Too-good-to-be true forestry investments?

Forestry investment projects are sprouting up around the country like trees, offering investors unbelievable returns on their investments.

Vajira Premawardena, director at Lanka Orix Securities (Pvt) Ltd said he could not comment on the viability of such schemes but did say investors feel it is viable because the share value is very high. Touchwood Investments Ltd, one such publicly quoted company on the Colombo Stock Exchange (CSE), had a turnover of Rs.1 billion this past financial year. It has seen a staggering 1806% profit growth within the last two years and a 100% annual asset growth in 2005/6. The company is Board of Investment and Forest Department approved, is ISO 9001 and 14001 certified, has commercial operations in five countries, employs over 900 people and has over 14,000 clients worldwide. Touchwood which recorded profits annually have maintained a dividend policy of 20%. Over 400,000 trees of high commercial value have been planted.

The company says their vision is to help the destruction of Sri Lanka's rain forests and meet future demand for timber by growing trees that are commercially valuable and environmentally sensitive, which is a sound investment opportunity to all while ensuring financial security for future needs. The Touchwood Group is global with offices in Sri Lanka, Thailand, Dubai, Qatar, and headquartered in Hong Kong and operates out of a total nine countries but plans to be operational in 27 countries by 2010. Furthermore, the company also has plans on horizontal and vertical diversification including banking, timber flooring and processed forest products.

It was reported at the end of November 2006 that the CSE brought the Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB) into an investigation of the company's accounting practices, more specifically, a revaluation and proposed bonus issue. Furthermore, the Securities and Exchange Commission (SEC) has been investigating Touchwood since mid 2006 on its valuation reports and the fact that tree growth is factored into their profit and loss accounts.

“The CSE has the right to do it as the SLAASMB monitors the standards. Everything is in compliance with accounting standards. The question is as to why they are taking so long. Nothing has been proven wrong. We are confident that nothing can be proven wrong. As a responsible corporate entity, TIL has depicted the true and fair position of the company by bringing in the total assets and liabilities of the company. Otherwise, the company's profit would skyrocket at the maturity of stock (timber), which would not have been clearly identified until it happened (overnight). This is exactly why such a standard exists. Thanks to the negative publicity by imbeciles, the share is now trading at 130+. Our earnings and assets are incomparable,” he said.

The company's 2005 – 2006 annual report declares a revenue of over Rs.1 billion but out of that sum, approximately Rs.800,000 is listed as "Gain Arising from Changes in Fair Value". The report further states in the notes to the accounts that the amount related to gain arising from changes in fair value of biological asset, by adoption of IAS-41 'Agriculture' that "this gain is entirely unrealized as at the Balance Sheet date." IAS-41 states that "An enterprise should recognize a biological asset or agriculture produce only when the enterprise controls the asset as a result of past events, it is probable that future economic benefits will flow to the enterprise, and the fair value or cost of the asset can be measured reliably." It specifies measurements and disclosures, amongst other issues pertaining to fair value and presumes that it can be reliably measured for most biological assets. IAS-41 also specifies that the fair value of a biological asset is based on current quoted market prices and is not adjusted to reflect the actual price in a binding sale contract that provides for delivery at a future date.

Touchwood's Chief Executive Officer, Asitha Koralage and its Regional Director for Business and Development, Channa Abeygunawardene told The Sunday Times FT in an interview that Touchwood is a true triple bottom line company which covers people, planet and makes profit.

"We have built communities and offered jobs to indigenous people of Sri Lanka helping the country to alleviate poverty. We maintain bio diversity and utilize land that is malnourished in compliance with vigorous world class agricultural practices while maintaining healthy profits." The company's concept and business model is simple. Purchase land, demarcate, grow trees, manage until harvest and then sell the produce with a guarantee. It has forward contracts with clients spanning over 17 years and a strong fixed long term income by means of annual maintenance fees.

In order to become an investor, one has to enter into a legally binding agreement with the company and is issued Touchwood Harvest Certificates which are tradable with a money back guarantee arrangement. The investor pays the initial cost for the purchase of woodlots and will thereafter pay an annual maintenance fee which is a fixed 10% of the initial cost paid after the first year. An investor in mahogany will have to wait close to 18 years to see any return on their investment. Other products are agarwood, sandalwood, teak and vanilla. The return on investment ranged anywhere from 4 to 21 years with with 16 years for sandalwood and 15 years for teak.

Touchwood has plantations in Matale, Kalutara, Badulla and Ratnapura and owns the land which is transferred as collateral to the client until maturity. The company claims that if an investor purchases one mahogany tree in 2006 and waits the 17 1/2 years for maturity, three options exist. One is that they will get Rs.200,000 at maturity, the second is that the investor gets the 20 cubic feet of timber at maturity or lastly, the investor will get the market return for 20 cubic feet, prevailing at maturity.
Touchwood has several packages available for purchase which the company says are "designed to be affordable to people of varied income levels."

The company has no insurance against floods, fires, or any types of manmade or natural disasters but says the clients can obtain insurance but at their own expense. However, they claim to have minimized the risk of disasters by having 100% buffer stocks and scattering the plantations across the wet zone. With the recent heavy rains the country has been experiencing, the company claims that they have not experienced any problems with flooding or landslides. "Not even 1% is affected," The investor can terminate the agreement before maturity by selling the investment at a higher price to a third party or transferring the certificate to another individual.

What happens in the event that the timber market crashes? According to Abeygunawardene, the company has enough evidence from the FAO and ITTO that the timber market will exist as the timber market during the past two decades have not taken any dips. "Consumption is directly equivalent to the population – that is 6.5 billion trees consumed every year and keeps increasing. Touchwood can control the supply as the liabilities can be met by disposing a third of the stock." What happens if consumers start using synthetic material as opposed to wood in the future? "That is why we are careful in the selection of our species by dealing with high class timber. In any case, carbon credits or trading alone will pave the way to derive our revenue." Furthermore, Touchwood has BOI status which expressly states the company must drive 75% of their income from overseas. So where does Touchwood's income come from? Abeygunawardene said that eventually, they are looking at exporting finished or semi finished timber based products. "We will definitely be one of the few companies that will bring revenue to Sri Lanka irrespective of all economic conditions that prevail in Sri Lanka." However, this is after the trees reach maturity.

What the experts say
The Sunday Times FT spoke to an eminent forestry expert who said investing in such forestry schemes do not seem feasible to him since it is much too lucrative. "However, companies might be in a position to obtain these objectives if they are managed well and have accurate information about the growth." The expert, who declined to be named, says there are a lot of risks involved in such long term investments, whether conducted by the government or the private sector. "Fires in the dry zone is a big risk and so are insect attacks in the wet zone or pest damage, especially for mahogany. These risks, such as fires can be manmade or natural. Then there are price fluctuations."

For mahogany, there is the broad leaf and narrow leaf variety. Seed quality depends on the mother tree. According to the expert, some companies are not satisfied with Sri Lankan seeds such as eucalyptus but most foresters maintain that timber is of extremely high quality.

Companies generally adopt mahogany management schemes from other countries or different areas of Sri Lanka. "It is impossible to project things like growth rates that were not available earlier on the ground so you need pre-existing data. Even the Forest Department is using growth equations and mathematical models with data borrowed from other countries, for example from India. Growth rates for the same species can be different in different countries so you should be able to calibrate the original equation to Sri Lankan conditions. Otherwise, projections could be different because you are projecting profits for specific customers."

The best way to ascertain the feasibility of the projected growth records as opposed to the actual growth records for mahogany is by looking at data pertaining to the trees' diameter records. For example, established plantations in low country wet zones and intermediate zones have projected diameters of 12 cm. Anything below 9 cm, in the words of the expert is "definitely not good." A projected height of 64 feet is possible for mature trees. "However, we don't have pure mahogany plantations maintained by the Forest Department. They are all mixtures. There are differences in growth rates between mixtures and pure trees."

There are also a lot of other factors that go into the management of these plantations. "Sometimes, you might add fertilizer after about 3 or 4 years to increase growth. You need labourers to clean the weeds, water the seedlings, check daily on insects and other pest problems. All this is very costly because you need fertilizer, transport, labour, night watchmen and security." There is maximum growth and limitations on trees but most importantly, success of such investments will depend on the company's management practices.

An official from the Institute of Chartered Accountants of Sri Lanka (ICASL) told The Sunday Times FT that international accounting standards on agriculture do not apply to Sri Lanka because of the way the country accounts for tea. Because of this, Sri Lanka has been maintaining its own accounting standards.

Nevertheless, more harmonization between local and international standards are coming into place now. "In case of agriculture, these long term investment projects are determined by future cash flow. When you develop forestry products of this nature, the method to account for it is what is the future cash flow? The difference from year to year is allowed to be taken as profits now. With new standards, there is a level of estimation that is allowed to take place. However, these new property valuations plan could become a major deterrent which our people will play around with." "Only the directors and auditors can know if it is prudent or maintainable to declare a major portion of revenue from non-cash sources. The new valuation standards in ascertaining the future cash flow value is based on future cash flows that are expected. Companies can understate maintenance costs or overstate the price at which you can sell it. Companies can understate the amount of losses or the cost of finance or discounting rates can be played around with." He added that all reserves have to be dealt with thought profit and loss and then put in reserve before dividends are paid out. The assumptions companies use and if they are prudent at managing all those risks are fundamental questions, the answers to which only the directors will know.