Pope Resources 10-K
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, 2006
 
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 Global Market

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, 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 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, or a non-accelerated filer. See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 in Rule 12b-2 of the Exchange Act.     Large Accelerated______  Filer Accelerated Filer     X     Non-Accelerated Filer ______ 

Indicate by check mark whether the registrant is a shell company (as defined by rule 12b-2 of the Act).
Yes______ No      X       

At June 30, 2006, the aggregate market value of the non-voting equity units of the registrant held by non-affiliates was approximately $133,730,000.

The number of the registrant’s limited partnership units outstanding as of February 16, 2007 was 4,673,121

Documents incorporated by reference: None

 
Pope Resources, A Delaware Limited Partnership
Form 10-K
For the Fiscal Year Ended December 31, 2006
Index
     
     
Part I
 
Page
     
 
3
 
13
 
15
 
16
 
17
 
17
Part II
   
     
 
18
 
20
 
23
46
 
47
  Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 70
 
70
 
71
Part III
   
     
 
72
 
74
 
81
 
83
   
Part IV
   
     
 
84
 
89
 
2

 
PART I

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 the 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 third-party owners of timberlands as well as working to acquire timberland properties on behalf of ORM Timber Fund I, LP (the “Fund”), which has acquired timberlands having an aggregate purchase price of $58 million as of December 31, 2006. Our total equity investment in the Fund is $11.7 million, which represents a 20% interest. 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 10 to our consolidated financial statements included in this report. General information can also be found at www.orm.com. The information contained on 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 which we have held substantially all of since our formation, 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. Operations on the tree farms consist of the growing of timber and the subsequent harvesting and marketing of timber and timber products to both domestic and Pacific Rim markets. The Partnership’s Fee Timber segment produced 53%, 78%, and 85% of the Partnership's consolidated revenue in 2006, 2005, and 2004, respectively.

Beginning in 2007 this segment will also include operations of the Fund, which is consolidated into our financial statements. The Fund acquired 24,000 acres of timberland in the fourth quarter of 2006. Harvest activities from these timberlands are expected to commence late in the first quarter of 2007. We are planning to harvest 5 MMBF from these timberlands in 2007. Harvest and other operations of the Fund are not expected to contribute significantly to income as a separate depletion pool will be applied to this harvest volume. The depletion charge is expected to approximate net stumpage realized from the harvest. Olympic Resource Management LLC is the Fund’s general partner and earns management fees and incurs expenses resulting from managing the Fund.

Inventory. Inventory information discussed below is for the Hood Canal and Columbia tree farms.

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, 2006, the tree farms’ total merchantable inventory volume was estimated to be 392 million board feet (MMBF). The Partnership’s estimated merchantable timber inventory volume as of December 31, 2005 was 427 MMBF. The decline in merchantable inventory on December 31, 2006 versus December 31, 2005 was expected and is primarily a function of the uneven age class distribution of the Partnership’s stands and the accelerated harvest of stands that have been allowed to grow well beyond their economic harvest age on the Hood Canal tree farm.
 
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While merchantable timber inventory is defined as timber in stands that are 35 years of age and older, the Partnership’s stands are not normally at their economic rotation age until after 40 years. Economic rotation age, which varies by species and the soil productivity site index, represents the estimated optimal age to harvest a specific stand of timber. Timber cost and volume is included in the calculation of depletion expense for financial statement purposes at 40 years of age which is consistent with the economic rotation age and our long term harvest plan.

The Partnership’s merchantable inventory as of December 31, 2006 and 2005 is spread between age classes as follows:

 
December 31,
 
Age Class
2006
Volume
(in MMBF)
2005
Volume
(in MMBF)
35 to 39
79
66
40 to 44
67
74
45 to 49
31
26
50 to 54
18
20
55 to 59
57
68
60 to 64
75
84
65+
65
89
 
392
427

Timber inventory volume is estimated using the Partnership's standing timber inventory system, which utilizes annual statistical sampling of the timber (a process called “cruising”) with adjustments made for estimated growth and depletion of areas harvested. The accuracy of this process is monitored by comparing actual harvest volume to the corresponding volume for those stands in the Partnership’s standing 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 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 the Forests and Fish Law that supplements Washington State’s forest practice regulations to provide for expanded riparian management zones and similar buffers, as well as wildlife habitat, and other harvest restrictions. The Partnership annually cruises about 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, 2006 is distributed among species as follows:
 
4

 
Species
Volume
(in MMBF)
 
Percent of total
Douglas-fir
290
 
74
Western hemlock
49
 
12
Western red cedar
13
 
3
Other conifer
14
 
4
Red alder
22
 
6
Other hardwood
4
 
1
Total
392
 
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 ownerships. 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 blocks of acreage 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 March 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.

The Partnership’s tree farms as of December 31, 2006 total nearly 114,000 acres. Of this total, approximately 96,000 acres are 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, 2006, total productive acres are spread by timber age class as follows:

Age Class
 
12/31/2006
Acres
 
%
 
Clear-cut
 
2,425
 
2%
 
0 to 4
 
8,460
 
9%
 
5 to 9
 
12,231
 
13%
 
10 to 14
 
6,438
 
7%
 
15 to 19
 
12,128
 
13%
 
20 to 24
 
16,184
 
17%
 
25 to 29
 
13,525
 
14%
 
30 to 34
 
5,040
 
5%
 
35 to 39
 
5,543
 
6%
 
40 to 44
 
3,684
 
4%
 
45 to 49
 
1,872
 
2%
 
50 to 54
 
941
 
1%
 
55 to 59
 
2,450
 
3%
 
60 to 64
 
3,158
 
3%
 
65+
 
2,389
 
1%
 
   
96,468
 
100%
 
 
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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 updates this plan periodically to take into account changes in timber inventory, including species mix, soil productivity site index, 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. Recent timberland acquisitions stocked primarily with merchantable timber have been harvested over the last two years resulting in incremental harvest volume in excess of our expected long term harvest levels. These incremental harvests are now complete. Annual harvest volume is expected to approximate 49 MMBF in 2007 and for the near future thereafter. Our long-term harvest plan has been reduced from last year due to a number of factors including: refined growth estimates and a reduction in harvestable acres due to land sales and increased riparian management zones.

The Fund’s Timber Inventory. The Fund’s estimated merchantable timber inventory as of December 31, 2006 is 61 MMBF with 49% of this inventory Douglas-fir and 31% western hemlock. The Fund owns 24,000 gross acres of which 20,000 are productive. We plan to harvest 7 MMBF in 2007 from this timberland and will manage the timberland as we do the rest of our timber holdings. As described above, we own 20% of the Fund and earn a management fee for managing this timberland.

Marketing and Markets. We market timber using the manufactured log method, where it engages independent logging contractors to harvest the standing timber and manufacture it into logs that the Partnership then sells on the open market. The Partnership or its subsidiaries 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%.

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.

The Fee Timber segment had two major customers in 2006, Simpson Timber Company and Weyerhaeuser Company, which represented 29% and 19%, respectively, of segment revenue. Similarly, in 2005 the Fee Timber segment had two major customers, Simpson Timber Company and Weyerhaeuser Company, which represented 13% and 12%, respectively, of segment revenue. Mill competition for available log supply is an important factor in the harvest and sale of logs. For a number of years beginning in the mid-1990’s, we observed in our operating areas a trend toward lumber mill ownership consolidation and mill closure. This trend has eased over the last several years with the actual and announced openings of several new mills in the Puget Sound region. Further consolidation of mill ownership in the Puget Sound area could cause a decline in prices realized for the Partnership’s logs. The Partnership delivered logs to over 40 separate customers during 2006.

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.
 
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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, and fertilization. During 2006, the Partnership planted 1,119,000 seedlings on 2,649 acres. This compares to the years 2005 and 2004 in which the Partnership planted 950,000 and 1,136,000 seedlings on 2,290 and 2,700 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.

Sustainable Forestry Initiative (SFI). Since 1993, our timberlands have received SFI certification from the American Forest & Paper Association (AF&PA). That certification is awarded following a third-party audit of the Partnership’s forestry and stewardship practices against those objectives and principles promulgated by the AF&PA. Management views this certification as an important indication of our commitment to manage our lands in a sustainable manner and to continue to treat the assets we own and manage with respect. 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 that address the SFI objectives. The SFI objectives are divided into seven categories: 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.

Management performs an annual self-assessment of its compliance with these objectives, and hires a third-party auditor to perform a summary audit to ensure that our policies address the SFI objectives and that management is following those policies. We were re-certified in 2006.  Certification under SFI is currently a requirement for us to sell 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 its timberland business into the Investor Portfolio Management Business (IPMB). The IPMB has two complementary business strategies: timberland management and timberland investment management. In 1997, the Partnership formed two wholly owned subsidiaries, ORM, Inc. and ORMLLC, to facilitate the IPMB activities.

Operations.  To date, the Timberland Management & Consulting segment’s key operation has been to provide various aspects of timberland management services to third-party timberland owners. The Timberland Management & Consulting segment represents 5%, 14%, and 4% of consolidated revenue for the years ended December 31, 2006, 2005, and 2004, respectively.

Timberland Management. Timberland management provides timberland management, acquisition, and disposition services to timberland 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 in 2005 and 2006 in the state of Washington have reduced the current acres under management for Cascade to approximately 292,000 acres of Oregon timberland. In 2006, Cascade was the Timberland Management & Consulting segment’s major customer, accounting for 83% 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 2009.
 
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Timberland Investment Management. Timberland Investment Management’s goal is to build and manage diversified timberland portfolios for third-party investors. The closing of the Fund in mid-2005 was a significant step toward this objective. We obtained equity capital commitments of $61.8 million, part of which includes the Partnership’s own $12.4 million co-investment commitment. In the fourth quarter of 2006, the Fund was successful in the acquisition of two timberland properties in Washington State with aggregate total acreage of approximately 24,000 acres. Acquisition of these properties placed $57.8 of the Fund’s committed capital, or approximately 94% of the Fund. In addition to serving as general partner, ORMLLC earns a management fee for providing timberland management services to the Fund. As a result of successful placement of this committed capital, we plan to seek additional third-party equity capital and establish a second fund in 2007.
 
Forestry Consulting.  In addition to its timberland management activities, ORMLLC also earns revenue by providing forestry-consulting services to third-party owners and managers of timberland assets in Washington, Oregon, and California.
 
Marketing. ORMLLC pursues third-party timberland management opportunities in the U.S. West 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 2006 includes one client that represented 83% of segment revenue.

Competition. ORMLLC and its subsidiaries compete against both larger and smaller companies providing similar services. There are approximately 15 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. An example of timberland investment management is the Fund. Now that the Fund has acquired timberland properties, both timberland management and asset management fees are earned from administering the Fund. These activities are, as well as the development and marketing costs associated with the Fund, 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 $5,000,000, including debt guarantees. As of December 31, 2006 cumulative expenditures incurred in pursuit of IPMB opportunities, including guarantees, were less than cumulative revenue generated. Therefore, cumulative net expenditures as of December 31, 2006 against the $5,000,000 limit are zero.

Allocation of Income: In addition, 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.

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Real Estate
 
Background. The Partnership's real estate activities are closely associated with the management of its timberlands. Management continually evaluates our timberlands in terms of 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 our 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 to hold it as development property for later development or sale.

Operations. Real Estate operations include work considered by management necessary to maximize the value of the Partnership’s nearly 2,700-acre portfolio of property that management feels has a higher-and-better-use than timberland, and leasing residential and commercial properties in the Port Gamble town site. The former objective is generally obtained by securing the entitlements and/or physical improvements necessary to make development possible. The Real Estate segment represents 42%, 8%, and 11% of consolidated revenue in 2006, 2005, and 2004, respectively.

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 include securing favorable zoning and obtaining final plat approvals to allow for the highest and best use of the properties.

We are working on master planned communities in Gig Harbor, Bremerton, and Kingston, Washington. 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 new activity aimed at a particular portion of the value-spectrum is the development of our “Rural Lifestyles” program through which rural residential lots are marketed both to those individuals intent on owning rural residential lots and to developers interested in building homes in rural locations.

Gig Harbor.  Gig Harbor, a suburb of Tacoma, Washington, is the site of a 327-acre mixed-use development. In 2003, management obtained an amendment to the City of Gig Harbor’s comprehensive plan that converted 35 acres of the property from business-park to commercial zoning. As such, the development plan for the 327-acre project breaks down roughly as follows: 217 acres for residential; 75 acres for business park; and 35 acres for commercial use. In 2006, the Partnership completed the sale of nearly 18 acres of commercial land to Costco Wholesale Corporation, approximately 11 additional acres of business park land to the YMCA, and approximately 6 commercial acres to Northwest Capital Investors (NCI). The sale to NCI was not recognized as revenue in 2006 due to a rescission clause that can be exercised by NCI if we do not complete certain infrastructure improvements. The Partnership is evaluating disposition alternatives for its remaining 11-acres of adjacent commercial lands. In 2006, the Partnership completed construction of the following infrastructure elements necessary to enable closing of sales from the project and to comply with obligations set forth when the property was annexed into Gig Harbor: over a half-mile of road (Harbor Hill Drive); a 2.3 million gallon water tank; off-site traffic improvements (widening of Borgen Boulevard); storm water detention pond; and installation of utilities.

Kingston. The Partnership has a 356-acre primarily residential development project in Kingston called Arborwood. In 2005, management successfully championed the inclusion of the property inside the Kingston Urban Growth Area and increased the property’s potential development density (and value). After a lengthy appeals process, the Central Puget Sound Growth Management Hearings Board validated the expansion of the Urban Growth Area in 2006 to include the Arborwood property with vested Urban Cluster Residential zoning. The Partnership will finalize the master plan and evaluate disposition alternatives in 2007 for the maximum density of 765 residential units. The Partnership owns an additional 366 acres bordering Arborwood for which Kitsap County has an option expiring in 2008 to purchase for use as a county park. This optioned property can be subdivided into 5-acre lots if the County does not exercise its option.
 
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Bremerton. The City of Bremerton approved our request for a planned development on the 264-acre West Hills mixed-use property within the city limits of Bremerton in 1999. The development includes 64 acres of industrial and 200 acres of residential property. In 2006, the Partnership completed the sale of 200 acres of residentially zoned land. As a condition of the sale, the Partnership constructed infrastructure in 2006 to serve the property and has some remaining construction obligations to complete this construction in 2007. The remaining 64 acres of property zoned as industrial park is being constructed in two phases. Construction of the 9 lots (totaling 24 acres) in Phase 1 is expected to be completed and ready for sale in 2007 while commencement of construction on the 15 lots (totaling 40 acres) in Phase 2 will depend on the sales absorption rate for Phase 1.

Rural Residential. Management has launched the Rural Lifestyles program to sell rural residential lots after harvest is completed or with properties that have marginal timber value or are encumbered by extended logging moratoriums. These properties are typically non-contiguous smaller lots ranging in size between 5 and 100 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.

Management intends to build on the success of these disposition efforts and offer a steady supply of rural residential lots to the market that will result in an ongoing revenue stream for the Real Estate segment. We have a target of selling 150 to 300 acres annually from this program but we have exceeded that target range for the last few years as a result of a strong market for this type of land in our marketplace. We expect 2007 rural residential sales to end up at the low end of this targeted range due to softening in our local markets for rural residential land.
 
Commercial Properties

Port Gamble. 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, all the while maintaining the town’s unique architectural character.

A negotiated settlement with P&T in 2002 resulted in the Partnership taking over the former millsite as well as providing for the initiation of environmental cleanup activities, the responsibility for which is being shared between P&T and the Partnership. That agreement represents a significant step toward defining Port Gamble’s future whereby P&T took responsibility of the landfills and Port Gamble Bay and the Partnership took responsibility of 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 will continue in 2007. 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 2006 consisted of marketing residential and commercial real estate for sale and lease.

Customers. Management typically markets its land for sale to private individuals, residential contractors, and developers of commercial property. Customers for Port Gamble townsite rental space consist of both individual and commercial tenants.
 
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Competition. Our 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. Other bulk parcel owners in the Puget Sound area have similar strategies.

Transportation. Land values for our Real Estate portfolio are strongly influenced by transportation limitations 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. The Washington State Department of Transportation has been working for several years to add a new span to the Tacoma Narrows Bridge connecting Tacoma and Gig Harbor. Construction of the new bridge is expected to be completed in the Fall of 2007, however, the existing bridge will undergo renovation during the following year; thus, both bridges are not expected to be completed and open to travelers until the end of 2008.

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 Seattle. In 2004 and extending into 2005, two private companies began offering passenger-only ferry service from the peninsula to Seattle. Kitsap Ferry Company continues in 2006 to operate passenger-only ferry service from Bremerton to Seattle. Aqua Express, however, after offering passenger-only ferry service from Kingston to Seattle during much of 2005, ultimately cancelled the service because of insufficient demand and high fuel costs.

Employees.

As of December 31, 2006, the Partnership employed 51 full-time, year-round salaried employees and 19 part-time and seasonal personnel, who are distributed among the segments as follows:

 
             
Segment
 
Full-Time
 
Part-Time/
Seasonal
 
Total
Fee Timber
 
15
 
4
 
19
Timberland Management & Consulting
 
12
 
12
 
24
Real Estate
 
14
 
3
 
17
General and Administrative
 
10
 
 
10
Totals
 
51
 
19
 
70
 
 
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 Washington State land use and environmental laws. Management's objective is to be in compliance with such laws and regulations at all times. We anticipate that increasingly strict requirements relating to the environment, threatened and endangered species, natural resources, forestry operations, and health and safety matters, as well as increasing social concern over environmental issues may result in additional restrictions on the timber operations of the Partnership. This will 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.

11

 
Regulatory Structure.Growing and harvesting timber are 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.

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, a number of 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; forest management practices or real estate development; and potential impact on timber supply and prices.

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: limit the size of clear-cut harvest units; require some timber to be left unharvested to protect water quality and fish and wildlife habitat; regulate construction and maintenance of forest roads; require reforestation following timber harvest; and contain 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 habitats; or advance other public policy objectives.

In the State of Washington, the Forest and Fish Report 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. 
 
12

 
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 believe that these kinds of programs have had a significant effect on the Partnership’s total timber harvest, although they may have such an effect in the future. Further, 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.

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.

Item 1A. RISK FACTORS

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.
 
13

 
Consolidation of sawmills in our geographic operating area may reduce competition among our customers, which could adversely affect our log prices. We have experienced in the past, 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 prohibitively expensive to transport logs over long 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 our fee timber income and, as that segment has traditionally represented our largest business unit, upon our results of operation and financial condition as a whole.
 
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 that resell to the export market. The domestic market for logs in the Puget Sound region of Washington State has been impacted by imported lumber from Canada and decreased demand for lumber as engineered wood products have gained market acceptance in the United States. These factors have had the effect of concentrating mill ownership with larger mill operators and decreasing the number of mills operating in the Puget Sound region. This characteristic may result in a decrease in local demand for logs, which in turn may decrease our profitability. Over the last few years we have seen log prices erode in the Japanese market as competing logs and lumber from regions outside of the U.S. and engineered wood products have gradually gained market acceptance. These export markets for Pacific Northwest logs are significantly affected by fluctuations in U.S. and Japanese economies, as well as by the foreign currency exchange rate between the Japanese yen and the U.S. dollar. 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 revenues.
 
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 amendments to federal wildlife habitat preservation laws, intended to afford additional protections to the threatened northern spotted owl, 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 and 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 have certain environmental remediation liabilities, and those liabilities may increase. We own certain real estate, and have developed and previously sold other real estate, at the Historic Port Gamble townsite on the Kitsap Peninsula in Western Washington. We are party to an agreement with Pope & Talbot, Inc., pursuant to which we are required to contribute certain environmental costs toward the cleanup of hazardous material released on the Port Gamble townsite. We maintain on our balance sheet an accrual that represents our estimated share of the remediation costs, and we adjust that accrual periodically based on such factors as test results, cleanup cost estimates, and related factors. We increase the reserve if our current estimates of those costs exceed the previously established accrual, and in increasing that reserve we recognize an expense in the period reflecting the adjustment. If our estimates are inaccurate, or if new or previously unknown facts are discovered that increase our share of these costs, we may experience adverse impacts upon our results of operations and financial condition.
 
14

 
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. Among other things, 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 for our chief executive officer, who serves as a director by virtue of his executive position. Unit holders may remove the managing general partner only in limited circumstances, including, among other things, a vote of the holders of a 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 Ms. 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, which allocations earned in 2006 and 2005 were $75,000 and $204,000, respectively. Reimbursements for expenses totaled $6,000 in 2006 and $2,000 in 2005, and we do not expect such reimbursements to decrease materially in 2007.
 
We benefit from certain tax treatment accorded to master limited partnership, 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 a taxable subsidiary corporation. 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.
 
Item 1B. UNRESOLVED SECURITIES AND EXCHANGE COMMISSION COMMENTS
 
None
 
15

Item 2.  PROPERTIES 
 
The following table reconciles acreage owned as of December 31, 2005 to acreage owned as of December 31, 2006. This table excludes the 24,000 acres of timberland purchased by the Fund in the fourth quarter of 2006. As noted previously we own 20% of the Fund. Properties are typically transferred from Fee Timber to the Real Estate segment when they become more valuable as development property than timber property. At that point the Real Estate segment is responsible for managing the properties with the goal of maximizing the properties’ value upon disposition.
   
Owned Acre Totals
 
       
Description
 
2005
 
Transfers
 
Sales
 
Misc (5)
 
2006
 
Office Building
   
G&A
   
Poulsbo headquarters
   
4
         
(1
)
       
3
 
Total Acres used for office space
   
4
         
(1
)
       
3
 
Timberland Property
   
Fee Timber
   
Hood Canal tree farm (2)
 
 
70,547
   
(447
)
       
136
   
70,236
 
Timberland Property
   
Fee Timber
   
Columbia tree farm
   
43,991
   
(106
)
 
(404
)
       
43,481
 
Total Fee Timber Acres
   
114,538
   
(553
)
 
(404
)
 
136
   
113,717
 
Land held for sale
   
Real Estate
   
Gig Harbor -Harbor Hill (4)
 
 
31
   
11
   
(28
)
       
14
 
Land held for sale
   
Real Estate
   
Cowlitz 160
   
   
160
   
(160
)
       
-
 
Land held for sale
   
Real Estate
   
Point No Point
   
20
   
132
               
152
 
Land held for sale
   
Real Estate
   
Lost Highway 1 & 2
   
40
                     
40
 
Land held for sale
   
Real Estate
   
Bremerton - West Hills (3)
 
 
200
   
20
   
(200
)
       
20
 
Land held for sale
   
Real Estate
   
Quilcene
         
27
               
27
 
Land held for sale
   
Real Estate
   
Cowlitz 80
   
10
   
71
   
(81
)
       
-
 
Land held for sale
   
Real Estate
   
Timberland Ridge
   
236
   
(98
)
 
(60
)
 
21
   
99
 
Land held for sale
   
Real Estate
   
Jefferson County HBU
         
34
   
(25
)
       
9
 
Land held for sale
   
Real Estate
   
Sandy Shore 40
         
40
   
(40
)
       
-
 
Land held for sale
   
Real Estate
   
Oak Bay
   
201
   
         
4
   
205
 
Land held for sale
   
Real Estate
   
Other (less than 20 Acres)
 
 
18
   
29
   
(43
)
 
(4
)
 
-
 
 
   
 
                                     
Subtotal land held for sale
   
756
   
426
   
(637
)
 
21
   
566
 
Land held for development
   
Real Estate
   
Gig Harbor - Harbor Hill (4)
 
 
296
   
(11
)
             
285
 
Land held for development
   
Real Estate
   
Kingston - Arborwood
   
356
                     
356
 
Land held for development
   
Real Estate
   
Bremerton - West Hills (3)
 
 
64
   
(20
)
             
44
 
Land held for development
   
Real Estate
   
Port Gamble townsite
   
130
                     
130
 
Land held for development
   
Real Estate
   
Shine Canyon
   
69
                     
69
 
Land held for development
   
Real Estate
   
Timberland Ridge
   
   
98
               
98
 
Land held for development
   
Real Estate
   
Heritage Park Option (1)
 
 
366
                     
366
 
Land held for development
   
Real Estate
   
Tala Point
   
230
   
38
               
268
 
Land held for development
   
Real Estate
   
Walden
         
120
               
120
 
Land held for development
   
Real Estate
   
Tarboo Easement
         
160
               
160
 
Land held for development
   
Real Estate
   
Nursery Hansville
         
53
               
53
 
Land held for development
   
Real Estate
   
Homestead
   
38
                     
38
 
Land held for development
   
Real Estate
   
Jefferson County HBU
         
83
               
83
 
Land held for development
   
Real Estate
   
Other (less than 20 Acres)
 
 
436
   
(370
)
 
(15
)
 
1
   
52
 
Land held for development
   
Real Estate
   
Clark 80
         
80
   
(80
)
       
-
 
Land held for development
   
Real Estate
   
Nisqually
         
28
   
(28
)
       
-
 
Land held for development
   
Real Estate
   
Point No Point
   
132
   
(132
)
             
-
 
 
   
 
   
 
                               
Subtotal land held for development
   
2,117
   
127
   
(123
)
 
1
   
2,122
 
                                             
Total Real Estate Acres
   
2,873
   
553
   
(760
)
 
22
   
2,688
 
                                             
Grand total acres
               
117,415
   
0
   
(1,165
)
 
158
   
116,408
 
 
(1)
Kitsap County has an option to acquire this property that expires in July 2008.
(2)
This property is used as collateral for the Partnership’s $33.2 million timberland mortgage.
(3)
This property is used as collateral for $191,000 of Local Improvement District debt.
(4)
This property is used as collateral for $367,000 of Local Improvement District debt.
(5)
Misc. represents miscellaneous changes resulting from surveys, boundary line adjustments, and acreage quit claimed to others without compensation.
 
16

 
 
The following table provides dwelling unit (DU) per acre zoning for the Partnership’s owned timberland and development properties as of December 31, 2006 and land sold during 2006:

 
                       
Current Land Inventory (acres)
 
2006 Land Sales
         
Zoning Designation
 
Real Estate
 
Fee Timber
   
Totals
   
Acres
 
 
$/Acre
   
Total Sales
Urban zoning
   
778
   
-
   
778
   
237
 
$
94,135
 
$
22,310,000
1 DU per 5 acres
   
250
   
-
   
250
   
40
   
11,550
   
462,000
1 DU per 10 acres
   
456
   
320
   
776
   
160
   
4,688
   
750,000
1 DU per 20 acres
   
500
   
38,200
   
38,700
   
63
   
4,873
   
307,000
1 DU per 40 acres
   
661
   
1,200
   
1,861
   
40
   
4,500
   
180,000
1 DU per 80 acres
   
46
   
42,000
   
42,046
   
625
   
3,675
   
2,297,000
Forest Resource Lands
         
31,997
   
31,997
   
-
   
-
   
-
Total
   
2,691
   
113,717
   
116,408
   
1,165
 
$
22,580
 
$
26,306,000
 
 
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 unit holders during the fourth quarter of 2006.
 
17

 
 
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 Global Market. The Partnership's units trade under the ticker symbol "POPEZ". The following table sets forth the 2006 and 2004 quarterly ranges of low and high prices, respectively, for the Partnership's units:
 
     
High 
   
Low 
   
Distributions  
 
Year Ended December 31, 2004 (Nasdaq Global Market)
             
First Quarter
 
$
24.00
 
$
15.00
 
$
0.07
 
Second Quarter
   
20.74
   
17.14
   
0.07
 
Third Quarter
   
24.00
   
18.02
   
0.15
 
Fourth Quarter
   
25.25
   
19.27
   
0.15
 
Year Ended December 31, 2005 (Nasdaq Global Market)
                   
First Quarter
   
56.85
   
19.35
   
0.15
 
Second Quarter
   
37.68
   
31.10
   
0.15
 
Third Quarter
   
37.00
   
31.30
   
0.25
 
Fourth Quarter
   
32.22
   
27.85
   
0.25
 
Year Ended December 31, 2006 (Nasdaq Global Market)
                   
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
 
 
Unitholders

As of February 16, 2007, there were 241 holders of record for 4,673,121 outstanding units. Units outstanding exclude 55,750 units granted to management that are currently restricted from trading. This restriction will be lifted upon vesting over the next four years.

Distributions

All cash distributions are at the discretion of the Partnership's managing general partner, Pope MGP, Inc. (the “Managing General Partner”). During 2006, the Partnership made two quarterly distributions of twenty-five cents per unit and two quarterly distributions of twenty-eight cents per unit, with the four distributions totaling $5.0 million. During 2005, the Partnership made two quarterly distributions of fifteen cents per unit and two quarterly distributions of twenty-five cents per unit, with the four distributions totaling $3.7 million. Management intends to continue to pay quarterly distributions in 2007 of twenty-eight cents per unit so long as the Managing General Partner, in its discretion, determines this amount to be appropriate. Management will periodically examine distribution levels to ensure it meets the long-term objective of maximizing Partnership value.

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, 2006. 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.

18

 

 
19

 
 
 
Cumulative Total Return
 
   
12/31/2001
   
12/31/2002
   
12/31/2003
   
12/31/2004
   
12/31/2005
   
12/31/2006
 
                                       
POPE RESOURCES
   
100.00
   
69.17
   
107.59
   
177.83
   
225.97
   
258.12
 
S & P 500
   
100.00
   
77.90
   
100.24
   
111.15
   
116.61
   
135.03
 
S & P SMALLCAP 600
   
100.00
   
85.37
   
118.48
   
145.32
   
156.48
   
180.14
 
S & P FOREST PRODUCTS
   
100.00
   
93.84
   
131.85
   
148.96
   
152.02
   
160.27
 
DOW JONES WILSHIRE 5000
   
100.00
   
79.14
   
104.18
   
117.33
   
124.75
   
144.56
 
DOW JONES WILSHIRE 4500
   
100.00
   
82.20
   
118.24
   
140.19
   
154.60
   
179.44
 
                                       
                                       
 
         
12/31/02
 
12/31/03
 
12/31/04
 
12/31/05
 
12/31/06
POPE RESOURCES
         
-30.83
%
 
55.54
%
 
65.28
%
 
27.07
%
 
14.23
%
S & P 500
         
-22.10
%
 
28.68
%
 
10.88
%
 
4.91
%
 
15.80
%
S & P SMALLCAP 600
         
-14.63
%
 
38.79
%
 
22.65
%
 
7.68
%
 
15.12
%
S & P FOREST PRODUCTS
         
-6.16
%
 
40.50
%
 
12.98
%
 
2.05
%
 
5.43
%
DOW JONES WILSHIRE 5000
         
-20.86
%
 
31.64
%
 
12.62
%
 
6.32
%
 
15.87
%
DOW JONES WILSHIRE 4500
         
-17.80
%
 
43.84
%
 
18.57
%
 
10.27
%
 
16.07
%
                                       
Copyright © 2006 Standard & Poor's, a division of The McGraw-Hill Companies, Inc. All rights reserved.
www.researchdatagroup.com/S&P.htm
         
 
Issuance of Unregistered Securities

The Partnership did not conduct any unregistered offering of its securities in 2006.

Repurchase of Equity Securities

The Partnership did not repurchase any of its equity securities in 2006.
 
 
Item 6. SELECTED FINANCIAL DATA

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

The table below includes non-GAAP financial measures including earnings before interest, taxes, depletion, depreciation, and amortization (EBITDDA) and free cash flow. Management believes both of these measures are useful to investors when evaluating the Partnership’s financial performance. EBITDDA is an important measure of operating performance, particularly when comparing results between different timber-owning companies because there are varying methods of calculating depletion expense under GAAP that may yield net and operating income results that are difficult or impossible to compare. With different issuers employing various depletion methodologies, disclosure of EBITDDA can facilitate the measurement and comparison between the operating results and cash-generating capabilities of different timber companies.

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 net income, not cash flow from 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.
 
20

(Dollars in thousands, except per unit data)
 
 Year Ended December 31,
 
     
2006
   
2005
   
2004
   
2003
   
2002
 
Statement of operations data
                               
Revenue:
                               
Fee Timber (1)
 
$
35,260
 
$
44,424
 
$
33,571
 
$
22,916
 
$
23,298
 
Timberland Management
                               
& Consulting
   
3,670
   
7,764
   
1,601
   
2,386
   
7,295
 
Real Estate
   
27,320
   
4,818
   
4,476
   
1,734
   
1,599
 
Total revenue
   
66,250
   
57,006
   
39,648
   
27,036
   
32,192
 
                                 
Operating income/(loss):
                               
Fee Timber (1)
   
14,592
   
16,320
   
15,126
   
9,669
   
10,199
 
Timberland Management
                             
& Consulting (2)
   
1,266
   
3,540
   
(598
)
 
272
   
919
 
Real Estate (3) (4)
   
13,864
   
1,270
   
1,586
   
(476
)
 
(1,667
)
General and Administrative
   
(3,817
)
 
(3,651
)
 
(2,986
)
 
(2,842
)
 
(3,864
)
Total operating income/(loss)
   
25,905
   
17,479
   
13,128
   
6,623
   
5,587
 
                                 
EBITDDA (5):
                               
Net income/(loss) (1) (2) (3) (4)
   
24,910
   
13,684
   
10,176
   
3,528
   
3,334
 
Plus:
                               
Net interest and income tax
   
1,064
   
3,474
   
2,952
   
3,048
   
2,106
 
Depreciation, depletion, and amortization (6)
   
7,204
   
11,252
   
5,752
   
3,546
   
3,864
 
EBITDDA
   
33,178
   
28,410
   
18,880
   
10,122
   
9,304
 
                                 
Free cash flow (5):
                               
Net income (loss)
   
24,910
   
13,684
   
10,176
   
3,528
   
3,334
 
Plus:
                               
Depreciation, depletion, and amortization (6)
   
7,204
   
11,252
   
5,752
   
3,546
   
3,864
 
Cost of land sold
   
7,818
   
434
   
209
   
200
   
189
 
Less:
                               
Principal payments
   
1,675
   
1,883
   
1,979
   
1,662
   
1,110
 
Capital expenditures, net of
                               
timberland acquisitions(1)
   
12,177
   
6,756
   
3,260
   
2,017
   
2,158
 
Free cash flow
   
26,080
   
16,731
   
10,898
   
3,595
   
4,119
 
                                 
Cash flow from operations
   
43,571
   
28,909
   
17,854
   
8,641
   
9,005
 
                                 
Earnings per unit – diluted
   
5.23
   
2.88
   
2.22
   
0.78
   
0.74
 
                                 
Distribution per unit
   
1.06
   
0.80
   
0.44
   
0.24
   
0.10
 
                                 
Balance sheet data
                               
Total assets
   
180,282
   
106,358
   
94,868
   
86,308
   
86,788
 
Long-term debt
   
30,866
   
32,281
   
34,164
   
36,114
   
37,665
 
Partners’ capital
   
87,605
   
66,405
   
54,533
   
46,036
   
43,598
 
Debt to total capitalization
   
27
%
 
34
%
 
40
%
 
45
%
 
47
%
Other data
                               
Acres owned/managed (thousands)
   
433
   
556
   
121
   
114
   
270
 
Fee timber harvested (MMBF)
   
55
   
74
   
60
   
45
   
45
 
 
21

 
(1)  
The Fund acquired 24,000 acres of timberland in 2006 and we acquired 4,700 acres of timberland in 2004. The cost of these acquisitions was not included in the calculation of free cash flow.
(2)  
Timberland Management & Consulting operating income in 2002 includes $583,000 of restructuring charges following the loss of the Hancock Timber Resource Group (HTRG) timberland management contract and closure of timberland consulting offices in Canada.
(3)  
Real Estate operating income in 2006, 2005, and 2004 includes $260,000, $198,000, and $466,000, respectively, of environmental remediation charges related to the Port Gamble townsite.
(4)  
Real Estate operating income in 2002 includes the following charges: $730,000 environmental remediation charge related to the Port Gamble townsite and a $165,000 charge for warranty liabilities for homes sold in Port Ludlow, Washington.
(5)  
Management considers earnings (net income or loss) before net interest expense, income taxes, depreciation, depletion and amortization (EBITDDA) and free cash flow to be relevant and meaningful indicators 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 net income or loss.
(6)  
Depreciation, depletion, and amortization in 2006 and 2005 include $2.7 million and $6.3 million, respectively, of depletion expense resulting from the separate depletion pool used to account for the harvest of timber from the Quilcene timberland acquisition.

22

 
 
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OFFINANCIAL 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 management's estimates based upon our current goals, in light of management's knowledge of existing circumstances and expectations about future developments. Statements about expectations and future performance are “forward looking statements” 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 environmental and land use regulations that limit our ability to harvest timber and develop property and economic conditions that affect consumer demand for our products and the prices we receive for them, and other risks and uncertainties which are discussed 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 Partnership's 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. Operations in this segment consist of growing timber to be harvested as logs for sale to domestic and to a lesser extent export manufacturers. 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 or 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 providing timberland-related services to third parties and raising investment capital from third parties for private equity timber funds like ORM Timber Fund I, LP (the Fund).

As of December 31, 2006, we owned nearly 114,000 acres of timberland in western Washington State plus nearly 2,700 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.

Macroeconomic factors that have a significant bearing on our business include housing starts in the U.S. (and to a lesser degree in Japan); interest rates; and currency exchange rates - particularly those between the U.S. and Canada, Japan, and Europe. The first two of these factors reflect or influence the health of the U.S. housing market. Currency exchange rates influence the competitiveness of our primary product compared to logs that might be imported from Canada, Europe, or the Southern Hemisphere. 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, Europe, or the Southern Hemisphere, thus increasing the price that we are able to realize from the sale of this export-quality log volume.

23

 
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, the Fund acquired 24,000 acres of timberland in late 2006 of which we own 20% and 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 2006, 2005, and 2004, on a percentage basis by segment, are as follows:

       
Segment
2006
2005
2004
Fee Timber
53%
78%
85%
Timberland Management & Consulting
5%
14%
4%
Real Estate
42%
8%
11%

Further segment financial information is presented in Note 10 to the Partnership's Consolidated Financial Statements included with this report.

Outlook

Management plans to decrease harvest volume from fee owned timberland from 54.5 MMBF in 2006 to 49.5 MMBF in 2007 in line with long-term sustainable harvest plans. At the end of 2006, when our 2006 harvest was largely complete, log prices softened from the prices realized earlier in the year. This softening was caused by a number of factors including a slow-down in domestic housing starts and an increase in lumber imported from Canada. The increase in Canadian imports followed resolution of the softwood lumber agreement. Management expects some recovery from this decline in log prices later in 2007, but we expect average 2007 log price realized to decline from 2006 levels. ORM Timber Fund I, LP (the Fund) is expected to begin harvesting in 2007. Revenue generated from this harvest will be consolidated into the Partnership’s financial statements but is not expected to contribute to operating income as the timberlands owned by this fund will have a separate depletion pool and depletion charges are expected to offset the majority of the net stumpage realized upon harvest. The 80% interest in the Fund owned by third-parties is reported beneath operating income and is labeled Minority Interest-ORM Timber Fund I, LP.

We are also anticipating a decrease in operating income generated by the Real Estate segment. In previous editions of this analysis, we have noted that our results from the Real Estate segment can vary significantly from year to year. Real Estate results in 2006 reflect the sales of a high-value commercial property and a business park property from our development at Gig Harbor and a large residential plat sale from our Bremerton project. Transactions planned for 2007 are expected to result in a substantial decline in both revenue and operating income from the levels achieved in 2006. Revenue generated by the Timberland Management & Consulting segment is expected to decrease as a result of the absence of a disposition fee earned in 2006 and lower timberland management fees, offset in part by higher fees from our Fund.
 
24

 
RESULTS OF OPERATIONS

The following table reconciles net income for the years ended December 31, 2006 to 2005 and 2005 to 2004. In addition to the table’s numeric analysis, the explanatory text that follows describes many of these changes by business segment.

YEAR TO YEAR COMPARISONS
 
(Amounts in $000's except per unit data)
 
               
 
 
2006 vs. 2005
 
2005 vs. 2004
 
               
 
 
Total
 
Total
 
Net income:
             
Year ended December 31, 2006
 
$
24,910
       
Year ended December 31, 2005
   
13,684
 
$
13,684
 
Year ended December 31, 2004
         
10,176
 
Variance
 
$
11,226
 
$
3,508
 
               
Detail of earnings variance:
             
Fee Timber
             
Log price realizations (A)
 
$
1,813
 
$
3,490
 
Log volumes (B)
   
(11,295
)
 
7,368
 
Production costs
   
4,583
   
(3,653
)
Depletion
   
2,993
   
(5,506
)
Other Fee Timber
   
173
   
(505
)
Timberland Management & Consulting
             
Management fee changes
   
(2,707
)
 
3,715
 
Disposition fees
   
(45
)
 
1,396
 
Other Timberland Mgmnt & Consulting
   
478
   
(973
)
Real Estate
             
Development property sales
   
14,436
   
10
 
Environmental remediation
   
46
   
268
 
Other Real Estate
   
(1,889
)
 
(594
)
General & administrative costs
   
(166
)
 
(665
)
Interest expense
   
1,100
   
173
 
Other (taxes, minority int., interest inc.)
   
1,706
   
(1,016
)
Total change in earnings
 
$
11,226
 
$
3,508
 
               
               
(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 price for the prior period less variance in log production costs.
 

25

 

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, 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, which we ordinarily express in terms of millions of board feet, or “MMBF”, and by the average prices realized on log sales, which we express in dollars per thousand board feet, or “MBF”. In late 2006, the Fund acquired 24,000 acres of timberland. Harvest activities from these properties are expect to begin in 2007 and will be 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, 2006, are as follows (all amounts in millions).

           
 
 
 
 
 
 
           
Year ended
Timber
revenue
Mineral, cell
tower, and
other revenue
Total segment
revenue
Operating
income
Harvest
volume
31-Dec-06
$33.3
$2.0
$35.3
$14.6
54.5
31-Dec-05
42.7
1.7
44.4
16.3
74.2
31-Dec-04
31.9
1.7
33.6
15.1
60.3
 
 
Fiscal Year 2006 compared to 2005. Harvest volume declined 27% from 2005 to 2006. This decrease was due to an elevated harvest in 2005 owing primarily to our harvest of two tracts acquired in late 2004. Average log prices in 2006 were up $35 per MBF, representing a 6% increase over 2005’s log prices. The $0.3 million increase in other revenue is due primarily to an increase in gravel royalties resulting from increased residential and commercial construction in our local markets. The decrease in harvest volume, offset somewhat by stronger prices and increased gravel royalties, resulted in the $9.1 million, or 20%, decrease in Fee Timber revenue for 2006 versus 2005.
 
Operating income in 2006 attributed to the Fee Timber segment decreased $1.7 million, or 10% from 2005. Harvest volume from one of the 2004 acquisitions has a separate depletion pool because the property has characteristics that are different from the pooled property. Specifically, the timber on this property at the time of acquisition was almost completely merchantable. As a result of accounting for harvests from this particular acreage using the separate depletion pool and its correspondingly high per MBF depletion charge, the incremental harvest from this acquisition generated significant cash flow but had much less impact on operating income. The cash generated through 2005 and into 2006 related to the timber harvested from this particular fourth quarter 2004 acquisition has served to recoup effectively its entire purchase price.
 
Fiscal Year 2005 compared to 2004. Harvest volume was up 23% during 2005 from 2004. This increase was due to a higher planned harvest in 2005. This increase in harvest was also due to the two timberland acquisitions from 2004. In addition, average log prices were up $47 per MBF, representing a 9% increase over 2004’s log prices. Taken together, these higher volumes and stronger prices resulted in the $10.8 million, or 32%, increase in revenue for 2005 versus 2004. Operating income in 2005 for the Fee Timber segment increased $1.2 million, or 8% from 2004. Notably, the increase in harvest volume did not result in a proportionate increase in operating income due primarily to a $58 per MBF, or $5.5 million, increase in depletion expense when comparing 2004 and 2005. This increase in depletion relates to the establishment of separate depletion cost pool to account for one of the 2004 acquisitions, as described above.
 
26

 
Log Volume

Log volume sold for each year in the three-year period ended December 31, 2006, is as follows:
               
Volume (in MMBF)
2006
% Total
2005
% Total
2004
% Total
 
Sawlogs
             
Douglas-fir
38.9
71%
43.7
59%
35.7
59%
 
Whitewood
3.8
7%
11.0
15%
10.6
18%
 
Cedar
1.1
2%
4.5
6%
1.4
2%
 
Hardwoods
3.6
7%
5.1
7%
2.9
5%
 
Pulp
             
All Species
7.1
13%
9.9
13%
9.7
16%
 
               
Total
54.5
100%
74.2
100%
60.3
100%
 
 
Log volume decreased 27% in 2006 from the elevated harvest in 2005 related to the 2004 timberland acquisitions. The aforementioned 2004 acquisitions were largely harvested in 2005 and contained a relatively high volume of cedar and red alder sawlogs. Pulp log volume as a percentage of total volume remained at 13% in 2006 when compared to 2005.

Log volume increased 23% in 2005 due to the 2004 timberland acquisitions. One of these properties contained a relatively high volume of cedar and red alder sawlogs. Pulp log volume as a percentage of total volume decreased to 13% from 16% as a result of the harvest of fewer low-quality timber stands in 2005 compared to 2004
 
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, 2006, is as follows:

                         
Price $/MBF
   
2006
 
% Change
   
2005
 
% Change
   
2004
Sawlogs
                   
Douglas-fir
 
 
$669
 
4
%
 
 
$644
 
4
%
 
 
$619
Whitewood
   
445
 
(6)
%
   
472
 
12
%
   
423
Cedar
   
1,093
 
16
%
   
942
 
(6)
%
   
999
Hardwoods
   
681
 
13
%
   
605
 
3
%
   
587
Pulp
                   
All Species
   
268
 
26
%
   
213
 
(5)
%
   
224
 
 
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. The price realized on Douglas-fir logs increased 4% in 2006 from 2005. The increase in price realized in 2006 is attributed to a combination of strong housing starts in the U.S. and additional lumber mills opening in the Puget Sound area of Washington. The price realized on Douglas-fir logs increased 4% in 2005 from 2004 due to the same trends noted as present in 2006.
 
27

 
Whitewood: “Whitewood” is a term used to describe several softwood species, but for us primarily refers to western hemlock. Though generally considered to be of a lower quality than Douglas-fir, these logs are also used for manufacturing construction grade lumber and plywood. The average price realized on whitewood decreased 6% in 2006 from 2005, and increased 12% in 2005 from 2004. In addition to a decline in whitewood market prices during 2006 a larger impact can be attributed to harvesting lower quality logs in 2006 versus 2005. Whitewood harvest volume in 2005 included a large component of high quality whitewood sawlogs from one of the 2004 timberland acquisitions which increased our average price realization in the prior year.

Cedar: Cedar prices have increased in 2006 from 2005 and decreased in 2005 from 2004. The strong price realized for 2006 reflects a general decline in cedar volume available in the Puget Sound area with resultant upward pressure on price due to continuing demand for such logs. Cedar prices declined from 2004 to 2005, with this downward shift attributable to a decrease in mills located in the Puget Sound area of Washington that manufacture cedar products.

Hardwood: “Hardwood” can refer to many different species, but on our tree farms primarily consists of red alder. The price realized from the sale of red alder sawlogs has increased steadily over the last two years with limited supply and increased demand as a result of new mills focused on hardwood lumber production in the Pacific Northwest. The local mills that process alder sawlogs are using the resource to manufacture lumber for use in furniture construction.

Pulp: Pulp is a lower quality log of any species that is manufactured into wood chips. These chips are used primarily to manufacture unbleached linerboard used in paper bags and cardboard boxes. The price realized from the sale of pulp logs is primarily driven by local pulp log inventories. The increases in pulp log prices result from a decline in sawmill production and a corresponding reduction in the inventory of residual chips from lumber manufacturing. Relatively strong prices combined with a weakening lumber market has resulted in an increase in sawmill downtime which has in turn reduced the supply of wood chips available in the Puget Sound market.

Customers

   
2006
 
2005
 
2004
Destination
 
Volume*
 
Price
 
Volume*
 
Price
 
Volume*
 
Price
Domestic mills
 
44.3
 
$659
 
59.0
 
$632
 
40.8
 
$574
Export brokers
   
3.1
   
700
   
5.3
   
629
   
9.8
   
638
Pulp
   
7.1
   
268
   
9.9
   
213
   
9.7
   
224
Total
   
54.5
 
 
$611
   
74.2
 
 
$576
   
60.3
 
 
$529
* Volume in MMBF
                                   
 
Lumber mills purchased 81% of our harvest volume sold in 2006, and average price realizations were 4% higher than the price realized in 2005. The increase in price realized is due to the strong housing market experienced in 2006. Export brokers represent those log buyers that purchase our logs and then resell them primarily to the export market. A factor in the increase in average price is the lower mix in 2006 compared to 2005 of western hemlock volume which carries a lower market value than Douglas-fir logs. Volume sold to pulp log customers represented 13% of total volume sold for both 2006 and 2005.

Lumber mills purchased 80% of our harvest volume sold in 2005 and price realizations were 10% higher than the price realized in 2004. The increase in price realized is due to the strong housing market experienced in 2005. Export brokers usually buy high-quality Douglas-fir logs, but in 2005 they also bought some western hemlock logs for export to Korea. As a result of this sort mix in 2005 with a heavier component than usual for us of western hemlock, the average price realized from sales to these brokers declined slightly in 2005 from 2004 levels despite a relatively strong export market for logs in 2005.
 
28

 
Harvest Volumes and Seasonality

The Partnership’s nearly 114,000 acres of timberland consist of both the 70,000-acre Hood Canal tree farm and the 44,000-acre Columbia tree farm. The Hood Canal tree farm is located in the Hood Canal region of Washington State. Most of this tree farm acreage is at a relatively low elevation where harvest activities are possible year-round. As a result of this competitive advantage, we are often able to harvest and sell a greater portion of our annual harvest in the first half of the year when the log supply in the marketplace tends to be lower.
 
The percentage of annual harvest volume by quarter for each year in the three-year period ended December 31, 2006 is as follows:

         
Year ended
Q1
Q2
Q3
Q4
31-Dec-06
40%
31%
22%
7%
31-Dec-05
31%
30%
28%
11%
31-Dec-04
34%
29%
22%
15%
         

Cost of Sales

Cost of sales for the Fee Timber segment consists of harvest costs and depletion expense. We are using two separate depletion rates in 2006, one for volume harvested from those timberlands we acquired in the fourth quarter of 2004 (the “Quilcene Timberlands”), and one for volume harvested from all other owned timberlands. Harvest costs represent the direct cost incurred to convert trees into logs and deliver those logs to their point of sale and associated state excise taxes owed on the harvest of logs. Depletion expense represents the cost of acquiring or growing the timber harvested. This cost is calculated using a depletion rate that is derived as follows:

Depletion rate =
Accumulated cost of timber and capitalized road expenditures
 
Estimated volume of 40-year-old merchantable timber available for harvest

The depletion rate is then applied to volume harvested to calculate depletion expense.

Fee Timber cost of sales, expressed on a per MBF basis for each year in the three-year period ended December 31, 2006, is as follows:

             
 
         
Harvest,haul,
   
Total cost
 
 
   
Depletion cost 
   
and other costs
   
of sales
 
Year Ended
 
per MBF
   
per MBF
   
per MBF
 
December 31,2006
 
$
110
 
$
187
 
$
297
 
December 31,2005
   
142
   
179
   
321
 
December 31,2004
 
84
   
159
   
243
 
 
As described above, a depletion rate is calculated based upon the historical cost of the timber and related capitalized road expenditures. That calculated rate is then applied to all volume harvested. We harvested a total of approximately 55 MMBF in 2006, with 7 MMBF attributable to the separate depletion pool created for the Quilcene Timberlands. The depletion expense resulting from Quilcene Timberlands log harvests approximated the net stumpage value (delivered log price less harvesting and transportation cost) realized on the sale of this particular timber. As such, the incremental harvest from this acquired property resulted in a negligible net income impact even as it generated significant operating cash flow and EBITDDA.
 
Depletion expense is generated from the harvest and sale of timber and some minor amount of depletion results from Real Estate sales when land is sold with standing timber. Depletion expense resulting from timber harvest for each year in the three-year period ended December 31, 2006 was made up of the following:
 
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Year ended December 31, 2006
 
 
 
Pooled 
 
Separate
 
Total
 
Volume harvested (MBF)
   
47,682
   
6,851
   
54,533
 
Rate/MBF
 
 
$68.97
 
 
$396.63
 
 
$110.13
 
Depletion expense ($ 000's)
 
 
$3,288
 
 
$2,717
 
 
$6,006
 
                     
                     
 
 
Year ended December 31, 2005
 
 
 
Pooled
 
Separate
 
Total
 
Volume harvested (MBF)
   
57,194
   
17,051
   
74,245
 
Rate/MBF
 
 
$73.29
 
 
$374.46
 
 
$142.46
 
Depletion expense ($ 000's)
 
 
$4,192
 
 
$6,385
 
 
$10,577
 
                     
                     
 
 
Year ended December 31, 2004
 
 
Pooled 
 
Separate
 
Total
 
Volume harvested (MBF)
   
57,987
   
2,329
   
60,316
 
Rate/MBF
 
 
$72.30
 
 
$377.35
 
 
$84.07
 
Depletion expense ($ 000's)
 
 
$4,192
 
 
$879
 
 
$5,071
 
 
Harvest costs vary based upon the physical site characteristics of acreage harvested. Harvest units that are difficult to access, or that are located on steep hillsides requiring cable harvest systems, are more expensive to harvest. Haul costs vary based upon the distance between the harvest site and the customer’s location. Per MBF harvest and haul costs have increased in 2006 relative to 2005 due to having harvested timber from harvest units located on hillsides rather than harvest units located on relatively flat ground. The increase in harvest and haul cost in 2005 relative to 2004 is due primarily to increased fuel costs.
 
Fee Timber cost of sales for each year in the three-year period ended December 31, 2006 is as follows (all dollar amounts in millions):

 
Year ended
 
Depletion
 
Harvest, haul
and other
 
Total cost of
sales
 
December 31, 2006
 
 
$6.0
 
 
$10.2
 
 
$16.2
 
December 31, 2005
   
10.6
   
13.2
   
23.8
 
December 31, 2004
   
5.1
   
9.6
   
14.7
 

Fee Timber cost of sales decreased $7.6 million in 2006 from 2005 and increased $9.1 million in 2005 from 2004. The decrease in 2006 from 2005 is due to a reduction in harvest from both our pooled and separate depletion pool harvest units. The increase in 2005 and 2004 is due to combination of increased harvest volume and an increase in depletion rate due to a separate depletion pool used for timber harvested from 2004 acquisitions. The impact of this additional depletion was particularly pronounced in 2005 due to the aforementioned harvest volume in that period from the 2004 timberland acquisitions. 

Operating Expenses 

Fee Timber operating expenses for each of the three years ended December 31, 2006, 2005, and 2004 were $4.4 million, $4.3 million, and $3.8 million, respectively. Operating costs remained constant in 2006 relative to 2005. Operating costs increased in 2005 relative to 2004 due primarily to an increase in road maintenance expenditures. The increase in road costs in 2005 result primarily from the increase in harvest volume, but also reflect increased costs resulting from the Road Maintenance and Abandonment Plan rules in Washington State. Washington State has enacted new water quality rules, which have resulted in changes to the rules surrounding road maintenance and construction. As a result, culverts that do not comply with the new rules need to be replaced, which has caused an increase in road maintenance costs over the last three years and is expected to continue into 2007.
 
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Timberland Management & Consulting

Revenue and Operating Income

The Timberland Management & Consulting segment generates revenue by providing timberland management and forestry consulting services to timberland owners and managers. An additional aspect of that segment’s activities is the development of timberland property portfolios on behalf of third-party clients and the Timber Fund.

The Timberland Management & Consulting segment is currently managing over 290,000 acres of timberland for Cascade Timberlands LLC and an additional 24,000 acres for the Fund. The Cascade project included management, consulting, and disposition services during 2005 and 2006. Revenue and operating income for the Timberland Management & Consulting segment for each year in the three-year period ended December 31, 2006, are as follows (all dollar amounts in millions):

               
Year ended
   
Revenue
   
Operating income (loss)
 
December 31, 2006
 
 
$3.7
 
 
$1.3
 
December 31, 2005
   
7.8
   
3.5
 
December 31, 2004
   
1.6
   
(0.6
)
 
Fiscal Year 2006 compared to 2005. Revenue and operating income for 2006 was $4.1 million and $2.2 million lower, respectively, than for 2005. These decreases are due to a decline in acres under management partially offset by timberland disposition fees earned by providing such services to our primary timberland management client, Cascade Timberlands LLC. Cascade’s sale of portions of its holdings resulted in a disposition fee earned in the first quarter of 2006 followed by a reduction in timberland management fees. We have entered into an agreement to continue managing Cascade’s timberland from 2007 through 2009.
 
On August 1, 2005 we announced that management had obtained capital commitments of $61.8 million, of which Pope Resources and ORMLLC have committed $12.4 million, to the Fund’s capital. In the fourth quarter of 2006 ORMLLC successfully placed $58.5 million of the Fund’s committed capital. Pope Resources and ORMLLC represent 20%, or $11.7 million, of the investment capital in the Fund. ORMLLC is the general partner of the Fund and earns management fees for managing the Fund’s timberlands and operations. As noted above, we also treat the Fund as a consolidated subsidiary and report these results under the Fee Timber segment. Operating results attributed to the 80% third party interest in the fund are reported under Minority Interest-ORM Timber Fund I, LP below operating income.
 
Fiscal Year 2005 compared to 2004. Revenue and operating income for 2005 were $6.2 million and $4.1 million higher, respectively, than 2004. The increase in revenue and operating income is primarily due to timberland management, timberland disposition, and consulting services provided to Cascade for its timberland located in Washington and Oregon. ORMLLC began providing timberland management and other timberland consulting services to this client in January 2005. Revenue generated in 2004 consisted of fees earned while providing advisory services to the parties that eventually became the owners of Cascade and fees generated through providing miscellaneous consulting and management services to a variety of timberland owners.
 
Operating Expenses
 
Fiscal Year 2006 compared to 2005. Timberland Management & Consulting operating expenses decreased $1.8 million in 2006 from 2005. The decrease in operating expenses resulted from the closing of two offices that were used for managing timberlands formerly owned by Cascade, and a decrease in activities surrounding capital raising for the Fund. Following the sale of two of Cascade’s tree farms we closed our forestry field offices in Port Angeles, Washington in late 2005 and in Sedro-Woolley, Washington in early 2006. The Timberland Management & Consulting segment was not engaged in raising capital in 2006 but was working to locate suitable timber properties for the Fund. This shift in activities resulted in a decline in operating expense.
 
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Fiscal Year 2005 compared to 2004. Timberland Management & Consulting operating expenses for 2005 were $2.0 million higher than in 2004. The increase in operating expenses is primarily attributable to the opening of two new forestry field office locations in Sedro-Woolley, Washington and Bend, Oregon and the additional staffing necessary to provide services under the timberland management agreement with Cascade. Organization and start-up expenses for the Fund totaled $559,000 during 2005. These expenses are included in Timberland Management & Consulting operating expenses.
 
Real Estate

Revenue and Operating Income

The Partnership’s Real Estate segment consists primarily of revenue from the sale of land together with residential and commercial property rents. The Partnership’s real estate holdings are located primarily in Pierce, Kitsap, and Jefferson Counties in Washington State.
 
Results from Real Estate operations are expected to vary significantly from year to year as we make multi-year investments in entitlements and infrastructure prior to selling entitled or developed land. Revenue and operating income for the Real Estate segment for each year in the three-year period ended December 31, 2006, are as follows (all dollar amounts in millions):

                     
 
Year ended
   
Revenue
   
Environmental
remediation expense
   
Operating income
 
December 31, 2006
 
 
$27.3
 
 
$0.3
 
 
$13.9
 
December 31, 2005
   
4.8
   
0.2
   
1.3
 
December 31, 2004
   
4.5
   
0.5
   
1.6
 

Revenue in the Real Estate segment is generated through the sale of land and the rental of homes and commercial properties at the Port Gamble townsite. Land sales include the sale of raw land which generally consist of larger acreage sales rather than single lot sales and are normally completed with very little capital investment prior to sale. Rural Lifestyles lot sales generally require some capital improvements such as zoning, road building, or utility access improvements prior to completing the sale. Commercial and residential plat land sales represent land sold after development rights have been obtained and are generally sold with certain infrastructure improvements.
 
32

 

Real Estate segment revenue for each of the years ended December 31, 2006, 2005 and 2004 consists of the following:

Description
 
Revenue
 
Gross Margin
 
Acres Sold
 
Revenue/Acre
 
Gross Margin/
Acre