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Investors should beware the paper products companies that benefited from a little-known tax windfall that boosted their earnings in 2009. These companies may experience disappoiting earnings growth this year and beyond becuase the tax-break expired after just one year and is a one-time, false boost to earnings.

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.

Two companies, Kapstone Paper and Packaging (NYSE:KS) and Verso Paper (NYSE: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.

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.

Disclosure: Author holds a long position in IP

Source: Little-Known Tax Windfall Overstates Paper Company Earnings