POPE RESOURCES, A DELAWARE LIMITED PARTNERSHIP This report contains a number of projections and statements about our expected financial condition, operating results, and business plans and objectives. These statements reflect management's estimates based upon our current goals, in light of management's knowledge of existing circumstances and expectations about future developments. Statements about expectations and future performance are "forward looking statements" within the meaning of applicable securities laws, which describe our goals, objectives and anticipated performance. These statements can be identified by words such as "anticipate," "believe," "expect," "intend" and similar expressions. These statements are inherently uncertain, and some or all of these statements may not come to pass. Accordingly, you should not interpret these statements as promises that we will perform at a given level or that we will take any or all of the actions we currently expect to take. Our future actions, as well as our actual performance, will vary from our current expectations, and under various circumstances these variations may be material and adverse. Some of the factors that may cause our actual operating results and financial condition to fall short of our expectations are set forth in the part of this report entitled "Risk Factors" in Item 1A above. From time to time we identify other risks and uncertainties in our other filings with theSecurities and Exchange Commission . The forward-looking statements in this report reflect our estimates and expectations as of the date of the report, and unless required by law, we do not undertake to update these statements as our business operations and environment change.
This discussion should be read in conjunction with the Partnership's audited consolidated financial statements included with this report.
EXECUTIVE OVERVIEW
Pope Resources, A Delaware Limited Partnership ("we" or the "Partnership"), is
engaged in four primary businesses. By far the most significant segments in
terms of owned assets and operations, are our two timber segments, which we
refer to as Partnership Timber and Funds Timber. These segments include
timberlands owned directly by the Partnership and operations of our three
private equity funds ("Fund II", "Fund III", and "Fund IV", collectively, the
"Funds"). We refer to the timberland owned by the Partnership as the
Partnership's tree farms, and our Partnership Timber segment reflects operations
from those properties. We refer to timberland owned by the Funds as the Funds'
tree farms, and operations from those properties are reported in our Funds
Timber segment. When referring collectively to the Partnership's and Funds'
timberland, we refer to them as the Combined tree farms. Operations in each of
these segments consist of growing timber to be harvested as logs for sale to
domestic manufacturers and export brokers.
Our Timberland Investment Management segment is engaged in organizing and
managing private equity timber funds using capital invested by third parties and
the Partnership. The Funds are consolidated into our financial statements, but
then income or loss attributable to equity owned by third parties is subtracted
from consolidated results in our Consolidated
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--------------------------------------------------------------------------------Statements of Comprehensive Income (Loss) under the caption "Net and comprehensive (income) loss attributable to non-controlling interests-ORM Timber Funds" to arrive at "Net and comprehensive income attributable to unitholders".
Our primary strategy for adding timberland acreage is centered on our private equity timber fund business model, although in some instances where not restricted by the Funds' governing documents, we may acquire timberlands for the Partnership. As ofDecember 31, 2019 , we have assets under management totaling approximately$520 million based on the most recent appraisals. Through our 20% co-investment in Fund II, our 5% co-investment in Fund III, and our 15% co-investment in Fund IV, we have deployed$51 million of Partnership capital. Our co-investment affords us a share of the Funds' operating cash flows while also allowing us to earn asset and timberland management fees, as well as potential future incentive fees, based upon the overall success of each fund. We also believe that this strategy allows us to maintain more sophisticated expertise in timberland acquisition, valuation, and management on a more cost-effective basis than we could for the Partnership's timberlands alone. We believe our co-investment strategy also enhances our credibility with existing and prospective Fund investors by demonstrating that we have both an operational and a financial commitment to the Funds' success. Our Real Estate segment's activities primarily include securing permits, entitlements, and, in some cases, installing infrastructure for raw land development and then realizing that land's value by selling larger parcels to buyers who will take the land further up the value chain by either selling homes to retail buyers or lots to developers of commercial property. Since these land projects span multiple years, the Real Estate segment may incur losses for multiple years while a project is developed, and will not recognize operating income until that project is sold. In addition, within this segment we sometimes negotiate and sell development rights in the form of conservation easements (CE's) on Partnership Timber properties which preclude future development, but allow for continued harvest operations. The strategy for our Real Estate segment centers around how and when to "harvest" a parcel of land and optimize value realization by selling the property, balancing the long-term risks and costs of carrying and developing a property against the potential for income and cash flows upon sale. Land held for development by our Real Estate segment represents property in westernWashington that has been deemed suitable for residential and commercial building sites. Land held for sale represents those properties in the development portfolio that we expect to sell in the next year.
Our consolidated revenue in 2019, 2018, and 2017, on a percentage basis by segment, was as follows: Segment
2019 2018 2017
Partnership Timber 37% 44% 40%
Funds Timber 44% 48% 34%
Timberland Investment Management * -% -% -%
Real Estate 19% 8% 26%
* Fee revenue earned from managing the Funds is eliminated in consolidation. See
Part II, Item 7: "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Timberland Investment Management (TIM)," and "-
Noncontrolling Interests - ORM Timber Funds" for further information.
Additional segment financial information is presented in Note 16 to the Partnership's Consolidated Financial Statements included with this report.
Recent Developments
OnJanuary 15, 2020 , we announced that we had entered into an Agreement and Plan of Merger datedJanuary 14, 2020 (the "Merger Agreement") with Rayonier, Inc., aNorth Carolina corporation,Rayonier Operating Company LLC , aDelaware limited liability company,Pacific GP Merger Sub I, LLC , aDelaware limited liability company and a wholly owned subsidiary of Rayonier,Pacific GP Merger Sub II, LLC , aDelaware limited liability company and a wholly owned subsidiary of Rayonier,Pacific LP Merger Sub III, LLC , aDelaware limited liability company and a wholly owned subsidiary of OpCo, and our general partners,Pope EGP, Inc. , aDelaware corporation, andPope MGP, Inc. , aDelaware corporation and the managing general partner of the Partnership. The Merger Agreement also provides for the entry into voting agreements by the shareholders of our general partners. The Merger Agreement provides that upon the satisfaction of certain conditions prescribed in the Merger Agreement and summarized below, (i) MGP will merge with and into Merger Sub 1, with Merger Sub 1 as the surviving corporation; (ii) EGP will merge with and into Merger Sub 2, with Merger Sub 2 as the surviving corporation; and (iii) Merger Sub 3 will merge with and into the Partnership, with the Partnership as the surviving entity. Please see "Business - Recent Developments" above for a summary of the Merger Agreement. 32 -------------------------------------------------------------------------------- Completion of the Mergers is subject to the satisfaction (or waiver, if permissible under applicable law) of customary closing conditions, including the approval of our unitholders, and the consummation of the mergers is not assured, nor can we predict the timing as to when closing will occur. Our entry into the Merger Agreement came as a result of a previously announced evaluation of strategic options by our board of directors, and resulted in a substantial increase in our general and administrative expense as a result of legal, accounting and other professional fees as further described herein. The Merger Agreement also contains operating covenants that may impact our ongoing operations, as we cannot take certain actions without the consent of Rayonier (which consent may not be unreasonably withheld). These covenants preclude our entering into transactions or making operational decisions outside the ordinary course of our business, which may limit our ability to realize certain business opportunities, and require us to conduct a meeting of our unitholders and, in connection with that meeting, to prepare and circulate a proxy statement to our unitholders, which will lead to continuing elevated general and administrative expenses. The Merger Agreement also contains certain termination rights for the Partnership and Rayonier, including, among others, the right of Rayonier to terminate the Merger Agreement as a result of the Board changing its recommendation with respect to the Merger Agreement and the Mergers. The Merger Agreement provides that in the event of a termination under specified circumstances, including the one described above, the Partnership will be required to pay Rayonier a termination fee of$20 million . We are optimistic that the closing conditions will be satisfied, and we hope to complete the merger during the second or third fiscal quarter, but we cannot offer assurances as to the timing or the ultimate completion of the mergers. RESULTS OF OPERATIONS Timber - Overall As ofDecember 31, 2019 , Timber results include operations on 119,000 acres of timberland owned by the Partnership, plus another 3,500 acres under timber deeds, in westernWashington (Partnership Timber), and 141,000 acres of timberland owned by the Funds (Funds Timber) in westernWashington , northwesternOregon , southwesternOregon , and northernCalifornia . Timber revenue is earned primarily from the harvest and sale of logs from these timberlands and is driven primarily by the volume of timber harvested and the average log price realized on the sale of those logs. Our harvest volume represents delivered log sales to domestic mills and log export brokers. We also occasionally sell rights to harvest timber (timber deed sales) from the Combined tree farms. The metrics used to calculate volumes sold and average price realized during the reporting periods exclude timber deed sales, except where stated otherwise. Harvest volumes are generally expressed in million board feet (MMBF) increments while harvest revenue and related costs are generally expressed in terms of revenue or cost per thousand board feet (MBF). Logs from the Combined tree farms serve a number of different domestic and export markets, with domestic mills historically representing our largest market destination. Export customers consist of log brokers who sell the logs primarily toJapan ,China and, to a lesser degree,Korea . The ultimate decision of whether to sell our logs to the domestic or export market is based on the net proceeds we receive after considering the cost to deliver logs to the customer. As such, our reported log price realizations will reflect our properties' proximity to customers as well as the broader log market. Revenue in our timber segments is also derived from commercial thinning operations, ground leases for cellular communication towers, and royalties from gravel mines and quarries, all of which are characterized as "other revenue" in the tables that follow. Commercial thinning consists of the selective cutting of timber stands not yet of optimal harvest age. The smaller diameter logs harvested in these operations do, however, have some commercial value, thus allowing us to earn revenue while at the same time improving the projected value at harvest of the remaining timber in the stand. Log Prices and Harvest Volume. For the Partnership, the weighted-average realized log price for 2019 decreased 17% from 2018 and for the Funds it decreased 16%. Average realized log prices in 2019 declined from the all-time historical highs achieved in 2018 due to a well-supplied log market. Demand fromChina for logs from the PNW diminished as a result of an increased supply of lower cost spruce logs supplied fromEurope . In recent years, European forests have experienced drought, severe storms and a spruce bark beetle infestation, the combination of which has resulted in the death of large areas of timber. The response has been an extensive timber salvage program in which most of the European volume is being shipped toChina .West Coast break-bulk log exports decreased 31% in 2019 from 2018, after having decreased by 9% in 2018 from 2017. With 33 -------------------------------------------------------------------------------- fewer logs from the PNW diverted to theChina market, logs available to the domestic market increased. Moreover, relatively mild weather throughout 2019 allowed for greater log production than usual, thus increasing supply. These factors combined to exert downward pressure on log prices. However, domestic demand for sawlogs in the PNW in 2019 was healthy, as the high lumber inventories at domestic mills from late 2018 normalized on improved construction take-away.West Coast softwood lumber production decreased 2% in 2019 from 2018, after having expanded by 5% in 2018 from 2017.
Partnership Timber
Partnership Timber operating results for each year in the three-year period
ended
2019 2018 2017
Partnership
Overall delivered log price per MBF$ 604 $ 726 $ 676 Total volume (in MMBF) 62.5 59.7 55.6 (in thousands) Log sale revenue$ 37,605 $ 43,038 $ 37,093 Timber deed sale revenue 25 92 422 Other revenue 2,357 2,292 2,157 Total revenue 39,987 45,422 39,672 Cost of sales (19,605 ) (17,828 ) (14,874 ) Operating expenses (5,288 ) (6,268 ) (5,671 ) Gain on sale of timberland 87 - - Operating income$ 15,181 $ 21,326 $ 19,127 Operating Income Fiscal Year 2019 compared to 2018. Operating income decreased$6.1 million , or 29%, in 2019 from 2018, reflecting a 17% decrease in weighted-average log price realizations and a 4% increase in per MBF cost of sales that was partially offset by a 5% increase in log volume, including timber deed sales, and a$980,000 decrease in operating expenses. Fiscal Year 2018 compared to 2017. Operating income increased by$2.2 million , or 11%, in 2018, reflecting a 7% increase in log volume, including timber deed sales, and a 7% increase in weighted-average log price realizations. These results reflect the favorable operating environment we enjoyed through the first three quarters of 2018. Revenue Fiscal Year 2019 compared to 2018. Log sale revenue in 2019 decreased by$5.4 million , or 13%, from 2018, due to a 17% decrease in weighted-average log price realizations that was partially offset by a 5% increase in log volume, including timber deed sales. The net changes in timber deed sale revenue and other revenue were offsetting. Fiscal Year 2018 compared to 2017. Log sale revenue in 2018 increased by$5.9 million , or 16%, from 2017, due to a 7% increase in harvest volume, including timber deed sales, and a 7% rise in average realized log prices. The$330,000 decrease in timber deed sale revenue was partially offset by a$135,000 increase in cell tower leases and mineral sales included in other revenue. Through much of 2018, log prices were strong as domestic housing continued its rebound and supply disruptions caused log and lumber prices to rise. Beginning in the fourth quarter, these factors reversed and trade tensions withChina caused a decline in export log prices, but not before we were able to take advantage of the relatively strong markets in the first three quarters of the year.
Log Prices
Partnership Timber log prices for each year in the three-year period ended
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Average price realizations (per MBF) 2019 2018 2017
Partnership
Douglas-fir domestic $ 652 $ 777 $ 734
Douglas-fir export 705 849 766
Whitewood domestic 521 607 532
Whitewood export 521 692 721
Cedar 986 1,270 1,452
Hardwood 604 732 678
Pulpwood 351 370 316
Overall delivered log price 604 726 676
Timber deed sales 145 230 594
Fiscal Year 2019 compared to 2018. Average realized log prices declined 17% in
2019. Our overall average is influenced heavily by price movements for
Douglas -fir and whitewood as these two saw log types represent the majority of
our harvest volume. Douglas -fir is a single species whereas whitewood represents
a collection of species with very similar wood characteristics. Douglas -fir will
command a premium over whitewood and that premium will grow in a strong domestic
market for logs. Domestic buyers will generally pay a premium for Douglas -fir
due to its strength characteristics and relative efficiency when manufactured
into lumber versus whitewood. This premium will also grow in the event of a soft
China export market, as China's demand for whitewood tends to support higher
whitewood log prices.
The Douglas -fir premium expanded during the first half of 2018 as domestic
markets gained traction with improved housing starts, but it then contracted
after mid-year as concerns over the domestic housing recovery mounted and
tariffs began to erode the export demand from the China market. During 2019,
this premium expanded again with renewed strength in the domestic market and
reduced demand from China . Realized log prices decreased by 16% for Douglas -fir
and by 19% for whitewood in 2019 from 2018. Other price declines included 22%
for cedar, 17% for hardwood and 5% for pulpwood.
Fiscal Year 2018 compared to 2017. Overall realized log prices increased 7% in
2018. During the first half of 2018, we saw a widening of the Douglas -fir
premium as domestic markets gained traction with improved housing starts. The
Douglas -fir premium weakened after mid-year as concerns over the domestic
housing recovery mounted. Douglas -fir realized log prices increased 7%, while
whitewood realized log prices remained flat. The Douglas -fir component of the
total volume mix increased 4% from 2017, which was additive to the overall
delivered log price.
Whitewood log prices are strongly influenced by the export market to China ,
which weakened after mid-year with the onset of trade tensions and tariffs,
resulting in a flat blended (domestic and export) whitewood log price for the
year. The 17% price increase for pulpwood resulted from relatively strong log
markets during the first three quarters of the year, which caused logs that
otherwise would have been chipped for pulp being diverted into mills for
sawlogs. This diversion of volume away from the pulp mills supported stronger
pricing for pulpwood. Hardwood log prices increased 8% and cedar prices
decreased 13%. Both of these are relatively minor species to the Partnership and
as such the price often reflects the relative quality of the logs harvested
during the period.
Log Volume
The Partnership sold the following log volumes by species for each year in the
three-year period ended
35
--------------------------------------------------------------------------------Volume (in MMBF) 2019 2018 2017 Partnership Douglas-fir domestic 33.5 54 % 34.8 59 % 29.1 53 % Douglas-fir export 8.9 14 % 8.4 14 % 8.7 16 % Whitewood domestic 3.8 6 % 1.9 3 % 2.1 4 % Whitewood export 1.1 2 % 1.6 3 % 3.2 6 % Cedar 1.4 2 % 1.2 2 % 1.2 2 % Hardwood 3.0 5 % 2.5 4 % 1.6 3 % Pulpwood 10.6 17 % 8.9 15 % 9.0 16 %
Log sale volume 62.3 100 % 59.3 100 % 54.9 100 % Timber deed sale volume 0.2
0.4 0.7
Total volume 62.5 59.7 55.6
Fiscal Year 2019 compared to 2018. 2019 total volume was 2.8 MMBF, or 5%, higher
than 2018. The greater volume is attributable to a recent increase to the
Partnership's annual sustained yield target. Volume harvested in excess of our
57 MMBF annual sustainable yield is attributable to the timber on Real Estate
property and recent small-tract timberland acquisitions. The relative volume mix
was similar to 2018, with slight variations attributable to the composition of
the units harvested. The continued decline in whitewood export volume was driven
by the weak export market to China .
Fiscal Year 2018 compared to 2017. Harvest volume, including timber deed sales,
increased 4.1 MMBF, or 7%, in 2018. The increase in volume is attributable to
harvest activity on recent small-tract acquisitions and Real Estate properties.
Volume sold to the domestic market grew relative to the export market due to a
mid-year weakening of China exports as U.S -China trade tensions developed during
the second half of 2018. This reduced the whitewood premium normally paid by our
export market customers to divert volume away from the domestic market, in turn
resulting in an increase in the proportion of log volume sold to the domestic
market.
Cost of Sales
Cost of sales in this segment, which consist predominantly of harvest, haul and
depletion costs, vary primarily with harvest volume. Harvest costs are affected
by terrain, with steeper slopes requiring more expensive cable systems and a
high labor component relative to more moderate slopes. Haul costs vary with the
distance traveled from logging sites to the customers and will also reflect the
volatility of fuel costs. Commercial thinning costs are a primary component of
other cost of sales.
Partnership Timber cost of sales for each year in the three-year period ended
December 31, 2019 , is as follows, with the first part of the table expressing
these costs in total dollars and the second part of the table expressing those
costs that are driven by volume on a per MBF basis:
(in thousands) 2019 2018 2017
Partnership
Harvest, haul, and tax$ 14,992 $ 13,701 $ 10,855 Depletion 4,524 4,114 4,019 Other 89 13 - Total cost of sales$ 19,605 $ 17,828 $ 14,874
Amounts per MBF *
Harvest, haul, and tax
$ 72 $ 69 $ 72
* Timber deed sale volumes are excluded in the per MBF computation for harvest, haul and tax costs but included in the per MBF computation for depletion.
36
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Fiscal Year 2019 compared to 2018. Cost of sales rose $1.8 million , or 10%, in
2019 due to 5% higher harvest volume, including timber deed sales, a 4% increase
in the per-MBF harvest, haul and tax rate, and a 4% increase in the depletion
rate. Note that timber deed sales include depletion expense but do not include
harvest, haul, and tax expense. The greater per-MBF harvest, haul and tax rate
reflects a higher relative proportion of harvesting operations occurring on
steep terrain as well as the species composition and average piece size within
the units harvested during 2019. The increase in the depletion rate is
attributable to recent small-tract timberland acquisitions.
Fiscal Year 2018 compared to 2017. Cost of sales increased $3.0 million , or 20%,
in 2018 due to a 7% increase in harvest volume, including timber deed sales, and
a 17% increase in the per-MBF harvest, haul and tax rate. The increase in the
per-MBF harvest, haul and tax rate reflects a higher relative proportion of
harvesting operations occurring on steeper terrain compared to 2017.
Operating Expenses
Operating expenses include the cost of both maintaining existing roads and building temporary roads for harvesting, silviculture costs, and other management expenses. For the years endedDecember 31, 2019 , 2018, and 2017, operating expenses were$5.3 million ,$6.3 million , and$5.7 million , respectively. The decrease from 2018 to 2019 was due to lower management and silviculture expenses that were partially offset by increased road maintenance expenses. The increase from 2017 to 2018 was due to higher road costs, professional services expenses, and personnel costs related to increased harvest activity. Funds Timber
Funds Timber operating results for each year in the three-year period ended
2019 2018 2017
Funds
Overall delivered log price per MBF$ 589 $ 700 $ 632 Total volume (in MMBF) 81.1 77.0 55.9 (in thousands) Log sale revenue$ 44,429 $ 37,262 $ 30,947 Timber deed sale revenue 2,378 11,440 2,337 Other revenue 1,839 1,117 558 Total revenue 48,646 49,819 33,842 Cost of sales (48,142 ) (36,732 ) (26,910 ) Operating expenses - internal (11,322 ) (9,239 ) (7,261 ) Gain on sale of timberland - - 12,547 Operating income - internal (10,818 ) 3,848 12,218 Eliminations * 5,532 4,567 3,368 Operating income - external$ (5,286 ) $ 8,415 $ 15,586
* Represents management fees charged to the Funds and eliminated from operating expenses in consolidation. In the TIM segment, these fees are reflected as revenue, on an internal reporting basis, and eliminated in consolidation.
Operating income
Fiscal Year 2019 compared to 2018. Operating income decreased
Fiscal Year 2018 compared to 2017. Similar to the results generated by Partnership Timber, Funds Timber benefited from a favorable operating environment through most of 2018. Funds Timber also added operations from the acquisition of two tree farms for Fund IV in early 2018 and a third in the 4th quarter of 2018. Operating income decreased$7.2 million , or 46% in 37 -------------------------------------------------------------------------------- 2018. Our 2017 results reflect a$12.5 million gain on theJanuary 2017 sale of a 6,500-acre tree farm on theOregon coast by Fund II. Excluding this gain, operating income increased by$5.4 million , driven by a$6.3 million rise in log sale revenue and a$9.1 million increase in timber deed sale revenue, which were partially offset by$9.8 million and$2.0 million increases in cost of sales and operating expenses, respectively.
Revenue
Fiscal Year 2019 compared to 2018. Log sale revenue increased$7.2 million , or 19%, from 2018. This increase was driven by a 42% rise in delivered log volume, which was partially offset by a 16% decline in average realized delivered log price. Timber deed sale revenue dropped$9.1 million in 2019, or 79%, driven primarily by a shift from timber deed to delivered log sales for two properties acquired by Fund IV in January of 2018. Once a property has been owned for a year, we can then begin delivered log sales and retain eligibility to be taxed as a REIT. The$722,000 increase in other revenue was primarily driven by salvage operations of fire-damaged timber on a Fund IV property. Fiscal Year 2018 compared to 2017. Log sale revenue increased by$6.3 million , or 20%, in 2017. This increase was driven by a 9% rise in delivered log volume and an 11% increase in average realized log prices from the strong log markets we enjoyed during the first three quarters of the year. Timber deed sale revenue increased$9.1 million in 2018, driven primarily by timber deed sales from two properties acquired by Fund IV in January of 2018. The$559,000 increase in other revenue was primarily driven by a$425,000 easement sale for a cell tower and a$90,000 increase in ground leases for cell towers.
Log Prices
Funds Timber log prices for each year in the three-year period ended
Average price realizations (per MBF) 2019 2018 2017 Funds Douglas-fir domestic$ 643 $ 784 $ 705 Douglas-fir export 700 853 810 Whitewood domestic 543 649 585 Whitewood export 538 693 687 Pine 438 545 496 Cedar 937 1,203 1,164 Hardwood 510 729 687 Pulpwood 329 365 295 Overall delivered log price 589 700 632 Timber deed sales 416 480 332 Fiscal Year 2019 compared to 2018. For the Funds, the overall realized log price was 16% lower in 2019 than 2018. Realized log prices forDouglas -fir and whitewood sawlogs (volume-weighted) declined 19% and 17%, respectively. Price decreases relative to 2018 were driven by abundant log supply for domestic producers that was primarily driven by greatly reduced demand from the log export market. Price decreases for other species groups include: pine (20%), cedar (22%), hardwood (30%), and pulpwood (10%). The 13% decline in the average price realized on timber deed sales is driven by the same market factors that resulted in price decreases for delivered log volume. Fiscal Year 2018 compared to 2017. Overall realized log prices increased 11% in 2018 as we took advantage of particularly strong log markets during the first three quarters of 2018. Realized log prices forDouglas -fir and whitewood sawlogs (volume-weighted) increased 10% and 7%, respectively. Price increases relative to 2017 were driven by strengthening domestic demand from the continued recovery in the domestic housing market, however, log prices dropped precipitously after the third quarter as the export market toChina lost steam as trade tensions intensified. Price increases for other species groups include: pine (10%), cedar (3%), hardwood (6%), and pulpwood (24%), again brought on by overall log market strength that weakened after the third quarter. The average price realized on timber deed sales increased 45% due to the sale of timber deeds from our recent Fund IV acquisitions in very strong log markets, as well as a higher mix ofDouglas -fir volume in 2018 versus 2017 timber deed sales, which contained a higher proportion of whitewood volume. 38 --------------------------------------------------------------------------------
Log Volume
The Funds sold the following log volumes by species for each year in the
three-year period ended
Volume (in MMBF) 2019 2018 2017 Funds Douglas-fir domestic 36.1 48 % 16.5 31 % 16.4 35 % Douglas-fir export 9.2 12 % 8.3 16 % 5.9 12 % Whitewood domestic 14.9 20 % 14.6 27 % 12.3 25 % Whitewood export 1.5 2 % 3.2 6 % 4.5 9 % Pine 4.5 6 % 3.1 6 % 3.6 7 % Cedar 1.0 1 % 0.8 2 % 0.5 1 % Hardwood 1.6 2 % 1.2 2 % 0.6 1 % Pulpwood 6.6 9 % 5.5 10 % 5.1 10 % Log sale volume 75.4 100 % 53.2 100 % 48.9 100 % Timber deed sale volume 5.7 23.8 7.0 Total volume 81.1 77.0 55.9 Partnership's share of Funds 10.6 9.0 6.2 Fiscal Year 2019 compared to 2018. Volume from harvest and timber deed sales was 4.1 MMBF, or 5%, higher in 2019, driven by the addition of two tree farms to Fund IV inOctober 2018 andJanuary 2019 . A 22.2 MMBF increase in delivered log sale volume was mostly offset by an 18.1 MMBF decrease in timber deed volume. The shift from timber deed to delivered log sales is driven primarily by two properties acquired by Fund IV in January of 2018. The change in relative volume mix reflects a decrease in export volume to 14% in 2019 from 22% in 2018, indicative of the reduced export demand. The relative volume mix forDouglas -fir increased by 13%, while that of whitewood decreased 11%. The relative volume mix of the other species was consistent between 2018 and 2019. Fiscal Year 2018 compared to 2017. Total harvest volume increased 21.1 MMBF, or 38%, in 2018. The increase was driven by a 16.8 MMBF increase in timber deed sales, which are primarily related to two properties that were acquired during Q1 2018 by Fund IV, and a 4.3 MMBF increase in delivered log sales. Douglas-fir export volume increased modestly as a percentage of total volume whileDouglas -fir sold to domestic markets retreated, which was driven primarily by the quality of theDouglas -fir stands harvested during 2018. High qualityDouglas -fir is often exported to theJapan market, and we harvested a greater proportion of high-qualityDouglas -fir in 2018 than 2017. We observed the opposite situation with whitewood volume. Whitewood exports shrank as a percent of total volume due to weakness in the export market toChina . As trade tensions increased in the latter half of 2018, the export market toChina weakened, causing a reduction in the premium paid to divert volume from the domestic to the export market. Cost of Sales Cost of sales in this segment, which consist predominantly of harvest, haul and depletion costs, vary primarily with harvest volume. Harvest costs are also affected by terrain, with steeper slopes requiring more expensive cable systems and a high labor component relative to more moderate slopes. Haul costs vary with the distance traveled from logging sites to the customers and with the volatility of fuel costs. Commercial thinning costs are a primary component of other cost of sales. Because of the relatively recent acquisition dates of the Funds' tree farms relative to the Partnership's tree farms, the Funds' properties were acquired at more recent, and higher, timberland values. Accordingly, the depletion rates associated with harvests from the Fund properties are considerably higher than those for the Partnership's tree farms. The depletion rate charged to harvest tends to decrease over time as a result of the purchase price allocation process, in which the most valuable, merchantable timber at the time of acquisition is assigned a higher cost than the younger timber. Over time, the depletion rate on an individual tree farm declines as we begin harvesting what was the younger timber at the time of acquisition. Funds Timber cost of sales for each year in the three-year period endedDecember 31, 2019 , is as follows, with the first part of the table expressing these costs in total dollars and the second part of the table expressing those costs that are driven by volume on a per MBF basis: 39 --------------------------------------------------------------------------------
(in thousands) 2019 2018 2017 Funds Harvest, haul, and tax$ 20,220 $ 13,304 $ 11,478 Depletion 26,654 23,007 15,168 Other 1,268 421 264 Total cost of sales$ 48,142 $ 36,732 $ 26,910
Partnership's share of Funds
Amounts per MBF * Harvest, haul, and tax$ 268 $ 250 $ 235 Depletion$ 329 $ 299 $ 271
* Timber deed sale volumes are excluded in the per MBF computation for harvest, haul and tax costs but included in the per MBF computation for depletion.
Fiscal Year 2019 compared to 2018. Cost of sales increased$11.4 million , or 31%, in 2018 due to 42% higher delivered log volume, 76% lower timber deed sale volume, a 7% increase in the per-MBF harvest, haul and tax rate, and a 10% increase in the per-MBF depletion rate. The increase in the harvest, haul, and tax rate reflects a higher relative proportion of harvesting operations occurring on steeper terrain in 2019 versus 2018. The increase in the average depletion rate between years reflects the increase in the relative share of total harvest volume from the newer Fund IV properties. Fiscal Year 2018 compared to 2017. Cost of sales increased$9.8 million , or 36%, in 2018 primarily due to a 9% increase in delivered log volume, a 240% increase in timber deed sale volume, a 6% increase in the per-MBF harvest, haul and tax rate, and a 10% increase in the per-MBF depletion rate. The increase in the harvest, haul, and tax rate reflects a more varied terrain across which we harvested in 2018 versus 2017. The change in the average depletion rate between years reflects the change in the mix of volume from each tree farm in any year, as each tree farm carries a unique depletion rate.
Operating Expenses
Operating expenses include the cost of maintaining existing roads and building temporary roads for harvesting, silviculture costs, and other management expenses that include the asset and timberland management fees charged to the Funds. These fees, which are the source of revenue for ourTimberland Investment Management segment (discussed below), are eliminated in consolidation. The following table presents operating expenses on an internal and external reporting basis. (in thousands) 2019 2018 2017 Funds Operating expenses - internal$ 11,322 $ 9,239 $ 7,261
Elimination of asset and management fees (5,532 ) (4,567 ) (3,368 ) Operating expenses - external
$ 5,790 $ 4,672 $ 3,893 The increase from 2018 to 2019 was due to increases in professional services, silviculture and road expenses attributed to operating the entire Fund IV portfolio for the entire year. The increase from 2017 to 2018 was due to increases in professional services, silviculture and road expenses attributed to the two tree farms acquired in early 2018, as well as the increase in harvest volume. Gain on Sale of Timberland
The
40
--------------------------------------------------------------------------------Other information
The table below reflects the Partnership's share of elements of the Funds' results based on its 20%, 5%, and 15% ownership interest in Fund II, Fund III, and Fund IV, respectively. We present this as additional information to help readers understand the financial impact from investing in these private equity vehicles and the resulting economics of owningPope Resources units. These results will fluctuate between periods based on the relative activity in each fund and the Partnership's different ownership interest in each fund: Year Ended December 31, 2019 2018 2017 Partnership's share of Funds Total volume (MMBF) 10.6 9.0 6.2 (in thousands) Log sale revenue$ 5,703 $ 4,064 $ 3,666 Timber deed sale revenue 386 1,609 117 Other revenue 264 127 94 Cost of sales (6,016 ) (3,928 ) (2,706 )
Operating expenses - internal (1,698 ) (1,105 ) (793 ) Gain on sale of timberland -
- 2,503
Eliminations * 656 504 328
* Represents the Partnership's share of management fees charged to the Funds and
eliminated from operating expenses in consolidation. In the TIM segment, these
fees are reflected as revenue, on an internal reporting basis, and eliminated in
consolidation.
Fund Distributions and Fees Paid to the Partnership
The Partnership received combined distributions from the Funds of$1.4 million ,$1.9 million , and$6.4 million in 2019, 2018, and 2017, respectively. Fund distributions are paid from available Fund cash, generated primarily from the harvest and sale of timber after paying Fund expenses, management fees, and recurring capital costs. Fund distributions received by the Partnership during 2017 included$5.5 million generated by the sale of one of Fund II's tree farms inJanuary 2017 . The Partnership earned investment and timberland management fees from the Funds which totaled$5.8 million ,$4.6 million , and$3.4 million in 2019, 2018, and 2017, respectively. These fees are eliminated in the Partnership's consolidated financial statements, but generate cash for the Partnership.
Revenue and Operating Loss
The fees earned from managing the Funds include a fixed component related to invested capital and acres under management, and a variable component related to harvest volume from the Funds' tree farms. As all fee revenue from the Funds is eliminated in consolidation, operating losses consist almost entirely of operating expenses incurred by the TIM segment.
Revenue and operating loss for the TIM segment for each year in the three-year
period ended
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Year ended December 31,
(in millions, except acre and volume data) 2019 2018 2017
Revenue - internal $ 5.8 $ 4.6 $ 3.4
Intersegment eliminations (5.7 ) (4.6 ) (3.4 )
Revenue - external $ 0.1 $ - $ -
Operating income (loss) - internal $ 0.6 $ - $ (0.2 )
Intersegment eliminations (5.5 ) (4.5 ) (3.3 )
Operating loss - external $ (4.9 ) $ (4.5 ) $ (3.5 )
Invested capital $ 406 $ 386 $ 240
Acres under management 141,000 134,000 88,000
Harvest volume, including timber deed sales -
Funds (MMBF) 81.1 77.0 55.9
Fiscal Year 2019 compared to 2018. TIM generated management fee revenue of $5.8
million and $4.6 million from managing the Funds in 2019 and 2018, respectively.
The increase in fee revenue resulted from a full year of management fees for the
entire Fund IV portfolio for all of 2019.
Fiscal Year 2018 compared to 2017. TIM generated management fee revenue of $4.6
million and $3.4 million from managing the Funds in 2018 and 2017, respectively.
The increase in fee revenue resulted from the acquisition of two tree farms by
Fund IV in Q1 2018 and a third tree farm in Q4 2018.
Operating expenses incurred by the TIM segment totaled $4.9 million in 2019,
$4.5 million in 2018, and $3.5 million in 2017. The increase in operating
expenses is attributable to the costs associated with managing most of the Fund
IV portfolio for all of 2019.
Real Estate
Revenue and Operating Income
The Real Estate segment's activities consist of investing in and later reselling
improved properties, holding properties for later development and sale, and
managing commercial properties. Revenue is generated primarily from the sale of
land within our 1,500-acre portfolio, sales of development rights known as
conservation easements (CE's), sales of tracts from the Partnership's timberland
portfolio, and residential and commercial rents from our Port Gamble and Poulsbo
properties. The CE sales allow us to continue conducting harvest operations on
the timberland, but bar any future subdivision, or real estate development on,
the property. The Partnership's Real Estate holdings are located primarily in
the Washington counties of Pierce , Kitsap , and Jefferson with sales of land for
this segment typically falling into one of three general types:
• Commercial, business park, and residential plat land sales represent land
sold after development rights have been obtained and generally are sold
with prescribed infrastructure improvements.
• Rural residential lot sales that generally require some capitalimprovements such as zoning, road building, or utility access improvements
prior to completing the sale.
• The sale of unimproved land, which generally consists of larger acreage
sales rather than single lot sales and is normally completed with very
little capital investment prior to sale.
Real Estate operations also include development, commercial real estate, and
environmental remediation activities in connection with our ownership of the
Port Gamble, Washington townsite and former millsite as discussed in greater
detail in "Business - Real Estate - Port Gamble ," and "- Environmental
Remediation."
Results from Real Estate operations are expected to vary significantly from year
to year as we make multi-year investments in entitlements and infrastructure
prior to selling entitled or developed land. Further, Real Estate results will
vary as a result of adjustments to our environmental remediation liability
related to Port Gamble . These adjustments are reflected in our Real Estate
segment within operating expenses. Real Estate segment revenue and gross margin
for each year in the three-year period ended December 31, 2019 , consisted of the
following components:
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(in thousands except acres) Per acre/lot *
Gross Gross Gross
Description Revenue margin margin % Units Sold Revenue margin
Development rights (CE) $ 2,610 $ 2,363 91 % Acres: 1,937 $ 1,347 $ 1,220
Gig Harbor residential 12,025 3,652 30 % Lots:* 65 185,000 56,185
Other residential 770 204 26 % Lots:* 7 110,000 29,143
Unimproved land 4,383 2,974 68 % Acres: 1,134 3,865 2,623
Total land 19,788 9,193 46 %
Rentals and other 1,464 622
2019 Total $ 21,252 $ 9,815 46 %
Development rights (CE) 3,730 3,485 93 % Acres: 7,800 478 447
Bremerton residential 1,375 292 21 % Lots:* 110 12,500 2,655
Other residential 751 247 33 % Lots: 3 250,333 82,333
Other commercial 400 124 31 % Acres: 1 400,000 124,000
Unimproved land 205 166 81 % Acres: 13 15,769 12,769
Total land 6,461 4,314 67 %
Rentals and other 1,843 463
2018 Total $ 8,304 $ 4,777 58 %
Conservation land sales $ 5,056 $ 4,289 85 % Acres: 1,720 $ 2,940 $ 2,494
Gig Harbor residential 14,157 3,557 25 % Lots:* 93 152,226 38,247
Gig Harbor commercial 3,500 1,414 40 % Acres: 12 291,667 117,833
Other residential 2,255 924 41 % Lots:* 12 187,917 77,000
Total land 24,968 10,184 41 %
Rentals and other 1,332 (84 )
2017 Total $ 26,300 $ 10,100 38 %
* Lots represent residential single-family lots
Revenue
Land transactions. In the third quarter of 2019, we closed on the sale of the final 65 residential lots from our Harbor Hill project inGig Harbor, Washington , for$12.0 million and seven residential rural lots for a combined$770,000 . In the fourth quarter of 2019, we closed on the sale of a 921-acre parcel of timberland for$3.3 million , though we retained timber deeds for periods ranging from five to 15 years on 128 of those acres, a conservation easement on 1,937 acres of ourHood Canal tree farm for$2.6 million , and a 210-acre parcel of undeveloped land for$1.1 million . In the second quarter of 2018, we closed on the sale of a conservation easement covering 7,800 acres inSkamania County to theWashington State Department of Natural Resources for$3.7 million . In the second and third quarters of 2018 we sold four residential parcels inBremerton ,Bainbridge Island , and northernKitsap County, Washington for a combined$2.1 million . The remaining land sales in 2018 included a commercial parcel inBremerton for$400,000 and two parcels of undeveloped land for$205,000 . In the fourth quarter of 2017, we closed on two conservation land sales totaling 1,720 acres for$5.1 million . Under one of these sales, we retained the right to harvest timber on 1,234 acres for a period of 25 years. In our Harbor Hill project, we closed on the sale of 93 single-family residential lots (15 in the third quarter and 78 in the fourth quarter) for$14.2 million and an 11.5-acre business park lot for$3.5 million in the fourth quarter. Included in the residential lot revenue from this project is$285,000 of revenue recognized on the percentage-of-completion method on lots sold in the fourth quarter of 2016. Over the course of the year, we also sold 12 residential lots from other properties for$2.2 million .
Rentals and other. Rental and other activities in our Real Estate segment are generally much less volatile from year-to-year than land sales. Rentals and other in 2019 and 2018 included development and investment management fees related to
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our joint-venture project on
Cost of Sales
Real Estate cost of sales for each of the three years endedDecember 31, 2019 , 2018, and 2017 was$11.4 million ,$3.5 million , and$16.2 million , respectively, with these amounts comprised of land basis, legal, other closing costs, as well as costs incurred in the generation of rental revenue. Unlike fee simple sales which include land basis in cost of sales, CE sales typically have little or no cost basis as part of the transaction. The changes in cost of sales from year-to-year are driven directly by the volume and types of sales withGig Harbor lot sales generally representing the most expensive lots we sell due to the amount of infrastructure improvement costs associated with these lots.
Operating Expenses
Real Estate operating expenses for each of the three years endedDecember 31, 2019 , 2018, and 2017 were$6.7 million ,$10.2 million , and$5.5 million , respectively. Excluding environmental remediation charges, described below, Real Estate operating expenses for each of the three years endedDecember 31, 2019 , 2018, and 2017 were$5.1 million ,$4.6 million , and$5.5 million , respectively. The increase from 2018 to 2019 is due primarily to our share of the net losses from an unconsolidated real estate joint venture while it is in the process of securing tenants for its new apartment building onBainbridge Island, Washington . The decrease from 2017 to 2018 is due primarily to lower professional fees in connection with planning and development for properties, as well as reduced labor costs resulting from lower personnel in the Real Estate segment in 2018 as the Harbor Hill project progressed towards completion.
Environmental Remediation
The environmental remediation liability represents estimated costs to remediate and monitor certain areas in and around the townsite/millsite ofPort Gamble, Washington . The history of that site is summarized at "Business - Real Estate - Environmental Remediation." We have adjusted the liability from time to time based on evolving circumstances. We recorded a$1.6 million increase to the liability in 2019 and a$5.6 million increase to the liability in 2018. Following is a summary of each of these adjustments and the next steps for the project: 2018 Adjustments During 2018, we worked with theWashington State Department of Ecology (DOE) to formulate the design of the millsite cleanup. As a result of this design work, we were informed byDOE during the second quarter that we needed to excavate, cap, and monitor a greater amount of soil contamination at the millsite than we had previously anticipated. These changes led us to increase our accrual by$2.9 million in the second quarter of 2018. During 2018, we finalized the remedial investigation/feasibility study (RI/FS) and draft Cleanup Action Plan (CAP) and submitted it toDOE in early 2019. These two documents reflected the new scope of the millsite cleanup. We also made progress on the Natural Resource Damages (NRD) component of the project during the second half of 2018. As we have disclosed previously, certain environmental laws allow state, federal, and tribal trustees (collectively, the Trustees) to bring suit against property owners to recover damages for injuries to natural resources. Like the liability that attaches to current property owners in the cleanup context, liability for NRD can attach to a property owner simply because an injury to natural resources resulted from releases of hazardous substances on that owner's property, regardless of culpability for the release. In the case ofPort Gamble , the Trustees are alleging that the Partnership has NRD liability because of releases that occurred on its property. We have been in discussions with the Trustees regarding their claims and the alleged conditions inPort Gamble Bay and have also been discussing restoration alternatives that might address the damages the Trustees allege. These discussions progressed to the point where we could identify a short list of restoration projects that would resolve the Trustees' NRD claims. We re-evaluated our liability to incorporate the information included in the RI/FS submission for the millsite and the status of the discussions with the NRD trustees and recorded an additional$2.7 million increase to our liability. This, along with the second quarter adjustment described above, brought the total adjustment to the liability to$5.6 million for 2018.
2019 Adjustment and next steps
The 2019 increase to the liability was necessary to address continuing developments in our NRD negotiations and an expansion of our long-term monitoring obligations. Ongoing negotiations with the NRD Trustees required us to expand on the
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scope of the restorations projects we had proposed earlier. In addition, results
from the landfill monitoring we had performed in 2018 and 2019 caused the Kitsap
Public Health District (KPHD) to require bi-annual monitoring through 2021,
rather than the annual monitoring that we had previously anticipated. The scope
expansion for the NRD restoration projects and more frequent landfill monitoring
activity required by KPHD resulted in a combined $1.6 million increase to our
liability in the fourth quarter of 2019.
The CAP and consent decree for the millsite are expected to be finalized during
mid-year 2020, following a public review period. For the NRD component of the
project, we are continuing to discuss settlement with the Trustees and remain
hopeful that we will also have a settlement agreement in place by mid-year 2020.
In both cases, it is reasonably possible that our cost estimates could change as
a result of changes to either the millsite cleanup or the NRD restoration
components of the liability, or both. With the 2018 adjustment and the in-water
cleanup completed, however, we expect that any future adjustments to the
liability should be less significant than they have been historically. We
currently expect the millsite cleanup and NRD restoration to occur over the next
two to three years.
Finally, there will be a monitoring period of approximately 10 to 15 more years
during which we will monitor conditions in the Bay, on the millsite, and at the
landfill containing the dredged and excavated sediments, which is on land that
we own a short distance from the town of Port Gamble . During this monitoring
phase, conditions may arise that require corrective action, and monitoring
protocols may change over time. In addition, extreme weather events could cause
damage to the sediment caps that would need to be repaired. These factors could
result in additional costs.
Should any future circumstances result in a change to the estimated cost of the
project, we will record an appropriate adjustment to the liability in the period
it becomes known and when we can reasonably estimate the amount.
General & Administrative (G&A)
G&A expenses were$12.1 million ,$7.2 million , and$5.7 million for 2019, 2018, and 2017, respectively. The increase in G&A expenses is due primarily to legal and professional fees of$5.3 million for the full year of 2019 related to our strategic evaluation project, which ultimately led to the recently announced pending merger with Rayonier, Inc. and its subsidiaries. The increase from 2017 to 2018 was due primarily to professional fees associated with the previously discussed review of the Partnership's capital allocation strategy, business mix, and organizational structure.
Interest Income and Expense
(in thousands) 2019 2018
2017
Interest income - Partnership$ 3 $ 132 $
3
Interest expense - Partnership (3,717 ) (3,075 ) (2,644 ) Interest expense - Funds (2,247 ) (2,247 ) (2,321 ) Capitalized interest expense - Partnership 164 295 491 Net interest expense$ (5,797 ) $ (4,895 ) $ (4,471 ) The increases in interest expense for the Partnership are due primarily to increasing debt balances. In 2019 and 2018, the Partnership borrowed on its credit facilities to finance its co-investment in Fund IV's timberland acquisitions. The Partnership's and Fund III's debt arrangements withNorthwest Farm Credit Services (NWFCS) include an annual rebate of a portion of interest expense paid in the prior year (patronage). This NWFCS patronage program is a feature common to most of this lender's loan agreements. The patronage program reduced interest expense by$1.4 million ,$1.4 million and$1.0 million in 2019, 2018, and 2017, respectively. The increase in the patronage rebate is due to the higher debt balances as well as an increase in the patronage rate in 2018. Capitalized interest relates to our Harbor Hill project. The changes in capitalized interest from year-to-year are due to the reduction in basis from completed construction activity at Harbor Hill. Following the sale of the final residential lots in Q3 2019, we are no longer capitalizing interest on the Gig Harbor project as we are not currently performing construction on the small remaining portion of that project. 45 --------------------------------------------------------------------------------
Income Taxes
We recorded income tax expense of$159,000 ,$104,000 and$1.2 million in 2019, 2018 and 2017, respectively, based on taxable income in our taxable corporate subsidiaries. The increase in income tax expense for 2017 resulted primarily from stronger log prices and higher harvest volumes which generated higher taxable income in 2017, particularly in the taxable corporations in our timber funds.Pope Resources is a limited partnership and, therefore, is not subject to income tax. Instead, most taxable income or loss is passed through and reported to unitholders each year on a Form K-1 for inclusion in each unitholder's income tax return.Pope Resources does, however, have certain corporate subsidiaries that are subject to income tax. The corporate tax-paying entities are utilized for the Funds and certain activities of the Partnership.
Noncontrolling Interests-ORM Timber Funds
Noncontrolling interests-ORM Timber Funds represents the portion of 2019, 2018, and 2017 net (income) losses of the Funds attributable to third-party owners of the Funds. Included in these results are the management fees charged byORM LLC (as subsidiary of the Partnership) to the Funds, interest, and income taxes. The portion of the loss or (income) attributable to these third-party investors is added back or deducted to determine "Net and comprehensive (income) loss attributable to unitholders" as follows: (in thousands) Noncontrolling interest-2019 Fund II Fund III Fund IV Total Management fees paid to ORM LLC$ (1,102 ) $ (2,281 ) $ (2,149 ) $ (5,532 ) Operations 3,765 (1,828 ) (7,223 ) (5,286 ) Fund operating income (loss) - internal 2,663 (4,109 ) (9,372 ) (10,818 ) Interest expense (1,086 ) (1,161 ) - (2,247 ) Income tax benefit (expense) 56 (193 ) 50 (87 ) Fund net income (loss) - internal 1,633 (5,463 ) (9,322 ) (13,152 ) Net (income) loss attributable to noncontrolling interest$ (1,306 ) $ 5,190 $ 7,929 $ 11,813 Noncontrolling interest-2018 Fund II Fund III Fund IV ** Total Management fees paid to ORM LLC$ (1,032 ) $ (2,321 ) $ (1,200 ) $ (4,553 ) Operations 5,359 2,188 854 8,401 Fund operating income (loss) - internal 4,327 (133 ) (346 ) 3,848 Interest expense (1,086 ) (1,161 ) - (2,247 ) Income tax benefit (expense) 23 (203 ) - (180 ) Fund net income (loss) - internal 3,264 (1,497 ) (346 ) 1,421 Net (income) loss attributable to noncontrolling interest$ (2,611 ) $ 1,421 $ 295 $ (895 ) Noncontrolling interest-2017 Fund II * Fund III Fund IV ** Total Management fees paid to ORM LLC$ (1,063 ) $ (2,305 ) $ -$ (3,368 ) Operations 16,461 (483 ) (392 ) 15,586 Fund operating income (loss) - internal 15,398 (2,788 ) (392 ) 12,218 Interest expense (1,087 ) (1,235 ) - (2,322 ) Income tax expense (448 ) (440 ) - (888 ) Fund net income (loss) - internal 13,863 (4,463 ) (392 ) 9,008 Net (income) loss attributable to noncontrolling interest$ (11,092 ) $ 4,240 $ 336 $ (6,516 ) * Fund II recognized a gain of$12.5 million on the sale of one of its tree farms inJanuary 2017 . ** Fund IV was launched inDecember 2016 , but did not acquire its first tree farm untilJanuary 2018 . 46
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Liquidity and Capital Resources
We ordinarily finance our business activities using operating cash flows and, where appropriate in management's assessment, commercial credit arrangements with banks or other financial institutions. We expect that funds generated internally from operations and externally through financing will provide the required resources for the Partnership's and Funds' future operations and capital expenditures for at least the next twelve months. The Partnership's debt consists of mortgage debt with fixed and variable interest rate tranches and an operating line of credit withNorthwest Farm Credit Services (NWFCS). The Partnership's mortgage debt atDecember 31, 2019 , includes a$71.8 million credit facility with NWFCS structured in ten tranches that mature from 2024 through 2036, as well as a$40.0 million delayed-draw facility under which the Partnership may borrow at any time throughOctober 2023 . This facility matures inOctober 2028 and$7.0 million was outstanding atDecember 31, 2019 . The Partnership's credit arrangements with NWFCS include an accordion feature under which the Partnership may borrow, subject to lender approval, up to an additional$50.0 million under either the$71.8 million or the$40.0 million facility. The Partnership has a$30.0 million operating line of credit that matures inOctober 2023 , and had$16.0 million outstanding as ofDecember 31, 2019 . The operating line of credit carries a variable interest rate that is based on the one-month LIBOR rate plus 1.6%. All of these facilities are collateralized by portions of the Partnership's timberland. In addition, our commercial office building inPoulsbo, Washington is collateral for a$2.2 million amortizing loan from NWFCS that matures through 2023.
These debt agreements contain covenants that are measured annually, consisting of the following:
• a maximum debt-to-total-capitalization ratio of 30%, with total
capitalization calculated using fair market (vs. carrying) value of
Partnership timberland, roads and timber; and
• a maximum loan-to-appraised value of collateral of 50%.
The Partnership is in compliance with these covenants as of
Mortgage debt within our private equity funds is collateralized by Fund properties only, with no recourse to the Partnership. Fund II has a timberland mortgage comprised of two fixed-rate tranches totaling$25.0 million withMetLife Insurance Company . The tranches are non-amortizing and both mature inSeptember 2020 . The loans allow for, but do not require, annual principal payments of up to 10% of outstanding principal without incurring a make-whole premium. This mortgage is collateralized by a portion of Fund II's timberland portfolio. Fund II's covenants contain a requirement to maintain a loan-to-value ratio of less than 50%, with the denominator defined as fair market value of the timberland pledged as collateral. Fund III has a timberland mortgage with NWFCS comprised of two fixed rate tranches totaling$32.4 million . This mortgage is collateralized by a portion of Fund III's timberland and is non-amortizing, with an$18.0 million tranche maturing inDecember 2023 and a$14.4 million tranche maturing inOctober 2024 . Fund III's loan contains covenants, measured annually, that require Fund III to maintain an interest coverage ratio of 1.5:1, not exceed a debt-to-appraised value of collateral of 50%, and maintain working capital of$500,000 . Fund II and Fund III are in compliance with these covenants as ofDecember 31, 2019 , and we expect they will remain in compliance for at least the next twelve months. The Partnership's and Fund III's debt arrangements withNorthwest Farm Credit Services (NWFCS) include an annual rebate of a portion of interest expense paid in the prior year (patronage). The weighted average interest rates on debt for the Partnership and Funds were as follows atDecember 31, 2019 : Weighted Average Interest Rate Gross Net After Patronage Partnership debt 4.39% 3.34% Funds debt 4.58% 3.88%
The change in cash flows from 2019 to 2018 and 2018 to 2017, respectively, is broken down in the following table:
47
--------------------------------------------------------------------------------(in thousands) 2019 Change 2018 Change 2017 Cash provided by operations$ 34,221 $ (5,557 ) $ 39,778 $ 7,798 $ 31,980 Investing activities Capital expenditures (3,358 ) 743 (4,101 ) (1,601 ) (2,500 ) Proceeds from sale of property and equipment 142 100 42 12 30 Proceeds from sale of timberland 90 90 - (26,590 ) 26,590 Proceeds from insurance recovery 365 365 - - - Investment in real estate joint venture - - - 5,790 (5,790 ) Deposits for acquisitions of timberland - Funds - 1,005 (1,005 ) 4,683 (5,688 ) Acquisition of timberland - Partnership (812 ) 5,544 (6,356 ) (475 ) (5,881 ) Acquisition of timberland - Funds (19,313 ) 121,326 (140,639 ) (140,639 ) - Cash provided by (used in) investing activities (22,886 ) 129,173 (152,059 ) (158,820 ) 6,761 Financing activities Line of credit borrowings 24,886 (7,589 ) 32,475 4,475 28,000 Line of credit repayments (25,286 ) (13,011 ) (12,275 ) 13,525 (25,800 ) Repayment of long term debt (128 ) (5 ) (123 ) 4,996 (5,119 ) Proceeds from issuance of long-term debt 3,000 (1,000 ) 4,000 4,000 - Debt issuance costs (125 ) 108 (233 ) (129 ) (104 ) Proceeds from unit issuances 42 (173 ) 215 206 9 Unit repurchases (863 ) 326 (1,189 ) 116 (1,305 ) Payroll taxes paid on unit net settlements (80 ) 21 (101 ) (7 ) (94 ) Cash distributions to unitholders (17,435 ) (3,492 ) (13,943 ) (1,728 ) (12,215 ) Cash distributions from Real Estate joint venture 136 136 - - - Cash distributions - ORM Timber Funds, net of
distributions to Partnership (9,886 ) 5,621 (15,507 )
15,396 (30,903 )
Capital call - ORM Timber Funds,
net of
Partnership contribution 17,259 (102,476 ) 119,735
114,498 5,237 Capital call - Real Estate, net of Partnership contribution - - - (5,900 ) 5,900 Preferred stock issuance - ORM Timber Funds 125 125 - - - Cash provided by (used in) financing activities (8,355 ) (121,409 ) 113,054 149,448 (36,394 ) Net increase in cash and restricted cash$ 2,980 $ 2,207 $ 773 $ (1,574 ) $ 2,347 Operating cash activities. The decrease in cash provided by operating activities of$5.6 million from 2018 to 2019 resulted primarily from$4.9 million increase in general and administrative expenses and a 17% decline in log prices. This decline was offset partially, however, by a$13.3 million increase in Real Estate sales and a 5% increase in harvest volume. The increase in cash provided by operating activities of$7.8 million from 2017 to 2018 resulted primarily from a 9% increase in log prices and a 22% increase in harvest volume. These favorable results were partially offset, however, by an$18.5 million decrease in Real Estate sales. Additional contributions to the increase in cash provided by operations included a$6.3 million decrease in environmental remediation expenditures and a$4.4 million decrease in real estate project expenditures. Investing cash activities. The$129.2 million increase in cash from investing activities from 2018 to 2019 resulted from a decrease in timberland acquisitions for Fund IV in 2019 compared to 2018 and a decrease in small tract acquisitions for the Partnership in 2019 compared to 2018. Capital expenditures were also higher in 2018. The$158.8 million decrease in cash from investing activities from 2017 to 2018 was due primarily to sales and acquisitions of timberland by the Partnership and Funds. In addition, a consolidated subsidiary of the Partnership invested$5.8 million in an unconsolidated real estate joint venture in 2017. 48 --------------------------------------------------------------------------------
Financing activities. The
The$149.4 million increase in cash from financing activities from 2017 to 2018 resulted primarily from a$108.6 million net increase in capital calls from the funds and real estate joint venture, a$27.0 million net increase in borrowings under our credit facilities, and a$15.4 million decrease in distributions by the Funds, primarily because 2017 included a distribution by Fund II of the proceeds from the sale of one of its tree farms.
Expected Future Changes to Cash Flows
Due to the recently announced pending acquisition of the Partnership, which is expected to close by mid-year 2020, changes to future cash flows are difficult to predict. We expect that our G&A expenses will continue at an elevated level until the transaction closes. For the first half of 2020, we expect timber prices to remain relatively flat. Management is currently projecting that cash on hand, cash generated from operating activities, and financing available from our existing credit facilities will be sufficient to meet our needs for the coming year. To date, the Partnership's strong financial position has enabled fairly easy access to credit at reasonable terms when needed.
Seasonality
Partnership Timber and Funds Timber. The elevation and terrain characteristics of our timberlands are such that we can conduct harvest operations virtually year-round on a significant portion of our tree farms. Generally, we concentrate our harvests from these areas in those months when weather limits operations on other properties, thus taking advantage of reduced competition for log supply to our customers and improving prices realized. As such, on a Combined basis the pattern of quarterly volumes harvested is flatter than would be the case if looking at one tree farm in isolation. However, this pattern may not hold true during periods of comparatively soft log prices, when we may defer harvest volume to capture greater value when log prices strengthen.
The percentage of total annual harvest volume, on a Combined basis and excluding
timber deed sales, by quarter for each year in the three-year period ended
Year ended Q1 Q2 Q3 Q4
2019 26% 30% 18% 25%
2018 23% 26% 25% 26%
2017 26% 22% 19% 31%
Timberland Investment Management . Management revenue generated by this segment
consists of asset and timberland management fees. These fees, which relate
primarily to our activities on behalf of the Funds and are eliminated in
consolidation, vary based upon the amount of invested capital, the number of
acres owned by the Funds, and the volume of timber harvested from properties
owned by the Funds. Only the latter has any component of seasonality as it is
based on harvest volume.
Real Estate. While Real Estate results are not normally seasonal, the nature of
the activities in this segment will likely result in periodic large transactions
that will have significant positive impacts on both revenue and operating income
of the Partnership in periods in which these transactions close, and much lower
revenue and income (or losses) in other periods. While the variability of these
results is not primarily a function of seasonal weather patterns, we do expect
to see some seasonal fluctuations in this segment because of the general effects
of weather on development activities in the Pacific Northwest .
Contractual Obligations, Commercial Commitments and Contingencies
Our commitments at
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(in thousands) Payments Due By Period /Commitment Expiration Date
Less than 1
Obligation or Commitment Total year 1-3 years 4-5 years After 5 years
Debt - Partnership $ 97,009 $ 133 $ 281 $ 23,793 $ 72,802
Debt - Funds 57,380 25,000 - 32,380 -
Operating leases 161 98 63 - -
Interest on debt -
Partnership 45,014 4,272 8,529 8,312 23,901
Interest on debt - Funds 10,409 2,629 4,901 2,879 -
Environmental remediation 10,010 1,105 7,361 218 1,326
Other long-term obligations 121 25 50 46 -
Total contractual obligations
or commitments $ 220,104 $ 33,262 $ 21,185 $ 67,628 $ 98,029 Environmental remediation represents our estimate of potential liability
associated with environmental contamination at
The impact of inflation on our consolidated financial condition and consolidated results of operations for each of the periods presented was not material.
Off-Balance Sheet Arrangements
The Partnership is not a party to any material off-balance sheet arrangements and does not hold any variable interests in unconsolidated entities.
Capital Expenditures and Commitments
We expect capital expenditures for 2020 will be largely consistent with prior years. With the sale of the final residential lots from our Harbor Hill project inGig Harbor in 2019, we do not expect significant Real Estate project expenditures in 2020.
Government Regulation
Compliance with laws and regulations usually involves capital expenditures as well as operating costs. We cannot reasonably quantify future amounts of capital expenditures required to comply with laws and regulations, or the effects on operating costs, because in some instances compliance standards have not been developed or have not become final or definitive. Accordingly, at this time, we have not attempted to quantify future capital requirements to comply with any new regulations being developed byUnited States regulatory agencies. Additionally, many federal and state environmental regulations, as well as local zoning and land use ordinances, place limits upon various aspects of our operations. These limits include restrictions on our harvest methods and volumes, remediation requirements that may increase our post-harvest reforestation costs, Endangered Species Act limitations on our ability to harvest in certain areas, zoning and development restrictions that impact our Real Estate segment, and a wide range of other existing and pending statutes and regulations. Various initiatives are presented from time to time that seek further restrictions on timber and real estate development businesses, and although management currently is not aware of any material noncompliance with applicable law, we cannot assure readers that we will ultimately be successful in complying with all such regulations or that additional regulations will not ultimately have a material adverse impact upon our business. ACCOUNTING MATTERS Critical Accounting Estimates Our significant accounting policies are discussed in note 1 to our consolidated financial statements. Certain of our accounting policies have a higher degree of complexity, and they involve estimates requiring a higher degree of judgment. We believe the accounting policies discussed below represent the most complex, difficult, and subjective matters in this regard. 50 -------------------------------------------------------------------------------- Purchased timberland cost allocation. When the Partnership or the Funds acquire timberlands, a purchase price allocation is performed that allocates cost between the categories of merchantable timber, pre-merchantable timber, roads, and land based upon the relative fair values pertaining to each of these categories. Land value may include uses other than timberland, including potential conservation easement sales and development opportunities. The allocation of costs between the asset categories is driven largely by estimates of the volume of timber at the time of acquisition and future log prices, harvest and haul costs, volume at harvest, timing of harvest, silviculture costs, other operating expenses, and capital expenditures. These factors must be estimated for periods of several decades depending on the age class distribution of the acquired timberland. The allocation among the asset categories, particularly merchantable timber, pre-merchantable timber, and roads, forms the basis for calculating the depletion rate used to record depletion expense as the timber is harvested. Timber volume. Timber volume includes only timber whose eventual harvest is not constrained by the applicable state and federal regulatory limits on timber harvests as applied to the Partnership's and Funds' properties. Timber volume is accounted for and adjusted by periodic statistical sampling of the harvestable timber acres. Since timber stands can be very heterogeneous, the accuracy of the statistical sampling of trees within a stand, known as a "timber cruise" or "cruising", can vary. The timber inventory system is designed in such a way that it is updated on a regular basis and thus the accuracy of the whole is reliable while any subset, or individual timber stand, will have a wider range of accuracy. The standing timber inventory system is subject to three processes each quarter to monitor and maintain accuracy. The first is the cruise update process, the second is a comparison of the volume actually extracted by harvest to the volume in the standing inventory system at the time of the harvest (otherwise known as "cutout analysis"), and the third is necessary adjustments to productive acres based on actual acres harvested. The portion of productive acres of timber stands on the Combined tree farms that are physically measured or re-measured by cruising is such that generally stands with actual volume are cruised every seven years. Specific acres are first selected for cruising with a bias towards those acres that have gone the longest without a cruise and, second, with a bias towards those acres that have been growing the longest. Only stands older than 20 years are selected as subject to a cruise and, as the cruise is performed, only those trees with a diameter at breast height (DBH) (approximately 4.5 feet from the ground) of at least 5.6 inches are measured for inclusion in the inventory. For younger stands, all trees are tallied during the cruise process so that growth models can accurately predict how future stands will develop. The cutout analysis compares the total volume for a stand which was grown annually using systems designed to predict future yields, based on growth models, to actual harvest volumes. Due to the nature of statistical sampling, the results of the quarterly cutout analysis is meaningful only in the context of accumulated results over several years, and not in the context of a single harvest unit. Minor adjustments both up and down to productive acres are made quarterly after foresters and managers accurately map those harvested acres in the Geographic Information System (GIS). These adjusted acres are linked to the inventory system and are used to drive the estimates of future available volume. Over the last five years, our overall volume variances from the cutout analysis, which examines harvested stands rather than the entire population of merchantable timber, have been as much as approximately 8% in any one year, but have averaged about 6% in the aggregate over that time frame. Moreover, as our volume estimates in our standing inventory system are adjusted regularly as part of the cruising process, our depletion rates are continually incorporating the resulting updated volumes.
The estimate of timber inventory impacts our financial statements in the following ways:
Depletion expense. Depletion represents the cost of timber harvested and the cost of the permanent road system that is charged to operations by applying a depletion rate to volume harvested during the period. The depletion rate is calculated onJanuary 1st of each year by dividing the recorded cost of merchantable timber and the cost of the permanent road system by the volume of merchantable timber. For purposes of the depletion calculation, merchantable timber is defined as timber that is equal to or greater than 35 years of age for all of our tree farms exceptCalifornia , for which merchantable timber is defined as timber with a DBH of 16 inches or greater because of the uneven-aged management regime of that tree farm. On an annual basis, the volume and recorded cost for stands that become 35 years of age or 16 inches in DBH are incorporated in the depletion rate calculation. To calculate the depletion rate, we use a combined pool for the Partnership's timberlands as they are managed as one unit and the characteristics of the individual tree farms are substantially similar to one another. Depletion rate calculations for the Funds' timberlands are specific to each tree farm, as each tree farm is managed individually and they tend to have a more diverse set of characteristics.
A hypothetical 5% change in estimated merchantable timber volume would have
changed 2019 depletion expense by approximately
Timber deed sale revenue. Our timber deed sale contracts provide the customer
the legal right to harvest timber on the Partnership's or Funds' property.
Revenue is generally recognized when the contract is signed, as this transfers
control
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of the timber to the customer. The value of a timber deed contract is determined
based on the estimated timber volume by tree species multiplied by the
contracted price. The total contract value is an estimate as it is based on the
estimated timber inventory and species mix of the harvest units subject to the
contract. A hypothetical 5% change in the estimated timber inventory volume of
timber deed sale contracts would have changed 2019 revenue by approximately
$120,000 .
Environmental remediation. The Partnership has an accrual for estimated
environmental remediation costs of $10.0 million and $9.1 million as of December
31, 2019 and 2018, respectively. The environmental remediation liability
represents estimated payments to be made to remedy and monitor certain areas in
and around Port Gamble Bay and complete related natural resource damages
restoration projects. Additional information about the Port Gamble site is
presented in "Business - Real Estate - Environmental Remediation" above and in
"Management's Discussion and Analysis - Real Estate". The remaining costs for
the project include costs to clean up the millsite and monitor the conditions in
Port Gamble Bay , on the millsite, and at the storage location of the dredged
sediments. The millsite remediation will include primarily excavation of
contaminated soils and placement of clean caps. Monitoring costs include
primarily evaluating and maintaining caps, as well as sampling and surveying the
conditions at the site and taking any corrective action that may be necessary
based on the results. The remaining monitoring period is estimated to be
approximately 13 years, but could be shorter or longer depending on the
information gathered during the monitoring period.
Costs may still vary as the project progresses due to a number of factors, some of which are outlined as follows:
Uncertainty with respect to the millsite cleanup: Although we do not anticipate material changes to our estimated costs for this element of the project, the design and scope of this work has not yet been finalized and our estimates could change. Natural Resource Damages (NRD): Certain environmental laws allow state, federal, and tribal trustees (collectively, the Trustees) to bring suit against property owners to recover damages for injuries to natural resources. Like the liability that attaches to current property owners in the cleanup context, liability for natural resource damages can attach to a property owner simply because an injury to natural resources resulted from releases of hazardous substances on that owner's property, regardless of culpability for the release. The Trustees are alleging thatPope Resources has NRD liability because of releases that occurred on its property. We have been in discussions with the Trustees regarding their claims and the alleged conditions inPort Gamble Bay . We have also been discussing restoration alternatives that might address the damages the Trustees allege. Discussions with the Trustees may result in an obligation for us to fund NRD restoration activities and past assessment costs that are greater than we have estimated, and it is reasonably possible that this component of the liability may increase. Unforeseen conditions: As we transition to the maintenance and monitoring phases of the project, conditions may arise that require corrective action, and monitoring protocols may change over time. In addition, extreme weather events could cause damage to caps that would need to be repaired. These factors could result in additional costs. Likewise, we cannot accurately predict the impacts, if any, of the alleged NRD claims.
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