Failing to see the wood for the trees

By BRIAN GAYNOR

What is wrong with our forestry industry?

Why has the sharemarket performance of Carter Holt Harvey, Evergreen Forests and Fletcher Forests been so poor?

Why do investors have little interest in an industry that will experience a huge increase in output over the next decade?

New Zealand has experienced a dramatic increase in new forest plantings since the late 1960s and now has 1.8 million hectares of planted production forest area, compared with just 0.4 million in 1967.

The forest harvest has also increased dramatically. Total removals have risen from 13.5 million cubic metres in 1991 to 19.5 million cu m in the March 2001 year. Growth will accelerate in the next 10 years and the total forest cut is expected to be 28.8 million cu m in 2005 and 31.3 million cu m in 2010.

The huge growth in output has not been matched by a corresponding increase in value-added productive facilities.

As a consequence, the export trade has become more dependent on low-value logs and wood products, mainly sawn timber. In wood-use terms these low-value products now represent 78 per cent of forestry exports compared with 68 per cent 10 years ago.

Two conclusions can be drawn from industry developments in the past 35 years:

* Production influences rather than market demand have driven the huge increase in plantings.

* New Zealanders are more willing to invest in the forest resource than the companies that add value to the forest output. As a result, the industry has become more reliant on low-priced commodity exports.

Export log prices have been depressed for some years because of increased competition, the 1998 Asian economic crisis and the poor performance of the Japanese economy.

New Zealand producers face heightened competition from several countries, including Australia, Chile and Russia. Russian softwood, mainly larch, is a strong market leader and accounts for nearly 60 per cent of softwood log exports to Asia.

Japan imports the more highly priced products and the drop in demand from that country has had a big impact on New Zealand's log exports.

Sawn timber exports to Australia and Asia have been relatively flat in recent years, but there has been a sharp upturn in sales to the United States. Fletcher Forests has played a big role in developing sawn timber exports to North America. The September 11 terrorist attacks have hurt export markets and prices remain depressed.

In mid-October Carter Holt Harvey reported that export log prices were below levels experienced during the 1998 Asian crisis. Sawn timber export prices were also soft, but a stronger Australian residential housing market had allowed the company to implement two 5 per cent price increases in recent months.

Mark Bogle, Evergreen Forests chief executive, told last week's annual general meeting that log prices were at their lowest level ever.

Sir Dryden Spring, Fletcher Forests' chairman, told shareholders this week that prices and demand were expected to remain depressed because of the Japanese recession and economic downturn in the United States.

The one bright sign on the horizon is China, with all three companies reporting a big increase in sales to that country. Carter Holt's log exports to China have increased from 36,000 tonnes in the March 1999 year to 145,000 tonnes in the March 2001 year and 111,000 tonnes in the six months ended September.

Notwithstanding strong Chinese demand, the earnings and forest values of Carter Holt and Fletcher Forests have been adversely affected by low log and wood product prices.

Carter Holt Harvey, the country's largest forest owner, has experienced a sharp decline in earnings since International Paper raised its shareholding to 50 per cent at $3.80 a share in April 1995.

Carter Holt is a diversified forest products company with 14 per cent of group sales in forests and logs and 29 per cent in wood products. Its pulp, paper and tissue operations also have a big influence on the group's operations and represent 35 per cent of total sales.

The group's forest resources are included at cost and limited updated information is released on these assets.

A new exposure draft on forestry accounting standards, based on International Accounting Standard 41, will soon be released. This policy requires forests to be valued annually and changes to be included in the earnings statement.

If this standard is adopted, New Zealand will fall into line with Australia and most other major countries, although Evergreen Forests and Fletcher Forests have already adopted a market valuation approach.

Investors have determined that Carter Holt's forests are overvalued because the company's share price is trading at a 37 per cent discount to net tangible asset backing. In other words, based on Carter Holt's share price, the market value of the group's forest estate is well below its establishment cost.

Evergreen Forests is a pure play forest investment as it has no downstream facilities, no longterm log supply commitments and can dramatically increase output over the next few years. Its forests are independently valued and at June 30 were worth $157.4 million compared with an establishment cost of $151.7 million.

The company's future is dependent on export markets, but management has shown that it can add value in a difficult environment. Its ordinary shares are trading at a 21 per cent discount to asset backing.

Fletcher Forests, which has destroyed a huge amount of shareholder value, is the country's second-largest forest owner. Forest and log sales represent 42 per cent of group sales with a number of downstream facilities manufacturing wood products accounting for most of the rest.

The company reported a net loss from continuing operations of $1.4 billion in the June 2001 year. This included a $533 million writedown on its Central North Island Forest Partnership (CNIFP) investment, which is in receivership, and a $752 million reduction in the value of its forests (the company switched to a current market value accounting policy in the June 2001 year).

Fletcher Forests still manages CNIFP's forests resource and has an outstanding loan to the partnership which has a book value of $357 million. Because of this, the sale of CNIFP's assets by receiver Michael Stiassny will have an important influence on the company's share price performance.

Fletcher Forests shares are trading at a 46 per cent discount to net asset backing and many shareholders at Wednesday's annual general meeting were extremely unhappy. Among the issues raised were:

* Only one board member has any forestry expertise.

* No board member has any direct experience of China or India yet these two markets offer huge growth potential.

* The directors are well paid yet they spend a great deal of money on outside advice from consultants.

The overall impression of the forestry sector is that there is too much emphasis on production and cost cutting and not enough on marketing and downstream development. Terry McFadgen, Fletcher Forests chief executive, told the meeting that in the past six months the group had employed specialists speaking Mandarin, Gujarati, Thai and Malaysian dialects to help in marketing.

But why has it taken so long? The three listed companies have invested $4.2 billion in their forests, yet one of the dominant players has waited until 2001 to fully develop its Asian marketing operations.

As the three forest estates have probably lost more than $1 billion in value because of poor market conditions, surely the companies should have allocated a greater proportion of their resources to market development.

Taking a medium-term view, all three forestry companies look attractive because they are trading at a large discount to asset backing and log and wood products markets will eventually recover.

But the sector will not reach its full potential until a greater commitment is made to market development, particularly in view of the huge increase in wood supply due in the next decade.

* Disclosure of interest: Brian Gaynor is a Carter Holt Harvey and Fletcher Forests shareholder.