UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-K
(Mark one)
x
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2008
or
¨
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  For the transition period from ________ to________

Commission File No.  1-9035

Pope Resources, A Delaware Limited Partnership
(Exact name of registrant as specified in its charter)
 
 
Delaware
 
91-1313292
 
 
(State of Organization)
 
(IRS Employer I.D. No.)
 

19245 Tenth Avenue NE, Poulsbo, WA 98370
(Address of principal executive offices, Zip Code)

Registrant's telephone number, including area code: (360) 697-6626

Securities registered pursuant to Section 12(b) of the Act:
 
 
Title of each class
 
Name of each exchange on which registered
 
 
Depositary Receipts (Units)
 
NASDAQ
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
                                                               Yes ¨ No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.
                                                               Yes ¨ No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 
                                                               Yes x No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x    
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer ¨ 
Accelerated Filer x
Non-Accelerated Filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Act).
                                                               Yes ¨ No x
 
At June 30, 2008, the aggregate market value of the non-voting equity units of the registrant held by non-affiliates was approximately $ 118,694,673

The number of the registrant’s limited partnership units outstanding as of February 19, 2008 was 4,658,016.

Documents incorporated by reference:  None

 
 

 

Pope Resources, A Delaware Limited Partnership
Form 10-K
For the Fiscal Year Ended December 31, 2008
Index

     
Page
Part I
     
       
 
Item 1.
Business.
3
 
Item 1A.
Risk Factors
15
 
Item 1B.
Unresolved Staff Comments
19
 
Item 2.
Properties
19
 
Item 3.
Legal Proceedings
20
 
Item 4.
Submission of Matters to a Vote of Security Holders
20
Part II
     
       
 
Item 5.
Market for Registrant’s Units, Related Security Holder  Matters and Issuer Purchases of Equity Securities
21
 
Item 6.
Selected Financial Data
24
 
Item 7.
Management’s Discussion and Analysis of Financial Condition  and Results of Operations
26
 
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
50
 
Item 8.
Financial Statements and Supplementary Data
51
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and  Financial Disclosure
75
 
Item 9A.
Controls and Procedures
75
 
Item 9B.
Other Information
76
Part III
     
       
 
Item 10.
Directors and Executive Officers of the Registrant
77
 
Item 11.
Executive Compensation; Compensation Discussion & Analysis
79
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management  and Related Security Holder Matters
90
 
Item 13.
Certain Relationships and Related Transactions
92
 
Item 14.
Principal Accountant Fees and Services
93
       
Part IV
     
       
 
Item 15.
93
 
Signatures
 
 
 
2

 

PART I

Item 1.
BUSINESS

OVERVIEW

Pope Resources, A Delaware Limited Partnership (the “Partnership”), was organized in 1985 as a result of a spin-off by Pope & Talbot, Inc.  (“P&T”), Pope & Talbot Development, Inc. and other P&T affiliates, of certain of P&T’s timberland and real estate development assets.

The Partnership currently operates in three primary business segments: (1) Fee Timber, (2) Timberland Management & Consulting and (3) Real Estate.  Fee Timber operations consist of growing and harvesting timber from our tree farms.  Timberland Management & Consulting, through our subsidiary, Olympic Resource Management LLC (“ORMLLC”), provides timberland management and forestry consulting services to owners of timberlands and serves as general partner of, and provides timberland management services to, ORM Timber Fund I, LP (Fund I), which owns 24,000 acres of timberlands in western Washington. ORMLLC is currently engaged in acquisition, identification and due diligence for a new timber investment fund, ORM Timber Fund II, Inc. (Fund II), which has not yet acquired any timberland.  Our total equity investment in Fund I is $11.7 million, which represents a 20% interest in Fund I’s total invested capital of $58.5 million.  Our total equity investment in Fund II is $92,500, which represents a 20% interest in Fund II’s total invested capital of $462,500, which in turn represents 1% of the $46.25 million of committed capital to date.  As additional capital commitments are secured for Fund II, we are obligated to contribute 1% of our co-investment that is based on 20% of Fund II’s total equity capital.  The remaining balance of our 20% co-investment in Fund II will be due upon the successful completion of acquisitions for the fund.  Real Estate operations consist of efforts to enhance the value of our land investments by obtaining the entitlements and, in some cases, building the infrastructure necessary to make further development possible.  Further segment financial information is presented in Note 12 to our consolidated financial statements included in this report.  Copies of the Partnership’s Securities Exchange Act reports and other information can also be found at www.orm.com.  The information contained in or connected to our web site is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this or any other report filed with or furnished to the SEC.

DESCRIPTION OF BUSINESS SEGMENTS

Fee Timber

Operations.  Our Fee Timber segment consists of operations surrounding management of the Partnership’s core assets: the Hood Canal tree farm, which consists of 70,000 acres located in the Hood Canal area of Washington, and the 44,000-acre Columbia tree farm located in southwestern Washington State.  The Partnership views its two tree farms as core holdings and manages them as a single operating unit.  We have owned the Hood Canal tree farm, substantially as currently comprised, since our formation, and we acquired the bulk of the Columbia tree farm in 2001.  Operations on the tree farms consist primarily of growing, harvesting, and marketing timber and timber products to both domestic and Pacific Rim markets but additionally include other revenue sources such as cell tower and mineral leases.  Our Fee Timber segment produced 84%, 68%, and 53% of our consolidated revenue in 2008, 2007, and 2006, respectively.

This segment also includes operations of Fund I and Fund II, which are consolidated into our financial statements.  Fund I acquired 24,000 acres of timberland in the fourth quarter of 2006.  We harvested 5 million board feet (MMBF) from these timberlands in 2008.   Harvest and other operations of Fund I are not expected to contribute significantly to income as a separate depletion pool with a higher depletion rate is applied to this harvest volume.  Under normal market conditions the depletion charge would be expected to approximate net stumpage realized (delivered log price less harvesting and transportation cost) from the harvest.  However, in the current weak market conditions the depletion charge exceeds net stumpage for Fund I.  ORMLLC is the general partner of Fund I and earns management fees and incurs expenses resulting from managing Fund I.  ORMLLC is the manager of Fund II and is expected to earn management fees predicated on this role once Fund II has acquired timberland. The fees generated from managing Fund I and Fund II are eliminated in consolidation of our financial results.

 
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Inventory.   Inventory information presented below includes only the Hood Canal and Columbia tree farms.  Fund I tree farms are broken out and discussed separately.

We define “merchantable timber inventory” to mean timber inventory in productive timber stands that are 35 years of age and older, which represents management’s estimate of when merchantable value would be assigned to the timber in a timberland sale. As of December 31, 2008, the tree farms’ total merchantable inventory volume was estimated to be 338 MMBF, which compares to estimated merchantable timber inventory volume of 356 MMBF at December 31, 2007.  Merchantable inventory of Fund I as of December 31, 2008 and 2007 was 49 MMBF and 50 MMBF, respectively.

Our Hood Canal tree farm has an overabundance of older age stands which have higher-than-average per acre inventory volumes.  As we harvest these older stands, total inventory will drop until we have worked down the bimodal weighting of the age class distribution and there is a more even distribution of volume across age classes. You will note in the acreage table below that we have a significant number of acres in the 25 to 34 year-old age-class brackets that will be moving into the merchantable category over coming years.  

While merchantable timber inventory has indeed decreased, it is important to note that we use a non-declining even flow harvest constraint when calculating our harvest rate.  As discussed in more detail below, we are currently harvesting less than our sustainable harvest due to weak log market conditions.

The Partnership’s merchantable inventory is spread among five-year age classes as follows:

   
December 31,
 
 
Age Class
 
2008
Volume
(in MMBF)
   
2007
Volume
(in MMBF)
 
35 to 39
    68       68  
40 to 44
    79       73  
45 to 49
    33       32  
50 to 54
    7       11  
55 to 59
    43       47  
60 to 64
    48       64  
65+
    60       61  
      338       356  

Fund I merchantable inventory is spread among age classes as follows:

   
December 31,
 
Age Class
 
2008
Volume
(in MMBF)
   
2007
Volume
(in MMBF)
 
35 to 39
    7       5  
40 to 44
    8       9  
45 to 49
    1       1  
50 to 54
    6       14  
55 to 59
    13       7  
60 to 64
    1       1  
65+
    13       13  
      49       50  
 
 
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Timber inventory volume is estimated using an annual statistical sampling of the timber (a process called “cruising”), with adjustments made for estimated growth and depletion of areas harvested.  This process is monitored by comparing actual harvest volume to the corresponding estimates for those stands in the Partnership’s standing timber inventory system.  This analysis looks at each harvest unit and measures the variance between the actual cut and the projected inventory volume, with specific harvest unit variances typically offsetting one another to a small net aggregate variance.  The difference between the volume reflected in the inventory for a given year’s harvest units and the amount of harvest volume actually removed from those stands is usually within one to three percent of the volume harvested.  Inventory volumes take into account the applicable state and federal regulatory limits on timber harvests as applied to our properties, including Washington State’s forest practice regulations that provide for expanded riparian management zones, wildlife habitat, and other harvest restrictions.  The Partnership annually cruises 15% to 20% of its productive timberland acres with stand ages of at least 20 years.

The dominant timber species on the Partnership’s tree farms is Douglas-fir.  Douglas-fir is noted for its structural characteristics that make it generally preferable to other softwoods and hardwoods for the production of construction grade lumber and plywood.  In addition to Douglas-fir, inventory species on the Partnership’s tree farms include western hemlock, western red cedar, and red alder.

The Partnership’s total merchantable timber inventory as of December 31, 2008 is distributed among species as follows:
 
Species
 
Volume
(in MMBF)
   
Percent of total
 
Douglas-fir
    249       74 %
Western hemlock
    42       12 %
Western red cedar
    11       3 %
Other conifer
    13       4 %
Red alder
    19       6 %
Other hardwood
    4       1 %
Total
    338       100 %

Fund I total merchantable timber inventory as of December 31, 2008 is distributed among species as follows:

Species
 
Volume
(in MMBF)
   
Percent of total
 
Douglas-fir
    21       43 %
Western hemlock
    17       33 %
Western red cedar
    1       2 %
Other conifer
    9       18 %
Red alder
    1       3 %
Other hardwood
    -       1 %
Total
    49       100 %

The Hood Canal tree farm has significant acreage with mature timber and even more acreage with relatively immature trees, which results in what we call a “bimodal” age class pattern that management believes is common among western U.S. timberland owners.  This bimodal pattern can be dealt with in three primary ways: (1) delay harvests of mature acres to backfill what would otherwise be smaller harvest years until the immature trees become merchantable; (2) harvest the mature acres at a rate that more closely approximates rotation age and allow later harvest cash flows to decline for some period while the younger stands mature; or (3) acquire timberland properties with age-class characteristics that fill in the trough in the bimodal pattern.  The acquisition of the Columbia tree farm in 2001 is an example of a strategic timberland acquisition where we acquired a tree farm with age-class characteristics that helped to fill in age classes where the Hood Canal tree farm was deficient.  Management believes it not only made a sound value investment on its own merits in acquiring the Columbia tree farm, but also made significant progress toward smoothing the age-class distribution of the Partnership’s timberland holdings.

 
5

 
 
The Partnership’s tree farms as of December 31, 2008 approximate 114,000 acres excluding Fund I’s tree farms.  Of this total, approximately 96,000 acres are designated productive acres.  Fund I’s tree farms as of December 31, 2008 totaled nearly 24,000 acres, of which approximately 20,000 of those acres were designated productive acres.  Productive acres represent land that is suitable for growing and harvesting timber and excludes acreage that is unavailable for harvest because it is in protected wetlands or riparian management zones (stream set-asides).  Productive acres also reflect deductions for roads and other land characteristics that inhibit suitability for growing or harvesting timber.  As of December 31, 2008, total productive acres are spread by timber age class as follows:

Age
Class
 
12/31/2008
 Partnership Acres
   
%
   
12/31/2008
Fund I Acres
   
%
 
Clear-cut
    1,460       2 %     201       1 %
0 to 4
    9,239       10 %     165       1 %
5 to 9
    9,665       10 %     1,733       9 %
10 to 14
    11,854       12 %     1,751       9 %
15 to 19
    7,530       8 %     2,729       14 %
20 to 24
    15,883       17 %     4,647       23 %
25 to 29
    15,372       16 %     2,795       14 %
30 to 34
    7,930       8 %     3,430       17 %
35 to 39
    4,717       5 %     503       3 %
40 to 44
    4,286       4 %     453       2 %
45 to 49
    1,840       2 %     93       0 %
50 to 54
    421       0 %     373       3 %
55 to 59
    1,695       2 %     512       2 %
60 to 64
    1,933       2 %     54       0 %
65+
    2,385       2 %     491       2 %
      96,210       100 %     19,930       100 %

Timberland Acquisitions.  We made three timberland purchases in 2008 that added 1,180 acres to our tree farm inventory for a total purchase price of $1.5 million.

Long-term Harvest Plan.  The Partnership’s annual harvest level is derived from a long-term harvest planning model that factors in economic rotation ages of all stands, existing timber inventory levels, growth and yield assumptions, and regulatory constraints associated with the Washington State Forest Practices Act.  From this information, management develops annual and long-term harvest plans predicated on their assessment of existing and anticipated economic conditions with the objective of maximizing long-term values.  Management generally updates this plan every other year, or more frequently as economic conditions require, to take into account changes in timber inventory, including species mix, available acres, soil productivity classifications, volume, size, and age of the timber.  The long-term harvest plan is calculated using a non-declining even-flow harvest constraint, meaning that absent changes to available inventory or estimated growth rates, future harvest levels will be as high as or higher than current levels.

We updated our annual harvest plan in 2008, resulting in a decline in our estimated sustainable harvest levels from the Hood Canal and Columbia tree farms, from 49 MMBF to 44 MMBF.  Estimated sustainable harvest level for Fund I remained at 8 MMBF.  Our reduction in estimated sustainable harvest level for the Hood Canal and Columbia tree farms was based on several factors but most notably because of a shift of use classifications of certain parcels from forestry to development. We also made an adjustment to the yield tables we used to estimate the expected future harvest volumes.  The yield tables used for the Hood Canal tree farm were adjusted down due to the impact of a slightly higher proportion of hardwoods, which may impact the growth rates of Douglas-fir. The Columbia and Timber Fund I tree farms were determined to be relatively consistent with the yield tables used.  As discussed below in greater detail, given the relatively poor log markets experienced in late 2008 and expected to continue at least through 2009, we have decided to defer approximately 30% of our sustainable harvest.  As a result, our planned harvest for 2009 is 32 MMBF on Partnership lands and 5 MMBF on Fund I lands.  The deferred harvest will be harvested when log markets have recovered.

 
6

 
 
Marketing and Markets.  We market timber using the manufactured log method, where we engage independent logging contractors to harvest the standing timber and manufacture it into logs that we then sell on the open market.  We retain title to the logs until delivery takes place, which normally occurs at a customer log yard.  We sell our logs both domestically and internationally through log exporting intermediaries.  Our principal international market is the Pacific Rim.  Logs going to this destination are generally sold to U.S.-based brokers who in turn sell direct to offshore customers.  Japan is by far the largest buyer of logs in the Pacific Rim market, though Korea and China represent secondary export markets that our customers sell to from time to time.  Over the last several years, the percentage of our annual production sold into export markets has ranged from 6% to 16%.  Factors that affect the proportion of our sales to export markets include the relative strength of U.S. and foreign building markets, currency exchange rates, and ocean transportation costs.

Customers.   The Partnership sells its logs domestically to lumber mills and other wood fiber processors located throughout western Washington and northwest Oregon.  The Partnership’s logs are also sold to export intermediaries located at the ports of Tacoma, Olympia, and Longview, Washington.  Whether destined for domestic or export markets, the cost of transporting logs limits the destinations to which the Partnership can profitably deliver and sell its logs.

Weyerhaeuser, Cascade Land Conservancy, and Simpson Timber Company were major customers for our Fee Timber segment in 2008 representing 11%, 10% and 10%, respectively, of segment revenue.  The Cascade Land Conservancy purchased an 8,035-acre conservation easement from Fund I in the second quarter of 2008.  In 2007, we had two major customers in our Fee Timber segment: Simpson Timber Company and Interfor Pacific Inc., which represented 13% and 12%, respectively, of segment revenue.  The trend towards mill consolidation has returned as weak lumber markets led to the closure of less competitive mills in our operating area. This trend is of some concern as the reduction in the number of mills may reduce buyers’ competition for logs.  On the other hand, past experience tells us that as the lumber markets improve additional mill capacity should return, with a corresponding improvement in competition among log buyers. The Partnership delivered logs to over 40 separate customers during 2008.

Competition.  Many of our competitors are comparable in size or larger.  Log sellers compete on the basis of quality, pricing, and the ability to satisfy volume demands for various types and grades of logs to particular markets.  Management believes that the location, type, and grade of the Partnership’s timber will enable it to compete effectively in these markets.  However, our products are subject to increasing competition from a variety of non-wood and engineered wood products as well as competition from foreign-produced logs.

Forestry and Stewardship Practices.  The Partnership’s timberland operations incorporate management activities that include reforestation, control of competing brush in young stands, thinning of the timber to achieve optimal spacing after stands are established, fertilization, and road maintenance.  During 2008, we planted 792,000 seedlings on 1,821 acres.  This compares to the years 2007 and 2006 in which the Partnership planted 1,197,000 and 1,119,000 seedlings on 2,751 and 2,649 acres, respectively.  Seedlings are generally planted from December to April depending on weather and soil conditions.  The number of acres and seedlings planted will vary from year to year based upon harvest level, the timing of harvest, and seedling mortality rates on stands planted in prior years.  Management’s policy is to stay current on its reforestation program, returning all timberlands to productive status as soon as economically feasible following harvest.

 
7

 

  All harvest and road construction activities are conducted under the Washington State Forest Practices Act, a comprehensive set of rules and regulations governing how a defined set of forest operations are allowed to go forward under State permit.   An application for harvest or road construction must address soil stability and potential impact to public resources; in many cases the consultation of scientifically based Watershed Analyses and third party, State qualified, geo-technical consultants are utilized to ensure safety of operations and compliance with regulations.

In addition to new road construction, the inventory of existing roads is maintained to the standards of the Forest Practices Act in order to minimize siltation and avoid slope failures.  Beginning in 2000, all roads are required to be evaluated for hazard and scheduled for upgrading or deconstruction (abandonment), if needed, by the end of 2015.  Our schedule was developed and accepted by the State, and efforts are on track to complete all maintenance activities by 2015.  

Sustainable Forestry Initiative (SFI®).  Since 2001, we have been a member of the SFI forest certification program, an independent environmental review and certification program that promotes sustainable forest management, focusing on water quality, biodiversity, wildlife habitat and species protection, and forests that have exceptional conservation value.  Beginning in 2003, in conjunction with participation in the certification program, we have been subject to independent audits of the required standards for the program.  Management views this certification as an important indication of our commitment to manage our lands in a sustainable manner and to look for ways to continually improve our management practices.  We believe this commitment is an important business practice that contributes to our reputation and the long-term value of the Partnership’s assets.

In order to maintain this certification, management must document its timberland management policies against seven discrete SFI objectives: Land Management, Procurement; Forestry Research Science and Technology, Training and Education, Regulatory Compliance, Public and Landowner Involvement in the Practice of Sustainable Forestry, and, finally, Review and Continual Improvement.

Beginning in 2007, SFI third-party audits increased in frequency from every three years to annually.  We were re-certified in 2008, including the newly acquired Fund I lands.  Certification under SFI is currently a requirement for us to sell logs to a number of our customers in the Partnership’s geographic market.  We believe this certification allows us to obtain the best price for our logs while protecting the core timberland assets of the Partnership.

Fire Management.  Management has taken a number of steps to mitigate risk of loss from fire, which is nonetheless possible on any timberland property.  First, management maintains a well-developed road system that allows access and quick response to fires that do occur.  Second, management maintains a fire plan and program that provides for increased monitoring activities and requires all operators to maintain adequate fire suppression equipment during the summer fire season.

Timberland Management & Consulting

Background.  In March 1997, our unitholders authorized management to expand our timberland business into the Investor Portfolio Management Business (IPMB).  The IPMB has two complementary business strategies: timberland investment management and timberland management.  In 1997, the Partnership formed two wholly owned subsidiaries, ORM, Inc. and ORMLLC, to facilitate the IPMB activities.

Operations.  The Timberland Management & Consulting segment’s key operation has been to provide various aspects of timberland management services to third-party timberland owners.  We anticipate growth in this segment as ORMLLC continues its management of Fund I and undertakes management of Fund II once Fund II acquires timberlands. The Partnership consolidates these timber funds into its financial statements and as a result $898,000 and $882,000 of fees generated through the management of these timber funds were eliminated from our statement of operations in 2008 and 2007, respectively.  The Timberland Management & Consulting segment represents 3%, 3%, and 5% of consolidated revenue for the years ended December 31, 2008, 2007, and 2006, respectively, after the elimination of the fees generated from management of Fund I.

 
8

 
 
Timberland Investment Management.  The goal of our timberland investment management program is to build and manage diversified timberland portfolios for third-party investors as well as the Partnership.  Management views this objective as a means of increasing the Partnership’s total timberland base, through our 20% co-investment, while at the same time improving overall management economies of scale, limiting acquisition costs, and generating fee income.  Progress toward this goal includes the 2005 closing of Fund I with equity capital commitments of $61.8 million.  The two-year drawdown period for Fund I ended on August 1, 2007, during which time Fund I had invested $58.5 million of its capital commitment and released investors from the remaining $3.2 million of equity capital commitment.  The $58.5 million of invested capital was used to acquire two separate tree farms in Washington State totaling approximately 24,000 acres.  These tree farms represent relatively young properties that are expected to result in a low cash-on-cash yield during the ten-year investment term.  Most of the anticipated investment return for Fund I will be generated upon disposition when a large portion of Fund I’s acreage, currently stocked with pre-merchantable timber, will grow into higher-value merchantable timber stands.  ORMLLC earns an asset management fee for serving as general partner of Fund I which is eliminated as a result of the consolidation of Fund I into the Partnership’s financial statements.  In addition to serving as general partner of Fund I, ORMLLC earns a management fee for providing timberland management services to Fund I which is also eliminated in consolidation.  The elimination of these fees results in a decrease in the reported cost of managing our tree farms under our Fee Timber segment as well as eliminating the revenue generated from managing the Fund I tree farms in the Timberland Management & Consulting segment.

In August 2008, we had our first of two expected closings for Fund II.  The first close was for $46.3 million of which the Partnership committed 20%.  The second and final close is anticipated during the first quarter of 2009 and is expected to bring the committed fund balance to $100 million, again including the Partnership’s 20% share.  At each closing, all investors are required to contribute 1% of their total capital commitment.  Once Fund II has completed its final close, the drawdown period begins, during which time we seek suitable properties to acquire on behalf of Fund II.  The drawdown period is typically two years, but can be extended an additional year by a vote of the investors in Fund II.  Investors fulfill the balance of their capital commitment as timberland properties are acquired.

Timberland Management.  Our timberland management activities provide forestland management, acquisition, and disposition services to timber property owners.  These services generally take the form of a long-term contract where ORMLLC personnel provide management expertise.  In December 2004, following an 18-month bankruptcy process, a court-approved liquidation plan transferred the ownership of 522,000 acres formerly owned by Crown Pacific LP to Cascade Timberlands LLC (“Cascade”).  On January 1, 2005 ORMLLC began managing those timberlands for Cascade.  Timberland sales by Cascade have reduced the current acres under management for Cascade to approximately 267,000 acres of Oregon timberland.  In 2008, Cascade was the Timberland Management & Consulting segment’s only client, accounting for 100% of segment revenue.  At the end of 2006, ORM and Cascade entered into a three-year management agreement for the Oregon timberlands that expires in December 2009 or upon the earlier sale of the managed property.  It is the goal of Cascade to ultimately dispose of these assets.

Marketing.  ORMLLC pursues third-party timberland management opportunities in the western U.S. through direct marketing to timberland owners.  Marketing and business development efforts include regular contact with forest products industry representatives, non-industry owners, and others who provide key financial services to the timberland sector.  ORMLLC’s acquisition and disposition activities keep management informed of changes in timberland ownership that can represent opportunities for us to market our management and consulting services.

Customers.  Timberland management revenue in 2008 includes one client that represented 100% of segment revenue.

 
9

 
 
Competition.  ORMLLC and its subsidiaries compete against both larger and smaller companies providing similar services.  There are approximately 20 established timberland investment management organizations competing against us in the timberland portfolio development business.  The companies in this group have access to established sources of capital and, in some cases, increased economies of scale that can put ORMLLC at a disadvantage.  Smaller regional companies compete effectively on price for limited scope consulting and land management projects.

Investor Portfolio Management Business (IPMB).  IPMB operations include timberland management and timberland investment management.  Our activities on behalf of the Funds are examples of timberland investment management activities.  Now that Fund I has acquired timberland properties, both timberland management and asset management fees are earned from administering Fund I.  These activities,  as well as the development and marketing costs associated with IPMB opportunities, are part of the IPMB.

Limitation on Expenditures:  The 1997 amendment to Pope Resources’ Limited Partnership Agreement authorizing launch of the IPMB limits our cumulative net expenditures incurred in connection with the IPMB to $5.0 million including debt guarantees.  As of December 31, 2008 cumulative expenditures incurred in pursuit of IPMB opportunities, including guarantees, were less than cumulative income generated.  Therefore, cumulative net expenditures as of December 31, 2008 against the $5.0 million limit are zero.

Allocation of Income:  The 1997 amendment to Pope Resources’ Limited Partnership Agreement further specifies that income from the IPMB will be split using a sliding scale allocation method beginning at 80% to the Partnership’s wholly-owned subsidiary, ORM, Inc., and 20% to Pope MGP, Inc., the managing general partner of the Partnership.  The sliding scale allocation method will evenly divide IPMB income between ORM, Inc. and Pope MGP, Inc. once such income reaches $7.0 million in any given fiscal year.

Real Estate

Background.  The Partnership’s real estate activities are closely associated with the management of its timberlands.  Management continually evaluates timberlands in terms of the best economic use, whether this means continuing to grow and harvest timber or seeking a rezone of the property for sale or development.  After logging timberlands, management has four primary options for what to do next with the land: reforest it, sell it as undeveloped property, improve it to various levels of development for sale as improved property, or hold it as property slated for later development or sale.  Generally speaking, our real estate segment consists of investing in and later reselling improved properties, and holding properties for later development and sale. As a result, revenues from this segment tend to fluctuate substantially, and are characterized by relatively long periods in which revenues from sales are relatively low, and expenses from developing properties may be higher.  When improved properties are sold, we recognize income in the form of sale prices net of acquisition and development costs.

Operations.   Real Estate operations include work considered by management necessary to maximize the value of the Partnership’s portfolio of property that management believes has a higher-and-better-use than timberland or leasing residential and commercial properties in the Port Gamble townsite. That portfolio currently consists of approximately 2,500 acres. For our Real Estate projects, we generally seek to secure the entitlements and/or physical improvements necessary to make development possible.  The Real Estate segment represents 13%, 29%, and 42% of consolidated revenue in 2008, 2007, and 2006, respectively.

 
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Development Properties

Other Land Investments.  Management recognizes the significant value represented by the Partnership’s real estate holdings and is focused on adding to that value.  The means and methods of adding value to our real estate portfolio vary considerably depending on the specific location and current zoning of each parcel.  This range extends from land that has commercial activity zoning where unit values are measured by the square foot to large lots of recently cutover timberland where value is measured in per acre terms.  In general, value-adding activities that allow for the highest and best use of the properties include: working with communities and elected officials to develop grass roots support for entitlement efforts, securing favorable zoning, acquiring easements, and obtaining final plat approvals.

We are working on master planned communities in Gig Harbor, Bremerton, Kingston, Port Ludlow, and Hansville, Washington.  During 2008, we did not generate sales from any of these projects. Due to each respective property’s size, development complexity, and regulatory environment, the projects are long-term in nature and require extensive time and capital investments to maximize returns.  An important activity within the Real Estate segment is the development of the “Rural Lifestyles” program through which rural residential lots are marketed both to those individuals intent on owning rural residential lots and to builders interested in building homes in rural locations.

Gig Harbor.   Gig Harbor, a suburb of Tacoma, Washington, is the site of a mixed-use development that includes a 16-acre retail/commercial site, 32 acres of business park lots, and 203 acres of land with residential zoning.  In 2008, management completed a preliminary plat submission for the 203-acre residential portion of this project.  In 2007, Management fulfilled obligations relating to road and utility infrastructure improvements, allowing previously deferred revenue from the 2006 sale of 6 acres zoned for retail/commercial use to be recognized.  A 6-acre business park lot sale to a local church was also completed.  Planning work for the residential portion of the Gig Harbor property continues, as development of the residential property is subject to resolution of transportation and sewer treatment plant capacity issues with the City of Gig Harbor.  The retail/commercial and business park parcels have transportation and sewer capacities reserved and are not subject to resolution of either of these issues.

Bremerton.   In 1999, the City of Bremerton approved the Partnership’s request for a planned 264-acre mixed-use development on property located within the Bremerton city limits.  The development plan included 61 acres zoned for industrial use and 203 acres zoned for residential.  In 2006, the Partnership completed the sale of the 203-acre residential land.  As a condition of the sale, the Partnership constructed infrastructure in 2006 and 2007 to serve the property.  The remaining 61-acre industrial park is being developed in two phases that will result in a total of 24 lots, with 9 acres set aside for roads and other common area improvements.  The construction for the 9-lot Phase I was completed in 2007 and facilitated the sale of 2 lots at the end of 2007.  The timing for the construction of Phase II is dependent on the absorption rate for the seven remaining Phase I lots.

Kingston.  The Partnership prepared and submitted a formal master plan and subdivision application in 2007 for the Kingston property that calls for the development of 750 residential units.  In 2008, a revised submittal was made in response to the County’s comments and a public hearing is expected in early 2009.  The Partnership owns an additional 366 acres bordering this project, which has zoning for 5-acre lots.

Hansville.     The Partnership owns a 152-acre residential development project in Hansville called Chatham.  The development is the result of a plat from 1913 that originally consisted of 10-acre lots that management has reestablished into 19 distinct parcels ranging from 3-10 acres in size.  Construction of 2,300 feet of road, utilities, and a gated front entrance was completed in 2007 and marketing is underway to sell the lots.

Port Ludlow.  Port Ludlow represents a 268-acre property located just outside the Master Planned Resort boundary of Port Ludlow, Washington.  We are currently working on entitlements for this project that would allow for up to 54 lots ranging from 1 to 1.5 acres each, with the balance of the property designated as open space.  We are processing the application at this time and expect to have a final plat approved by 2010. Development beyond the point of plat approval will not commence until demand for rural residential lots improves.

 
11

 
 
Rural Residential.  Management launched the Rural Lifestyles program to sell rural residential lots to capitalize on higher-and-better-use real estate values.  These properties are typically non-contiguous smaller lots generally ranging in size between 5 and 40 acres with zoning ranging from one dwelling unit per 5 acres to one per 80 acres.  Development and disposition strategies vary depending on the property’s unique characteristics.  Development efforts and costs expended to ready these properties for sale include work to obtain development entitlements that will increase the property’s value as residential property as well as making improvements to existing logging roads, constructing new roads, extending dry utilities, and sometimes establishing gated entrances.

Commercial Properties

Port Gamble.  The Partnership currently owns and operates the town of Port Gamble, Washington, north of Kingston on the Olympic Peninsula.  Port Gamble was designated a “Rural Historic Town” under Washington State’s Growth Management Act (GMA) in 1999.  This designation allows for substantial new commercial, industrial, and residential development using historic land use patterns and densities while maintaining the town’s unique architectural character.  Operations at Port Gamble include commercial and residential lease activities and the wedding and events business.

P&T operated a sawmill at Port Gamble, from 1853 to 1995 and since 2000 management was been working with P&T to remedy environmental contamination at the townsite and millsite and to monitor results of the cleanup efforts.  After contamination was discovered at the townsite, millsite, and in the adjacent bay, the Partnership entered into a settlement and remediation agreement with P&T pursuant to which both parties allocated responsibility for cleanup costs.  Under Washington law, both Pope Resources and P&T are “potentially liable persons” based on historic ownership and/or operation of the site.  These laws provide for joint and several liability among parties owning or operating property on which contamination occurs, meaning that cleanup costs can be assessed against any or all such parties.

 Our agreement with P&T, negotiated in 2002, was intended to apportion responsibility based on this principle, with P&T bearing the larger share of responsibility due to their role in operating the site and upon their relatively lengthy ownership.  The P&T agreement resulted in the termination of a lease by P&T to operate the millsite as well as providing for the initiation of environmental cleanup activities, the responsibility for which has been shared by the Partnership and P&T.  Under that agreement P&T took responsibility for the landfills and cleanup of Port Gamble Bay and the Partnership took responsibility for the millsite and townsite.  At the end of 2006, cleanup of the landfills and townsite were completed as both received “No Further Action” letters from the Washington State Department of Ecology.  Efforts to cleanup the millsite and sediments in Port Gamble Bay continued in 2007.  However, P&T sought bankruptcy protection under Canadian law in October 2007 and filed a petition under Chapter 11 of the U.S.  Bankruptcy Code in Delaware in November 2007.  In May 2008, a bankruptcy judge approved a request from P&T to convert the Chapter 11 reorganization to a Chapter 7 liquidation plan.  The Chapter 7 was subsequently converted to Chapter 15 liquidation in August 2008.  Chapter 15 was added to the U.S. Bankruptcy code as a mechanism for effectively dealing with cross border insolvency cases.  This final conversion places the Canadian receiver, PricewaterhouseCoopers, in the role of managing the liquidation of the remaining P&T assets.  These events involving P&T led management to conclude that P&T will not satisfy its remaining obligations under our settlement and remediation agreement.  Accordingly, in 2007 we increased our remediation liability by $1.9 million to reflect our current estimate of the future remediation costs.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Real Estate – Environmental Remediation Costs.”

Marketing.  Marketing activities in the Real Estate segment during 2008 consisted of marketing residential and commercial real estate for sale and lease.

 
12

 

Customers.  Management typically markets its land for sale to private individuals, residential contractors, and developers of commercial property.  Customers for rental space in the Port Gamble townsite consist of both residential and commercial tenants.

Competition.  Real Estate activities consist primarily of adding value to current land holdings.  Once those properties are ready for development, management will in most instances seek to market the property for sale, but in some instances may consider a strategy that would involve another developer with building expertise as a joint venture partner.

Transportation.  Land values for the Real Estate portfolio are strongly influenced by transportation options between the Kitsap Peninsula and the Seattle-Tacoma corridor.  Transportation options between Seattle-Tacoma and Kitsap County include driving on the Tacoma Narrows Bridge or taking one of several car ferries.  In 2007, the Washington State Department of Transportation completed a multi-year construction project to add a second span to the Tacoma Narrows Bridge connecting Tacoma and Gig Harbor.  Ferry transportation in our market area currently utilizes vessels that carry both automobiles and passengers from each of the communities of Kingston, Bremerton, and Bainbridge Island, respectively, to and from Edmonds and Seattle.

Employees

As of December 31, 2008, the Partnership employed 57 full-time, year-round salaried employees and part-time and seasonal personnel, who are distributed among the segments as follows:

Segment
 
Full-Time
   
Part-Time/
Seasonal
   
Total
 
Fee Timber
    15       3       18  
Timberland Management & Consulting
    7       1       8  
Real Estate
    17       3       20  
General & Administrative
    11       -       11  
Totals
    50       7       57  

None of our employees are subject to a collective bargaining agreement and the Partnership has no knowledge that any steps toward unionization are in progress.  Management considers the Partnership’s relations with its employees to be good.

Government Regulation

In the operation and management of its tree farms, the Partnership is subject to Federal and State law, including the Washington State Forest Practices Act.  In effect since 1974, and augmented over time, including the 1999 passage of the Forest and Fish Law, Washington State’s forest practice regulations are among the most rigorous in the nation.  In 2006, and in concert with the Forest and Fish Law, Washington State received a Federal multi-species Habitat Conservation Plan designation covering its forest regulations, meant to give timberland owners 50 years of regulatory stability.  Management’s objective is to be in compliance with state and Federal laws and regulations at all times.  New information based on scientific findings may result in some new or modified regulations within the adaptive management features of the Forest Practices Act, which may result in additional restrictions to the timber operations of the Partnership.  This could in turn result in increased costs, additional capital expenditures, and reduced operating flexibility.  Management believes that the Partnership’s operating practices, assets and properties are in material compliance with all applicable Federal, state and local laws, regulations and ordinances applicable to its business.  However, there can be no assurance that future legislative, governmental, or judicial decisions will not adversely affect the Partnership’s operations.  In particular, recent and well-publicized flooding and environmental damage associated with existing forestry management practices may cause Federal or state officials to impose more stringent requirements and limitations on timberland management, which may have the effect of increasing our production costs, reducing our productive acres, or both.

 
13

 
 
Regulatory Structure.  The growing and harvesting of timber is subject to numerous laws and government policies to protect the environment, non-timber resources such as wildlife and water, and other social values.  Changes in those laws and policies can significantly affect local or regional timber harvest levels and market values of timber-based raw materials.  Real estate development activities are also subject to numerous state and local regulations such as the Washington State Growth Management Act.  In addition, the Partnership is subject to Federal, state, and local pollution controls (with regard to air, water and land), solid and hazardous waste management, disposal and remediation laws, and regulations in each segment and all geographic regions in which it has operations.

Washington State Growth Management Act (GMA).  Land holdings throughout Washington State are affected by the GMA, which requires counties to submit comprehensive plans that identify the future direction of growth and stipulate where population densities are to be concentrated.  The purposes of the GMA include: (1) direction of population growth to population centers (Urban Growth Areas), (2) reduction of “suburban sprawl”, and (3) protection of historical sites.  The Partnership works with local governments within the framework of the GMA to develop its real estate holdings to their highest and best use.

Forestry Management Practices.  Forest practice acts in some U.S. states increasingly affect present or future harvest and forest management activities.  For example, in some states, these rules have one or more of the following impacts: limiting the size of clear-cut harvest units, requiring some timber to be left unharvested to protect water quality and fish and wildlife habitat, regulating construction and maintenance of forest roads, requiring reforestation following timber harvest, and providing for procedures for state agencies to review and approve proposed forest practice activities.  Federal, state, and local regulations protecting wetlands could affect future harvest and forest management practices on some of the Partnership’s timberlands.

Each state in which the Partnership owns or manages timberlands has developed “best management practices” to reduce the effects of forest practices on water quality and aquatic habitats.  Additional, more stringent regulations may be adopted in order to achieve the following: enhance water quality standards under the Federal Clean Water Act, protect fish and wildlife habitat, or advance other public policy objectives.

In the State of Washington, the Forests & Fish Law became the basis for revised Forest Practices Rules and Regulations that were adopted in 1999 and finalized in 2001.  The Washington Forest Protection Association produced the Forest and Fish Report through the collaborative efforts of Washington State’s private landowners, Federal, state and county governments, and Native American tribes.  The goals of these revised rules are to:

 
·
Provide compliance with the Endangered Species Act (ESA) for aquatic and riparian dependent species on private forest lands;
 
·
Restore and maintain riparian habitat on private land to support a harvestable supply of fish;
 
·
Meet the requirements of the Clean Water Act for water quality on private forest lands; and
 
·
Keep the timber industry economically viable in the State.

The proposed Water Quality Standards that the Washington State Department of Ecology adopted in 2003 have undergone Department of Ecology and public scrutiny.  As such, these rules should be sufficient to comply with the Anti-Degradation Implementation Plan as described in the Clean Water Act.  In June 2006, the U.S. Fish & Wildlife Service and NOAA Fisheries signed the Forest Practices Habitat Conservation Plan (HCP).  The HCP is a statewide program protecting 60,000 miles of streams on 9.3 million acres of forestland, set in motion by the Forests & Fish Law.  It ensures landowners that practicing forestry in Washington State meets the requirements for aquatic species designated by the federal Endangered Species Act.

 
14

 
 
The regulatory and non-regulatory forest management programs described above have increased operating costs and resulted in changes in the value of timber and logs from the Partnership’s timberlands.  These kinds of programs also can make it more difficult to respond to rapid changes in markets, extreme weather or other unexpected circumstances.  One additional effect may be further reductions in usage of (and some substitution of other products for) lumber and plywood.  Management does not expect the Partnership to be disproportionately affected by these programs as compared with typical timberland owners.  Likewise, management does not expect that these programs will significantly disrupt its planned operations over large areas or for extended periods.

Water Quality.  The U.S. Environmental Protection Agency also promulgated regulations in 2000 requiring states to develop total maximum daily load (“TMDL”) allocations for pollutants in water bodies that have been determined to be “water quality impaired.”  The TMDL requirements set limits on pollutants that may be discharged to a body of water or set additional requirements, such as best management practices for nonpoint sources, including timberland operations, to reduce the amounts of pollutants in water quality impaired bodies of water.  These requirements have impacted tree farming principally through rules requiring tree farms to better minimize silt caused by roads, harvest units and other management activities from coming in contact with water quality impaired bodies of water.  TMDL targets will be established for specific water bodies in the states where the Partnership operates and these targets will be set so as to achieve water quality standards within 10 years, when practicable.  It is not possible at this time to either estimate the capital expenditures that may be required for the Partnership to stay below the targets until a specific TMDL is promulgated or to determine whether these expenditures will have a material impact on the Partnership’s financial condition or results of operations.

Endangered Species and Habitats.  A number of fish and wildlife species that inhabit geographic areas near or within Partnership timberlands have been listed as threatened or endangered under the Federal Endangered Species Act (ESA) or similar state laws in the United States.  Federal ESA listings include the northern spotted owl, marbled murrelet, numerous salmon species, bull trout and steelhead trout in the Pacific Northwest.  Listings of additional species or populations may result from pending or future citizen petitions or be initiated by Federal or state agencies.  Federal and state requirements to protect habitat for threatened and endangered species have resulted in restrictions on timber harvest on some timberlands, including some timberlands of the Partnership.  Additional listings of fish and wildlife species as endangered, threatened, or sensitive under the ESA and similar state laws as well as regulatory actions taken by Federal or state agencies to protect habitat for these species may, in the future, result in the following: an increase in operating costs; additional restrictions on timber harvests; impacts to forest management practices or real estate development activities; and potential impact on timber supply and prices.

Item 1A.
RISK FACTORS
 
We have certain environmental remediation liabilities associated with our Port Gamble property, and those liabilities may increase.  We own certain real estate at Port Gamble on the Kitsap Peninsula in western Washington.  We are party to an agreement with P&T, pursuant to which we, along with P&T, allocated responsibility for cleanup costs.  Under Washington law, both Pope Resources and P&T are “potentially liable persons” based on ownership and/or operation of the site.  These laws provide for joint and several liability among parties owning or operating property on which contamination occurs, meaning that cleanup costs can be assessed against any or all such parties.  Our agreement with P&T was intended to apportion responsibility based on this principle, with P&T bearing the larger share of responsibility based upon their role in operating the site and upon their relatively lengthy ownership.

 
15

 
 
In response to an October 2007 bankruptcy filing by P&T in Canada and a November 2007 Chapter 11 bankruptcy filing by P&T in the United States we recorded a $1.9 million charge to earnings in the fourth quarter of 2007 to increase our environmental remediation liability for Port Gamble.   This charge reflects P&T’s inability to complete their portion of the remediation that had not been completed.  In May 2008, a bankruptcy judge approved a request from P&T to convert the Chapter 11 reorganization to a Chapter 7 liquidation plan. In August 2008, this was subsequently converted to Chapter 15 liquidation of the remaining P&T assets. We are in active discussions with the Washington State Department of Ecology to promote protection of the environment, optimize and appropriately allocate the remaining cleanup liabilities, and maximize our control over the remediation process.
 
Management continues to monitor the Port Gamble cleanup process closely.  The $1.6 million remediation liability balance as of December 31, 2008 represents our best current estimate of the remaining cleanup cost and most likely outcome to various contingencies within the overall project.  However the balance is based upon a number of estimates and judgments that may change as the project progresses.
 
We may incur liabilities as a result of natural disasters that may occur, or be alleged to have occurred, on properties adjacent to our timberland. During periods of unusually heavy rain and snowmelt, flooding and mudslides may damage homes and personal property. Some of these incidents may happen down slope from and/or adjacent to our tree farms. While management believes we follow sound management and risk mitigation procedures, and all forest operations meet or exceed the rules and regulations governing forest practices in the State of Washington, we cannot be certain that we will not be the subject of claims based on allegations that we acted improperly in managing our property. These claims may take the form of individual or class action litigation, regulatory or enforcement proceedings, or both. Any such claims could likely result in substantial defense costs and could divert management’s attention from the ongoing operation of our business, and if any such claims were successful, could result in substantial damages awards in favor of property owners, fines or civil money penalties imposed by forestry regulators, or both.

We compete with a number of larger competitors that may be better able than we to absorb the effects of price fluctuations, may be able to expend greater resources on production, may have greater access to capital, and may operate more efficiently than we can.  We compete against much larger companies in each of our business segments.  We compete with these companies for management and line personnel, as well as for purchases of relatively scarce capital assets such as land and standing timber and for sales of our products.  These larger competitors may have access to larger amounts of capital and significantly greater economies of scale, and they may be better able to absorb the risks of our line of business.  Moreover, the timber industry has experienced significant consolidation in recent years and, as that consolidation occurs, our relative market share decreases and the relative financial capacity of our competitors’ increases.  While management believes the Partnership is at a competitive advantage over some of these companies because of our lack of vertical integration into forest products manufacturing, our advantageous tax structure, and management’s attempts to diversify our asset base, we cannot assure readers that competition will not have a material and adverse effect on our results of operations or our financial condition.
 
Consolidation of sawmills in our geographic operating area may reduce competition among our customers, which could adversely affect our log prices.  In the past we have experienced, and may continue to experience, consolidation of sawmills in the Pacific Northwest.  Because a portion of our cost of sales in our Fee Timber segment consists of transportation costs for delivery of logs to domestic sawmills, it becomes increasingly expensive to transport logs over longer distances for sales in domestic markets.  As a result, a reduction in the number of sawmills, or in the number of sawmill operators, may reduce competition for our logs, may increase our transportation costs, or both.  These consolidations thus may have a material adverse impact upon our Fee Timber revenue or income and, as that segment has traditionally represented our largest business unit, upon our results of operation and financial condition as a whole.

 
16

 

We are sensitive to demand and price issues relating to our sales of logs in both domestic and foreign markets.  We generate Fee Timber revenue primarily by selling softwood logs to domestic mills and to third-party intermediaries who resell them to the export market.  The domestic market for logs in the Puget Sound region of Washington State depends heavily on housing starts.  Recent economic events have dramatically slowed housing starts, which has reduced demand for lumber.  In addition, imported lumber from Canada and increasing market acceptance of engineered wood products have acted to hold down the price of lumber. These factors have had the effect of concentrating mill ownership in larger, more efficient, mill operators and decreasing the number of mills operating in the Puget Sound region.  These characteristics have resulted in a decrease in local demand for logs, which in turn has decreased our profitability.  To the extent the housing crisis continues or deepens the negative impacts on our operating results will continue.  In addition, the settlement of a dispute under the North American Free Trade Agreement, alleging unfair trade practices related to sales of Canadian softwoods into the United States, may result in an increase in the volume of timber available in domestic log markets, which could adversely impact log prices and, derivatively, our Fee Timber revenue.  Over the past decade, we have seen log prices erode in the Japanese market as competing logs and lumber from regions outside of the United States and engineered wood products have gradually gained market acceptance.  These export markets for Pacific Northwest logs are significantly affected by fluctuations in United States and Japanese economies, as well as by the foreign currency exchange rate between the Japanese yen and the U.S. dollar, and ocean transportation costs.
 
We are subject to statutory and regulatory risks that currently limit, and may increasingly limit, our ability to generate Fee Timber and Real Estate income.  Our ability to grow and harvest timber can be significantly impacted by legislation, regulations or court rulings that restrict or stop forest practices.  For example, recent storm events have brought increasing public attention to stability of slopes during extreme weather events.  Additional regulations surrounding operating activities conducted on and around slopes may make it more difficult for us to harvest timber and may reduce the amount of harvestable timber on our properties.  These and other restrictions on logging, planting, road building, fertilizing, managing competing vegetation and other activities can significantly increase the cost or reduce available inventory thereby reducing income.  These regulations are likely to have a similar effect on our Timberland Management & Consulting operations.  Moreover, the value of our real estate investments, and our income from Real Estate operations, are sensitive to changes in the economic and regulatory environment, as well as various land-use regulations and development risks, including the ability to obtain the necessary permits and zoning variances that would allow us to maximize the revenue from our real estate investments.  Our real estate investments are long-term in nature, which raises the risk that unforeseen changes in the economy or laws surrounding development activities may have an adverse affect on our investments.  Moreover, these investments often are highly illiquid and thus may not generate cash flow if and when needed to support our other operations.
 
We and our customers are dependent upon active credit markets to fund operations.  We sell logs from our Fee Timber segment to mills and log brokers that in most circumstances rely upon an active credit market to fund their operations.  Our Real Estate sales are also often dependent upon credit markets in order to fund acquisitions.  To the extent the ongoing economic crisis exacerbates existing borrowing restrictions that impact many of our customers, we expect those customers to respond by reducing their expenditures, and those reductions may have the effect of directly reducing our revenues and of indirectly reducing the demand for our products. Any such outcomes could materially and adversely impact our results of operations, cash flows, and financial condition.
 
We have two timberland mortgages with 2011 maturations that may be challenging to refinance. The Partnership has a low level of leverage relative to our asset base; however, we do have two timberland mortgages with a balance owed of $29.1 million at December 31, 2008.  These mortgages mature in 2011 with an expected amount due of $26.6 million.  During 2008 credit markets weakened considerably which has had both direct and indirect impacts on our operations and to the extent these circumstances continue our operating results will be adversely affected and our ability to refinance our timberland mortgages in 2011 could be impaired.

 
17

 

We are controlled by our managing general partner.  As a limited partnership, substantially all of our day-to-day affairs are controlled by our managing general partner, Pope MGP, Inc.  The board of directors of Pope MGP, Inc. serves as our board of directors, and by virtue of a stockholder agreement, the shareholders of Pope MGP, Inc., Emily T. Andrews and Peter T. Pope, each have the ability to designate one of our directors and to veto the selection of each of our other directors, other than our chief executive officer, who serves as a director by virtue of his executive position.  Unitholders may remove the managing general partner only in limited circumstances, including, among other things, a vote of the holders of a two-thirds majority of the “qualified units,” which means the units that have been owned by their respective holders for at least five years prior to such vote.  By virtue of the terms of our agreement of limited partnership, as amended, or “partnership agreement”, our managing general partner directly, and Mrs. Andrews and Mr. Pope indirectly, have the ability to prevent or impede transactions that would result in a change of control of the Partnership; to prevent or, upon the approval of limited partners holding a majority of the units, to cause, the sale of the assets of the Partnership; and to cause the Partnership to take or refrain from taking certain other actions that you might otherwise perceive to be in the Partnership’s best interest.  Under our partnership agreement, we are required to pay to Pope MGP, Inc., an annual management fee of $150,000, and to reimburse Pope MGP, Inc., for certain expenses incurred in managing our business.  The managing general partner also receives a special allocation of profits from our investor portfolio management business. No such allocations were earned in 2008 and 2007.  Reimbursements for expenses totaled $8,000 in 2008 and $21,000 in 2007.
 
We benefit from certain tax treatment accorded to master limited partnerships, and if that status changes the holders of our units may realize less advantageous tax consequences.  The Partnership is a Master Limited Partnership (MLP) and is therefore not generally subject to U.S. federal income taxes.  If that changed due to a change in tax law (or interpretation of current tax law) such that the Partnership became subject to income taxes, operating results would be adversely affected.  We also have two taxable subsidiaries.  The estimation of income tax expense and preparation of income tax returns requires complex calculations and judgments.  We believe the estimates and calculations used in this process are proper and reasonable but if a Federal or state taxing authority disagreed with the positions we have taken, a material change in provision for income taxes, net income, or cash flows could result.
 
 
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Item 1B.  UNRESOLVED SECURITIES AND EXCHANGE COMMISSION COMMENTS

None

Item 2. 
PROPERTIES

The following table reconciles acreage owned as of December 31, 2008 to acreage owned as of December 31, 2007.  As noted previously we own 20% of the Funds, and this table excludes the 24,000 acres of timberland purchased by Fund I in the fourth quarter of 2006.  Properties are typically transferred from Fee Timber to the Real Estate segment at the point in time when the Real Estate segment takes over responsibility for managing the properties with the goal of maximizing the properties’ value upon disposition.

Description
 
2007
   
Transfers
   
Acquisitions
   
Sales
   
2008
 
Timberland:
                             
Hood Canal tree farm (1)
    70,284       (36 )     444       (115 )     70,577  
Columbia tree farm (2)
    42,981       -       736       -       43,717  
    Total Timberland
    113,265       (36 )     1,180       (115 )     114,294  
Land held for sale:
                                       
Bremerton - Wright Creek  (3)
    3       -       -       -       3  
Hansville
    15       (5 )     -       -       10  
Lost Highway Parcel 1
    25       (1 )     -       (24 )     -  
Oak Bay
    -       40       -       -       40  
Quilcene
    29       -       -       (29 )     -  
Tarbo 24
    -       24       -       (24 )     -  
Timberland Ridge
    40       -       -       -       40  
    Subtotal land held for sale
    112       58       -       (77 )     93  
Land held for development:
                                       
Bremerton - Wright Creek  (3)
    40       -       -       -       40  
Gig Harbor - Harbor Hill (4)
    251       -       -       -       251  
Homestead
    38       -       -       -       38  
Jefferson County
    84       -       -       -       84  
Kingston - Arborwood
    356       -       -       -       356  
Kingston - 5-Acre zoning
    366       -       -       -       366  
Lost Highway Parcel 2
    25       (1 )     -       (24 )     -  
Nursery Hansville
    53       -       -       -       53  
Oak Bay
    205       (40 )     -       -       165  
Hansville
    137       5       -       -       142  
Port Gamble townsite
    170       -       -       -       170  
Shine Canyon
    69       -       -       -       69  
Port Ludlow
    258       10       -       -       268  
Tarboo Easement
    160       -       -       -       160  
Timberland Ridge
    96       2       -       -       98  
Walden
    120       -       -       -       120  
Other
    49       2       -       -       51  
Subtotal land held for development
    2,477       (22 )     -       (24 )     2,431  
Total Real Estate Acres
    2,589       36       -       (101 )     2,524  
Grand Total Acres
    115,854       -       1,180       (216 )     116,818  
 
(1) This property is used as collateral for the Partnership's $29.1 million timberland mortgages.
(2) 2007 balance includes a four-acre adjustment related to a 2007 property sale.
(3) This property is used as collateral for the Partnership's $104,000 of Local Improvement District debt.
(4) This property is used as collateral for the Partnership's $208,000 of Local Improvement District debt.

 
19

 

The following table provides dwelling unit (DU) per acre zoning for the Partnership’s owned timberland and development properties as of December 31, 2008 and land sold during 2008:

   
Current Land Inventory (acres)
   
2008 Land Sales
 
Zoning Designation
 
Real Estate
   
Fee Timber
   
Totals
   
Acres
   
$/Acre
   
Total Sales
 
Urban zoning
    317       -       317       -     $ -     $ -  
1 DU per 5 acres
    420       848       1,268       80       7,950       636,000  
1 DU per 10 acres
    259       485       744       -       -       -  
1 DU per 20 acres
    1,149       16,193       17,342       136       7,279       990,000  
1 DU per 40 acres
    -       2,163       2,163       -       -       -  
1 DU per 80 acres
    186       40,149       40,335       -       -       -  
Forest Resource Lands
    -       54,203       54,203       -       -       -  
Open Space
    193       253       446       -       -       -  
Total
    2,524       114,294       116,818       216     $ 7,528     $ 1,626,000  

Item 3. 
LEGAL PROCEEDINGS

None.

Item 4. 
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the Partnership’s limited partners during the fourth quarter of 2008.

 
20

 
PART II

Item 5.
MARKET FOR REGISTRANT’S UNITS, RELATED SECURITY HOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Certain information respecting trades in the Partnership’s equity securities is quoted on the NASDAQ.  In April 2008, our ticker symbol on the NASDAQ changed to “POPE”.  For many years, the Partnerships units traded under the ticker symbol POPEZ.  The following table sets forth the 2006 to 2008 quarterly ranges of low and high prices, respectively, for the Partnerships units together with per unit distribution amounts by the period in which they were paid:
 
   
High
   
Low
   
Distributions
 
 Year Ended December 31, 2006
                 
 First Quarter
    36.00       30.00       0.25  
 Second Quarter
    34.70       30.10       0.25  
 Third Quarter
    33.10       30.04       0.28  
 Fourth Quarter
    35.59       31.54       0.28  
 Year Ended December 31, 2007
                       
 First Quarter
    50.01       34.25       0.28  
 Second Quarter
    49.41       36.41       0.28  
 Third Quarter
    50.00       37.60       0.40  
 Fourth Quarter
    48.00       38.17       0.40  
 Year Ended December 31, 2008
                       
 First Quarter
    38.50       34.01       0.40  
 Second Quarter
    37.50       32.01       0.40  
 Third Quarter
    34.00       28.06       0.40  
 Fourth Quarter
    28.48       15.00       0.40  

Unitholders

As of January 31, 2009, there were 309 holders of record for 4,596,141 outstanding units.  Units outstanding exclude 61,875 units granted to management and the board of directors that are currently restricted from trading.  The trading restriction for these units is lifted as the units vest.  Ordinarily these grants vest 50% on the third anniversary of the grant date and the remaining 50% on the fourth anniversary of the grant date.

Distributions

All cash distributions are at the discretion of the Partnerships managing general partner, Pope MGP, Inc. (the “Managing General Partner”).  During 2008, the Partnership made four quarterly distributions of 40 cents per unit, totaling $7.4 million in the aggregate.  During 2007, the Partnership made two quarterly distributions of 28 cents per unit and two quarterly distributions with each at 40 cents per unit, reflecting aggregate distributions totaling $6.4 million.

In recognition of the current economic environment, including extremely challenging log markets and the absence of an active market for raw and developed land, the Partnership reduced its first quarterly distribution in 2009 to 20 cents per unit. The Managing General Partner, in its discretion, determines the amount of the quarterly distribution and plans to re-consider distribution levels quarterly during 2009. The Partnership recognizes that current economic conditions warrant a heightened sensitivity to the management of cash balances. As such, the quarterly determination of distribution amounts, if any, will reflect the expectations of management and the Managing General Partner for the Partnership’s liquidity needs given the reduction in anticipated harvest volume coupled with log prices at historic lows and a stagnant market for our real estate.

 
21

 

Equity Compensation Plan Information

The Partnership maintains the Pope Resources 2005 Unit Incentive Plan, which authorizes the granting of nonqualified equity compensation in order to provide incentives to align the interests of management and other employees with those of unitholders. Pursuant to the plan, the Partnership issues restricted unit grants with 50% vesting on the third anniversary of the grant date and 50% vesting on the fourth anniversary. As of December 31, 2008 there were outstanding restricted units totaling 61,875 units, of which none were vested and of which 16,375 units vest in 2009. Previously, the Partnership maintained the Pope Resources 1997 Unit Option Plan pursuant to which unit options were granted for purposes similar to the 2005 incentive plan. Upon the adoption of the 2005 Unit Incentive Plan, the Partnership ceased making further awards under the 1997 plan. As of December 31, 2008 there were options outstanding for the purchase of 166,053 units, all of which were vested.

Repurchase of Equity Securities

On October 31, 2007, the Partnership announced the adoption of a unit repurchase plan which commenced November 1, 2007.  Under the 2007 repurchase plan, the Partnership repurchased limited partner units having an aggregate value of $5 million.  Partnership unit repurchases under the 2007 plan were as follows:
 
2007 $5.0 million unit repurchase plan
 
   
2007
   
2007
   
2008
   
2008
   
2008
   
2008
 
Month
 
November
   
December
   
January
   
February
   
March
   
April
 
Total number of units purchased
    9,321       22,335       41,221       41,064       12,013       3,003  
Average price paid per unit
  $ 42.15     $ 43.94     $ 36.96     $ 38.21     $ 37.19     $ 34.53  
Total number of units purchased as part of publicly announced plans or programs
    9,321       31,656       72,877       113,941       125,954       128,957  
Approximate dollar value remaning to purchase units under the announced plans or programs ($000's) *
  $ 4,607     $ 3,626     $ 2,103     $ 534     $ 87       -  
* Total amount of repurchase plan less cumulative repurchases

On December 10, 2008 we announced an additional unit repurchase plan under which the Partnership may repurchase limited partner units with an aggregate value of up to $2.5 million.  The unit repurchase period commenced on December 10, 2008 and is to continue for up to one year.  Partnership unit repurchases under the 2008 plan through the end of Fiscal 2008 were as follows:
 
2008 $2.5 million unit repurchase plan
 
   
2008
 
Month
 
December
 
Total number of units purchased
    15,252  
Average price paid per unit
  $ 19.44  
Total number of units purchased as part of publicly announced plans or programs
    15,252  
Approximate dollar value remaining to purchase units under the announced plans or programs ($000's) *
  $ 2,203  
         
* Total amount of repurchase plan less cumulative repurchases
       
 
 
22

 

As of February 16, 2009 we had repurchased 18,526 units under the $2.5 million unit repurchase plan for a total of approximately $363,000.

Performance Graph

The following graph shows a five-year comparison of cumulative total unitholder returns for the Partnership, the Standard and Poor’s Forest Products Index and the Wilshire 4500 for the five years ended December 31, 2008.  The total unitholder return assumes $100 invested at the beginning of the period in the Partnership’s units, the Standard and Poor’s Forest Products Index, and the Wilshire 4500.  The graph assumes distributions are reinvested.

 
      12/03       12/04       12/05       12/06       12/07       12/08  
                                                 
Pope Resources
    100.00       165.28       210.03       239.91       308.76       152.80  
S&P 500
    100.00       110.88       116.33       134.70       142.10       89.53  
S&P Smallcap 600
    100.00       122.65       132.07       152.04       151.58       104.48  
S&P Forest Products
    100.00       112.98       115.30       121.56       131.07       57.09  
Dow Jones Wilshire 5000
    100.00       112.48       119.65       138.52       146.30       91.83  
Dow Jones Wilshire 4500
    100.00       118.10       129.94       149.80       157.88       96.26  

Copyright © 2009 Standard & Poor's, a division of The McGraw-Hill Companies Inc. All rights reserved. Copyright © 2009 Dow Jones & Company. All rights reserved.

 
23

 

Issuance of Unregistered Securities

The Partnership did not conduct any unregistered offering of its securities in 2008.

Item 6. 
SELECTED FINANCIAL DATA

Actual Results.  The financial information set forth below for each of the indicated years is derived from the Partnerships audited consolidated financial statements.  This information should be read in conjunction with the consolidated financial statements and related notes included with this report.

The measure of free cash flow provides users of financial statements a benchmark for the amount of cash available for distributions and investments after making debt payments and recurring capital expenditures.  Since this measure starts with cash provided by operations, it does not include the increases or decreases resulting from changes in working capital that are included in operating cash flow presented on the Statement of Cash Flows.  The Partnership has used the method detailed below for calculating free cash flow.  Management recognizes that there are varying methods of calculating free cash flow and has provided the calculation below to aid investors that are attempting to reconcile between those different methods.

 
24

 
 
(Dollars in thousands, except per unit data)
 
Year Ended December 31,
 
 
 
2008
   
2007
   
2006
   
2005
   
2004
 
Statement of operations data
                             
Revenue:
                             
Fee Timber
  $ 23,551     $ 35,514     $ 35,260     $ 44,424     $ 33,571  
Timberland Management & Consulting
    944       1,344       3,670       7,764       1,601  
Real Estate
    3,683       15,037       27,320       4,818       4,476  
Total revenue
    28,178       51,895       66,250       57,006       39,648  
                                         
Operating income/(loss):
                                       
Fee Timber
    6,294       15,215       14,592       16,320       15,126  
Timberland Management & Consulting
    (543 )     (883 )     1,266       3,540       (598 )
Real Estate (1)
    (1,111 )     5,163       13,864       1,270       1,586  
General and Administrative
    (3,951 )     (4,782 )     (3,817 )     (3,651 )     (2,986 )
Total operating income
    689       14,713       25,905       17,479       13,128  
                                         
Net income
    1,162       15,508       24,910       13,684       10,176  
                                         
Earnings per unit – diluted
  $ 0.25     $ 3.21     $ 5.23     $ 2.88     $ 2.22  
                                         
Distributions per unit
  $ 1.60     $ 1.36     $ 1.06     $ 0.80     $ 0.44  
                                         
Balance sheet data
                                       
Total assets
    165,411       179,325       180,282       106,358       94,868  
Long-term debt
    28,169       29,385       30,866       32,281       34,164  
Partners’ capital
    87,817       96,644       87,605       66,405       54,533  
Debt to total capitalization
    25 %     24 %     27 %     34 %     40 %
                                         
Free cash flow (2):
                                       
Cash provided by operations
    7,403       21,981       43,571       28,909       17,854  
Plus:
                                       
Change in operating accounts and non-cash charges (3)
    1,062       2,930       (3,935 )     (3,539 )     (1,717 )
Less:
                                       
Principal payments
    1,342       1,481       1,675       1,883       1,979  
Capital expenditures, net of
                                       
timberland acquisitions (4)
    5,166       12,162       12,177       6,756       3,260  
Free cash flow
    1,957       11,268       25,784       16,731       10,898  
                                         
Other data
                                       
Acres owned/managed (thousands)
    405       430       433       556       121  
Fee timber harvested (MMBF)
    38       55       55       74       60  

(1)
Real Estate operating income in 2007, 2006, and 2005 includes $1,878,000, $260,000 and $198,000, respectively, of environmental remediation charges related to Port Gamble.
(2)
Management considers free cash flow to be a relevant and meaningful indicator of liquidity and earnings performance commonly used by investors, financial analysts and others in evaluating companies in its industry and, as such, has provided this information in addition to the generally accepted accounting principle-based presentation of cash provided by operating activities.
(3)
Non-cash charges exclude cost of land sold, depletion, depreciation and amortization because they are already factored into cash provided by operations.
(4)
The Partnership acquired 1,180 and 4,700 acres of timberland in 2008 and 2004, respectively, and Fund I acquired 24,000 acres of timberland in 2006.  The cost of these acquisitions was not included in the calculation of free cash flow.

 
25

 
 
Item 7. 
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
This report contains a number of projections and statements about our expected financial condition, operating results, and business plans and objectives.  These statements reflect managements estimates based upon our current goals, in light of managements knowledge of existing circumstances and expectations about future developments.  Statements about expectations and future performance are “forward looking statements” which describe our goals, objectives and anticipated performance.  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.  Other issues that may have an adverse and material impact on our business, operating results and financial condition include our ability to accurately estimate the potential for environmental remediation costs at Port Gamble; the impacts of natural disasters on our timberlands and on surrounding areas; credit and economic conditions that affect demand for our products; and environmental and land use regulations that limit our ability to harvest timber and develop property. From time to time we identify other risks and uncertainties in our other filings with the Securities and Exchange Commission.  The forward-looking statements in this report reflect our estimates as of the date of the report, and we cannot undertake to update these statements as our business operations and environment change.

This discussion should be read in conjunction with the Partnerships audited consolidated financial statements included with this report.

EXECUTIVE OVERVIEW

Pope Resources, A Delaware Limited Partnership (“we” or the Partnership), was organized in late 1985 as a result of a spin-off by Pope & Talbot, Inc. (“P&T”).  We are engaged in three primary businesses.  The first, and by far most significant segment in terms of owned assets and operations, is the Fee Timber segment.  This segment includes timberlands owned directly by the Partnership and operations of Fund I and to a lesser extent Fund II.  Operations in this segment consist of growing timber to be harvested as logs for sale to domestic manufacturers and to a lesser extent export brokers.  The second most significant business in terms of total assets owned is the development and sale of real estate.  Real Estate activities primarily take the form of securing permits, entitlements, and, in some cases, installing infrastructure for raw land development and then realizing that land’s value by the selling of larger parcels to buyers who will take the land further up the value chain, either to home buyers or to operators and lessors 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 until that project is sold resulting in operating income.  Our third business is raising and investing capital from third parties for private equity timber funds and managing the timberland owned by both these funds and unaffiliated owners.

As of December 31, 2008, we owned 114,000 acres of timberland in western Washington State plus 2,500 acres of real estate held for sale or development.  Our third-party Timberland Management & Consulting services have historically been conducted in Washington, Oregon, and California.

Net income for the year ended December 31, 2008 totaled $1.2 million, or $0.25 per diluted ownership unit, on revenues of $28.2 million.  For the corresponding period in 2007, net income totaled $15.5 million, or $3.21 per diluted ownership unit, on revenues of $51.9 million.  For the year ended December 31, 2008, cash flow from operations was $7.4 million, compared to $22.0 million in 2007.  Net loss for the quarter ended December 31, 2008 totaled $1.4 million, or $0.31 per ownership unit, on revenues of $3.2 million.  This compares to net income of $6.3 million, or $1.30 per diluted ownership unit, on revenues of $17.6 million for the quarter ended December 31, 2007.  Fourth quarter 2007 results include a $1.9 million charge for environmental remediation at Port Gamble.

 
26

 

Our revenues, net income and cash flows are lower than in recent years owing largely to the well-publicized macroeconomic factors that have resulted in a dramatic reduction in housing starts in the United States, and to a much lesser degree in Japan; interest rates; overseas shipping rates; and currency exchange rates, particularly those between the United States and Canada, Japan, and Europe.  Credit markets also have a significant impact on our business as our customers rely on those markets for liquidity.  Housing starts, interest rates, and credit markets reflect or influence the health of the U.S. housing market.  Currency exchange rates influence the competitiveness of our domestic sawmill customers as it relates to imported lumber from Canada, Europe, or the Southern Hemisphere as well as with the competitiveness of our logs in export markets in Asia.  Our export logs are sold to domestic intermediaries who then export the logs.  A favorable US$/yen exchange rate can help these intermediaries compete in the Japanese market with logs that originate from Canada, Russia, or the Southern Hemisphere, thus increasing the price that we are able to realize from the sale of this export-quality log volume.

As an owner and manager of timberland, we focus keenly on three “product” markets: lumber, logs, and timberland.  Each of these markets has unique and distinct market factors so that they do not move up or down in lockstep with each other.  Generally, the lumber market is the most volatile as it responds quickly (even daily) to changes in housing-driven demand and to changes in lumber inventories.  Log markets will in turn be affected by what is happening in the lumber spot markets, but pricing shifts typically adjust monthly rather than daily.  Log price volatility is also moderated because logs are used to produce products besides just lumber (especially pulp).  The market for timberland tends to be less volatile with pricing that lags both lumber and log markets.  This is a function of the longer time horizons utilized by timberland investors where the short-swing fluctuations of log or lumber prices become stabilized in acquisition modeling.  We watch the lumber market because activity there can presage log price changes.  We are in the log market constantly as we negotiate delivery prices to our customers.  The timberland market is important as we are constantly evaluating our own portfolio and its underlying value as well as the opportunities to adjust that portfolio through either the acquisition or disposition of such land.

Management’s major opportunity and challenge is to grow our revenue base profitably.  Our current strategy for adding timberland acreage is centered on our timber fund business model.  For example, Fund I acquired 24,000 acres of timberland in late 2006 and we are currently looking to acquire properties for Fund II.  Each of these funds is owned 20% by the Partnership and we earn both an asset management and on-the-ground timberland management fee from managing these timberlands.  Our real estate challenges center around how and when to “harvest” a parcel of land and capture the optimum value increment by selling the property.

Our consolidated revenue in 2008, 2007, and 2006, on a percentage basis by segment, is as follows:

Segment
 
2008
   
2007
   
2006
 
Fee Timber
    84 %     68 %     53 %
Timberland Management & Consulting
    3 %     3 %     5 %
Real Estate
    13 %     29 %     42 %

Further segment financial information is presented in Note 12 to the Partnerships Consolidated Financial Statements included with this report.

Outlook

We expect 2009 revenue and income to decline from 2008 due to weakness in domestic housing starts and declines in the real estate and credit markets both of which impact the Fee Timber and Real Estate segments.  Our strong balance sheet provides us the opportunity to defer timber harvest and land sales until these markets improve, and management has announced an intention to take that action, reducing our forecasted timber harvest for 2009 by approximately 30% from what we consider to be our sustainable harvest level.  We also plan to look for opportunities to acquire timberland through Fund II at favorable prices during the current market weakness.

 
27

 

We plan to harvest 37 MMBF in 2009 which represents a 30% decline from our estimated sustainable harvest of 52 MMBF.  The decision to defer harvest was made in response to our expectation of continued weakness in log markets resulting from the slowdown in housing starts that is associated with widely publicized declines in the credit and housing markets.  In addition to the planned 32 MMBF harvest from our own lands, we plan to harvest 5 MMBF from Fund I tree farms in 2009.  This represents a 42% reduction from the Fund I sustainable harvest level of 8 MMBF.  Revenue generated by Fund I and II is consolidated into the Partnership’s financial statements.  The 80% interest in the Funds owned by third-party investors is reported beneath operating income and is labeled Minority Interest.  When speaking to inventory, volumes are expressed in millions of board feet, or “MMBF”, while elsewhere in the document, volumes harvested are expressed in thousands of board feet, or “MBF”.

We are also anticipating a decrease in Real Estate operating income, as the market for developable land is expected to remain extremely weak in the Pacific Northwest.  Until the market improves, we expect to concentrate our Real Estate activities primarily on preparing properties for sale through obtaining valuable entitlements and completing infrastructure improvements.

We are currently reviewing General & Administrative and other costs across our business units in an effort to reduce expenses in response to this historic recessionary period.  As a result of these cost reducing efforts, General & Administrative costs in 2009 are expected to decline relative to 2008.

RESULTS OF OPERATIONS

The following table reconciles net income for the years ended December 31, 2008 to 2007 and 2007 to 2006.  In addition to the table’s numeric analysis, the explanatory text that follows describes many of these changes by business segment.

 
28

 

YEAR TO YEAR COMPARISONS
(Amounts in $000's except per unit data)

   
2008 vs. 2007
   
2007 vs. 2006
 
   
Total
   
Total
 
Net income:
           
Year ended December 31, 2008
  $ 1,162        
Year ended December 31, 2007
    15,508     $ 15,508  
Year ended December 31, 2006
            24,910  
Variance
  $ (14,346 )   $ (9,402 )
                 
Detail of earnings variance:
               
Fee Timber
               
Log price realizations (A)
  $ (3,783 )   $ (219 )
Log volumes (B)
    (10,600 )     440  
Harvest & haul
    3,600       (1,203 )
Depletion
    1,355       1,580  
Other Fee Timber
    474       19  
Timberland Management & Consulting
               
Management fee changes
    (176 )     (433 )
Disposition fees
    -       (1,343 )
Other Timberland Mgmnt & Consulting
    548       (373 )
Real Estate
               
Development property sales
    (7,510 )     (7,409 )
Environmental remediation
    1,878       (1,618 )
Timber depletion on HBU sale
    (478 )     -  
Other Real Estate
    (164 )     330  
General & Administrative costs
    831       (965 )
Interest expense
    239       470  
Other (taxes, minority int., interest inc.)
    (560 )     1,322  
Total change in earnings
  $ (14,346 )   $ (9,402 )

(A) Price variance allocated based on changes in price using the current period volume.
(B) Volume variance allocated based on change in sales volume and the average log sales orice for the prior period less variance in log production costs.

 
29

 

Fee Timber

Revenue and Operating Income

Fee Timber revenue is earned primarily from the harvest and sale of logs from the Partnership’s 114,000 acres of fee timberland located in Western Washington and, to a lesser extent, from the lease of cellular communication towers together with the sale of gravel and other forest products that result from timberland operations.  Revenue from the sale of timberland tracts will also appear periodically in results for this segment.  Our Fee Timber revenue is driven primarily by the volume of timber harvested and by the average prices realized on log sales.  In late 2006, Fund I acquired 24,000 acres of timberland with operating activities from these properties beginning in 2007 and consolidated into this discussion of operations.
 
Revenue and operating income for the Fee Timber segment for each year in the three-year period ended December 31, 2008, are as follows (all dollar amounts in millions, harvest volume in thousand board feet).
 
($ Million)
Year ended
 
Log Sale
Revenue
   
Mineral, Cell
Tower & Other
Revenue
   
Total Fee
Timber
Revenue
   
Operating
Income
(loss)
   
Harvest
Volume
(MBF)
 
Pope Resources Timber
  $ 16.7     $ 2.0     $ 18.7     $ 6.7       32,455  
Fund I
    2.4       2.4 *     4.8       (0.4 )     5,293  
2008
  $ 19.1     $ 4.4     $ 23.5     $ 6.3       37,748  
                                         
Pope Resources Timber
  $ 30.5     $ 2.0     $ 32.5     $ 14.8       49,825  
Fund I
    3.0       -       3.0       0.4       5,336  
2007
  $ 33.5     $ 2.0     $ 35.5     $ 15.2       55,161  
                                         
Pope Resources Timber
  $ 33.3     $ 2.0     $ 35.3     $ 14.6       54,533  
Fund I
    -       -       -       -       -  
2006
  $ 33.3     $ 2.0     $ 35.3     $ 14.6       54,533  
 
*Conservation easement sale revenue
 
Fiscal Year 2008 compared to 2007.  Revenue and operating income decreased in 2008 from 2007 due to a combination of less harvest volume and lower log prices partially offset by a $2.4 million conservation easement sale from Fund I.  We planned to decrease our harvest volume in 2008 from 2007 in response to weak log markets.  The decline in log prices is due to weak housing and credit markets experienced in 2008.  Harvest volume in 2008 decreased 32% from 2007.  Average log prices decreased $101 per MBF, or 17%, from log prices realized in 2007.  Operating income in 2008 attributed to the Fee Timber segment decreased $8.9 million, or 59% from 2007.
 
The conservation easement sale completed by Fund I is accounted for in the Fee Timber segment due to our policy of including all operations of Fund I and Fund II in the Fee Timber segment.  Conservation easement sales and land sales from the Hood Canal and Columbia tree farms made to buyers that plan to use the land for purposes other than timber production are accounted for in the Real Estate segment.
 
Fiscal Year 2007 compared to 2006.  Revenue and operating income increased modestly in 2007 from 2006.  The increase in revenue was due to an increase in harvest volume partially offset by a decline in average price realized.  Harvest volume in 2007 increased 1% from 2006 and includes 5,336 MBF harvested by Fund I.  The increase in harvest volume was offset in part by a decline in average log prices of $4 per MBF, or 1%, from log prices realized in 2006.  Operating income in 2007 attributed to the Fee Timber segment increased $623,000, or 4%, from 2006.  This increase was due primarily to a decline in depletion expense in 2007 from 2006.  Harvest volume in 2006 included 6,851 MBF from a separate depletion pool that carried a higher depletion rate than our other depletion pools.
 

 
30

 
 
Log Volume

Log volume sold for each year in the three-year period ended December 31, 2008 is as follows:
  
Volume (in MBF)
2008
% Total
2007
% Total
2006
% Total
Sawlogs
           
Douglas-fir
24,913
66%
35,114
64%
38,954
71%
Whitewood
3,121
8%
6,492
12%
3,800
7%
Cedar
795
2%
2,238
4%
1,075
2%
Hardwoods
977
3%
2,733
5%
3,591
7%
Pulp
           
All Species
7,942
21%
8,584
15%
7,113
13%
             
Total
37,748
100%
55,161
100%
54,533
100%
   
Log volume decreased 32% in 2008 from the 2007 harvest as management sought to reduce volume and preserve our asset value while log, lumber, and housing markets continued to decline throughout 2008.  Spot markets developed at times during the year for pulp and export quality Douglas-fir and white woods.  We took advantage of these spot markets when available but most log markets were extremely weak during the year.  Pulp prices also weakened as 2008 progressed due in part to a surge of available supply of whitewood pulp logs resulting from salvage logging of timber stands damaged in a December 2007 storm event.

Log volume increased 1% in 2007 from the 2006 harvest.  With the weakened market for Douglas-fir sawlogs, as a direct result of the soft housing market, we focused 2007 harvest on units with less Douglas-fir volume and more whitewood, cedar, and pulp.  This allowed us to take advantage of those selected log markets that remained relatively strong.  The export markets for high quality whitewood sawlogs strengthened in 2007 as log exporters were able to identify low cost opportunities to ship logs to Korea.  The market for pulp and cedar strengthened as supplies declined.  This is a common occurrence during weak log and lumber markets.  Wood chips used to manufacture pulp are a by-product of lumber manufacturing so when mills reduce production, fewer wood chips are created thus increasing demand for pulp logs.

Log Prices

We have categorized our sawlog volume by species, which is a significant driver of price realized as indicated by the table below.  The average log price realized by species for each year in the three-year period ended December 31, 2008, is as follows:
 
Price $/MBF
 
2008
 
% Change
 
2007
 
% Change
 
2006
 
Sawlogs
                             
Douglas-fir
  $ 537       -14 %   $ 621       -7 %   $ 669  
Whitewood
    412       -11 %     462