The forest sector is no exception.
Great Southern and Timbercorp have spun off course,
FEA is currently in a lengthy pit stop, refuelling and searching for additional
sponsors, and now Gunns is showing signs of distress.
The strategic review into the restructure of Gunns
is due to issue an interim report by the end of April.
The rationale for the demerger proposal is to
unlock the value that the market is currently failing to recognise. Why is the
market mispricing Gunns’ shares? Has the market got it that wrong? What is
contained in the financials that gives the current Board reason for such
optimism?
The string of corporate collapses over the past few
years has certainly drawn attention to the modus operandi of the high fliers
who have since plummeted to earth with a thud.
It has also exposed how some pushed the envelope a
little too far when it came to interpreting accounting standards.
The following is an attempt to have a closer look
at Gunns’ financial statements to highlight some of the less well known feature
of financial statements and the subjective judgements required from time to
time in their preparation. The aim is to help interpret the financial
statements with a view to understanding the structure of the forest industry,
Gunns being one of the major players.
First a glossary. [2009] refers to the 2009 Annual
Report, [1H2010] refers to the Report for the half year ended 31st December
2009. Whilst the latter is more up to date, the former is a full set of
accounts with detailed Notes to Accounts, and as a consequence, much more
revealing.
Let’s look at Gunns’ balance sheet, a statement of
their assets and liabilities, the difference being the net assets of the
Company. The [2009] report showed net assets of $1,321 million. The [1H2010]
report showed an increase in net assets to $1,458 million. Net assets increase,
as a rule, with additional retained earnings and issued capital. It was
principally the latter in Gunns’ case as the long suffering shareholders
contributed another $144 million in the last 6 months.
The current market price of 55 cents per share
values Gunns at about $450 million, much less than the net assets shown in the
financials.
The assets worthy of closer inspection are loans
and receivables ($480 million in [2009]), biological assets (plantations,
vineyards etc $370 million), property, plant and equipment ($1,348 million),
intangibles ($55 million), and investments of $19 million. The only other asset
of significance is stock on hand ($163 million).Gunns’ gross assets total
$2,456 million.
Struggling companies have a tendency to overvalue
assets, but rarely are liabilities inflated. The only liabilities of interest
in Gunns’ case are a ‘non-current payable’ of $56 million and an ‘other
liability’ of $5 million. Loans and borrowings of $662 million, current
payables including trade creditors etc ($138 million), and provisions, mainly
employee benefits due ($27 million) are non controversial and fairly self
explanatory. Liabilities total $1134 million.
Receivables are not always received
Loans and receivables of $480 million are
receivable from customers, both trade customers and MIS investors. This is a
large amount for a Company of Gunns’ size and turnover and reflects the special
nature of its business.
Included is $63 million of trade debtors, due from
trade customers. They appear quite in order, a figure to be expected from a
business turning over $767 million [2009].
Also included is $258 million in respect of loans
to MIS investors. This figure is after writing off $15 million for bad debts,
$9 million of it in 2009.
Approximately 70% of MIS investors use borrowed
funds often from the MIS Company itself, and $258 million is the amount that
Gunns are yet to collect from investors. These amounts have been included as
MIS income (approximately $700 million in total since Gunns started MIS’s in
1999) but are yet to be received.
Having an asset of $258 million in ‘loans
receivable’ from MIS investors, is a lot riskier than having $258 million in
the bank. This was one of the problems with Great Southern. Its MIS loans
turned bad at an alarming rate, as the poor returns on the Woodlots gradually
came to light.
Towards the end Great Southern was happy to sell
its loan book to third parties at a 50% discount, so desperate was it for a
cash injection.
Selling the loan book or a part of the loan book is
a common practice, or at least it was before the GFC. Gunns have done this to a
limited extent, bundling or securitising loans and selling them. The reason for
this is primarily to boost cash flow, get the money in one lump rather than in
dribs and drabs over an extended period,
After all what is Gunns’ business, a forest
products company or a financier? (TT readers may offer other alternatives?). In
[2009] the amount owing in respect of securitised loans was $93 million. We
know this because it is included in loans and borrowings of $662 million.
From an accounting viewpoint when securitised loans
are sold to a financier, the amount received is recorded as a loan.
So when Gunns receive a payment in respect of a
securitised loan they immediately pay it to the financier who purchased the
bundle of loans from Gunns.
It is both an asset (forming part of the total $258
million loan receivable) and a corresponding liability.
It is not known to what extent Gunns is still
liable for bad debts (or impairment to use the argot of accountants) on the
securitised loans.
Included amongst loan receivables are just under $1
million due from the Chairman and one of his senior managers, both enthusiastic
purchasers of Woodlots.
The final component of loans and receivables is
amounts ‘receivable for services in relation to MIS’ of $141 million as per
[2009]. This is an estimate of amounts receivable by Gunns as a commission when
MIS crops are harvested in the future, maybe even 5 years hence.
To explain this, a little digression in the matter
of revenue recognition is needed.
Most people are familiar with the concept that if
one receives a payment in cash then that’s income at that point.
But accrual accounting standards that apply to most
businesses also recognises income when an account is raised, even though
payment may not be received for 30 or 60 days. In fact if there’s the required
amount of certainty with a future payment, then it should be income at the
point of certainty.
Say a real estate agent arranges for an
unconditional contract for a house sale with settlement 12 months hence.
Because of the certainty regarding the collection of the contracted amount (the
contract is unconditional) the commission should be recognised as income at the
time of the contract, not the time of settlement.
Likewise if a MIS company stitches up an agreement
with MIS investors to take a share of harvest proceeds, then as soon as harvest
proceeds can be reliably measured then it’s ok by accounting standards to
recognise the harvest commission as income. It doesn’t have to be received,
merely receivable with a degree of certainty. It may be as distant as 5 years hence,
in Gunns’ case.
The matter of income recognition was an interesting
issue as Great Southern battled to survive.
The final desperate attempt to shore up its
miserable cash flow, involved trying to persuade MIS investors to exchange
their disappointing Woodlots with soon to be worthless Great Southern shares,
with the aim that when harvest occurred, 100% of the proceeds would accrue to
Great Southern rather than just the 5.5% harvest commission.
Great Southern was ably assisted by one of the Big
Four accounting firms in this endeavour.
To do so required an assessment of the yields and
hence the future harvest proceeds.
Great Southern concluded it was reasonable to make
an assessment of harvest yields after 4 years. Wow! MIS watchers were
gobsmacked. Great Southern confessed to being able to assess future yields (at
10+ years) after only 4 years of tree growth. If only investors had the benefit
of this vital fact, the whole course of the MIS industry may well have been
different.
By comparison, Gunns recognise harvest commissions
within 5 years of harvest.
Still fairly bold.
It is hoped that the implicit yields and growth
rates become publicly available. ASIC have recently released a report
recommending more stringent reporting requirements.
Better late than never.
At least it will mean more information for policy
makers as they attempt to build a new forest industry from the current ruins.
Getting back to Gunns’ financials, if it’s included
as an amount receivable for MIS services, then it must be also included as MIS
income.
That’s the way simple double entry accounting
works.
This means that MIS income increases at the same
time the assets of the MIS Company are boosted.
A win-win situation.
The only downside is that tax is payable on the yet
to be received amounts. But the extra income may be required to satisfy banking
covenants. (Gunns’ banking covenants are explained HERE: Gunns’ banking dilemma). Maybe the rest of the business is
not travelling too well so extra income doesn’t present any tax problems?
So each year Gunns includes an amount in MIS
revenue reflecting the extra harvest commission it hopes to earn, possibly 5
years hence. In [2009] $27 million was included as income, taking the total
amount due in [2009] to $141 million.
MIS companies have without exception, struggled to
make the transition to become sustainable businesses. The first flush of cash
(and profits) is gradually flooded with increasing costs as more MIS projects
come on line. It is exacerbated if profits are used to prop up returns to investors
with the aim of enticing new investors ( a primary Ponzi ) or if profits are
paid as dividends to MIS shareholders to encourage them to keep propping up the
Company ( a secondary Ponzi).
Gunns adopted the latter approach. Gunns wasn’t
quite as greedy as Great Southern and Timbercorp. It charges less upfront but
takes a bigger bite at harvest time to compensate. It has had a stronger
capital base.
But soon the declining cash inflows from MIS sales
collided with the increasing service costs.
Or the legacy costs as Great Southern Directors
described them. The costs that keep increasing each year that have to be paid
out of declining revenues.
Soon the only way to make MIS half presentable was
to keep including future harvest commissions as income. This can be quite
legitimate as legacy costs are paid each year and the eventual harvest
commission is supposedly intended to reimburse those costs plus provide a
little profit as well.
Hence when the harvest proceeds are received there
will be a negligible effect on profits as they have been accrued as income
already. Even the cash flow benefits of the harvest commissions will be largely
eaten away with costs on the continuing projects and are unlikely to be
sufficient to fund replanting.
Problems ahead.
The partial boycott by MIS investors is starting to
hurt.
Another reason (the real reason?) for
restructuring.
Hence the asset of ‘loans and receivables’ of $480
million [2009] is a little soft. Most of it relates to MIS schemes, either as
increasingly impaired MIS loans due, or as a share of future MIS harvest
proceeds, at best a reasonable certainty, but at worst a mere expectancy.
It’s not the sort of asset that will have a
compelling attraction for new equity investors that Gunns are seeking,
particularly after the travails of Great Southern and Timbercorp.
Standing timber, is it always a growth asset?
Now to look at biological assets of $370 million
[2009].Included here is grape vines and walnut trees ($29 million), with the
balance being forest plantations. All comments will ignore the former and just
concentrate on standing timber.
Standing timber comprises trees owned by Gunns. It
doesn’t include MIS growers’ trees growing on Gunns’ land.
Each year the value of standing timber harvested is
transferred to the P&L statement (unlike FT which produces a much less
informative set of accounts than Gunns). Additions are recorded at cost, sale
amounts (as in the sale of 33,000 hectares of Auspine trees in [2009]) will
cause reductions, but then a ‘change in fair value’ amount will result in a
closing balance of standing timber equal to the net present value of future
harvest proceeds.
Changes in the fair value of plantation assets are
recorded in the P&L, an increment as revenue and a decrement as an expense.
That is the way of accounting standards.
But it must be remembered that such increments are
only book entries. Even if perfectly valid, a profitable business whose profits
derive solely from revaluations is unlikely to survive if operating cash flow
is inadequate.
In arriving at a figure for the value of standing
timber, it is necessary to make assumptions about growth rates, harvest yields,
harvest costs, and then apply a discount factor to reduce it to present value
terms reflecting the risks involved ( or the return required by a forest
investor).With an uncertain yield ( publicly at least) , a declining real price
for wood fibre and a higher premium (a higher discount factor) required by
investors, there is possibly little upside with plantation values. It is easy
to significantly influence the value merely by small changes to the parameters.
This is always a concern, but it is too difficult in most instances to assess
whether the assumptions used (if indeed they are made available) are
reasonable.
Standing timber also includes timber owned by Gunns
but grown on other persons’ land pursuant to share farming arrangements. The
landowner supplies the land and Gunns supplies the trees. At harvest time,
proceeds are split with the landowner getting about 35%. But the trees belong
to Gunns and are recorded as such in the financials. An estimate of the land
owners’ share is included as a liability, as a non current liability of $56
million.
Also included in standing timber is Gunns’ share of
2 joint venture arrangements, Tamar Tree Farms (a 62% share) and Plantation
Platform of Tasmania (15%). Both are described as being in the business of
plantation establishment but the presence of standing timber, suggests the
entities are tree growers. It is not known who owns the rest of the joint
ventures. There are no related party disclosures. Gunns ‘share of the joint
ventures’ net profit for [2009] was $12.2 million, mainly due to an increase in
the value of standing timber.
The current net book value of standing timber is
therefore $285 million ($370 million for biological assets less $29 million for
vines and walnut trees less $56 million due to share farmers).
But with the forest industry in a current state of
uncertainty, any changes to assumptions underlying the valuation process will
be critical.
It is not beyond the realms of possibility that the
value of standing timber may fall from time to time.
Property, plant and equipment, how are these
valued?
Property, plant and equipment represent the biggest
asset owned by Gunns, $1,321 million in [2009].
Buildings have a value of $81 million, plant
(sawmills, woodchipping plant etc) a value of $157 million, forest roads a
value of $70 million. These look fairly straightforward, being the written down
values (after depreciation). At a guess it is unlikely the market values will
be higher.
Then comes capital works in progress of $165
million, the bulk of which are pulp mill expenses of $150 million. In [1H2010]
the latter figure had grown to $184 million including another $7 million in
finance expenses. Sometimes companies err on the side of expensing finance
costs so as to reduce taxable income. But sometimes a company may be more
concerned with increasing profits and boosting its balance sheet.
Finally there’s freehold land of $874 million which
makes up the balance of property, plant and equipment. Land with a cost of $469
million has been revalued upwards by $405 million.
Gunns owns 275,000 hectares of land, but 45,000
hectares is voluntarily reserved and a further 27,000 hectares unsuitable for
timber production. Of the balance some is native forest, some leased to MIS
investors, some used to grow Gunns’ own plantations, some used to grow
plantations for other investors such as GMO and some is owned as a part of joint
ventures discussed above. Approximately 45% or 125,000 hectares was acquired as
part of the North Forests deal in 2001. The Norths deal closely followed the
Boral acquisition in 2000 which involved 30,000 hectares. The Auspine purchase
in 2008 involved another 46,000 hectares. Most of the other acquisitions since
2000 have been for land subsequently leased to MIS investors.
Given the diverse nature of the land just described
it is impossible for a mere reader of Gunns’ financials to ascertain whether
the value of the land as listed is reasonable. Suffice to say that if
plantation proceeds fall due to either lower growth rates or lower expected
prices then the value of the underlying land may need to be adjusted downwards.
Similarly if the discount rate, being the rate of return that a tree investor
expects, rises because prevailing interest rates rise or the perceived risks
are greater, land values may also fall. Also the bank of forestry land
currently for sale due to industry problems will also need to be taken into
account when assessing a fair market value for Gunns’ land to be recorded in
the financials.
Movements in the fair value of land, usually
bypasses the P&L statement and is recorded directly in ‘reserves ‘which
forms part of a Company’s equity. The net assets (or equity) of a Company
(assets less liabilities) are usually represented by issued capital, retained
earnings and reserves.
Whilst on the question of land, Gunns manage
110,000 hectares of MIS plantations, some on their land and some on land leased
from other parties. Included in the latter is land leased from Australian
Forestry Plantation Trust an entity 30% owned by Gunns. The identity of the
remaining 70% is not disclosed.
The overall amount of land leased is not known but
the financials do contain a note, Note 28 [2009], detailing $19 million of land
lease payments due in 2010, with a total of $212 million due over the term of
the non-cancellable leases. In [2006], the figures were $6 million for the
ensuing year and $59 million in total; hence there’s been a threefold increase
in 3 years.
Intangibles are invaluable
Most of Gunns’ intangibles have arisen recently
with the Auspine and ITC Timber purchases.
In the case of the Auspine purchase in [2008]
intangible assets (mainly trademarks) worth $25 million was acquired along with
assets such as stock, plant, property etc less loans and other liabilities,
giving a total net purchase price of $348 million. The book value of all the
assets and liabilities acquired as part of the deal was only $319 million, a
difference of $29 million. The balancing amount being the excess of the
purchase price over the book value is classed as goodwill on acquisition,
another intangible asset. To quote Note 30(b) [2008] “the goodwill recognised
on the acquisition is attributable to the skills and technical talent of the
acquired business’ work force and the synergies expected to be achieved from
integrating the Company into the existing operations”. Workers at Scottsdale or
those that still have jobs will be pleased to know that it was their skills and
talent which enabled Gunns to boost its balance sheet.
The treatment of goodwill has been the source of
amazement over the years. Eddy Groves from recent corporate casualty ABC
Learning, or Fast Eddy as he was dubbed, was an innovator in this regard, a
pioneer in the art of income recognition. In 2008 Eddy purchased Leapfrog
Nurseries for $51 million less than what he reckoned it was worth. He
immediately booked the $51 million as profit, a discount on acquisition. That
master stroke certainly improved the bottom line. But the market’s tolerance
for such behaviour finally peaked. Shortly thereafter Eddy literally lived up
to his name, disappearing via a whirlpool into oblivion, as his bankers
ruthlessly sold shares to meet margin calls.
Adam Schwab in his recent book ‘Pigs at the Trough’
detailing lessons from Australia’s decade of corporate greed gives a succinct
summary of Eddy’s actions.
“Accountants have a funny way of detailing with
discounts on acquisitions compared with overpaying for businesses…... in most
cases acquirers pay more for a business than what the target’s book value of
assets indicates. When that happens, the purchaser labels the difference
’goodwill’, which sits on the balance sheet until it is impaired…..By contrast,
when a company pays less for another company than the target company’s book
value, that difference is allowed to be claimed as a ‘discount on acquisition’,
resulting in a direct increase in the company’s profit for the current year. It
is a good deal for acquirers—if they pay too much for an asset then that
overpayment sits on the balance sheet while the business is able to claim to
possess a larger asset base. If the acquirer claims to have underpaid for a
business, it can immediately (and arbitrarily) increase its profits for that
year—- which is exactly what ABC did.”
And so did Gunns, when it acquired ITC Timber in
[1H2010]. It paid $88 million for assets with a book value of $91 million and
immediately booked the $3 million discount on acquisition as profit. Which
certainly helped drag Gunns out of the red into the black (just!) with a profit
of $420,000 for the half year. But more about that below when we look at Gunns’
P&L
Just reverting back to the Auspine deal for a
moment. The book value of standing timber acquired was $216 million. Shortly
afterwards Gunns announced (Note 37 [2008]) that a sizable part of the Auspine
trees would be sold for approximately $170 million. Most observers assumed,
wrongly as it turned out, that the trees were being sold at book value. The
[2009] accounts revealed that the net proceeds received were $173 million, as
expected, but the book profit was $23 million, a surprise, but no doubt a very
much welcome boost to the bottom line at the time.
It certainly begs the question that had the
acquired standing timber been recorded in Gunns’ books at a figure that was $23
million higher, then the goodwill on acquisition figure, the balancing item,
would have been $23 million lower. But Gunns would have missed out on extra
profit of $23 million in [2009].
Creative accountants or canny deal makers? Hard to
know. But it’s not unreasonable to be sceptical given the Company’s recent
cavalier interpretation of its continuous disclosure obligation to keep the market
informed about material movements in expected profits and the brazen disposal
by the Chairman of a significant parcel of shares at a time when arguably he
had some knowledge of the impending slide in profit.
Perhaps Fast Eddy, reputedly named after Fast Eddie
Felsen in the cult movie “The Hustler” passed on a few tips to Minnesota Fats,
the film’s other main character, last seen working in Launceston under an
alias?
Investments, just what are they?
Investments of $19 million on the balance sheet
[2009] is made up of $7 million invested in the Australian Forestry Plantations
Trust (AFP) plus $12 million via registered covenants over third party land,
presumably (?) representing a share of trees to be harvested on land owned by
other parties.
According to Note 38 [2009] Gunns have a 30%
interest in AFP worth $7 million (Note14).This entity earned $1.4 million
during the year (Gunns’ share $0.5 million). It leases land to Gunns which is
then sublet to MIS investors. The identity of the other 70% owners is not
known. No related party disclosures have been made. If I were a shareholder I’d
be interested.
During the year Gunns acquired the remaining 70%
interest in AFP No 2 and it now forms part of Gunns’ financial statements in
[2009]. The purchase price was $7 million but who the vendors were is not
readily apparent. No related party disclosures have been made.
During [1H2010] one of Gunns’ institutional backers
was also a 17% shareholder in the fast disappearing FEA. It wanted to exit FEA.
Gunns agreed to buy FEA’s shares and paid $7 million in cash plus $5 million
with new Gunns shares. In [1H2010] the value of Gunns’ investment in FEA was
written back by $1.8 million. And with more to come no doubt?
The value of ‘investments’ in [2010] was $22
million.
And what of the liabilities?
The only liabilities of interest in Gunns ‘case is
a ‘non-current payable’ of $56 million and an ‘other liability’ of $5 million
The non current payable has been detailed above,
basically the expected share of eventual harvest proceeds payable to landowners
who agreed to Gunns carpeting their land with trees.
The other liability of $5 million helps explain how
MIS works. Each year the Company makes MIS sales, mostly in June, as taxpayers
are persuaded by the wisdom of their financial advisers, to purchase Woodlots.
Some of the sales are included as MIS revenue for that year with the balance
included as ‘deferred woodlot establishment revenue’ as a liability, to be
transferred to the P&L as MIS revenue in the following year when plantation
establishment occurs. $4 million of ‘other liability’ is deferred woodlot
establishment revenue.
Before a look at Gunns’ P&L just a quick note
on ‘reserves’. As mentioned above most reserves are created when fair market
increases in land occur. These bypass the P&L and are directly credited to
reserves. If the value of land falls then a loss is not recorded in the
P&L, simply a reduction in the land revaluation reserve.
Gunns has also established a maintenance reserve of
$23 million using book entry transfers from retained earnings. The express
purpose of this reserve according to Note 24 [2009] is “for the provision of
future maintenance services under Gunns Plantations Limited’s woodlot
projects.” The usual treatment is that such expenditure is included in the
P&L, but Gunns must be planning to bypass the P&L and record it as a
reduction in the maintenance reserve.
It is uncertain as to the type of maintenance
contemplated.
Transactions ‘below the line’ as accountants
describe them, generally attract less scrutiny than those in the P&L.
Cash Ebbs and Flows
Gunns have certainly been profitable.
Over the last 8 years it has generated after tax
profits of $612 million. But, and this is a big but, net operating cash flow
has only been $505 million.
A company’s cash flow statement splits cash flow
into three, cash from operations (revenues less expenses), cash from investing
(sales of existing assets and investments less purchases of new assets and
investments ) and cash from financing (new loans, share issues less dividends,
loan repayments etc).
It is an invaluable statement because it allows the
reader to determine if the business is being supported by its operations or by
its borrowings and how new assets etc are being paid for.
When net profits exceed net operating cash flow
over a period, warning bells ring. Lots of book entries are envisaged.
There may be perfectly reasonable explanations.
Even so, it’s a case as to whether the situation is
sustainable.
Gunns’ depreciation and amortisation claims over 8
years amount to $156 million. This is a non cash amount, a book entry, and
generally means that operating profits will be less than operating cash flow.
This then provides a little surplus cash for investing and financing
operations, purchasing new assets, repaying loans, paying dividends etc.
But in Gunns’ case, its profits have been boosted
by including projected income from future harvest commissions as soon as
possible ($141 million over 8 years) and bringing to account increases in the
book value of biological asset, mainly standing timber, of $204 million.
These additions make the profit look respectable
but it means that operating profits exceeded operating cash flow, by $107
million.
Despite this, cash dividends paid over the last 8
years have totalled $280 million. This doesn’t include non cash dividends paid
via dividend reinvestment plans.
It’s little wonder that shareholders were so happy
for so long.
Because operations didn’t generate enough cash,
perhaps dividends were paid from borrowings? This was a common characteristic
of the so called Macquarie model, which is now viewed as being unsustainable
and largely abandoned in the last 18 months,
But a perusal of Gunns’ cash flow statements
reveals that over the last 8 years, net borrowings only increased by $28
million.
Dividends of $280 million must have been funded
from the proceeds of share issues (including hybrids) of $531 million.
But if dividends are paid from share proceeds, then
it’s little more than a Ponzi scheme. Keep the shareholders happy, in case they
need to be tapped for more shares in the future.
Great Southern was similar. During its halcyon days
dividends were plentiful.
But times have changed. Gunns’ dividend flow has
dried to a trickle.
Shareholders often don’t start asking questions
until share prices and dividends fall. .
Profits and Losses
Let’s take a closer look at the 3 segments which
comprise the Gunns’ Group; MIS, Hardware Wine and Construction and Forest
Products.
MISs contributed 49% of Gunns’ profits in 2006, 50%
in 2007, 25% in 2008 and only 7% in 2009. MIS revenue was $124 million in 2006,
$145 million in 2007, $124 million in 2008 and $68 million in 2009. As revenue
falls in $ terms its % contribution to profits falls even faster.
The good ole days are over.
Gunns issue an announcement early in July each year
disclosing its MIS sales for the year just completed. For 2009 the figure was
$45 million including GST or $41 million excluding GST. The deferred woodlot
establishment revenue as detailed above was $4 million, hence $37 million of
2009 MIS sales was included as MIS income in that year. This seems a high
proportion given that most plantation establishment didn’t occur till the next
year, but it seemed to follow the pattern of prior years. Book it as revenue
ASAP seems to be the guiding principle.
The balance of MIS revenue as per the P&L was
deferred revenue from the previous period plus an estimate of the extra harvest
commission as discussed above.
After MIS expenses MIS profits were only $7 million
for the year.
It’s gets worse in [1H2010]. Revenue was $5.8
million, basically the deferred revenue from [2009], (although presumably there
will be some MIS sales for 2010). After expenses the loss for [1H 2010] was
$3.7 million.
Over the last 8 years MIS has generated 24% of
Gunns’ total profits. But the % contribution is fast dropping.
The relentless legacy costs, including current
lease payments of $19 million per year for leased land, will almost certainly
mean MIS profits and MIS cash flow will be negative for a few years unless
investors regain their appetite for another bout of self flagellation.
The second segment containing hardware, wine and
construction contributed about 12% of turnover but only 3% of profits over the
last 8 years.
This leaves the forest products segment
contributing about 75% of revenue and profits over the last 8 years. It is only
in [1H2010] that wood fibre has been presented separately from sawn timber and
other forest products. Even though wood fibre income was down it still
contributed 53% of total revenue and 88% of total profits.
Over the last 8 years at a rough guess, wood fibre
has probably contributed 50% of revenue and 65% of profits, mostly from native
forests.
Going back to [1H2010], the overall profit after
tax was only $420,000. But included in other income was $9.5 million increase
in the value of standing timber and, and, as detailed above, $2.8 million from
the discount on acquisition of ITC Timber.
Not the result of a sustainable cash flow behemoth.
Little wonder a strategic review is underway.
The latest half yearly result followed [2009] where
after tax profit was $58 million. Contributing to this latter result was $34
million in the increased value of trees etc, $22 million from the sale of
33,000 hectares of Auspine trees shortly after their purchase and $26 million
being an estimate of additional projected harvest commission accrued during the
year.
Again a pretty soft, probably unsustainable result
boosted by a few paper entries.
The figures for the full year [2010] will have to
address whether any of the intangibles, the goodwill and trademarks have been
impaired, such that they have to be written off, and also whether MIS loans and
receivables have been further impaired.
There’s a fair few crucial judgments to be made
before preparing the [2010] figures. No doubt the strategic review will start
the groundwork.
Woodchipping and MIS have contributed approximately
90% of Gunns’ profits over the past 8 years. But without them the picture will
be completely different.
That’s the problem facing Gunns.
To describe it as a lack of appreciation by the
market of the true value of its assets is a little misleading.
Gunns’ breakup?
The Board has foreshadowed breaking the Company
into four, with separate Boards if necessary.
The Pulp Mill, if it proceeds will be in a separate
entity. If not Gunns will be able to expense the $185+ million which will make
its bottom line bright red for a while.
The hardware, construction and wine businesses are
collectively worth, at a guess, about $100 million. These are likely to be
sold.
The sawmill businesses may be worth somewhere between
$150 and $250 million. It is assumed that any woodchipping plant will be
assigned to the plantation business even though export of native forest
woodchips will remain with the sawmill businesses.
The plantation business will have land, trees and
infrastructure assets. The value on the books is about $1 billion but there is
still about $600 million owing.
One problem with the majority of the land is that
it is leased to others to grow trees, even though Gunns may manage the
plantations. This fact restricts the amounts that third parties are willing to
pay for the land while the leases are still in place. That certainly was the
experience of Great Southern and Timbercorp. Also FEA is believed to be unable
to sell, as yet, any of its land at a price it was seeking.
The AFR reported on 12th April 2010 that Great
Southern’s Receiver is currently trying to dispose of Great Southern’s land,
subject to all leases with growers remaining in place. The book value is $725
million but industry analyst and valuer Sam Paton thought a figure closer to
$500 million was more likely.
If a similar discount is applied to Gunns’ land
(current book value of $874 million [2009]), the value is $610 million. Add the
standing timber of $285 million less say liabilities of $600 million gives a
figure of $300 million.
Another problem with the Gunns restructure is what
discount the new plantation entity will require if it also assumes all the
obligations of the ongoing MIS contractual arrangements.
It will be surprising if the market values Gunns’
MIS receivables at the same figure as Gunns’ current book value.
It appears a better than even chance that the land
and trees and MIS obligations will end up in a separate entity. But how many
borrowings will that entity have? And what will be Gunns’ share of that entity?
40%? 20%? Nil?
Gunns are hoping for a cash flow lifeline from
other investors.
Disappointment may await.
Maybe it’s time to start barracking for Richmond
instead?
How did we get to this stage?
Many of excesses of the last decade that have
afflicted economic life were enthusiastically embraced by the forest industry.
They were always in the peloton, perhaps not in maillot jaune but certainly
high in the GC.
Changes may emanate from legislative or political
favours or from mispricing in the market. As soon as arbitrage opportunities
arise there will always be entrepreneurs trying to exploit the situation.
Ten or twelve years ago, productive farm land in
Tasmania was selling for $1,000 to $1,500 per acre ($2,500 to $3,750 per hectare).
Plant a few trees, lease the land for 10 to 12 years for $7,000 to $10,000 per
hectare. Investors were queuing. Retain ownership of the land. Who could
resist? With an opened ended arrangement from Governments the inevitable
happened. There was an explosion of MIS schemes. Everywhere. In inappropriate
sites, just everywhere.
The forest industry pretended that the Market had
spoken. This was to be the Way of the Future. City investors seeking diversity
were helping to develop rural Australia.
But it was not the Market reflecting a paradigm
shift. It was simply a few arbitrageurs ably assisted by a well remunerated
sales force who couldn’t believe their good fortune when confronted with a
willing stream of investors who refused to be dissuaded.
When land prices were low and expected harvest
proceeds perceived to be on an increasing upward slope, it seemed that everyone
would be a winner, the land owners, the growers and the end users,
But over 10 years the split up of the pie changed.
First the pie shrank, growth rates weren’t quite as
expected.
Second, real prices gradually fell, as is not
uncommon with bulk commodities like wood fibre.
Third, land prices doubled; hence a higher return
for landowners was required.
It has proved difficult to keep splitting up the
pie and keep everyone happy.
Those who have borrowed to fund their share of the
pie are in particular difficulty.
Traditional finance and economic theory teaches the
virtues of leveraging to increase % rates of returns. Upwards of 70% of
investors were willing to borrow to finance their Woodlots.
MIS Companies willingly obliged.
They weren’t alone. Credit growth was growing
everywhere at a non sustainable rate.
But soon MIS Companies discovered that they needed
more cash. Financing MIS growers has its limits. Cash is needed. To buy more
land. To look after existing projects.
So they bundled up some loans and arranged for
third parties to purchase them. More borrowings. But the cash injection enabled
MIS Companies to keep going, to keep spruiking for more investors.
In case interest was flagging simply boost the
returns to investors as Great Southern blatantly did, or keep paying
unsustainably high levels of dividends to shareholders as both Great Southern
and Gunns have done.
The latter was considered de rigueur. The Macquarie
model for years condoned paying distributions to investors using borrowed funds
rather than operating profits. Old timers kept scratching their heads. How long
can this go on?
The Macquarie model was the progenitor of MISs.
The boys from Martin Place scoured the world for
suitable assets, airports for instance. They purchased them, packaged them with
management agreements, and then sold them off to investors, who were queuing
with their chequebooks, quite willing to pay Macquarie fees of a size
sufficient to choke a hippopotamus.
MIS companies took their cue. They purchased land,
undertook to plant a few seedlings, and then sold a lease for 10+ years
together with management agreements, reaping fees of a similar magnitude.
It’s the same pattern. Different industries but the
same deal.
Woodchipping, due to favourable arrangements with
you and I, the ultimate shareholders of FT, has also presented a lucrative
arbitrage advantage. Given such a favourable selling price for our timber, it’s
not unsurprising that arbitrageurs should run as hard as they did. After all
that’s the genius of capitalism at work.
Why FT didn’t insist on a better price for a
monopoly product will long remain a mystery. As a result FT is probably in even
worse shape than its major customer at this stage.
It’s not only Gunns which needs a strategic review.
FT is also in need of a check up.
Not only governance but the entire business
structure.
Where to from here?
Gunns have failed to build a sustainable business
that will survive when the chips are down, when MIS loses favour and when
native forest woodchipping’s glory days are finished.
Will MISs survive? The AFR reported on 6th April
2010 about the sector’s problems with seeking new investors. A director of AAG,
one of the industry spruikers, still believes the industry is viable, floating
the idea of reserving funds to ensure projects were developed. Gosh, what a
splendid idea, saving money for a rainy day. Grandpa will be pleased.
It gets back to whether the pie’s big enough for
growers, landowners and end users to all get a reasonable slice. The numbers
will have to change a bit.
Or maybe the pie can grow a bit. That’s the
rationale behind carbon sink plantations. To revive MISs. This possibility was
given a scathing assessment by the The Weekly Times in a recent editorial: HERE
It is highly unlikely that Gunns’ current market
value will exceed the amount of capital contributed by shareholders of $1
billion. All reserves and retained earnings gone but no lasting residual
benefits, just 10 years of argy bargy, a loss of native forests, replaced by
monocultures, where the end user is yet to be identified.
Whatever doubts people harbour about Gunns, there’s
often a lingering feeling, a feeling of State pride that one of ours has made
it in the fiercely competitive world, a feeling that prevents an honest
appraisal of Gunns’ position.
Which is … it’s a crock.
The current market value of Gunns is likely to be a
more pragmatic assessment than the Directors’ values as recorded in Gunns’
books.
It’s time that policy makers tried a little harder
to understand the structure of the companies that are supposed to form the basis
of The New Forest Industry. Constructing an edifice on such shaky foundations
after the State has endured 10 years of wasted opportunities will be
catastrophic.
With a new Minister there’s always hope.
No comments:
Post a Comment