Underperforming against a low target

Forestry Tasmania is failing to meet its financial or community targets in a worst-of-both-worlds scenario

Forestry Tasmania’s targets
Under the Government Business Enterprises Act 1995, Forestry Tasmania (FT) is charged with the "sustainable production and delivery of forest products and services for optimum community benefit." FT has refined these general goals into four corporate targets, which are:

The purpose of this report is to present an overview, through analysis of the financial statements, of FT’s performance against its first target. A commentary on the fourth target and its correlation with the others is also offered in this report.

All information in this report comes from FT’s Annual Reports and Financial Statements for the years ended 30 June 1994, 1995, 1996, 1997, 1998, 1999, 2000 and 2001. Some of the graphs below are incomplete where comparable information was not available from the reports.

Improve profitability – what does it mean?
The most common measure of profitability is Return on Equity (ROE). The ROE looks at net profit/total equity as a measure of the financial return being generated by a company’s assets.

Generally, a target ROE is set based on a risk adjusted target rate of return, set using a capital asset pricing model, or similar. Briefly, a target ROE is set using:

ROE = risk free rate + equity premium * risk factor

The risk free rate in Australia is currently around 5.25% based on the Government 10 year bond rate. The equity premium reflects the fact that investing in business activities is more risky than investing in Government bonds, and is normally set between 4 and 6. The risk factor reflects the relative riskiness of the industry. The average risk factor for the whole market is one, and hence the average target ROE for companies is currently between 9.25% and 11.25%. But ROE’s can vary considerably depending on the riskiness of the business. For example, electricity network businesses, which are very stable with little risk, have a target ROE of 7.5%. Electricity retail businesses, which are riskier because they are exposed to commodity price fluctuations, currently have a target ROE of 14%.

FT does not disclose its target ROE in its Financial Statements and, unusually, its corporate objective for improving profitability is only expressed as a sales revenue target. This is not the approach used by the market, as increased sales can be associated with low prices and hence low profitability.

Under the new accounting standard for forest estates (AAS35), companies must determine a suitable real discount rate for valuing the forest estate. FT has been required to determine a discount rate in its 2001 returns and has used 7.07%. The report notes that the market-based discount applied to plantation crops is 9.39%. We can thus assume that FT views its target ROE as 7% which is lower than the market would require for a listed company.

How is FT going against this low target? The graph below shows this:

Comparing results against prior time periods is extremely difficult because of the change in reporting method to AAS35 in 2001. Therefore the 2001 profit has been adjusted for consistency with prior years by eliminating the effect of AAS35 that now puts movements in the forest asset through the revenue statement. Including this would increase the 2001 ROE from 0.3% to 2.5%. However the general picture is clear – FT is an under-performer against either its own target or against the market target.

Why is FT’s Return on Equity so low?
FT’s 2000-2001 return on equity was 0.3%. Generally, ROE’s are low when:

We now consider each of these in turn:

Forestry Tasmania Revenues
FT revenues have been growing steadily for each of the last three years. The graph below shows the increase in two items:

The graph shows clearly that revenues have been increasing at a fast rate, although in 2001 revenue increased by only half the rate of increase in native forest harvested.

Thus it is clearly not the rate of native forest harvesting that is holding down the ROE. As we will see later, it could be the gap between the 2001 rate of clearing – which also drives costs – and the rate of revenue increase, which is driven by pricing structures.

Forestry Tasmania Expenses
FT expenses have also been growing steadily for each of the last three years. The graph below shows the increase in the expenses overall as well as the contractor expenses. In 2001, contractor’s expenses increased by 37%, from $37m to $50m.

This growth in operating costs compared to revenues drove down the operating margin, as shown below.

The recent severe reduction in operating margin is due to a number of factors:

1. Costs spent on new roads increased from $17 million to $22 million in the last year. The new roads, constructed to access new areas of native forest, created only marginal additional returns.

2. The profitability of the GMO joint venture reduced from a 25% operating margin in 2000 to a 15% profit margin in 2001. While this is still higher than FT’s normal operating margins, it shows both the potential variability of the GMO joint venture as well as a worrying trend.

3. A one off jump in "Contractors expenses" from $37 million in 2000 to $50 million in 2001 has also affected operating margins. This is likely to be correlated to the additional spending on new roads.

An operating margin of below 6% is extremely low for the forestry industry. It means that profits are vulnerable to being wiped out in a poor year.

The reduction in operating margin also has an impact on the day to day cash being generated by the operations. This is shown below – the cash margin is the ratio of cash receipts to payments to suppliers and employees.

Comparison with FT customers & market expectations
It is useful to compare the ROE being made by Forestry Tasmania with that being made by its customers. An imbalance between the two normally means that there is inappropriate pricing occurring or that the balance of power is skewed in favour of one party.

FT’s largest customer by some margin is Gunns (following Gunns’ acquisition of Boral’s Tasmanian operations and North Forest Products (NFP) in May 2001). In a year in which Forestry Tasmania generated a ROE of 2.5% and operating margins fell to below 6%, Gunns achieved a profit or $17.8 million (up from $8.7 million the previous year).

It thus appears that there is subsidization within the vertical chain i.e. that Gunns is making disproportionately high profits compared to its supplier, Forestry Tasmania. This possibility is supported by the fact that, while sales of forest products to Gunns have increased significantly over the past three years, the underlying costs of supplying those materials has increased even more.

Is FT losing profitability because of its community charter?
Maintaining profitability is only one of FT’s four corporate objectives. If the low ROE is occurring because of the commitment to gaining community support for Forestry Tasmania’s operations, then perhaps it could be justified.

Unfortunately, however, the exact opposite is true. The community opposes clear-felling of native forest and prefers plantation forests. While supportive of the logging industry, the community also believes that tourism is the key to Tasmania’s long term success. It is the very same rapid expansion of native forest felling and low price sales that is pulling down the ROE of FT, which is also losing it support within sectors of the community. Hence, in the words of the title of this report "Forestry Tasmania is failing to meet its financial or its community targets in a worst of both worlds scenario".

NJ Edwards BSc(Hons)
Fellow of the Institute of Actuaries (London)
Fellow of The Institute of Actuaries of Australia
Fellow of the Society of Actuaries of New Zealand