Black Liquor Tax Credit Clouds Paper Companies’ Earnings

Paper mills aren't making money just on paper

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?During 2009, paper companies that converted black liquor (a byproduct of paper mills) into alternative fuel became eligible for an Alternative Fuel Mixture (AFMC) tax credit. The tax credit was an unexpected boon for paper companies. Sixteen paper companies reported an AFMC Windfall in 2009, averaging 8% of revenues and 161% of pre-tax income. The tax credit lasted for less than a year—it expired on December 31, 2009. Click here for our detailed report.

Investors betting on those companies to continue the earnings growth trend from 2009 may be sorely disappointed.

The AFMC windfall is a one-time, non-recurring source of income that can mask poor economic earnings with record-breaking accounting earnings. Accounting earnings are full of distortions that mask true economic earnings—-the AFMC windfall is just another example of why accounting earnings were not designed for equity analysis.

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Two companies, Kapstone Paper and Packaging (KS) and Verso Paper (VRS), reported positive pre-tax income with the AFMC windfall while they actually had negative pre-tax income after removing the AFMC windfall. These companies also had record-breaking accounting earnings and worst-ever economic earnings.

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The AFMC windfall also offers a unique opportunity to assess the consistency of companies’ accounting treatment and disclosure of this one-time item. We expected to see similar accounting treatment and disclosure, but the companies’ disclosure was highly inconsistent, and in several cases, misleading. In fact, we give two companies a failing grade for poor disclosure. More details on Disclosure Grades are in Figure 4 of our report on the AMFC windfall.

Of the 16 companies receiving the AFMC windfall, only one company, Kapstone Paper and Packaging (KS), chose to capitalize part of the AFMC windfall into inventory. This aggressive accounting essentially gives KS a cookie jar of earnings to use in 2010.

Despite the fact that the AFMC expired on December 31, 2009, KS’s aggressive accounting will allow it to book $0.31 in earnings per share in 2010 related to the windfall. KS is the only company in 2010 to book earnings from 2009’s expired AFMC Windfall. It should be no surprise that this company also had the worst disclosure. As Warren Buffett says, “There is never just one cockroach in the kitchen.”

Poor disclosure and aggressive accounting make it extremely difficult for everyday investors to reverse accounting distortions to measure a company’s true economic earnings. Though navigating poor and confusing disclosure in the Financial Footnotes to find the truth about corporate profitability and valuation takes hard work and expertise, I believe investors who do it sleep better at night.

There is no substitute for “doing the diligence.”? In the meantime, watch your back when investing in this market because no one else is watching it for you.

The AFMC windfall report is the second in a series of Red Flag reports that focus on culliing key details from the Financial Footnotes..? Our first Red Flag report focused on off-balance sheet debt and how it affects over 2900 companies.

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Black Liquor Tax Credit Comes Back To Burn Paper Companies

Image by Getty Images via @daylife

During 2009, paper companies that converted black liquor (a byproduct of paper mills) into alternative fuel became eligible for an Alternative Fuel Mixture (AFMC) tax credit. The tax credit was an unexpected boon for paper companies. Sixteen paper companies reported an AFMC Windfall in 2009, averaging 8% of revenues and 161% of pre-tax income. The tax credit lasted for less than a year—it expired on December 31, 2009.

Investors betting on those companies to continue the earnings growth trend from 2009 may be sorely disappointed.

The AFMC windfall is a one-time, non-recurring source of income that can mask poor economic earnings with record-breaking accounting earnings. Accounting earnings are full of distortions that mask true economic earnings—-the AFMC Windfall is just another example of why accounting earnings were not designed for equity analysis. Two companies, Kapstone Paper and Packaging (KS) and Verso Paper (VRS), reported positive pre-tax income with the AFMC Windfall while they actually had negative pre-tax income after removing the AFMC Windfall. These companies also had record-breaking accounting earnings and worst-ever economic earnings.

Special Offer: Why bother with stocks when you can beat the pants off of them with fixed income while taking on less risk? Earn 8% yields on top of chunky capital gains. Click here for recommended buys in Forbes-Lehmann Income Securities Investor.

The AFMC windfall also offers a unique opportunity to assess the consistency of companies’ accounting treatment and disclosure of this one-time item. We expected to see similar accounting treatment and disclosure, but the companies’ disclosure was highly inconsistent, and in several cases, misleading. In fact, we give two companies a failing grade for poor disclosure. More details on Disclosure Grades are in Figure 4 of our report on the AMFC Windfall.

Of the 16 companies receiving the AFMC windfall, only one company, Kapstone Paper and Packaging (KS), chose to capitalize part of the AFMC windfall into inventory. This aggressive accounting essentially gives KS a cookie jar of earnings to use in 2010. Despite the fact that the AFMC expired on December 31, 2009, KS’s aggressive accounting will allow it to book $0.31 in earnings per share in 2010 related to the windfall. KS is the only company in 2010 to book earnings from 2009’s expired AFMC Windfall. It should be no surprise that this company also had the worst disclosure. As Warren Buffett says, “There is never just one cockroach in the kitchen.”

Poor disclosure and aggressive accounting make it extremely difficult for everyday investors to reverse accounting distortions to measure a company’s true economic earnings. Though navigating poor and confusing disclosure in the Financial Footnotes to find the truth about corporate profitability and valuation takes hard work and expertise, I believe investors who do it sleep better at night.

There is no substitute for “doing the diligence.”? In the meantime, watch your back when investing in this market because no one else is watching it for you.

The AFMC Windfall report is the second in a series of Red Flag reports.? Our first Red Flag report focused on off-balance sheet debt and how it affects over 2900 companies.

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Gold Endures While Paper Money Goes Up In Flames

Gold has a track record that predates King Tut

U.S. stocks are up about 6% so far this year. Gold has gone up three times as much.? The Fed’s money has been losing ground against nature’s money for the last 10 years. Roughly, if you’d stuck with gold you’d have five times the purchasing power you got from the U.S. dollar.

That’s pretty clear, isn’t it?

But you could go back and look at the history of every pure paper money. Look at how it did against the yellow stuff. Same story every time. No exceptions. Once you let human beings print “money” at will, they will print a lot of it. And unless they repeal the laws of diminishing returns, marginal utility and supply and demand, the paper money will lose out.

The law of diminishing returns says the more you do something the less good it does you. We’re not sure that’s true of everything… Mae West had a slight twist on the concept. “Too much of a good thing is wonderful,” or something like that. But for almost everything but THAT thing, the more you do it, the less you get out of it. It applies to printing up $100 bills too.

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The law of marginal utility is just another way of looking at the same concept. It tells you that when you get more and more of something, each additional unit has less value than the one that came before it. You can see how that works in the case of dessert, for example. The first chocolate pudding tastes great. The 10th one makes you sick. At that point, you’re getting not only diminished marginal utility, you’re getting negative marginal utility – which is what you get from bank credit too, but that’s another story.

We once knew a very rich man. He ran for governor of New York. We asked him why he bothered. He didn’t need to steal from the taxpayers; he already had enough money.

“Yes,” he replied. “But that’s just it. I’ve reached the point where the marginal utility of more money is extremely low. I need to do something else.”

He didn’t win the race.

But the point is, the fed’s gazillionth dollar is going to be worth a whole lot less than its first dollar. The more they print, the more you wish you had gold.

And you know the law of supply and demand already. There is a certain amount of goods and services available. This amount can be increased. But not overnight. It takes time, investment, expertise…and so forth.

By contrast, the feds can increase the supply of dollars almost instantly. It can just add zeros and multiply the supply by 10. These new dollars compete with the old ones for the available goods and services. Pretty soon, prices are rising and fast.

Oh, if it were only that simple. Trouble is, there’s the velocity of money too. When the economy takes a cold shower, the velocity of money slows to a crawl. Then, the feds can add as much new money as they want. It doesn’t necessarily get around the way the old money used to. Everybody holds onto it. The banks just keep it in their vaults. Householders keep it in their wallets and mattresses. Everyone figures he might need it.

When trouble hit in 2007, the banking sector had just $2.3 billion in excess reserves (money they held beyond the legal requirement) – barely enough to buy a drink in a good bar. Now they’re swimming in it. They’re got $976 billion in excess reserves. So how come consumer prices aren’t going wild?

By the way, where’d that money come from? The Fed already gave the economy a BIG dose of paper money. The feds were afraid that the banks were failing. They were right to be afraid. They were wrong to try to do something about it. It would have been much better to let the chips fall where they may…maintain the integrity of the government’s own finances and protect the dollar. There were plenty of sensible, well-funded bankers to pick up the pieces of the broken ones and make something good of them.

And by the way, again. This is not just our opinion. Mexico and Chile went through a similar crisis in the early ’80s. Mexico did what the US would do a quarter century later. It “allowed [its] archaic bankruptcy system to perpetuate the lives of money-losing businesses and allocated credit by government direction,” says Grant’s Interest Rate Observer.

And Chile? It let companies fail and allowed its markets to clear.

And what was the difference in outcome? Chile was back on track a decade later, soon surpassing its pre-crisis growth trendline. Mexico, on the other hand, never fully recovered. It’s still 30% below trend.

Just what you’d expect, in other words.

Why the Value of Paper Money Declines as the Quantity Rises by Bill Bonner originally appeared in the Daily Reckoning.

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