Tuesday, 14 September 2010

The death of Forestry Tasmania

If Forestry Tasmania was a private company it would now be in the hands of an Administrator.

The recently released financial accounts for the 2009/10 year paint a bleak picture.

Warning bells ring on the very first page with the introduction of a new accounting concept of profit, an underlying profit figure. Don’t worry that the accounting loss for the year is $305 million; the underlying profit is $1.2 million.

Sounds much better.

The land which didn’t belong to it was removed from the accounts.

The trees owned by FT lost value.

FT’s unfunded superannuation liability grew.

There was a cash flow deficit from operations.

FT is now in breach of one of its lending covenants and its lenders are currently relying on a Letter of Comfort from the Treasurer pending new arrangements. The only security for its borrowings is receivables and they’re a little shaky.

A bad debt of $1.2m was written off during the year.

The Letter of Comfort was probably more welcomed by the Directors than by the Lenders. They were then able to sign a solvency declaration.

If it was a private company, FT would be unable to refinance its borrowings without a Letter of Comfort from the Treasurer.

It’s just another badly managed forest company. Moral hazard has probably once again led to errant behaviour. FT is blessed with a shareholder who is likely to bail it out.

After the write-offs, FT’s equity, its book value, is only $275 million And $235 million of that was our (the Government’s) contribution. Most of the balance has come from retained earnings, all of this likely to be ‘earnings’ from the increased value of trees yet to be harvested.

It’s not as if dividend payments to Government have drained the retained earnings. They’ve been conspicuously absent of late.

So after 15 years of corporatised life, FT’s equity has grown by only $40 million. We’re $40 million better off for 15 years of FT managing our State forests, 15 years of conflict and argy bargy. Seems a bit on the low side.

But according to the Chairman, Mr Kloeden, “FT had emerged from the crisis in better shape than others – particularly some publicly listed companies”.

Which ones?



Great Southern?

How did FT survive? This is where it gets interesting.

Companies survive during tough times by scrupulous attention to their cash flows. Sometimes more capital is needed. But when operating cash flows are negative and lending covenants are breached lenders won’t help. And when the shareholders don’t contribute extra, what is Plan C?

Plan C involves the use of funds allocated to FT under TCFA. These grants are supplied to FT to help meet operating expenses and for capital expenditures on plantation establishment and maintenance. Compensation for locking up forests is the rationale. The grants are paid irregularly, in the first instance recorded as ‘revenue in advance’. Amounts are transferred to the P&L as ‘revenue’ when the matching expenditure occurs.

At 30th June 2009 FT had revenue in advance of $56 million. $47 million was listed as a current liability, meaning it was to be spent in the next 12 months, in the 2009/10 year. The balance was due to be spent in ensuing years and was included as a non current liability. FT watchers were acutely interested in how FT was going to find $47 million to meet their TCFA obligations when there was only $37 million in the bank and FT was struggling.

Amongst those watching was the Auditor General who commented in his report to Parliament:

“As its cash position has become tighter, Forestry has utilised these funds on a short term basis to meet operational requirements. Funds withdrawn are replaced at a future date when cash from normal activities is available to do so. Management are aware that the money ‘withdrawn’ as at 30 June 2009 needs to be replaced and expended on TCFA specified activities and regularly manage the overall cash position of the organisation on this basis. In the absence of TCFA funds Forestry would need the flexibility provided by a working overdraft account. The TCFA infers the agreement can be terminated by the Commonwealth if there is a failure to use money for the purpose for which it was allocated. There is no indication that Forestry will breach this agreement.”

How did FT find the necessary $47 million?

It didn’t.

Instead the current portion was reclassified to $20 million and the non-current portion increased to $36 million.

Even so, the 2010 financial accounts only show $10 million of TCFA funds being spent during the year.

FT received a further $10 million in TCFA grants in 2009/10.The unspent grants now total $60 million.

But there’s only $30 million in the bank.

If FT was a private company in a shaky industry, there is no way customers would have paid $60 million worth of revenue in advance.

FT would not have survived.

FT may be able to find the cash for this year’s TCFA expenditure commitment of $14 million; however it may struggle to find the cash to meet its non-current commitments of $46 million.

The notes to accounts (Note 24) says, “there is currently no intent for Forestry Tasmania to undertake new borrowings”.

What’s the answer?

A bank robbery?

A demerger?

FT’s situation is eerily similar to MIS companies which relied on a cash boost from annual MIS sales to help cash flow the ensuing year. When MIS sales failed to materialise, the end was nigh.

What are the effects of the cash flow problems? In 2008/09 $12 million of capital spending on plantations and $18 million on plant and equipment was outlaid. This year (2010) the figures were $8 million and $2 million.

This is a company positioning itself for the future.

Another area of great concern is FT’s unfunded superannuation liability. It is similar to the problems facing the General Government sector.

Just by way of explanation. Most people understand superannuation accumulation schemes, where employers contribute 9% of salary into a fund. Maybe the employee contributes as well. These schemes are known as defined contribution schemes.

Less familiar are defined benefit (DB) schemes where members receive an end benefit based on factors like final salary, years of service and the level of employee contributions. The employee’s share is funded but the employer’s share is often unfunded. Instead when the benefit, usually a pension benefit, arises, employers simply pay their share out of current revenue, on an emerging cost basis to use the jargon.

FT’s DB scheme has been closed for 15 years but there is still a large unfunded liability. There are some plan assets, mainly employee contributions and earnings thereon; about $33 million. But the total liability for future benefits is $155 million, leaving an unfunded amount of $122 million. This is a considerable amount. FT’s bank borrowing (now secured by the Treasurer’s Letter of Comfort) is only $40 million.

Due to poor returns on plan assets as a result of the GFC, and other actuarial assumptions, the unfunded liability grew by $15 million in 2009 and $19 million in 2010. This additional superannuation ‘expense’ is recorded in the P&L. But not in the calculation of FT’s headline profit which appears in media releases or in the new calculation of underlying profit.

Each year FT is required to contribute 70% to 75% as its share of benefit payments, plus an amount to cover its super guarantee obligations for DB members. Last year, 2010, the amount was $6 million. But this amount does not appear in the P&L. It is merely a reduction in the unfunded liability which as explained in the previous paragraph is excluded by FT from their convenient measure of profit.

Hence the cost of FT’s unfunded super liability is excluded from its publicly discussed profit figures. Pretty misleading.

The $6 million outlay by FT appears in the cash flow statements but not the income statement.

The figures for the General Government’s unfunded super liability and the cash amounts required to fund future benefit payments were provided under questioning at Legislative Council Estimates hearings this year. If the same pattern is followed with FT, the unfunded liability will increase by at least one third, say by $40 million over the next 15 years, and the annual cash amounts to meet benefit obligations will increase by 2.5 times, from $4 million up to $10 million pa. Not to mention the DB super guarantee obligation.

How’s FT going to manage? Cash from operations is negative. It can’t borrow any more. It hasn’t any assets to sell. Unless ... surely not ... they’d have to clearfell half the forest estate just to pay super benefits if their performance over the last 15 years is taken as a guide.

If FT was a private company and I was a member of their DB scheme I would be afraid. Very afraid.

The General Government includes a ‘nominal superannuation interest’ amount in its P&L (see Appendices to the Budget or the Treasurer’s Annual Financial Statement) in order to account for the annual cost of its unfunded liability. Perhaps FT should do likewise. To omit any costs of the liability from its headline profit and underlying profit figures is quite misleading. After all, the unfunded liability is FT’s largest liability and likely to get larger.

Also misleading is the fact that the headline and underlying profit figures only include revenue from timber sales. Any ‘cost of sales’ or movement in timber values is omitted at this stage. Chop down another tree and even with a stumpage value of $1, profits will increase. The costs of logging roads are capital. They don’t appear in the P&L.

FT’s financials are of little assistance when it comes to trying to understand the breakup of its revenue and hence profits. At the urging of the Auditor General FT did isolate what it described as the costs of its community service obligations (CSOs) which includes looking after non commercial forests.

But a more complete set of segment accounts would have been more helpful.

Or at a minimum a breakup of its ‘sales revenue’ of $114 million (from Note 5) would be useful. From past experience it is likely that over 50% of this amount comes from harvest, cartage and road tolls, in other words the costs of extraction and cartage to the mill door or the wharf.

The source of FT’s profits are what it receives from stumpage royalties. These are likely to have been only about $50 million. But what is the breakup between log types? I attempted a breakup for 2009 ( Forestry Tasmania is the stumbling block, HERE ) but there’s not enough info available yet to attempt the same for 2010. But the question is of crucial importance for FT’s survival.

What were the royalties from native forests in 2010?

Last year (Note 11) employee expenses (including unfunded super) of $45 million was listed. This year the note excludes the increase in unfunded super. Had it done so the employee expenses would have totalled $50 million? About the same as the stumpage royalties.

It is starkly apparent that FT is teetering. It is unlikely to survive in its current form.

We sometimes forget how often businesses just disappear from view. Economist Paul Ormerod in his book “Why most things fail” describes how only 48 out of the world’s top 100 industrial companies in 1912 survived until 1995. Only 28 were larger. “Disappearance or decline was almost 3 times more likely than growth ... eventually age claims them. Most firms fail ... They innovate; they respond creatively to changes in their external environment; they strive not merely to survive but to succeed. Some do, but for the most part they fail”.

Like trees in a forest. Most die eventually.

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