Tuesday, 4 October 2011

Greg's report card

Greg L’Estrange completed another semester last Friday with the release of Gunns’ latest set of consolidated financial statements for 2010/11.

Greg may be looking for a social license, but the statements highlight Greg’s progress as he staggers towards D Day, in January 2012, a date with debt and destiny when his bankers will decide whether to roll over or refinance a large part of Gunns’ debt. The dramatic decline in asset values and tight cash flows continues the pattern of 2010, a pattern that largely came to light with the abdication Greg’s predecessor.

The Directors “are confident that new banking arrangements on mutually agreeable terms and conditions will be established prior to the maturity date of the existing facilities.”

If Gunns hasn’t enough cash from operations or from additional lines of finance or from selling the assets currently for resale, then Gunns will reduce working capital, raise more equity and further reduce operating and non operating capital expenditures. Goodness me what a comprehensive plan. Are there any other options? Any bases not covered? At least the problems confronting Gunns are laid out for all to see.

In previous years the auditor has drawn attention to the “material uncertainty as to whether the carrying value of capitalised pulp mill expenditure can be recovered for the amount stated and as to whether additional obligations will be incurred in relation to committed project costs”. In other words should the costs be written off in the income statement? Gunns is not short of deductible write offs so it will desist for as long as the dream is alive.

The same statement about the material uncertainty of the pulp mill appears this year. In addition this year the auditor has chosen to draw attention to “the existence of a material uncertainty in respect of financing requirements which includes the planned sale of certain assets in the course of the next twelve months. The Group’s ability to operate as a going concern and therefore whether it will realise its assets and extinguish its liabilities at the amounts stated in the financial report is dependent on these matters”.

Whenever Directors and indeed auditors refer to going concern problems things are reasonably serious. There needs to be reasonable grounds to be able to affirm a company’s solvency that it can pay its debts as and when they fall due, not simply an affirmation that assets exceed liabilities.

That is the very problem. Most of Gunns’ $628 million debt is due to be repaid in this current financial year 2011/12. So the Directors need to be able to show this is possible. Assets are reclassified as ‘assets held for resale’. In 2009/10 the problem wasn’t as pressing as only $78 million of assets were so classified, but at the end of 2010/11 the assets available for resale totalled $953 million.

One perennial problem when trying to ascertain a company’s value is whether the balance sheet values are realistic. Accountants traditionally record assets on a historical cost basis. Some assets may remain on a balance sheet with values that bear no relationship to a possible realisable price. Other assets need to be updated each year to a fair value as mandated by accounting standards and such adjustments are reflected in the income statement either as revenue or as an expense. When assets are reclassified as held for resale they too need to be revalued to reflect a fair market value. The $953 million of assets now held for resale have already suffered a $425 million haircut. They’ve been written back by 30%. That not to say they will fetch $953 million. The market may disagree with Gunns’ values. One thing is reasonably certain, Gunns won’t get more.

It’s mainly the write down of asset values that has caused Gunns’ large loss for this year 2010/11. As stated above most write backs are reflected in the income statement, but esoteric accounting standards mean some write downs bypass the income statement and directly reduce a company’s equity.

Now to have a closer look at a few aspects of the financials statements.


Earnings before interest and tax (EBIT) are the best measure of profit if one is making comparisons. In 2009/10 Gunns’ EBIT was an $85 million loss, this year 2010/11 the EBIT was a $439 million loss. This year also saw a $99 million write off direct to the equity account, in respect of land revaluations.

A lot of the write offs are book entries at the end of the year, rather than actual realised losses. There was a couple of interesting mark ups which went against the overwhelming tide.

1. MIS related assets have suffered a $77 million impairment. Gunns doesn’t offer new MIS schemes, hasn’t done so since 2009 when the world finally realised they had less to offer than a Nigerian scam. Nevertheless Gunns is still responsible for 8 of its own schemes and 9 Great Southern schemes, the management rights which it purchased from Great Southern’s liquidator in 2010. MIS assets essentially consist of loans to Growers and future harvest commission receivable. Loans to the long suffering Growers are, in most instances being repaid, some loans are bad, others doubtful, and future harvest commissions have been revised downwards because of lower than expected yields and prices, and in some cases where Growers have defaulted on their loans and Gunns has become the proud owner of a few more woodlots, these too have fallen in value necessitating further write offs. Gunns now owns $36 million in woodlots after $12 million was written off in the latest year. To cap it all Gunns is trying to bundle up and sell the remaining MIS loans for a lump sum and were forced to write down their potential value by a further $25 million when they were classified as ‘assets for resale’. Whether or not a spendthrift punter with poor judgment can be found is yet to be seen. The total write offs just described amount to $77 million.

2. Auspine assets have suffered a $218 million impairment, $162 million of which relates to the remaining land and tree assets in the Green Triangle due for settlement this month. The sale price of $105 million implies a discount to book value of 61%. Assets at the Scottsdale mills were written back by $20 million, the trademark was thrashed and written off, and the overpayment for Auspine’s assets a few years ago which has been carried on the balance sheet as ‘goodwill’ was also finally written off. Auspine’s softwood sawmilling business complemented by the 2011 purchase of FEA’s Bell Bay sawmill is still recorded at cost although it too is likely to be impaired. An ASX announcement in June 2011 indicated the Board “has agreed a clear way forward ......(to) progress the following initiatives…..(including)the sale as a going concern of all softwood sawmilling and timber distribution businesses”. That seems a reasonably unambiguous statement but Gunns didn’t revalue the asset and shift it to ‘assets for resale’ in the financial statements. Nor did it bother telling the ASX that it had changed its mind. Then again continuous disclosure was never a top priority. However the most outstanding book entry relating to Green Triangle assets, amongst all the carnage, was a $10 million addition to revenue being a “gain from harmonisation of Green Triangle offtake agreement”. (This could relate to MIS hardwood plantations ex Great Southern, the Directors never offered an explanation).

3. Tasmanian plantation forest assets both land and trees suffered an $88 million impairment as the assets were revalued prior to shifting to ‘assets for resale’. The reduction in value was 19% supposedly to reflect current market values. But Gunns will be fortunate if it can realise the revalued amount. The lower value is in part due to the less than adequate return from expected future harvest commissions on land leased to MIS growers, and the values of Gunns’ own plantation due to lower future stumpage values. Two years ago Gunns purchased the balance of an associated trust which owns land and tree plantations. It appeared to overpay for its interest because when land and trees were included in Gunns’ books at a fair value there remained a residual amount of $9 million which was conveniently classified as an intangible asset, goodwill, an asset that supposedly will ‘generate’ future income streams and deserves a place on the balance sheet rather than written off immediately. The $9 million worth of goodwill has now been written off and probably form part of the impairment amount relating to Tasmanian plantation assets of $88 million.

4. The exit from native forest, mainly in Tasmania, meant a further impairment of $88 million. Closure costs of sawmilling businesses was $21 million, the value of Gunns’ native forest declined by $15 million to nil, the value of roads on crown land puffed out last year in expectation of largesse from Lara were devalued by $18 million to nil, and the closure of jarrah mills in WA cost $12 million.

5. Further to the above note on the possibility of recovery of capitalised pulp mill costs, it was decided to write off $18 million being the capitalised interest incurred to date in respect of all the mill outgoings. They were obviously beyond recovery. A JV partner obviously won’t count interest costs incurred to date. It’s gone on for so long, why should they pay a premium for incompetence?

6. Greg managed to increase EBIT by $18 million by recording the bargain purchase of the Bell Bay saw mill as income. As noted above the rest of the softwood sawmilling assets probably need a trim, but that was deferred to another day.

Underlying profit

With such appalling EBITs how does Gunns survive? Keep the banks happy? Keep punters buying its shares?

Gunns constantly refers to its underlying EBIT (or underlying profit) as distinct from its statutory EBIT in its audited financial statements prepared in accordance with accounting standards. The calculation of underlying profit is not necessarily a subterfuge, analysts have used it for years to compare profits of, say, a company over a few years by excluding one off items to ‘normalise’ the profit figures.

Accounting standards exist to guide users as to what should be excluded (or included for that matter) to calculate an underlying EBIT figure from the statutory figure presented in the financial statements.

Over the past 3 years the statutory EBIT and underlying figures have been as follows:

• 2008/09 $111 million and $107 million.

• 2009/10 $ 85 million loss and $51 million.

• 2010/11 $439 million loss and $42 million.

Not much difference in 2008/09 but a $136 million difference in 2009/10 and $481 million in the latest year. Gunns bravely keeps telling us it’s basically still a profitable business. This is what is reported to ASX. This is what share market punters read as most don’t read statutory accounts.

The first and most significant feature is that the adjustments used to calculate underlying EBIT from statutory EBIT are not audited. That provides Directors with a little latitude.

The basic principle here is to exclude one off events, asset sales and asset write downs for example, and to exclude the effects of non core activities, so the underlying profit of the business can be calculated.

Gunns has been a business in such turmoil over the past 2 years that it is difficult at times to ascertain its core activities. The only thing we can be sure about is that it proposes to continue to process plantation woodchips preferably with a pulp mill. All other assets have been sold, listed for sale, mooted for sale or scrapped. Yet the underlying profit figure contains more than just hardwood plantation chip income.

The underlying profit figure is an easily manipulated figure free from audit scrutiny. Last year in 2009/10 Gunns took over management of Great Southern MIS schemes and in a stunning display immediately booked $68 million in operating revenue. It was a book entry, the amount was not cash received but rather included with ‘receivables’, a future expectation.

When calculating underlying EBIT in 2009/10, $24 million of the last book entry was excluded on the basis that it was “a one off profit effect”.

Now in 2010/11, whether or not at the insistence of the auditors, we learn, from reasonably small print, that $46 million of the $68 million is not a ‘receivable’ but rather an ‘intangible asset’, the bargain basement discount identified when Gunns assumed the role as Responsible (sic) Entity RE for Great Southern MIS projects. In which case $46 million should have been excluded from the calculation of underlying EBIT not just $24 million. The $46 million was the amount of harvest commission that had allegedly accrued at the date Gunns assumed its RE role. To accountants it is an asset, representing the future value of income, not income per se. Which would have meant Gunns would have failed to meet earnings guidelines as advised to the ASX. Which further means that investors relying on such advice may have been misled? Even in the latest year Gunns have failed to correct the underlying EBIT figure in its ASX presentation issued the same day as the Preliminary Results in August.

One is left with the impression that underlying earnings is an artificial figure easily corrupted and presented in such a way via PowerPoint presentations that makes reconciliation and comparisons with earlier years quite difficult.


Gunns dissects its income into segments, notably forest operations and timber operations and reports EBIT and underlying EBIT for each segment. In the latest year 2010/11 75% of underlying EBIT came from forest operations which comprised woodchipping and plantation management.

Woodchipping represented one third of forest operations’ EBIT, almost all from native forests which has now ceased, with plantation management the balance. Woodchip exports are forecast to pick up measurably in 2011/12 and some analysts are drooling at the prospect. But most forget that the chips won’t be from Gunns’ plantations. Almost all the increased exports are from Portland and Albany which means it is likely they are ex Great Southern plantation woodchips. Gunns doesn’t own these chips. It is only entitled to a 5.5% share of net harvest proceeds. This was not made clear in Gunns’ PowerPoint presentation.

While on the subject of the PP presentation, small print identified the underlying assumption that future availability of woodchips from the mainland’s Great Southern plantations will be replanted and managed by Gunns. Two pretty big assumptions, first the land is majority owned by Canadian pensioners and second who is going to pay for the trees? Another batallion of gullible investors? The same applies to Gunns MIS plantations. Who will replant? Using what funds? The harvest commissions will not be enough.

Strictly speaking the income from commissions isn’t classed as revenue from sale of goods, but rather from rendering of services. MIS companies went broke in the past because the cash flow burden necessitated meeting expenses on a regular basis, yet income was only received on a deferred basis at harvest time. It is not immediately apparent that Gunns has solved this dilemma, future commitments as contracted described in Note 28 describe a worrying level of outlays that will have to be met. Currently its operating cash flow is as bad as some of the recently departed MIS companies.

The timber products or sawn timber segment represents about 25% of the remaining operating EBIT, almost all from softwood sawmilling. Sawn timber from native forests contributed nothing to the bottom line. When this is coupled with the fact that the supplier of much of the native forest timber is Forestry Tasmania which also makes a loss, and which would be even larger if it adopted a more reasonable treatment for the costs of logs, similar to the treatment adopted by Gunns in its financial statements. It’s not often Gunns can be shown to be a leader when it comes to meaningful financial statements, but it’s a shining knight alongside Forestry Tasmania.

We are bogged down in the seemingly interminable debate re the transition from native forests. It would indeed be pleasing and informative if some of the most vociferous contributors to the debate would take a little more time to study the turnover and profitability from the 2 main players in the native forest industry in recent years and construct their arguments accordingly. To date there has been an embarrassment of assertions, from all sides I might add, so that any possible path forward for a native forest processing industry is still at square one waiting for the cerebrally challenged participants to begin to construct their arguments upon evidence based premises.

Cash flow

It’s of great concern when book entries make up such a large part of a company’s financial statements. Without cash flow, book entries have little meaning as a company battles to survive.
A cash flow statement informs of the source and application of a business’ cash, from operations, from investing (which includes purchases and sales of plant and purchases and sales of other companies) and from financing (which includes new loans and loan repayments, new equity and dividend payments).

Again accounting standards aren’t perfect and literal interpretations of standards can make cash flow statements quite misleading, which often Directors feel disobliged to correct. They’ve discharged their responsibilities, so the argument goes, if they meet the standards.

Gunns’ cash position deteriorated by $49 million during 2010/11. Whilst overall borrowings reduced by $31 million to $628 million, the amounts included as bank loans increased by $34 million from $467 million to $501 million. The blow out in the aforementioned overdraft by $49 million was the contributing factor. Hence not a lot of progress as yet with the debt reduction strategy. The banks are understandably edgy. Asset sales leading up to January 2011 will be crucial both for Gunns’ survival and Greg’s Xmas bonus.

Operating cash flow is listed at $37 million. But this is very misleading.

1. In some instances grower loans have been bundled up and sold already (the rest are now listed for resale). In accounting jargon the risks and rewards of ownership have not fully transferred to the new owner even though Gunns has received a lump sum payment in consideration for the loans. Accordingly the loans are still included as owing to Gunns with a corresponding liability to the new owner. Gunns acts as a conduit, it still receives payments from growers but immediately forwards the payments to the new owner. However when the loans are received ($29 million in 2010/11, $46 million in 2009/10) they are treated as operating cash inflows yet when they are remitted to the new owner they are treated as an ‘investing’ outlays. Hence operating cash is overstated by $29 million in 2010/11 ($46 million in the previous year).

2. Gunns purchased $6 million of stock when it took over the Bell Bay sawmill but this was included as an ‘investing’ outlay because Gunns bought an entity which owned inventory plant etc rather than the items themselves. In 2009/09 Gunns purchased $56 million worth of inventory when it acquired ITC Timber for $88 million. That stock was included as an ‘investing’ outlay rather than an ‘operating’ outlay. Operating cash outlays are understated as a consequence.

3. Adjusting for 1 and 2 above implies operating cash was only $2 million for 2010/11 and minus $50 million for 2009/10.

4. When one tries to ascertain the underlying cash flow even more adjustments need to be made. Tax refunds of $12 million and $16 million in the last 2 years have been included as operating cash receipts. These won’t be repeated. The dividend payments to holders of hybrids (see below) of $8 million pa are de facto interest payments and arguably should form part of operating outflows rather than financing outlays. The latest year 2010/11 has also seen a $40 million run down in inventories, from the rationalisation of sawn timber inventory following the ITC purchase and the wind down of native forest operations, so actual operating cash flow certainly exceeds the underlying maintainable levels.

The reality is the underlying cash flow of Gunns is beyond salvation and that is why it is seeking an alternative. Asset sales have not reaped a cash whirlwind. The rundown of inventories is about the only thing that kept the wolf from the door in 2010/11.

Balance sheet

$953 million of assets have been revalued downwards and transferred to an ‘assets for resale’ account. These assets at the revalued amounts include land ($482 million), buildings ($12 million), plant ($7 million), trees ($303 million) and grower loans ($115 million). There also appears to be a liability to accompany the ‘assets for resale’, in all likelihood the value of covenants, representing the value of some of Gunns’ trees growing as part of share farming arrangements with third parties, who are entitled to a share of crop proceeds at harvest . The available for sale assets includes the Green Triangle land and trees at the contracted price of $105 million.

The remaining assets are a straggly bunch, consisting mainly of $90 million worth of assets for each of woodchipping and hardwood processing, $202 million worth of softwood processing assets, $212 million worth of book entries and woodlots described as MIS assets, and last and certainly not least the capitalised pulp mill expenses to date of $218 million. Most people have views as to the real value of the latter, the auditors have consistently referred to the material uncertainty re its recoverability, in other words whether or not a JV partner, if and when that eventuates, will give Gunns full credit for the amount on its books.

The softwood processing assets of $202 million are still recorded at historical cost. The latest EBIT from this activity was $14 million although there was not a full year with the recently acquired Bell Bay sawmill. When Gunns purchased Auspine the going rate of a softwood processing business was 7 or 8 times EBIT. Things wouldn’t have improved given movements in the $AUD. It is also completely dependent on maintaining the supply contract from the FT/GMO joint venture. Maybe not a problem, if Gunns lost the contract there’s now a precedence that residual rights might still belong to Gunns, resulting in a lump sum payment??

IGA matters

The financial statements refer by way of a note to the $23 million payment agreed to in regard to the residual rights attaching to native forest wood supply agreements.

There is also a more obtuse reference to the mutual release (with FT) of certain current and future claims arising out of those agreements.

But no specific mention of the $11.5 million paid to FT.

It doesn’t appear as if Gunns have or will record an amount payable to FT of $11.5 million.

If it had done so both EBIT and underlying EBIT would have been affected, placing the latter outside the guidance band advised to ASX. ASX would have demanded answers. Underlying EBIT is indeed a fickle easily manipulated figure.

It is unclear how FT will treat the $11.5 million, whether as payment for a receivable, a cash operating inflow or as an equity injection from the State Government.

If it is the latter it will confirm that the recent agreement is little more than a ruse to get much needed funds into FT to address the yawning cash flow deficit recently identified by both the Auditor General and the Leg Co Sessional Committee.

Gunns as a majority JV partner?

Given the level of skill on display as reflected in the financial statements and given the complete lack of experience in operating a pulp mill of the type proposed, it is plainly ridiculous to pretend Gunns will have a controlling interest in any project.

To give the project a modicum of credibility extra help has been obtained. The financial statements disclose that Timo Piilonen was appointed as Project Director for the pulp mill in October 2011 on a salary package of about $1 million pa. The incumbent was shown the door in January 2011 accompanied by a termination benefit of $320,000, most of which appears to have been used to reduce his grower loan from $746,000 to $508,000. Borrowing $746,000 to acquire 333 Gunns woodlots appears to be nudging the boundary between prudence and recklessness, so perhaps lack of judgement was a factor in the separation?

Shares and equity interests

Gunns has been blessed with a reasonably stable shareholding base with 70% to 80% of shares held by the major shareholders although not quite as concentrated as earlier years. They tip in extra equity when needed $334 million @ $1.50 per share in 2009, $145 million @ 90 cents in 2010 and $25 million @ 60 cents in 2011. But any future capital raising will need to be large and it will mean a significant dilution of the interests of current shareholders, many of whom have helped Gunns survive.

Most of the substantial shareholders (greater than 5%) do so as fund managers, often for many funds. Most of the funds they act for are small, even smaller now as a consequence of their misadventure. Major shareholders are unlikely to head for the exits in the near future, as that may upset the delicately balanced apple cart. It would be akin to shooting oneself in the foot. Most are waiting with crossed fingers, watching the asset sales.

The movement in the price of Gunns’ hybrids is more interesting. The securities are a hybrid between a share and a debenture. They have a face value of $100 and pay interest of about 10% on that face value. Currently a hybrid can be purchased for about $33 yet will pay $10 interest pa. In the past $7 approximately was paid as a franked dividend and $3 as a franking credit. But there are no franking credits left so Gunns has to pay ATO franking deficits tax in order to offset the tax credits given to hybrid holders each year. In other words Gunns has to find 10% to pay hybrid holders so it’s quite expensive money. Gunn has discretion as whether or not to pay quarterly interest, so there’s a risk involved. But I understand if interest payment cease then Gunns may find future capital raising restricted, hence interest payments while Gunns is a going concern are reasonably likely.

In the next twelve months the most likely events are:

• Gunns summons the undertakers and the hybrids become worthless.

• Gunns continues as a going concern whether or not with the pulp mill and the hybrids are redeemed for their face value of $100 in addition to the interest earned for the year.

The respective $ outcomes for an investor are from nil to $10 in the first instance and from $100 to $110 in the latter case. (There are other possible outcomes but these two are the most likely). With hybrids trading at say $33, this implies the rough chance of the former is about one in three and the latter two in three.

To Sportsbet fans, Wipeout is a firm odds on favourite at about $1.45 with Longreach Flyer a $2.90 outsider.

It will be interesting to watch the betting on the hybrids leading up to Xmas.

Concluding remarks

It’s difficult to believe that after two years of large losses, all the bad news is on the table. But what we’ve seen is bad enough. There are no longer any retained earnings. MIS punters have been duped, forests thrashed and there is nothing to show. The rest of the forest industry is hollowed out and shell shocked. The company’s remaining equity is all due to shareholder contributions. But they too are all facing losses. Their equity is represented by an assortment of crappy nonperforming overleveraged assets and yet this company, we are told, will rise from the ashes and lead the State onwards and upwards. And so it continues to bluff and bully the State Government into supplementing its negative operating cash flow and disappointing asset sales as it lurches towards its date with bankers.

Most potential JV partners would find little appeal in Greg’s botox accounting methods. Due diligence is always going to uncover what’s really happening. Who is he kidding?

Further, it is difficult to envisage a JV partner ticking off before the banks are sorted, and it is difficult to see that happening before money for asset sales is in the vault.

Even then the tortuously convoluted maze that suffocates Gunns’ major asset, plantation land leased to MIS growers, if the trials and tribulations of insolvency practitioners trying to bury the Timbercorp, Great Southern and FEA corpses are any guide, means that completing all asset sales as planned will be difficult.


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