Thursday, 15 April 2010

Gunns through the looking glass

Readers of financial statements of failed and failing companies over the last few years can be forgiven for concluding that some were prepared with the assistance of the same additives that Lewis Carroll allegedly used to clear his writer’s block.

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.

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