Friday, 8 October 2010

Gunns: Is the worst over?

The forest industry’s slow motion train wreck continues its inexorable journey.

There are many, on both sides of the forest debate who appear to accept the urban myth that had it not been for the actions of high profile activists, Gunns’ former CEO would still be ensconced in Lindsay St Launceston.

A quick glance at the ASX announcement on 16th August 2010 outlining Gunns’ achievements in the financial year 2010 reveal that Gunns’ old business plan was a failure. The company’s old model was described as being “a conglomerate of long life low yielding assets…..(consisting of) many businesses….. excessive levels of encumbered assets .....excessive debt levels to earnings,..... (where) potential investors do not understand the business.”

It took the new Board less than 3 months to clearfell the legacy of Miranda Devine’s Working Class Hero ( Devine retribution ... John Gay: working class hero and The Devine lie ).

The CEO’s demise and the uncertain state of his former bailiwick are due to its flawed business model, not the actions of one or two of its opponents.

There’s a real danger that erroneous reasons for the predicament facing the forest industry will lead to erroneous recommendations for a way forward.

Whatever the outcome of the Roundtable the next step will require heaps of money. From taxpayers probably. So an understanding of the current situation from a $ viewpoint must surely be close to the top of the list of current priorities.

Gunns’ latest full financials released on 30th September attempt to gloss over the grim reality.

The headline profit after tax of $28.5 million has been presented as a vast improvement on the first half year’s result of a $400,000 profit.

While its second half year’s net profit after tax was a considerable improvement, Gunns’ EBIT (earnings before tax and interest) was minus $85 million for the full year.

In these situations companies often present instead a figure of ‘underlying EBIT’. Gunns’ underlying EBIT was calculated at plus $51 million, by excluding many of the write offs which caused the negative EBIT, even though they had been included in previous years to boost EBIT.

The new Gunns Board has undertaken to build a strong cash generating business. So perhaps it may be timely to start by taking a closer look at its cash flow, as per the 2010 financials, before examining the paper entries used to finalise the net profit figure.

Gunns’ cash flow

A company’s cash flow statement splits cash in and out of a business into 3 categories - operating, investing and financing cash flows. Cash is a business’ life blood, and operating cash flow forms the cornerstone of a firm’s profit.

Sometimes cash flows which have the characteristics of ‘financing’ cash flows are instead allocated to ‘operating’. This has happened with Gunns and arguably gives an overstatement of its operating cash flow.

Understanding how MISs are recorded is crucial to understanding Gunns’ financials.

Some MIS investors pay cash up front but most borrow, often from the MIS company. A MIS sale using a borrowing facility will give rise to a ‘sale’ (in the P&L) and also a ‘loan receivable’ (on the Balance Sheet).

Over time the investor gradually reduces the ‘loan receivable’ with cash contributions. This doesn’t affect the P&L as the ‘sale’ has already been recorded. It simply reduces the ‘loan receivable’ and increases the ‘bank’.

But in the cash flow statement every loan repayment is recorded as an ‘operating’ cash inflow.

Too many ‘loan receivables’ may leave a MIS company without enough cash to operate.

So they are bundled up and sold to third parties, banks for instance. The sale proceeds are not recorded as a reduction in the ‘loan receivable’ but instead as a ‘securitised loan’ from the particular institution. The reason for this is that the ‘loan receivables’ remain on the balance sheet as well as the corresponding ‘securitised loan’ because, to use the accounting jargon, the risks and rewards of ownership have not been transferred.

There is still a lingering liability for the MIS company.

Accordingly when an investor with a securitised loan pays off the ‘loan receivable’ it is immediately paid in full to the ‘securitised loan’ lender. There is no impact on the P&L. The inflow is included as an ‘operating’ cash inflow, yet the immediate outflow is a ‘financing’ outflow being repayment of the securitised loan.

The loan repayment by the investor is never available to meet operating expenses because it is immediately paid to the lender in full. Yet the inflow is included as an ‘operating’ cash inflow.

Arguably misleading. Within the rules but a little misleading. Especially if one is interested in trying to work out the sustainable cash flows of the various segments of Gunns’ business.

In 2010 $44.5 million of securitised loans were repaid to Gunns by investors, then immediately paid to securitised lenders. Most analysts exclude amounts like the $44.5 million when assessing operating cash inflows of companies like Gunns. It’s not available to meet operating expenses.

Also normally excluded by analysts when trying to determine underlying operating cash flows are one off tax refunds. In 2010 a fortuitous review of the tax consolidation regime produced a tax refund of $29 million, $16.5 million in 2010 with the balance in 2011.

The stated net operating cash flow of $62 million is quickly reduced to $1 million if adjustments are made for $44.5 million of securitised loan repayments and the one off tax refund of $16.5 million.
Included in net operating cash flows was, needless to say, income from the sale of sawn timber. During the year, Gunns purchased ITC Timber for $88.5 million. The major asset was $56 million worth of inventory.

However the entire purchase price was included in the cash flow statement as an ‘investing’ activity.

The argument for buying ITC was that synergies existed and working capital could be reduced by $30 million for the new combined sawmilling businesses thus creating a more sustainable business. Inventory reductions of $12 million were achieved during 2010.But to include the purchase of the sawn timber inventory as a ‘financing’ cash outflow, and then to assign the sale of some of that inventory as ‘operating’ cash flow simply overstates operating cash flow. Allowing for this anomaly means that operating cash flow for Gunns was clearly negative.

A bad sign indeed.

Gunns’ Profits and Losses

Given such awful operating cash flow, how does Gunns produce a net profit after tax of $28.5 million?

A few ‘book entries’ are required. In the argot of accountants, a few ‘non cash’ adjustments.

First the non cash write offs.

• The book value of standing timber, felled and sold, worth $23 million was included as an expense.
• Depreciation and amortisation costs were $32 million.
• Bad debts relating to MIS loans were $9.3 million. (There were further defaults from MIS investors as $10.8 million appeared amongst Gunns’ assets under ‘investments’ as the fair value of MIS schemes taken over from growers who had defaulted on their loan repayment to Gunns).
• Unrealised currency hedging losses were $8.8 million.
• Future MIS commissions previously included as ‘revenue’ were revised downwards by $80.7 million. That’s not a misprint. $80.7 million is correct. Previous expectations were re assessed.
• Some MIS contracts were also assessed to be so onerous to Gunns that a future loss of $7.7 million needed to be recorded.
• The assets of the wine business (sold to Brown Bros in 2011) were marked down by $29.4 million. Perhaps the Working Class Hero should have stuck to Boags?
• Land leased to MIS growers was revalued downwards by $4.5 million due to the lower than expected ‘rents’ to be received from harvest proceeds.
• The FEA investment of $10.7 million was written off.
• Timber processing assets were written down by $5.7 million.

In total, write offs of over $200 million.

How did Gunns come back after all those write offs?

As mentioned above Gunns bought ITC Timber for $88.5 million. But they reckoned it was worth $92.6 million so they booked the difference, $4.1 million, as profit, a discount on acquisition. Eddie Groves was a good role model.

Gunns also became the Responsible Entity for 9 Great Southern MISs. It didn’t acquire any land or trees, simply took over the management responsibilities. In the process it acquired 5 companies with a few miscellaneous assets for $6.1 million. But Gunns reckoned they were worth $9.3 million so they booked a further $3.2 million profit.

Every little bit helps.

But then in a breathtaking display of bravado Gunns included as revenue, an amount of $67.7 million for the current value of future commissions to be received at harvest time from trees owned by Great Southern investors.

So for a payment of $6.1 million to Great Southern’s Liquidator, Gunns improved their reported revenue by $70.9 million, a truly awe inspiring effort. When it comes to award winning book entries, this was a peerless performance.

A UBS analyst, (UBS is one of Gunns’ major shareholders) was reported in the AFR on 16th August of this year as saying “(w)hile Gunns has given earnings guidance for 2010, the high contribution of EBIT from MISs, almost entirely non-cash, means it is of questionable quality”.

It is now evident what he meant.

A couple of extra book entries were required; standing timber was revalued upwards by $17.3 million and recorded as ‘revenue’ and a management fee of $15 million was recorded as an expense of managing the former Great Southern woodlots.

And last, profit on the sale of assets mainly from the hardware business was $5.2 million.

All the book entries meant Gunns’ EBIT was minus $85 million. After interest the earnings before tax were minus $103 million.

Ordinarily one would then expect a negative tax expense of $31 million, 30%, the prima facie tax expense, making the net profit after tax minus $72 million. A negative tax expense either offsets against prior deferred tax liabilities (on unrealised gains in the value of standing timber for instance) or is carried forward as a tax asset to be offset against future tax liabilities.

But in a stroke of good fortune Gunns’ tax liabilities as a consolidated entity were adjusted for prior years. This resulted in a negative tax expense of $132 million, made up mainly of the prima facie amount of $31 million plus an adjustment of $90 million resulting from changes in Tax Legislation relating to standing timber. There was a refund received in 2010 of $16.5 million (mentioned above) with a further amount due in 2011 of $12 million. Most of the balance was offset against deferred tax liabilities.

The tax expense of minus $132 million transforms the earnings before tax of minus $103 million into a net profit after tax of $28.5 million.

This is a pretty meaningless measure of Gunns’ current position, not only because of all the book entries, but because of the large one off adjustments like the tax expense.

If unsure about a company’s set of accounts, analysts always go back to the cash flow statement and the accompanying Notes to deduce what book entries have been made. Especially if some idea of the contribution of Gunns’ various business segments is to be gauged.

Segment Cash Flow

Gunns’ reformation has resulted in a change in the segment reporting.

The forest products segment contains woodchipping, forest and plantation management including management of MIS woodlots.

The timber products segment contains sawmilling veneers and other timber products.

The ‘other’ segment contains the residue, including hardware merchandising (sold in 2010) wine (sale contract signed in 2011) construction (to be transferred to Hazell Bros in 2011), MIS financing and MIS Responsible Entity admin services.

The Notes to the 2010 financials indicates the discontinued businesses of hardware and wine had net operating cash flows of $2.4 million, so it is not unreasonable to conclude that the total net operating cash flow of the ‘other’ segment was marginally positive.

The timber products segment produced an EBIT of $15.6 million which included depreciation of $11 million. But also as we have seen inventory was reduced by $12 million. This implies net operating cash for this segment was $38.6 million, say $40 million.

As was set out above, Gunns’ overall net operating cash flow was likely to be negative in 2010. If the ‘other’ segment produced a small positive cash surplus and the timber products segment produced a $40 million surplus, then the contribution from the forest products segment was at least a $40 million deficit.

In other words the cash deficit from woodchipping and plantation management was at least $40 million.

This is the segment that is supposed to provide a springboard for Tasmania’s future. Prospective investors won’t be too impressed.

If the Roundtable doesn’t decide soon, Gunns may not be able to cope with too many more cash flow deficits. Great Southern couldn’t. Nor could FEA.

Perhaps Mr Bartlett was mindful of history when he recently urged parties to expedite their deliberations.

This hasn’t escaped Gunns’ Board. Its Report contains some interesting observations.

Gunns as a Going Concern

“In preparing the Financial Report, the Directors annually make an assessment of the ability of the Consolidated Entity to continue as a going concern which contemplates the continuity of business operations, realisation of assets and settlement of liabilities in the ordinary course of business…. in this regard the current economic environment presents challenges in terms of sales volumes and pricing as well as input costs… whilst the sale of certain non-core assets is anticipated, there exists some uncertainty about the timing and completion of those sales…..should the ability of the Consolidated Entity to realise sufficient cash flows from trading operations or the sale of non-core assets be restricted, the Consolidated Entity will actively pursue alternative funding arrangements and institute additional measures to preserve cash.”

The Directors expressed a note of caution. There are clouds on the horizon. Gunns as a going concern faces tough times.

Gunns’ Balance Sheet

Gunns’ cash flow is sluggish and its profits pretty soft. Its balance sheet is no better.

• Loans to MIS investors are $240 million of which $20 million has been written off as impaired.
• Investors defaulted on other MIS loans which resulted in Gunns taking over their woodlots which are now listed as being worth $11 million.
• The expectant value of future MIS services is listed at $140 million. In other words Gunns have already booked $140 million of revenue on the yet to be received harvest commissions.
• There are $78 million of assets listed for resale mainly the wine business and the 28,000 hectares of non forest land under contract of sale.
• Freehold land was revalued downwards by $70 million and much is subject to leases to third parties to grow trees.
• There is still $62 million of intangibles comprising mainly goodwill from the Auspine purchase and trademarks bought as part of the Auspine deal. At a time when Gunns are reportedly considering closing the second of the Scottsdale sawmills bought from Auspine after already selling off ¾ of the trees bought, it’s surprising that the intangibles have much value.
• Forest roads were revalued upwards by $74 million. Maybe in case Gunns’ future compensation for assets forgone is to be based on the book value of assets surrendered as one cynic suggested? Or maybe to boost a flagging balance sheet where debt to equity was a little shaky?
• A total of $205 million for pulp mill capital outlays is still listed as ‘work in progress’.Gunns spent $55 million on the project during 2010.

Quite a few issues of concern.

But not the only ones.

During 2009 Gunns assumed full ownership of Australian Plantation Trust No 2 by buying a 70% interest for $9.6 million. The assets were almost entirely freehold land (see Note 31(b) in 2009).

There was no suggestion in 2009 that the acquisition was only ‘provisionally’ recorded as was revealed in 2010 in Note 17 which stated inter alia “the finalisation of the acquisition accounting in 2010 identified goodwill of $9,494,000.” In accountants speak this means, whoops, we’ve overpaid by $9.5 million, we better assign that to ‘goodwill on acquisition’. Accounting conventions are flexible. Pay too little, it’s revenue; too much, it’s an asset.

In a buyer’s market for forest land at that time it’s a little odd that Gunns paid $9.5 million more than its value. The vendor was well known to Gunns as they were partners. It smells a bit.

Such deals do little to endear the company to investors and bankers.

Reconstructure Progress Report

Gunns told the ASX on 22nd February 2010 they will “seek to announce a final structure and external investors by 30th June 2010”.

Another deadline missed, but at least the hardware business was sold for $38.7 million. Another $140 million (net) was raised from a share issue, a further $16 million from new securitised loans.

But it soon disappeared. $88.5 million for ITC, $6 million to Great Southern’s Liquidator, another $55 million on the pulp mill, dividends of $16 million, a few operating expenses.

Not much left to repay borrowings. They were reduced by only $3 million, from $662 million to $659 million (see note 20).

The proposed debt restructure is going to be painful. Very painful.

The wine business and non forest land auctioned in 2010 (but not settled) were listed as ‘assets for resale’ at $78 million. Will this help reduce debt when the proceeds are paid in 2011?

Not by much.

Gunns has contracted to spend $17 million (see Note 28) probably on the Portland port facility.

In addition there are $24 million of rents to be paid on MIS land (see Note 28). The forest products segment which includes MIS plantations is unlikely to be cash flow positive for 2011.

Then there are the dividends paid. In 2010 half of the $16 million in dividends were paid to ordinary shareholders, the rest to hybrid security holders.

There is $120 million worth of hybrid securities which rank ahead of ordinary shareholders but behind unsecured creditors. They are paid a variable return on a quarterly basis, currently about 10% pa. But instead of receiving a 10% return on the face value of their security (as if they were bonds), they receive a 7% cash dividend and a 30% (non cash) franking credit. It costs Gunns less from a cash viewpoint.

But now after the tax expense adjustment in 2010 Gunns franking account is now nil. Which means they will be unable to pay franked dividends, So they will have to pay a 10% cash return, a total of $12 million pa. Unless they renege as other companies have in tight situations with hybrid securities. If they continue to pay quarterly interest, the securities are de facto borrowing with a 10% rate.

So instead of Gunns’ borrowings being $660 million, they are $780 million.


Even with all the asset sales and restructure proposals debt is unlikely to fall by much.

Where to?

The sawmilling business probably peaked this year with a cash surplus of $40 million. 2011 will be ok as inventory is gradually run down in the new merged entity, but if and when native forest logging ceases, the pressure will be on again.

The woodchipping and plantation business is in a cash flow deficit situation. If markets don’t pick up or the Roundtable fails in any way, then Gunns will have some anxious moments.

The current CEO has been reported as being offered a large contract for services until the end of 2011.Which coincides with the fact that a large chunk of Gunns’ borrowings, over $450 million, is up for review early in 2012.

It is quite amazing to sit back and look at the $ numbers being posted by Gunns.

There doesn’t appear to be a Plan B.

If the pulp mill does not get off the ground then Gunns will become just another has-been. The absence of any risk assessment or any alternatives are simply mind boggling.

Therein lies the real reasons for the departure of the Working Class Hero.

No comments:

Post a Comment