Sunday, 25 April 2010

Accounting for Dummies: Lessons from the forest industry

The suggestion in the title is that accountants are smarter than the average. Most aren’t.

Accounting is essentially about debits and credits, plusses and minuses to use the generic terms. Not exactly rocket science. But much of what is presented in financial statements confuses rather than promotes understanding, deliberately so at times, unfortunately not an uncommon occurrence amongst professions.

The following is an attempt to outline the lessons, 17 in total, from the financial statements of Great Southern, Timbercorp, Forest Enterprises (FEA), Gunns and Forestry Tasmania (FT), by presenting a common sense interpretation of some of the more significant features, and perhaps provide the new Minister with an accounting analysis of the current forest industry, lest he thinks it is in suitable shape to provide a springboard for the future.

Lesson No 1.

Beware of companies whose profits are consistently higher than their net operating cash flow. This means there’s a lot of book entries.

The net operating cash flow, revenue less expenses, forms the cornerstone of a company’s net profit. The difference between the two is represented by book entries. Normally the book entry for depreciation is sufficient to ensure that net profit is less than net operating cash flow.

Gunns’ net operating cash flow over the last 8 years was $505 million and their depreciation and amortisation claims were $156 million. Furthermore a book entry for the value of harvested trees reduced profit by a further $158 million. Then there’s impairment charges (bad debts for instance) and accrued employee benefits which further reduce profit.

Yet profit was $612 million over the 8 year period boosted by book entries, the major ones being a $204 million increase in the value of standing trees, $141 million in yet to be received harvest commissions and about $250 million for MIS amounts still owing by investors.

FT is even shakier. In 2009 its net operating cash flow was $3 million, yet its net profit was $32 million. An increase in the book value of trees of $43 million was partially offset by a $15 million increase in FT’s unfunded superannuation liability.

Lesson No 2.

Check the cash flow statement to ascertain the source of cash, whether from operations, from asset sales, from borrowings or from shareholders.

A company’s cash flow statement splits cash flow into three, cash from operations (revenues less expenses), cash from investing (sales of existing assets and investments less purchases of new assets and investments ) and cash from financing (new loans, share issues less dividends, loan repayments etc).

It is an invaluable statement because it allows the reader to determine if the business is being supported by its operations or by its borrowings and how new assets etc are being paid for.

In Gunns’ case, operating cash flow was $505 million for 8 years, net borrowings produced only $28 million in extra cash, sale of assets $185 million (mainly the Auspine trees) and equity raisings another $531 million.

In FT’s case operating cash flow is miserable, $5 million in 2008 and $3 million in 2009. CFA capital grants are included as cash from investing (because it’s supposed to be spent on plant and plantations, etc which are investing activities). A total of $42 million was received from this source in 2009 and $14 million in 2008. There is nil cash from financing for FT, as there have been no further borrowings, nor has the Government contributed any more equity.

Not yet anyway.

Lesson No 3.

Check to see where all the cash went, whether on new plant and equipment, investments in other companies, loan repayments or dividend payments. Beware of companies paying dividends from borrowings or share proceeds.

Gunns’ spent $173 million planting its own trees, say $200 million updating its plant and equipment (an estimate only as the depreciation for the period was $156 million) and $150 million on the pulp mill. This just about exhausts the net operating cash flow of $505 million.

But another $154 million was spent on new plant, $327 million on investments (mainly Auspine), and $280 million paying dividends.

It’s a bit of a chicken and egg argument. Were the dividends paid from operating cash flow or from share issues, as the borrowings were negligible? If the former is to be argued then the implication is that there was insufficient cash remaining to keep planting its trees and updating its plant, in other words to keep operating its core activities, without further equity raisings. And that is not a healthy sign.

To put it another way, Gunns either raised equity to pay dividends, or it exhausted its operating cash flow with dividend payments so that equity raisings were required to fund the balance of new plant and trees normally funded out of cash flow. Either way a warning sign.

In the 2000/01 year Gunns paid $407 million to acquire the woodchipping and plantation businesses of Boral and North Forest Products. It raised $130 million with a share issue. Its net borrowings for the year were $300 million. Since then Gunns’ debt has only increased by $28 million, so arguably its core debt of $300 million relating to the Boral and Norths’ businesses still remain. What are those assets now worth?

Interestingly the Auspine purchase of $348 million only required $266 million in cash, with the rest paid with Gunns’ shares. But $334 million was raised from shareholders, and $173 million received when pine trees were sold to GMO. Looking with hindsight the Auspine deal was probably a back door way of financing the pulp mill. The same occurred in the last 6 months with new equity raisings of $145 million for the ITC Timber purchase of $88 million.

In FT’s case, in 2009, $12 million was spent on new plantations and $18 million on new plant. Yet only $3 million was provided from operations. A bit tight!! Without CFA grants, FT will be unable to keep investing, unless its shareholder puts in more.

FT must be finding it harder to pay its operating expenses. At the end of 2009 FT started using unspent CFA funds to pay operating expenses. The Auditor General made FT aware of his concerns.

Lesson No 4.

Examine the makeup of the earnings. Are they sustainable? From operations? Or book entries?

Even if perfectly valid, a profitable business whose profits derive solely from book entries is likely to struggle if operating cash flow is inadequate.

FEA never made any profits from sawmilling, only MISs.

In Gunns’ case, with the decline of new MISs and woodchipping, its profits are increasingly made up with book entries.

FT makes virtually nothing from operations, any fluctuations in net profit result from movements in the book value of standing timber.

Lesson No 5.

Beware of one off book profits used to boost earnings.

Stated earnings often include one off items, like asset sales. Profits can be boosted if an amount in excess of the book value is received. Sometimes it’s an artificial boost as the book value can be the subject to a little creativity.

In the 2008 year Gunns’ took over Auspine and related entities. Included was 33,000 hectares of radiata, which were almost immediately put up for resale. The book value of the trees acquired was such that when sold for $173 million, a profit of $23 million was booked. The acquisition price of assets acquired as part of the Auspine deal was subject to ‘fair value adjustments’ at the time they were recorded in Gunns’ books.

The question is whether the ‘fair value adjustments’ were fair?

Lesson No 6.

Beware of profits boosted by a ‘discount on acquisition’

If a company pays less for a takeover company, than its claimed value, the difference is included as part of profits. When Gunns acquired ITC Timber from Elders recently, it paid $88 million for assets with a book value of $91 million and immediately booked the $3 million discount on acquisition as profit.

The book values recorded in the acquirer’s books are subject to fair value adjustment. Gunns wrote back $11 million in assets, mainly inventory, at the time of the ITC takeover, but the total value still exceeded the purchase price. If that hadn’t occurred the discount on acquisition would have been $14 million. Might have looked a bit too obvious. It certainly would have helped the full year 2010 results. Too late to change?

Lesson No 7.

Be aware that the % contribution to revenue is not the same as the % contribution to net profit. Check the segment information.

Segment information splits revenue, net profit, assets and liabilities between the various segments of a company’s business that are significant to understanding the business as a whole. It is essentially an ASX requirement for listed companies.

In Gunns’ case the 3 segments have been forest products, MIS and other. In the latest half yearly’s, forest products has been split between wood fibre and timber products.

A few years ago MIS’s were contributing a higher % share to Gunns’ profits than their revenue share indicated. With declining MIS sales, however, the opposite will be true, with MIS’s in the red. Woodchipping always a big contributor to both revenue and profits has suffered a decline in the latest half yearly’s so that its % contributions are similar to timber products.

When Timbercorp and Great Southern fell, Gunns’ management and supporters were keen to downplay Gunns’ dependence at that time on MIS’s, by citing MIS’s contribution to revenue not profits.

FEA were even more misleading, talking about the revenue from sawmilling and not the losses, even including book revaluations as revenue, trying to downplay MIS’s share.

FT tries to avoid any controversy by not bothering with segment information at all, at least not in 2009.In the previous year they obliged with segment information for hardwood, softwood and infrastructure.

FT is forever complaining about the costs of their Community Service Obligations, which are limiting the bottom line. The Auditor General has responded by recommending that FT “give consideration to restructuring Forestry’s Income Statements to separately highlight community service obligations and other costs not directly associated with forestry activities”. It’s an indication of FTs increasing paranoia, that they apparently felt it unnecessary to give the same information to shareholders as is given by listed companies, information that is clearly important understanding the business as a whole.

Lesson No 8.

Be aware of the difference between ‘sales’ and ‘revenue’.

In early July of each year, MIS companies report the ‘sales’ of new MISs for the year. This is simply a total of amounts contributed by new investors persuaded by their financial advisors to purchase some seedlings on a leased plot of land goodness knows where rather than pay a lesser amount to the ATO.

The ‘sales ‘are not all included as ‘revenue’ for that year, some is treated as ‘deferred revenue’ and held over until the next year when planting occurs. It becomes ‘revenue’ in that year.

In that next year, at some stage, MIS companies proudly announce their expected MIS revenue for that year. Much has already been declared as ‘sales’ in the prior year. So there’s a double counting aspect. Also included as MIS revenue will be the expected commissions from the harvest of MIS crops.

Most of current year MIS ‘revenue’ comes from either last year’s ‘sales’ or an estimate of future years commissions.

Lesson No 9.

Be sceptical about intangibles acquired as part of a takeover/merger.

If a company overpays for a target company, it’s called goodwill on acquisition. It may be a dud deal but the balance sheet look stronger.

The rationale is that it’s a measure of the synergies that will flow as a result of the acquisition.

But often it disguises the real story. Great Southern acquiring goodwill as part of the Sylvatech deal (see Lesson 13) was a related party transaction. Gunns paying for goodwill on the acquisition of Auspine was arguably part of a transaction which produced a book profit when newly acquired trees were sold to GMO (see Lesson 5). How much goodwill remains after the 2010 financials will be of interest. If impaired it needs to be written off. Auditors have a role to play. And the audit committee of the Board needs to be controlled by independent Directors.

Lesson No 10.

Become acquainted with the treatment of standing timber and be aware where companies don’t assign a cost to standing timber felled.

Standing timber is an asset like plant and equipment. Expenditure on new plantings adds to the asset value, rather than being expensed in the P&L.

At the end of the year movements in the value of standing timber is brought to account, an increment as revenue and a decrement as an expense.

FT’s financials are not strictly comparable with Gunns’ and those of other listed companies.

Gunns produce a figure for net profit after tax, which includes a cost for trees harvested as well as a figure for changes in the value of standing timber.

FT produces two net profit figures. The first is comparable to Gunns’ although changes in standing timber value are recorded using a single figure which doesn’t permit the reader to ascertain how much has been chopped down and sold and how much of the remaining has altered in value.

FT also calculates what it calls ‘operating profit’ that excludes any ‘cost of timber sold’ figure as well as any movements in the value of standing timber. This is used as FT’s headline profit. How FT, a forest company, can shout from the rooftops each year that yet another operating profit is evidence of a well run business, when there’s no account whatsoever of debits and credits, plusses and minuses if you like, relating to its custodianship of the State’s forest assets, its raison d’etre. Only the revenue from timber sales is included. The FT boys have been watching too much John Cleese! The operating profit figure is a dodgy figure. More a hybrid surplus figure, not a meaningful profit figure.

Lesson No 11.

Check the impairment charges. Beware of companies with assets that are easily impaired

Consider Great Southern’s 2008 figures, its last set of financials.

Despite MIS sales of $314 million, a loss of $64 million was achieved, after asset write downs and allowances for goodwill impairment and doubtful debts. In the case of goodwill, $30 million was written off. In the case of doubtful debts a further $57 million in doubtful debts relating to MIS loans was written off, taking total write offs to $62 million.

The total MIS loans owing to Great Southern were approximately $130 million, but only about half was considered collectable. Half its goodwill was also written off during its penultimate year.

At 30th June 2009 Gunns had $258 million in loans due from investors and $29 million in goodwill (from the Auspine purchase).

Investors’ reluctance to repay MIS loans has led to impairment. The reluctance to pay loans arose when the disappointing returns became apparent. Great Southern’s MIS’s started in 1994 and the bulk of its impairment charges were in 2007 and 2008. Gunns started MIS’s 5 years later. Whether the pattern will be repeated in Gunns’ case is yet to be seen.

Lesson No 12.

Beware of companies with complex structures.

It now transpires that no one ever understood how Allco worked. And very few understood Babcock and Brown. If a structure is unduly complex then it is likely to be hiding something. Even those with a broad understanding of MISs have failed to grasp exactly what was happening in the books of account of forest companies with MISs.

The Receivers and Liquidators attending to the affairs of Timbercorp, Great Southern and FEA have found themselves on a steep learning curve trying to deal with all the various interests, the banks as mortgagees, the investors as tree owners, the investors as lessees of MIS company land, sometimes the investors as sub-lessees of land owned by 3rd parties, it’s a lawyer’s feast.

How Gunns thinks it can just transfer plantation assets into Southern Star and make it look attractive to new investors and bankers is puzzling observers.

Lesson No 13.

Beware of related party dealings.

The most worrisome related party dealings arise when assets are sold to companies at inflated prices, and when companies contract with related parties for services at mate’s rates.

Both Timbercorp and Great Southern were rife with related party dealings. In 2005 for instance Great Southern paid $40 million for a related party Sylvatech, $37 million of which was goodwill on acquisition, an overpayment in other words.

FEA and Gunns have largely be free of such practices, although there’s a lot of land leases and joint venture arrangements which could involve persons, if not related parties, certainly well known to the companies.

Lesson No 14.

Beware of financial commitments recorded off balance sheet.

If a company owes the bank $100 million it’s recorded as a liability, the bit repayable in 12 months as a current liability with the balance as a non-current liability.

But if a company has entered into a 10 year lease for land, the only evidence is in the Notes which detail future commitments.

FEA’s 2009 financials disclosed $106 million in lease payments for MIS land committed over the term of the leases with $7 million due within 12 months. When the Voluntary Administrator took over FEA the other day, he found the cupboard bare, but a half yearly rent payment of $4.5 million due in July 2010. That was the last straw.

Gunns’ latest full year financials detail $19 million of land lease payments due in 2010, with a total of $212 million due over the term of the non-cancellable leases. In 2006, the figures were $6 million for the ensuing year and $59 million in total; hence there’s been a threefold increase in 3 years. These figures are considerably more than any of its fallen comrades.

Lesson No 15.

Beware when assets are listed for resale just to boost working capital.

When companies run into cashflow difficulties, sometimes it’s easy to tell because the current liabilities (those due within 12 months) exceed the current assets (the readily realisable assets like cash, stock, money due from customers etc). In order to dress up the accounts, it is not unusual to see fixed assets (like land) reclassified as a current asset, by listing them as an ‘asset for resale’.

FEA’s woes became starkly apparent with the release of their half yearly’s as at December 2008, when bank loans requiring repayment in the next 12 months (current liabilities) were $52 million. To help boost current assets, $59 million worth of assets were reclassified as being for resale (and therefore current assets).

By 30th June 2009, all of FEA’s bank debt of $208 million was immediately repayable because FEA was in breach of its banking covenants. FEA reclassified more assets as current, ‘assets for resale’. As at 30th June 2009, $70 million of land (leased to MIS growers) and $37 million of MIS loans to investors were listed as assets for resale.

The 30th June 2009 financials are likely to be the last financials issued by FEA.

Lesson No 16.

Beware of companies that try to sell assets to survive.

FEA tried to sell assets towards the end (see Lesson 15). The task was made more difficult because of the complexities involved (see Lesson 12).

As a general rule companies that try to sell assets to survive will achieve neither. Great Southern and FEA fall into this category.

Gunns, if one can believe their response to the ASX query about their recent unexpected profit dive, only found out a day or so before lodging their financials with ASX about their profitability. It was immediately decided to conduct a strategic review, code words for trying to flog off bits to survive.

The latest ASX announcements by Gunns regarding the new pulp mill entity Southern Star and Mr Gay’s future plans also confirms its expected profit EBIT of $30 to $40 million which will put it in breach of its banking covenants. Maybe this is the real reason for re-arranging the deck chairs. The iceberg has been spotted on the horizon.

Media reports have concentrated on Mr Gay and Southern Star. The venerable Mr Eastment who is forever being wheeled out as an expert, was positively dribbling in his support for the latest paper shuffle when he spoke to Ms Ward on ‘Stateline’ on Friday 23rd April. Why didn’t they canvas chronic breaches of loan covenants? Don’t they understand?

Gunns has always kept out of trouble because of its capacity to raise equity.

At least that’s been the pattern in the past.

Lesson No 17.

Be alert for departing Directors

It’s not always to spend more time with the family.

Two of Great Southern’s Directors resigned in 2005, because, as we have subsequently discovered, they objected to the Board’s plan to artificially boost the returns to the 1994 investors, the Ponzi Plan.

The resignations of Elders’ nominee, Vince Erasmus, from FEA’s Board on 26th March 2010, signalled that the end was nigh.

Then there’s Mr Gay and Mr Gray …

Where to?

Given that the forest industry has led to so much community angst, it remains a source of amazement that few commentators and advisors have much idea about the financials of participants, whose causes they unreservedly support. They read the accompanying media releases but that’s it. ‘Clueless’ the word the Premier used to describe people with a contrary view on forestry issues perhaps should be used to describe most on his side of the debate as well when it comes to a grasp of how some of the forest companies work.

Glossy reports about the forest industry never seem to quite gel if one looks at the financials of some of the players. The sum of the parts always seems to be different than the whole.Try consolidating Gunns, FEA and FT. The result is radically different from the picture of the industry presented by FFIC.

The industry, FFIC and the Pulp and Paper Taskforce, blissfully continue to ignore the structural flaws in their industry, and with a nerve unmatched by anyone except perhaps Wall Street bankers keep asking for more assistance to overcome problems which are largely of their own making.

Fortunately it is just a few players in the forest industry, the MISers and native forest chippers who have done such a major disservice to their fellow industry participants. With a greater understanding of their books and how they work hopefully they won’t be permitted to re-emerge, to dominate and chart the course for their colleagues to quite the same extent as they’ve done in the past, and as a consequence, enable a sustainable forest industry to get on with business away from the ugliness and division of the past 20 years.


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