STT and the unsustainable sustainability myth

 

Tasmania’s forestry industry is world-class and sustainable “said Resources Minister Barnett when releasing the 2020/21 Annual Report for Sustainable Timbers Tasmania (STT),

There’s a useful rule when trying to assess the financial sustainability of any company: Beware if profits are only achieved with book entries.

That’s certainly the case for STT, our publicly owned forest company. It reported another small profit for the 2020/21 year, the fourth in succession. Without book entries and government grants however it would have been another loss, a pattern that has been occurring for a long time.

Another useful rule says beware if there aren’t underlying cash surpluses from operations. STT claim there are but that’s only because it doesn’t include all relevant ones. Replanting and roading costs are treated as capital outlays. For three of the past six years, including 2020/21 net operating cash including roading and regeneration costs has been negative.

As a general proposition for most businesses operating cash is usually more than book profits. Most of the difference is usually explained by book entries such as depreciation.  If the opposite is occurring, where book profits exceed operating cash as it often does with STT, alarm bells should be sounding.

A further rule which triggers alarm bells is when companies sell core assets to survive. STT did just that in 2018. The cash from the sale of 29,000 hectares of hardwood plantations for $62 million is gradually disappearing. There’s only $9 million remaining.

A casual reader of STT accounts might be impressed to learn that in the 2020/21-year STT paid the government a $2 million dividend and gave Tas Rail $5 million as directed by the government and conclude that STT must be a successful business if it can afford to do that. The reality however is those payments were funded by receipts from plantations sales, which were established to help STT transition to a plantation-based business funded by generous government handouts but sold at a massive loss to help keep STT afloat. Half the proceeds from the sale, which strictly speaking was the sale of a forestry right over certain areas with plantations, can be attributed to the trees but the other half is attributable to a 99 year right over the underlying land which STT didn’t own anyway. It belongs to the Crown.

At the heart of the issue of book entries being used to boost profits, lies the perennial accounting question, as when to recognise revenue. Most people know that revenue for a small operator is recognised when cash is received. For a larger operation it occurs when a sale is made, when the liability for payment occurs, not when a payment is made. In the case of STT there’s an added complication from the nature of its major asset, its native forests. Movements in the value of forests, both up and down, directly affect profits. Movements are recognised as revenue.

How are forest valued? On the basis of future estimated net proceeds is the answer. When calculating net proceeds harvesting and other costs to sell are included but not replanting costs, even though there is a mandatory obligation to regenerate harvested coupes. By valuing forests in this manner and bringing to account any changes as income, STT is, in effect, recording future income but leaving out some future costs. Legendary companies like Enron aren’t the only companies to book future proceeds as revenue. Forest companies do it too.  Virtually the entire net asset value of STT ($179 million at 30^th June 2021) is represented by the value of its trees ($178 million) based on estimated future net proceeds after conveniently overlooking some costs. Each year the liability to regenerate logged forest is recorded as an additional liability, but as a capital expense, not a cost against revenue. Doing it this way doesn’t affect reported profits. It’s a con. Regeneration is a mandatory requirement for logging operations. Regeneration costs logically form part of assessing whether felling a coupe has been a profitable exercise.

If estimated regeneration and roading costs to increasingly remote coupes, were included when estimating future net proceeds, the resultant figure will probably be negative, the value of STT trees would therefore disappear and STT would look like the emperor without clothes. Not a good look for a world class sustainable logger. A negative value for trees would appear as a liability, as a provision for future harvest losses. Readers would then clearly understand STT’s true situation.

STT can and always will claim its accounts adhere to the necessary accounting standards. That may be true. But that doesn’t prevent them from being misleading.

The best measure of STT’s recent financial performance is to ignore the headline profit figures that appear in the Chairman’s Reports and assorted media releases and instead focus on operating profits adjusted to include roading and regeneration costs and to exclude book entries and government grants, thereby deriving the cash earnings from operations before government assistance. The results are not pretty. Over the past four years cash operating losses before government grants have totalled $47 million. This supports the contention that realistically estimated future net harvest proceeds and therefore forest values are likely to be negative.

At the same time as STT was hiding its net cash operating losses, it was posting headline net profits after tax amounting to $115 million. The large gap of $162 million between headline profits and the cash earnings over the four-year period is explained by government grants of $86 million and book entries of $90 million. 

This is what the headline profits and the cash earnings for the past four years look like:

          

 

The cash earnings are known by the label EBITDA which means earnings before interest tax depreciation and amortisation. It’s a standard measure for assessing the underlying cash operating earnings of businesses. In this instance government grants have also been excluded so as to arrive at cash earnings before government handouts.  It’s a good basis for assessing sustainability.

At the end of 20/21 there was only $2 million in the bank plus the above mentioned $9 million remaining from the plantation sale. But there’s $10 million worth of regeneration to complete and another dividend to government of $2 million beckoning. It’s hardly a robust situation.

It is interesting to check other State owned forest companies. VicForests which runs a similar operation to STT, for the first time in 20/21 started expensing regeneration costs when the liability first arises (when the coupe is felled), rather than treating them as capital outlays, which STT continues to do. It gives a more realistic view of operating profits. VicForests also expenses roading costs, again unlike STT. Native forest logging is due to be phased out in 2030 in Victoria. The value of VicForests’ forest estate is based on the net harvest proceeds likely between now and 2030. But the net proceeds do not include the regeneration costs which are mandatory. Future income is used to boost the balance sheet but not all future costs. It doesn’t pass the pub test.The costs of regeneration always exceed the net proceeds from harvest which means VicForests makes operating cash losses just like STT.As with STT if the costs of regenerating forests were included when calculating net proceeds, the figure would be negative, the value of the forest estate would disappear to be replaced by a liability for future harvest losses. The only way to discharge the liability will be with more government funding.

That’s the cold hard reality of native forest loggers like STT. They’re financially unsustainable without handouts from governments. If listed companies made the same baseless claims as publicly owned forest companies, they’d get a please explain email from the ASX.

When valuing trees on the basis of estimated net proceeds what is actually being valued is the forest estate which comprises land, roads and trees. They are valued as one cash generating unit. The ensuing value overstated by overlooking some future costs is then split between the three assets which comprise the forest estate. Back in 2009 the forest estate was valued at $778 million. Land was allocated $277 million and roads $115 million. The rest was the trees, $386 million. It was an arbitrary split.

The latest values for 20/21 show a total forest estate at $186 million. Trees were allocated $178 million and roads $8 million. There wasn’t enough to go around so land missed out. It has a zero value. It’s been zero ever since 2010. Even though STT owns some land and is deemed to control a swathe of other forested land pursuant to the Forest Management Act, and therefore should account for it as an asset, it chooses to do so by giving land a zero value. Greens are sometimes accused of believing in fairies at the bottom of the garden, often by foresters who believe land has no value and trees are best valued by cherry-picking a few numbers. It’s a bit like a kettle being called black by a particularly sooty pot.

If land has no value then losses suffered by land escapes the notice of STT’s financial statements. Freshly harvested forests often end up resembling downtown Dresden circa 1943, with a plethora of unrecorded losses, water, habitat, carbon to name a few, but no where is that recorded. Land has a nil value regardless of what happens. It’s a nonsense proposition.

Yet it underpins the financial model adopted by native forest loggers. The model is a dumb representation of reality. In practice, if not by design. The faults allow the myth of sustainable native forest logging to persist, an activity which is not only financially unsustainable from an income aspect, but even more so when all the unrecorded balance sheet losses are considered. The rules governing accounting for native forests needs a complete overhaul. It is preposterous to continue to assert sustainability based on arcane outdated precepts.