Monday, 8 September 2008

The death of MIS

Are we seeing the beginning of a change in the managed investment scheme (MIS) industry?

The question of whether or not the pulp mill will proceed has accounted for most of the recent attention directed at Gunns and the rest of the forest industry. Gunns announced a trading halt as they endeavoor to boost their balance sheet with $430 million of additional equity. Their ASX announcements released on 29th August make interesting reading.

But even more interesting were the ASX announcements by Great Southern Limited (GSL) issued last week at the end of their self imposed trading halt. GSL is involved in the forest industry as an MIS manager and an exporter of plantation woodchips as well as administering non forestry MIS projects involving cattle, olives almonds etc. Hence GSL is similar to Gunns in many respects.

GSL is now seeking to buy back trees and cattle from MIS investors and issue GSL shares in consideration.

The recent change of mind by the ATO with respect to MIS’s has led to a cessation of most non forestry MIS’s (currently under challenge in the Federal Court). There is also a new section in the Tax Act (div 394) which allows a deduction for MIS investments without the investor having to farcically pretend that he/she is carrying on a business of afforestation by leasing 1/3rd of a hectare of land and entering into a myriad of legal agreements designed to promote form over substance.

Div 394 of the Tax Act also allows for secondary trading of MIS interests. Previously MIS investors were required via Income Tax and Product Rulings to hold their interest until harvest time. There were many voices against secondary trading but others felt that a more informed market will lead to better outcomes. It is believed that GSL is relying on the secondary market provisions of Div 394 in proposing to repurchase trees from MIS investors in six projects in exchange for GSL shares.

There is now available actual and expected yield data on GSL’s first six crops of trees (from 1994 to 1999) as well as a value of the six projects (from 1998 to 2003) that GSL intends to repurchase. This is invaluable information for MIS investors and others wishing to analyse the returns. And the resultant picture is not pretty and throws doubt on GSL’s MIS model.

The product disclosure documents (PDS) for GSL tree projects typically predicted a return of 250 cubic metres of green timber per hectare for a 10 year rotation. The outcomes (and expected outcome in the cases of 1996, 1997 and 1999 projects) are much different.

Year of project
Yield m3 per ha
GSL Investment update May 2008
GSL Investment update May 2008
GSL Investment update May 2008
estimated from GSL Investment update May 2008
from GSL annexure to ASX announcement 26th Aug 2008
from GSL annexure to ASX announcement 26th Aug 2008

These yields are way short of the yields contained in the PDS’s. But GSL persisted with the predicted yield of 250 m3. Even with hindsight the PDS for GSL’s 2005 and 2006 projects contained a report from an independent forester dated 21st Feb 2005 stating that “it is reasonable to assume that the plantations will be capable of being managed as a whole to produce an average growth rate of 250 cubic metres gross of timber produce per hectare of Woodlots after approximately 10 years growth for each project”. The independent forester clearly felt it was unnecessary to mention the substandard yields to date.

Faced with poor yields one would have expected an open revolt by investors. But GSL stepped in and arranged for a subsidiary to purchase the 1994 and 1995 crops at an inflated price.
The 1994 crop was bought in full from investors by a GSL subsidiary in July 2005 for $6.4 million. The crop was then harvested and sold as GSL product. The before tax cost to GSL of this exercise was $4.3 million. This meant that investors received $6.4m instead of $2.1m, a trebling of their strict entitlements.

GSL again intervened to double the returns to 1995 investors at a cost to GSL of $4.7 m before tax. In the case of the 1996 project, GSL again propped up the returns so that investors received the same as if a yield of 250 m3 per ha had been achieved. Good business perhaps? Or part of a scheme to inflate the returns to initial investors so that new investors were not deterred? And just to seduce any waverers, GSL offered a 10% discount to the 1994, 1995 and 1996 investors if they signed up for another bite of the cherry.

A scheme which uses new money to inflate the returns to older investors is often described as a Ponzi scheme. ASIC specifically warns investors to be wary of Ponzi schemes The tradition of Charlie Ponzi continues. (See Charlie’s curriculum vitae at ).

How long could GSL continue to prop up returns to investors in this manner? To head off potential problems with investors (and possibly ASIC) something had to change.

But other parameters were changing and the ground was shifting.

The ATO changed their interpretation re MIS schemes forcing the cessation of non forestry schemes and a new tax provision for forestry schemes.

The disappointing yields meant that land rent paid to GSL by investors at harvest time of 2.5% of net harvest proceeds was also well below budget. Given the woodchip prices and harvest and chipping costs as per the GSL annexure dated 26th August 2008 and assuming a yield of say 160 m3 per ha, the net harvest yield per ha is only $8,000 which means rent is only $200 per ha. And this is rent for 10 years!( It was always well known that the establishment fee for a MIS investor contained a chunk of prepaid rent, but MIS companies were allowed to get away with hiding this prepayment amongst other plantation establishment costs. The new Div 394 incidentally allows for prepaid rents to be included in the MIS fee paid by investors.) GSL assess their 179,000 ha of land to be worth $6,000 per ha, so it is reasonable to expect a return of at least 6% to 8% on this asset, say $400 pa not $200 for 10 years. So the MIS companies that helped force up the price of land in the first place, paradoxically need to obtain higher returns for their shareholders as a consequence.

The higher land prices also mean that additional land is harder to obtain at a price that suits the MIS model. Why not simply charge the investors more rent either at establishment time or at harvest time? Unfortunately there’s not enough fat in the system. An investor who parts with $3,000 to buy a Woodlot of 1/3rd ha will get a tax deduction so it might only cost him $1,800 after tax. But he will want a 15% return before tax over 10 years considering the risks involved which means $7,282 for 1/3rd ha or $21,846 per ha. Even with a lower return of 10% pa the return needed is $4,669 for 1/3rd ha or $14,006 per ha. But on current yields and prices the net harvest yields are maybe only $8,000 per ha. One feature of the past 10 years has been the gradual erosion of the risk premium. Investors have been willing to take on additional risks for only a small increase in the promised rate of return. All this is now changing as investors will demand higher rates of return on riskier projects.

MIS products will inevitably be reassessed by investors to include a greater risk premium. GSL provides finance for the majority of MIS sales even though most loans to investors are bundled up (or securitised) and transferred off balance sheet to other lenders. But the shrinking of credit as a result of our recent economic woes will mean that fewer people will borrow, which will mean fewer MIS sales. GSL has during the 2008 year written off $38m in doubtful debts in respect of funds lent to MIS investors. Included in this amount is “an allowance in respect of a particular group of investors who no longer (surprisingly—my emphasis) do business with GSL”.

GSL has released financial statements for the first 9 months of 2008 (its year ends on 30th Sept 2008) but has stated that, because of seasonality, the 9 month’s figures overstate the likely 12 month’s profits and cash position. A cynic may suggest that the restructure proposals have arisen before the full year’s financial statements become available.

Even so profit after tax is down from $71.5m to $21.8m. MIS forestry revenue is down from $255m to $165m. After operating expenses the MIS segment contributed $59m before overheads and finance costs (down from $117m).As stated above GSL ‘s provision for doubtful debts of $38 m impacted on profits but revaluing its land by $27.6 m helped boost the bottom line.

GSL also reported that their cash position deteriorated during the first 9 months of 2008 by $131m from $207m to $76m, not a good sign.

Hence GSL has proposed to internalise eight MIS projects by buying back six forestry projects and two cattle projects. For example the 1998 forestry project which will be harvested soon is only valued at $2,576 per Woodlot or $7,728 per ha .The cost to investors per Woodlot was $3,000 before tax (This was the 2005 Woodlot price. I have been unable to confirm the 1998 price). Even so it is a very poor return for a risky ten year investment.

GSL have proposed issuing shares at $1.10 each for the Woodlots and cattle as valued. But currently the share price is only 60 cents. So it’s going to be an interesting standoff between investors and existing shareholders. Both groups need to agree to the proposal. Existing shareholders will not wish to see their shares diluted too much, while investors may be grateful for increased liquidity of their investment even though the share price may languish for a while.

GSL have also indicated that future MIS activity will be confined to high value timber (Tiwi Islands mahogany) and high value plantation timber. By the latter I presume they mean plantations that yield 250 m3 over a 10 year period.

Meanwhile Gunns who are still in a trading halt have released some info to the market on 29th August 2008.

Three years ago Gunns borrowed $120m by way of an issue of hybrid securities to help with the purchase of MIS land. As from October 2008 Gunns will have to pay hybrid security holders 5% above the 90 day bank bill rate (currently about 7%). That makes a coupon rate of 12%, although 30% is paid as a franking credit, so the cash cost to Gunns will only be 8.4% approx. Perhaps not such a bad figure given their other woes.

Gunns is still trying to negotiate the sale of $170 m worth of plantation timber (not the land).But they will continue to manage the trees. For a Company that has excelled as a wood chipper, to sell an asset that is integral to its business, is not a sign of obvious financial health. It’s a little like pawning one’s tools of trade. The pawnbroker will no doubt expect a healthy fee. A healthy fee is certainly what Gunns is to pay brokers as part of the recently announced $430m equity raising. Business Spectator reported a fee of $15.25m is to be paid to brokers if the full amount is raised. This is considered to be high given the amount is not underwritten.

In other words there is no downside for the brokers if they come up short. Again not a sign of obvious financial health Gunns during 2008 experienced a similar downturn in MIS sales as did GSL, The revenue from MIS forestry was down from $144m to $124m. After direct expenses, MIS forestry contributed $44m, down from $69m. Gunn’s cash position deteriorated by $55m during the 2008 year.

Approximately $50m was spent during the year on pulp mill preparations. This amount has been capitalised. There is now an amount of $90m on Gunns’ balance sheet in respect of the mill, waiting for the directors to decide if the mill is not to proceed then $90m needs to be transferred to the profit and loss statement as an expense.

Either that or waiting for the auditors to tell them to transfer it in the light of recent announcements by David Bartlett. Gunns will cease non forestry MIS offerings, and have noted the problems with securitising loans to investors as experienced by GSL. Such loans are important because in the past MIS investors have used borrowed funds to invest in MIS’s. Gunns also noted the high cost of land on their MIS business.

Gunns are more recent players in the MIS industry and to date haven’t completed a project through to harvest stage. So information on yields is not as readily available as with GSL.

There are similarities in Gunns and GSL situations:

·       declining profitability

·       cash flow pressures

·       declining MIS sales

·       inadequate return on MIS land (in GSL’s case)

·       inadequate returns to MIS investors( in GSL’s case) 

·       greater difficulties with arranging finance for MIS investors 

·       greater reluctance by MIS investors to borrow in the current climate

·       less than expected yields

·       the effect of regulatory changes by ATO

The above are just the economic issues. There are of course all the planning, social and environment issues as well.

In the same way as we are now witnessing the decline of financial engineers and their vehicles such as Centro, Allco, Babcock and Brown, ABC Learning Centres et al, are we also seeing the beginning of the end of the current MIS model?

If the MIS model is dead, then from where will Gunns get 15,000 ha of plantation timber each year to feed its pulp mill. From native forests? Most likely.


No comments:

Post a Comment