Sunday, 31 January 2016

Are Forestry Tasmania's losses even greater?

Assumptions of 80 to 90 year rotations in native forests formed the basis for estimating the future sustainable volumes that could be extracted from our public forests as part of the forest peace process.

It would be a pure coincidence if the sustainable rotations led to a sustainable FT.

If timber is sold with inadequate margins as FT does then it won’t be financially sustainable regardless of whether the forests are sustainable.

Yet FT claims logging a small poorly managed production forests like Lapoinya after 60 years of regrowth yielding only 245 tonnes of timber per hectare is a profitable exercise.

It’s only profitable if a lot of costs are ignored.

When FT personnel talk about a coupe being profitable they are usually oblivious to the fact that from a strict accounting viewpoint, profits now accrue each year with changes in the value of trees brought to account

Harvesting a coupe is a cash realisation exercise not a profit making event. This is a crucial distinction which most fail to grasp.

The following is a discussion about the subjective assumptions that underpin the way FT values its forest estate which is the crucial determinant of whether FT is profitable.

Perhaps losses are even greater?

A slightly different set of assumptions would make FT irrevocably unsustainable as it currently operates.

In 2010 FT adopted a new way of valuing its forest estate which is comprised of land, roads and trees. Future expected returns are discounted back to derive a present value which is then split between the three components. Land draws the short straw. It is allocated a zero value. Roads are allocated their written down value and trees end up with the balance.

Forest companies, whether government or private, don’t all do it this way.

The suspicion is the method chosen best tarts up the accounts, rather than forming the best basis for optimum decision making. Publicly owned forest companies, having forests with non-production values adds another layer of complexity.

FT’s total estate in 2014 was worth about $170 million roughly 50:50 between roads and trees. It’s quite bizarre, roads were valued at $85 million yet the land upon which they were constructed was valueless.

 In 2015 $18 million worth of roads were reclassified as trees.

The split and reclassifications involve subjective judgements.

Imagine trying to convince a dairy farmer that whilst his farm may be worth $5 million say, the land’s worthless; the milking shed, laneways and irrigation set-up have a written down value of $2.5 million, which leaves a crop of perennial ryegrass worth $2.5 million. Grass is the crop that feeds the cows to earn the income. Surely any residual value of the dairy farm must be assigned to grass? The result is a logical absurdity. Land has no value?

It’s one thing to value a working forest estate on the basis of future cash flows, but it’s a separate matter to arbitrarily split any value as FT does.

What gets included in future cash flows becomes a salient question?

Obviously revenue. In this case it’s the stumpage return which is sales less harvest and cartage costs. That’s fine.

Cost outgoings over the rotation are taken into account, forest maintenance, overheads etc. Again no worries.

Land rental would ordinarily be included as a cost. But because FT owns (or controls) the land an imputed rent should instead be included.

However the chosen valuation methodology, in theory, splits the forest estate and thereby allocates a value to land so there is no need to include an imputed rental figure as a forest management cost. That’s FT’s argument.

But, in practice, land is subsequently given a zero value. 

There’s a self fulfilling odour about the argument that imputed rent needn’t be considered because land is to be assigned a value and then a moment later giving it a zero value.

When assessing future net income from a perpetual asset like a forest, FT only considers the current crop of standing timber. It ignores what happens after harvest. Establishment costs of the current rotation are ignored as only prospective costs are considered.

That’s ok, but FT only offsets a few costs of the current rotation against harvest proceeds.

Post harvest costs such as regeneration are ignored even though most are mandatory under the Forests Practices Code. Whilst harvest and cartage costs are deducted from sales to calculate net revenue, the costs of roading aren’t.

It may be the costs of roads are not included when working out future net income using the same logic that excluded imputed land rents. Land and roads are assigned a value as part of the forest estate so the costs do not have to be included when assessing its value?

At least overheads are included when assessing future net income from forests. Different from when foresters talk about profitability.

However roading and post harvest costs are conspicuously absent from both tree valuations and foresters’ profit calculations.

The conventional accounting approach is that expenditure on new plantations and roads is capitalised as assets, rather than recorded as expenses in the income statement. When assets become impaired, an impairment charge is recorded in the income statement.

But if those assets are impaired from day one, in other words they are a crappy lot unlikely to produce future profits, perhaps they should be written off immediately?

That’s what the Auditor General suggested in April 2009 in one of the earlier drafts of his Report no. 100 into the Financial and Economic Performance of FT finally completed and tabled in July 2011. (The AG was referring to plantations, but his argument equally applies to regenerated native forests).

That’s what happens at Tas Rail chaired by FT’s outgoing chairman Annells. Tas Rail spends heaps on capex each year upgrading what it terms below rail assets which are immediately impaired and written off as future profits are unlikely.

Roading and regeneration costs should be offset against revenue when incurred. And in the case of yet to be harvested coupes they should be taken into account when estimating future management costs as part of the tree value calculation.

The tree valuation process is much like a Net Present Value (NPV) investment appraisal where a series of costs and income are reduced to a single NPV figure to ascertain whether it’s positive or negative, in other words whether the investment is profitable or not. The main difference with FT is that it doesn’t include all the costs.

How land is accounted for isn’t just an esoteric accounting argument. Land use is a crucial public policy decision.

Whether it’s native forests or plantations?

In the case of native forests there are non production values so land arguably should be treated differently than land with a monoculture plantation.

FT is in the process of selling the latter so the question of the land and tree split is important.

The sale is likely to be a sale of trees but retention of the land pursuant to the Forests Rights Registration Act 1990. This is essentially a rent free arrangement for the term of the right.

FT directors need to make it plain to Tasmanian taxpayers that they are about to sell trees for, at best, $1,000 per hectare, trees that have cost $4 to $5,000 to establish, and grant the buyer rent free use of the underlying land for 75 years.

One suspects a few people might be interested to know FT is granting rent free leases for 75 years.

What’s the odds a potential buyer of FT’s hardwood plantations with a 75 year forestry right, crunching the numbers, will take into account all costs (or estimates thereof) over the 75 year period in order to assess the value of the trees, not just the period covering the life of the current crop?

The anticipated low offers for FT’s hardwood plantation estate will certainly, in part, be due to the inclusion of costs beyond the current rotation whether they’re opex amounts or whether they form part of what FT regards as capex, roading and regeneration costs to be specific.

Wouldn’t it make sense for FT to adopt the same approach when it values a perpetual asset such as a forest?

For native forest with non production values, land surely has a value? By definition, if you’re not clearfelling, you’re acknowledging other values that are worth something.  Proceeding on the basis that land has zero value can only lead to incorrect resource allocation decisions.

FT may claim a coupe has value and worth logging, but it really depends on the way it’s valued in the first place.

If you assign nil value to land it’s easy to argue harvesting creates no losses.

Yet it’s difficult to understand how logging native forest coupes don’t result in land losses.

Especially clear felling.

The valuation methodology assumes no return on land, no $ returns on FT’s land whatsoever.  If there’s surplus value from forests, assign it to trees not land?

 If you exclude a whole raft of costs including roading and post harvest costs when calculating future returns from forests the value will be overstated.

And then splitting any derived value in the way FT does it is very subjective.

The value of FT’s forest estate, the only asset in its shrinking portfolio, is based on some questionable assumptions.

One needn’t stray from the path of reason and reasonableness to calculate a much lower value for trees thereby making FT irrevocably unsustainable as it currently operates.

Does the current approach provide the best basis for sound public policy making?

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