Tuesday, 5 May 2009

Decision time is nigh

The woodchips that will come onto the market in the next few years from Timbercorp and Great Southern woodlots will be at the behest of administrators and managers trying to wind up the MIS structures. This will help suppress Gunns’ woodchip price already under stress from the effects of the current global crisis which has seen all commodities suffer price falls. Most commodities are in excess supply now so the rapid rise in price in the future is unlikely.

Gunns is a different company than Timbercorp and Great Southern. The latter two have been run by paper shufflers. Gunns has more forestry experience. Gunns has more institutional support on its share register which saw it able to raise $336 million in September 2008, a very fortunate event when viewed with hindsight.

Gunns has a stronger balance sheet with debt facilities available until 2012, and a more diverse revenue base. It earns income not just from MIS sales but also from forest products. Its other divisions, wine, construction and retail hardware are insignificant.

It’s not dependent on MIS sales although it has benefited enormously from the practice. Getting MIS investors to raise money essentially for and on behalf of forest companies has been an unbelievable cash flow boon.

The CFMEU and their ilk, the Pied Pipers of TCA’s Hamelin branch have acted as double agents removing risks from Gunns’ balance sheet by persuading their own members to assume disproportionate burdens with plant and equipment finance arrangements in return for inadequate contractual rewards from Gunns.

But Gunns is not without problems.

Back in 2007 Mr Gay acted as if kryptonite was his only danger. The pulp mill was on the drawing board and swallowing Auspine was seen as a mere formality. Gunns purchased all the shares in Auspine during 2008. The purchase price was $327 million, $269 million in cash and the balance in Gunns shares at the then current value of $3.35. Auspine’s main assets at the time were pine trees ($217 million), land and a few buildings ($228 million), and plant and equipment, mainly sawmills ($45 million). The bank debt was $154 million. The difference between the value of the net assets acquired and price paid for the shares was $29 million worth of goodwill.

But even outlaying $269 million of cash to fund the Auspine purchase was too much. The institutions had to stump up $336 million in September to help repay bank debt. And the banks further insisted on the sale of $173 million worth of recently purchased trees.

Auspine still exists, it’s merely a 100% owned subsidiary of Gunns. The assets listed above are still on Auspine’s balance sheet. Except for $173 million worth of pine trees sold to GMO Resources in March 2009. Gunns informed shareholders via Note 37 in their 2008 accounts that the expected consideration was pre tax. This suggested tax is payable on the sale. Indeed it is. On the excess of the sale price over the historical cost, not the current book value.

When one looks at the balance sheet for Auspine prior to its takeover, the historical cost of pine trees was only $7 million. Like MIS investors Auspine would have immediately expensed any plantation establishment costs. The $7 million may be standing timber bought elsewhere. It’s immaterial. Gunns valued these trees at $217 million but they weren’t purchased per se. Gunns merely acquired the trees via the acquisition of Auspine’s shares.

In its latest set of accounts Gunns has deferred tax liabilities of $260 million. These have occurred mainly as a result of tax on the unrealised increases in value of land and plantation assets which accounting standards require in order for the accounts to be a true and fair summation of an entity’s financial position. Tax is only actually paid when an assets is sold, in which case a deferred tax liability becomes a current tax liability. The tax chickens coming home to roost so to speak.

Notwithstanding that a company may be trying to survive by selling assets at or even below current book value, the sales may trigger a current tax liability. An unwelcome impost at a time when cash flow is critical.

Hence when the trees were sold to GMO, the proceeds were taxable. Just like any tree investor who sell trees, tax is payable on the proceeds less any unclaimed costs. Income of $170 million means tax of $50 million. Unless an offsetting deduction can be found.

The most obvious offsetting deduction will arise if Mr Gay is unable to obtain finance and a joint venture partner for the mill, and the Board decides not to proceed by 30th June 2009. It will then be able to offset the mill establishment costs to date of $125 million against other income. So far these expenses have been recorded in the balance sheet as a capital expense.

Gunns canvassed the write off possibility in Note 18 in the latest half yearly accounts when it said “If the project were not probable, this would involve the expensing of a substantial proportion of the $125.5 million included in capital work in progress at 31 December 2008 through the profit and loss.” The deductibility of the mill costs incurred to date is covered in Division 40-I of the 1997 Tax Act. Immediate write off requires Gunns to “abandon, sell or otherwise dispose of a project” for which the capital work in progress exists.

To date Mr Gay has been happy to play a game with his detractors by continually extending the time frame needed to find finance and an equity partner. If he continues to do so beyond 30th June 2009, Gunns will pay tax of $50 million on the sale of the Auspine trees.

It’s as if Mr Gay is sitting at a poker table with a fast disappearing pile of chips in front of him (no pun intended) calling everyone’s bluff, probably holding a pair of twos, although nobody’s quite sure. He keeps his cards close to his chest. He talks all the time, mainly provocative nonsense and unsubstantiated assertions. But come 1st July 2009 he’ll have to put up or shut up. He’ll have to chip in a further $50 million just to stay in the game. That’s the tax he’ll have to pay on the sale of Auspine’s trees without the offsetting deduction for the abandoned mill expenses. He will probably have to scrounge a loan for the $50 million. Otherwise if he wants to claim a deduction for the mill costs to date he’ll have to stop spruiking the project. Decision time is nigh.

The second hint of a problem was the cost of the $336 million equity raising in Sept 2008. The cost was $18 million or just over 5%. A high figure for an amount not underwritten by the brokers.

Third, Gunns arranged in December 2008 via an ASIC registered prospectus, to raise $15 million in unsecured notes for working capital. To date it doesn’t appear as if the prospectus has been activated. For a company of Gunns’ size contemplating a $2 billion pulp mill, $15 million in unsecured notes is an insignificant amount. Gunns hasn’t needed the extra working capital yet as it has used its monopoly position to outsource a lot of its working capital requirements to forest contractors and suppliers. What options do the latter have? Another job?

Fourth, cash flow from operations (cash in and out the door from operating, not necessarily profits) was a negative $4 million in the latest 6 months report compared to a positive $35 million during the same period last year. It’s hard to imagine the next 6 months will be positive although there has been a reduction in finance costs. Cash flow from operations in 2008 was a positive $70 million split evenly between the two halves of the year.

Fifth, MIS sales will be down this year (some estimates by as much as 90% on an industry wide basis) and other sales of woodchips down by at least 15% (Gunns’ estimate in Feb 2009).

Sixth, Gunns has yet to experience any serious default on loans to investors as have Great Southern and Timbercorp. Gunns’ tree growth rates are allegedly superior, but investors haven’t exactly been flooded with information about their crops.

Seventh, Gunns in its 2008 report claims it manages 150,000 hectares of hardwood plantations in Tasmania, and 50,000 hectares of pine plantations mainly in SA and Victoria. Being a good corporate citizen, a further 45,000 hectares is voluntarily reserved.

But 95,000 hectares of the hardwood plantations are leased to MIS investors and a further 33,000 hectares worth of trees since sold to GMO. The MIS deal is that Gunns will pick up 5.5% of the proceeds at harvest time, and the GMO deal is Gunns will have to pay market price for the pine trees when they’re ready for processing.

There are no fortunes to be made with either of these deals. Gunns has to look after the land, 128,000 hectares, with no return until harvest time. This is what brought Timbercorp and Great Southern undone. The land represents over half Gunns’ plantation land. And a lot of its other plantations are the older, slower growing, poorer yielding plantations inherited from APPM/AFH. So in this respect Gunns has similarities with Timbercorp and Great Southern. Looking after crops owned by others. These costs can only be met out of current income. And if current MIS income is down, then the forest products business will have to assist. And if the forest product income is down then?? Cash flow problems??

The land assets are considerable, but the income derived is inadequate.

And eighth, in the latest half yearly accounts Gunns suggested that once the proceeds of the tree sale to GMO were received, Gunns’ gearing would be 32 %. It will rise if the mill costs are written off. The Auspine goodwill ($29 million) appears to have been impaired by the new owners and may have to be written off as well, which won’t help gearing levels. If all this happens, then Gunns may well fall into the category of just another MIS company, battling to survive, blessed however by the favourable deal with Tasmanian taxpayers via Forestry Tasmania.

Institutional shareholders are likely to want a definite decision by 30th June 2009 whether to abandon, sell or otherwise dispose of the mill project. If any of these three options are not adopted, Gunns will have to find $50 million to pay the ATO. A not insignificant amount given their current position.


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