CANA TECA PHASE I LIMITED PARTNERSHIP TEAK PLANTATION

BAGACES, GUANACASTE. COSTA RICA.

INTERNAL REPORT FINAL DRAFT

By Alan McCulloch

in consultation with Ing. Alvaro Solano Acosta

APRIL, 2003

TABLE OF CONTENTS INTRODUCTION................................................................................................................................. 2 PLANTATION PROFILE ..................................................................................................................... 2 SITE CONDITION ............................................................................................................................... 2 PRUNING............................................................................................................................................ 3 GROWTH RATES ............................................................................................................................... 3 THINNING PROGRAMME.................................................................................................................. 4 MARKET ASSESSMENT.................................................................................................................... 6 PRICING.............................................................................................................................................. 7 SALES............................................................................................................................................... 11 OUTLOOK......................................................................................................................................... 12 CONCLUSIONS ................................................................................................................................ 12 RECOMMENDATIONS..................................................................................................................... 13

2

INTRODUCTION In October of 2002, Cana Teca’s plantation management commenced the culling of approximately 31,000 teak trees spread over 170 ha in conjunction with its first rotation of thinning in a 50 yr production cycle. A brief overview is provided as to the recent history of the property and its current status. PLANTATION PROFILE Together with a 50-hectare area planted with complimentary native species, as proscribed under the Reforestation Act of Costa Rica, the table below summarizes the actual land use of the farm:

TABLE 1 - Plantation Profile

Actual Distribution

Area in Hectares

Percentage

TEAK REFORESTATION 294.82 63.16PRIMARY/SECONDARY FOREST 90.01 19.28FOREST REMEDIATON (native species) 50.00 10.71FIREBREAKS 8.22 1.76ROADS 0.77 1.16INFRASTRUCTURE 8.93 1.91PROTECTED ZONE 2.84 0.61CANAL 11.21 2.40TOTAL 466.80 100.00 SITE CONDITION According to the Forester, the plantation is comprised of approximately 247 hectares of teak in relatively good stages of development with average or above average growth rates. It is critical that these areas be maintained as they show the greatest potential for sustained production of merchantable timber over the next 18- 25 years. There are also areas where tree growth has been less than optimal and where after four years of growth, the average tree height does not surpass 2 metres. As a result, the canopy never closes and the grass continues to grow in much more abundance resulting in higher maintenance costs. The forested area can be categorized as providing good quality sites for the continuing development of native species. Among those planted are Guanacaste, Cocobolo, Pochote, and Guapiñol. The only two species that have not responded well with high mortality rates and/or low growth rates are Mahogany and Cenizaro. Given the configuration of the property, roughly 200 ha are afforded easy access for machinery to do mowing and extract logs derived from the thinning.

3

PRUNING Pruning has been completed in roughly 85% of the subject area. And without a doubt this has produced positive results given that the first 5 metres of the trunk is notably absent of knots and could produce up to 33% clear lumber, while in Costa Rica generally speaking the average is to produce a knot free log no longer than 3.36m. At the same time there is still roughly 125 hectares where sucker shoots and young branches need to be pruned. GROWTH RATES Since 1994, management has maintained some twenty different sites to monitor the progress of tree development and certainly there is now sufficient cumulative data upon which to extrapolate volumetric growth over the next five years. It is significant to mention the farm has achieved MAI (mean annual increments) equalling or exceeding 2cm per year The annual incremental growth rates for height correspond to or exceed 2 metres a year. The growth rates analyzed correspond to planting done in 1992-93 and 1996 that cover an area of 74 hectares and is equal to 25% of total planted.

TABLE 2. Tree growth by Trunk Diameter: Cana Teca vs. Guanacaste Average

DBH in Centimetres Year Cana Teca Average Max* 1996 7.7 6 8 1998 12 9 12 1999 15 12 14 2000 14.6 14 16

TABLE 3. Tree Growth by Height: Cana Teca vs. Guanacaste Average

Height in Metres Year Cana Teca Average Max* 1996 7.7 6 8 1998 12 9 12 1999 15 12 14 2000 13.7 14.4 16.8

* This data sourced from “ Yield and Site Quality for Teak in the Guanacaste” by William Vasquéz y Luis Ugalde.

4

THINNING PROGRAMME In 1998, the first thinning was undertaken whereby the most deformed of the thinnest trees were removed from area planted in 1992 and 1996. To ensure the continuity of favourable tree development and to avoid treetops crossing which inhibit growth. As expected, the diameters were not of girth for commercial use and they were utilized as fence posts throughout the farm. More than 2500 old posts were replaced with new teak ones. 2002 Extraction: Working an 8-hour day with chainsaw and machete the work crew of four can extract 147 trees on average per hectare per day. Arguably the work can be conducted more quickly but because of marketing constraints, the Forester chose a more methodical approach.

The logs are felled and cut into the 2.25 metre lengths as requested by prospective buyers while the branches are piled in parallel fashion to the tree rows. Logs are peeled and dried on site prior to hauling by hand to the roadside where a tractor and small flat bed trailer transport them to the plantation nucleus for stockpiling. To date roughly 20 hectares has been thinned representing approximately half of the most critical thinning needed in the oldest (1992) standing inventory. As at Jan 30th the extraction programme was suspended pending the availability of additional working capital derived from sales or other sources

5

Cross section of 10 yr old Tectona grandis with 25cm base Contract milling: A key marketing consideration was whether it would be economic to contract mill for the conversion of the thinnings as opposed to using an on site portable mill given that exploiting scale of efficiency of lumber mills specialized in processing small diameter logs might achieve better wood yields. With the expectation that an adequate number of logs of sufficient volume could be accumulated for conversion to sawnwood, the Consultant canvassed several sawmills in the region. The prices quoted by the three companies queried averaged 30 colones per pulgada a volumetric measurement used in Costa Rican Forestry. This equates to $28.00/ m3 (363 pulgada = 1 m3) based on the size of the logs that Can Teca was proposing to deliver. Of particular interest was Ambientales de la Industria. A Costa Rican firm involved in the processing of lumber coming from tree plantations. The company’s operation is based on sawmill equipment with two parallel lines of production, one for small diameter logs, and one for larger diameters. Currently, it is manufacturing pallets from gmelina for exporting companies finished goods and boxed ag products, but is also producing some dressed lumber and moulding products. Neither Ambientales nor other companies queried used teak for the production of pallets nor expressed any genuine interest to do so.

6

MARKET ASSESSMENT Domestic marketing efforts were concentrated on conferring with two major players in the Costa Rican teak industry, Flor Y Fauna and Pan American Woods, with a view to augmenting their raw material supply or possibly providing sawn wood. A brief background is provided below on these two companies. Pan American Woods Inc. The company has largely been transformed from the scandal ridden days of its predecessor company, Bosque Puerto Carrillo into an active exporter of teak thinnings and parquet flooring. Pan American is now the operating subsidiary of the Dutch forestry group, NIBO, which acquired a controlling interest in Pan American in 2000. The first teak planting occurred in 1989 and the average age of the 1653 ha planted is 9 yrs old. The company has achieved good results in the field with an average diameter at breast height (dbh) of 20-22 cm and an MIA of 2.2 cm. The company is almost debt-free and owns all the hard assets. PanAmerican Woods has planned for ecological corridors as a integral part of their to FSC certification. The fact that the teak trees are already 8 to 10 years old on average, means that in theory, as with Cana Teca, the Company should not need to wait a long time for the first distributable income to appear. According to management, Pan American is close to reaching break even. This contrasts with other plantations, where investors have to reckon with a period in which there has to be provided money for maintenance, with all sorts of risks along the road. Moreover, participation is through equity ownership as opposed to usufruct contracts with a limited time span. Production Since the major management change in Pan American back in 2000, the current team canvassed the world’s largest teak market, India, and was able to establish export sales with several large buyers including large strip flooring manufacturers in that country. For the time being, there is more demand for this raw material than can be produced. Whereas the margins on these log sales are low, it does give the company a basis for the steady cash flow, which according to management should be positive for 2003 and the breathing room needed to expand sales of its flooring products. In 2002, 18,000 cbm of teak wood was produced of which 15,000 went to India as half squares. For 2003, production is expected to increase to 24000 cbm with exports dropping Pan American woods biggest challenge is the underutilization of its plant capacity of 12,000 cbm per year, hampering economy of scale to achieve profitability. This is not as result of lack of raw material, but rather a dearth of purchase orders for its finished products i.e parquet flooring. The Company has benefited from increasing sales to Europe and North America as large retailers scramble to source more certified forest products and this is reflected in the reduced export volume of half squares to India. Its ultimate goal is develop the Company

7

into a producer of engineered flooring where more sophisticated production is geared towards combining MDF with hardwood laminate. The company certainly has plant infrastructure and space to accommodate new lines of production but how this would be capitalized is not known PRICING At arguably the lowest value as raw posts, the price range for small diameter teak ranges between $1.00 to 1.25 each based on a 2.25m length and a minimum diameter of 12 cm thus equating to roughly US$25-30/cbm. Beyond that, Pan American quoted the following prices for logs

Logs $/cbm All lengths 2.25m Cants $/cbm 13/14 cm 30 10x10 50 15/16 cm 40 12X12 60 17/19 cm 60 14X16 75 20/22 cm 80 16X16 115

Following the Consultant’s brief visit to the plant for discussion with its President, Pan American dispatched their chief forester to inspect the Cana Teca plantation to determine if there was any prospect of collaborating with the Partnership as a new source for raw material. In theory Cana Teca would be responsible for producing half squares by employing a portable saw on site and Pan American would deliver a 20’ container to site and pack it. (The half square method is simply to maximize the efficiency of the container space.) Pan American would then handle all documentation and shipping to its Indian buyers. Unfortunately, after conferring with Mr Solano and inspecting the property, the forester concluded that there were not enough trees of sufficient volume to merit their involvement in the thinning at this time. Flor y Fauna ( FyF) FyF was founded by in 1989 and has approximately 4000 ha under management. The average tree age is approximately 6 years. The Company achieved its initial reforestation goal of planting all available pastureland (2568 hectares). This includes a system of permanent monitoring plots, which cover almost 1% of the total area planted. They have subsequently been limited in their goal of further expansion due to the lack of land and the areas that are available have relatively high prices. FyF’s growth strategy is presently directed toward the marketing of Teak products obtained from the process of managing the plantations. However, in terms of converting its trees to merchantable timber, the inventory of viable standing volume (89-90 plantings) for industrialization represent only about 4% of the total teak inventory. After several years of marketing attempts, Flor Y Fauna has ostensibly abandoned its line of teak furniture largely due to its inability to compete with lower costs higher quality product from Indonesia. Its niche market is moulding where it has made some inroads in

8

establishing a minor presence in part, through just in time delivery to North America for some of its moulding products From its inception, the Dutch insurance firm, OHRA, has primarily funded the company. At the time of the Consultant’s visit, intensive consultation and negotiations were still being concluded between all major parties in FyF about the structure of future management. After much rancour amongst shareholder blocs, management was optimistic that FyF will be improved structurally. Because of this, the current manager was somewhat guarded about disclosure of company information. When queried about the financial outlook for its investors the Manager responded only that FyF might possibly pay out in the beginning of 2003. FSC Certification Through the Forestry Stewardship Council and the advice and suggestions from Smartwood, management believes a considerable improvement of the quality of management and its operations has been achieved. In 1995 Rainforest Alliance (SmartWood program) certified FyF as a “Well managed forestry operation”. In 1997 certification of the “Chain of Custody” Process was added. That same year FyF was accredited by the Forest Stewardship Council (FSC) as a certified company under the rules of the FSC. In 2001 FyF was FSC certification was renewed for another 5 years. Some plantation forestry consultants view FyF as one of the most promising Teak reforestation projects. Certainly the operation from a cursory on site inspection appears well managed and possesses relatively large inventories of good diameter logs but, in the Consultant’s opinion, the region is not consistently producing the kind of teak, i.e. dark heartwood, which the market continues to demand. Like Pan American, Flor y Fauna is dependent to a large degree upon log sales to India for cashflow. Since February 2002, a considerable volume of log sales has started, primarily to India but management preferred not to make available these figures to the writer. In terms of potential purchase orders, FyF was willing to pay US$ 90.00 per cbm FOB plant for logs with a minimum 15 cm TED (top end diameter). FyF management also expressed interest in purchasing sawn wood for its domestic marketing: The mill also expressed interest in buying sawnwood with the following dimensions:

Width: 7.0, 8.5, 10, 12 cm Thickness: 30 35 mm Min length 15 m maxim 2.25

For this type of material they we’re offering to pay USD180 per cbm CNF Altamira. Grading rules specified that knots are permitted except for loose knots. All sapwood permitted. Pith not permitted In reality FyF rules are extremely generous as compared to export grade requirements concerning tolerance of knots and sapwood. However, the biggest challenge with such small logs is the elimination of pith, which severely reduces the recovery of merchantable sawn wood.

9

If Cana Teca could come to some type of supply agreement, FyF is hardly ideal for delivery standpoint since it is located in the San Carlos region. However, since Cana Teca is still in the process of finalizing delivery of fence posts to a buyer in Los Chiles, there was the potential for realizing some transport savings by piggybacking log orders to the Flor y Fauna’s plant located at Altamira. In addition, the specialized Ambientales mill was also en route to Altamira if sawnwood sales could be realized. Trial sawing of the logs Based on the interest expressed by For y Fauna and its relatively attractive delivered price, management set up some preliminary trials, Cana Teca was able to access locally a portable sawmill to test wood yields. Using a Canadian made horizontal band saw, a handful of logs were sawn in order to gauge what the approximate rate of recovery might be for 18 to 20 cm diameter logs. If economic, then management could continue on site milling provided it had sufficient working capital to do so.

Canadian-made horizontal band saw on site at Cana Teca (11/2002)

10

Preliminary Results Based on limited testing, the sawn wood yield was estimated at approximately 40-50%. However, when the sawyer is obliged to eliminate pith, and to take into account non-merchantable dimensions this seriously reduces the yield to 15-20%. At this rate of recovery, economically converting the extracted logs become a dubious prospect Although the handful of logs milled was representative of the oldest tree inventory, management cautions that it is not necessarily justifiable to extrapolate these preliminary results over the entire volume of wood to be extracted. More extensive saw milling should be undertaken.

11

Examples of dimensional lumber from thinning

SALES Since the field report began there was some expectation that there would be more sales to report in 2003. In February of this year a small lot of 500 posts was sold to a local property owner. To date, the partnership has realized $20,000 in teak wood sales. With regard to log sales to Flor y Fauna, of the 3400 trees cut to date only about 150 conformed to their required minimum TED. A potentially significant sale of logs to a finished fence post manufacturer in San Jose was dashed when testing revealed that the teak logs proved to exert too much wear and tear on the machinery and the buyer abandoned the idea of using teak.

12

Management is currently working with Sylveron, a US based tropical hardwoods importer with saw mill operations in Costa Rica, that seems to have some expertise in processing and marketing small diameter plantation wood. OUTLOOK Based on discussions with industry executives one can fairly draw the conclusion that young plantation teak has limited market access internationally. One of the exceptions being the relatively modest success of flooring manufacturers like Pan American Woods that have established itself in both the North America and European markets with its parquet flooring. In all likelihood for the short term Cana Teca will be limited to the domestic market for sales. Over the past eighteen months there has been a resurgence of new construction as tourism and housing projects that continue to fuel the Costa Rican economy. Cana Teca could be better served by allocating its scarce resources towards focussing on this segment of the market.

CONCLUSIONS

1. At this time the plantation is comprised of 247 hectares of teak in a favourable stage of development with average or above average growth rates and it is critical that these areas be maintained as show the greatest potential for sustained production of merchantable timber over the next 18- 25 years. Without a doubt those parcels with poor yields should be managed with the absolute minimum amount of expense without abandoning them altogether to avert the risk of fire.

2. The trees that are being culled, for the most part, are of insufficient volume to

provide merchantable timber. For larger operations such as Pan American, the conclusion drawn was that, in most cases, after felling the trees it was more cost efficient to leave them on the forest floor. In the case of Cana Teca, however, the partnership should over time be able to, even on a sporadic basis, realize additional sales of its inventory of logs as fence posts, particularly as demand increase with a recovery in the local and regional farm economy.

3. Since management has concluded definitively that there is significant direct benefit

to grazing cattle as a way to reduce maintenance costs without damaging the trees, this programme should be implemented during the wet season throughout the plantation generally, and the low growth areas in particular, and rental income derived therefrom.

4. The Forester has concluded that once the thinning is completed, the annual

maintenance cost can be reduced to as little as $50,000 per year. The partnership then, must decide whether it can, or is willing to, carry these costs for the next 3-5 years assuming an absolute worst case scenario of only minimal revenue derived from the sale of the inventory. With management’s input, the partnership must decide collectively whether it is prepared to provide ongoing maintenance for the next 3-5 years at an annual cost

13

of $50,000 in order to maintain the plantation until the standing inventory reaches sufficient volume This begs the question whether the investors are prepared continue to wait for a return on their investment versus consider selling the asset at fair market taking into account their reduced adjusted cost base resulting from the significant tax saving they have realized over the period of their investment. From the writer’s preliminary investigation, teak plantations and attendant land values for roughly 6 year-old plantations range in price from US $3,000 to US $4,500 per hectare which would equate to an estimated property value of between US $1.4 million to $1.75 million. Of course, many factors would affect the price including market demand, the general slow down in the economy and uncertainty in world conditions. The other consideration is whether the unitholders would consider contributing the assets for a smaller share in a bigger company such as Pan American Woods.

RECOMMENDATIONS

1. Based on the cumulative growth site data the partnership must now assess in a more detailed manner the plantation inventory to quantify the standing volume of teak in order to be able to develop more accurate financial projections. The timber cruise could conceivably be undertaken at very little cost by contracting forestry students from CATIE or the University of Costa Rica.

2. Expand its limited marketing campaign to include a more intensive search for

international buyers and or joint venture partners. Intensify its marketing efforts on new domestic construction projects.

3. Incentives There are still some forestry incentives available to the Partnership.

Previously the General Partner opted to take advantage the Resident Investor rules to help capitalize the project rather than apply for conservation incentives. The forester believes that roughly 170 hectares could qualify for these incentives totally $30,600 spread over five annual equal payments which would reduce overheads. Management should inscribe the area even though the compensation is minimal as it would serve as a way to reduce overheads. Under a five-year contract the Partnership could receive approximately less annual inspection cost of roughly $12 per ha and the upfront cost estimated at $2000 for a forestry evaluation.

4. Forest Management certification: As exporters of plantation wood continue to

exploit, and to some extent rely upon, certification for its market penetration, the partnership must be aware that it could find its market access limited or even restricted as expressed by the Pan American Woods unwillingness to source Cana Teca thinnings for production of flooring because of certification rules.

Accordingly, Cana Teca must further examine the implication of certifying in reference to its eventual expanded marketing plan whether for supply to domestic buyers that export or as an exporter proper.

14

This would entail some paperwork and the cost is borne by the concessionaire or plantation owner. This is conceivably a 2-year process and would cost up to $5000 for a major audit. The annual cost thereafter is minimal perhaps less than $1000 given the size of the Cana Teca plantation. By not certifying its plantation, Cana Teca could, to some extent, become isolated from not only export markets but from the local buyer because of the predilection for buying raw material from only certified sources.