it on the company website.  Some rebuttals are quite elaborate with presentations and lots of good information, others are simply a few lines.

For all this back and forth the company claims to have spent over $300,000 defending themselves.  Keweenaw tries to paint Mr Gutstein and Mr Frisoli as corporate raiders who will come along and gut the company with financial engineering.  Some of the shareholder proposals are a little out in left field, but others have a lot of merit.

For all the defense management has put into the proxy fight they aren't exactly shining defenders of shareholder value either.  Management likes to discuss how they've increased the asset value of their holdings with organic (literally and figuratively) growth.  For all this growth management seems to have a plan to grow on a much later scale, this past proxy season they increased the authorized shares from 2.5m shares to 10m shares.  Management has stated that they might need extra shares to raise capital and expand.  The expansion would be good for themselves as they'd be able to draw a larger salary and run a bigger company but would utterly dilute current shareholders.  Amazingly enough the current holders voted for this measure.  Based on the current outstanding shares (1.29m) raising the full amount of capital would reduce shareholders ownership by almost 90%, a staggering number.

I think management would probably be quick to dismiss a massive dilution, but their actions say otherwise.  The previous amount of outstanding shares was 2.5m meaning that 1.21 shares were available to be issued which at current market prices is around $94m.  For some reason management believes they need to raise more than $94m for "General corporate purposes" to grow the company, which in turn will cut current holders' stakes in half or less.

Gutstein and Frisoli have been reducing their demands each year while at the same time trying to secure a board seat.  I think in a situation like Keweenaw having a vocal investor is actually helpful in highlighting issues that might not be much visibility due to the non-reporting nature.

One last thought before moving onto the valuation, reading these letters and the corresponding shareholder reaction reminds me of what Ben Graham says about shareholders in Security Analysis "It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity.  He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers."  This could not be more true than with Keweenaw, in reading some message board posts most shareholders voted for the dilution and consider Ron Gutstein a thorn in the companies side.  It blows me away that people would voluntarily vote to reduce their stake in a company up to 90%

Valuation

Keweenaw has worked very hard to help investors understand how to value a sometimes complex investment, on their website they have a file called "Understanding KLA Asset Value and Operations".  The company commissioned appraisals in 1998, 2000, 2003 and 2006 of the land value, and the timber value.

The appraisal valued the company in two different ways.  The first was on a single transaction basis, this means they looked at comparable timber sales and estimated what the company would fetch in the market if everything was sold at once.  The second was a discount cash flow based on selling the timber down over a period of seven years.  This method assumes that the company sells down their trees for both pulp and lumber at 06 market prices and then adds in a raw land value.

There is also some discussion in the report about the value of the land if it was sold for non-timber uses in parcels, but no work is taken to peg a value for that.  Obviously liquidating a company in this manner would be difficult and costly.

The last item relevant to a valuation is the mineral rights.  The appraisals didn't include mineral rights, but the company touches on the possible value briefly.  From 1891 to 2006 Keweenaw recognized $78m dollars in mineral royalties, which translated to 2006 dollars is $552m.  The company claims there are still significant copper, iron ore, and silver deposits on the land but at the time they're not economical to recover on a large scale.

With regards to mineral rights, there are two companies currently interested in mining operations.  One company has permits and could begin exploration soon, the other has leased the land, but there isn't any further information on them.

So piecing this together, at the price the market is valuing Keweenaw at $640 per acre of standing timber.  This is down from the 2006 appraised value of $836 an acre, and more in line with the 2003 assessed value of $668.  I wasn't able to find any charts going back to 2003 but I did find some going back to 2006 regarding timber prices.  Sawtimber prices have fallen from the $40s to the low $20s while pulp wood has remained slightly steady at just under $10 a ton.

Considering current wood prices, and the composition of timber offerings I think Keweenaw is probably fairly valued on a standing timber basis.  If we look at a liquidation value, or add in mineral rights they are probably slightly undervalued.  The problem is they don't have any intention of liquidating so a liquidation valuation isn't appropriate.  With regards to mineral rights it's yet to be seen if anything can be extracted, all of the easy minerals are gone, I think the market is correct to peg the mineral rights at or near zero.

One thing worthy of a mention, the company does have earnings and cash flow that I've largely neglected in this post.  The reason is that neither the market, the company, or competitors operating in this market value standing timber on the basis of cut earnings.  The money earned from timbering is used for administrative expenses and reinvested in the properties.

Final Thoughts

I think Keweenaw is doing a lot of the right things to manage their resources appropriately, they've worked to increase the quality of the wood, they're selling off non-core rural lots for residential use, and they're working to maximize the mineral assets.  At this point I think Keweenaw is probably fairly valued, the stock price seems to be accurately reflecting a $600-$700 per acre price for the standing wood.  The company would argue they're worth more due to the mineral rights, but my view is that if the mineral deposits were as rich as they say then someone would be mining already.  I think the fact that mining isn't taking place at any level reinforces the claim in the appraisal that the deposits might be large, but they're extremely hard to get to at this point.

I think Keweenaw could probably be best looked at as a pure play on raw timber lands with the minerals adding a bit of a potential upside in the form of a free option.  If the minerals are extracted it will provide a really nice boost, but if nothing happens the company's valuation doesn't change.

I really like Keweenaw and their approach to managing the forest and their properties, but I just can't get past the potential dilution.  I realize that a dilution possibility exists for almost every equity investment, but Keweenaw management has stated that they intend to dilute, it's just a matter of the magnitude of the dilution.  Increasing the shares 10x is a major concern, and for the time being will keep me from being a shareholder.  It's worth keeping the company on the radar, and if this is an interesting investment maybe holding off until after the dilution.

I'd love to hear thoughts and comments on Keweenaw.  If anyone has experience in small cap pink sheet activism I'd love to hear about that as well.

Talk to Nate about Keweenaw

Disclosure: No position