Financial analysis of Gunns' half year report 18 February 2011 by John Lawrence

He’s done it again.

This time in broad daylight.

Under the gaze of thousands of Gunns’ watchers, CEO Greg L'Estrange has once again manufactured a few book entries to help Gunns achieve a modicum of profit and loss respectability.

That boy certainly has chutzpah.

He didn’t quite make a profit, but an EBIT of $5 million loss for the first half of the 2010/11 year took a bit of work.

With asset impairment charges, loss on asset divestment and other restructuring charges totalling $50 million Gunns were a few goals down at three quarter time with the wind against them in the last stanza.

Then Greg delivered.

Three of Greg’s book entries totalling $45 million warrant a mention.

First, Gunns’ trees, the ones still standing, were considered to be worth another $11 million. That was booked as profit.

The second book entry was all class. Gunns underpaid for FEA’s sawmill and that underpayment of $19 million was included as income. Shades of the previous year when an underpayment for ITC Timber’s assets of $4 million and a further $3 million for Great Southern’s plantation management assets were both booked as income.

Memories of Eddy Groves from ABC Learning come flooding back. Eddy has recently been charged by ASIC.

Profit earned from acquiring an asset was, in the past, described as ‘a discount on acquisition’. It is now described in a more hubristic way as a ‘gain on bargain purchase’.

It’s as if Harvey Norman advertising executives have helped modernise accounting terminology.

Gunns doesn’t always acquire bargains. When Auspine was purchased Gunns had to pay $29 million in excess of the value of the assets. That amount was described at the time “as the goodwill ... attributable to the skills and technical talent of the acquired business’ workforce and the synergies expected to be achieved from integrating the Company into the existing operations”.

The goodwill amount was not recorded as an expense but rather included as an asset on the balance sheet.

I’m struggling to get my head around Gunns Directors’ willingness to include a gain on a bargain purchase as income yet continue to retain on the balance sheet, an obviously impaired asset being the goodwill on purchase of Auspine.

The financial statements are supposed to give a true and fair view.

The closure of the 2 Scottsdale mills suggests that any potential synergies that may have existed at the time of the Auspine takeover have either been utilised or have evaporated.

Gunns also reckoned the land they bought from FEA’s receivers as part of the FEA mill deal was worth $11 million rather than the $7 million paid. But this gain on bargain purchase was not included as income.

Accounting standards treat land differently from other assets.

Accountants do draw a line in the sand.

Occasionally.

Revaluation of land occurs via reserve accounts which appear in the balance sheet. It is not recorded in the P&L Statement.

The third book entry was $15 million worth of commission and fees payable as a result of Gunns’ role as Responsible Entity of various MIS schemes. It is not known which MIS schemes were involved with this upwards revision of future MIS commissions, whether just one or two or whether the whole lot have been reassessed. The latter is unlikely.

Last year when Gunns paid $6 million for certain plantation management rights from Great Southern’s liquidator, Greg underlined his worth as a CEO by immediately booking $68 million as profits being expected future commission from the harvest of trees belonging to Great Southern investors.

This took the value of expected future commissions already included as income to $140 million.

Greg has just boosted this by a further $15 million. But the breakup has changed, $105 million relates to Gunns’ projects whilst only $50 million is for former Great Southern projects. No explanation is given for the changes.

Hence Gunns ended up with an EBIT of a $5 million loss. Without the above book entries the EBIT would have been $55 million loss.

With a reported EBIT of $5 million loss, the inclusion of finance charges of $12 million took earnings before tax to a $17 million loss.

Actually the figure of finance costs of $12 million is a net figure. An amount of $24 million worth of interest paid was recorded in the P&L but this was offset by $12 million worth of interest paid to Gunns by all those poor buggers who borrowed from Gunns to finance their MIS dreams.

There’s still about $200 million worth of unpaid dreams on Gunns’ books.

The loans includes some walnut and wine MIS loans which are still there even though the land, trees and vines have been sold to Brown Bros and Websters.

Gunns is still the Responsible Entity for the wine and walnut schemes even though the assets have gone and the management responsibilities transferred.

Apart from the finance charges that appear in the P&L there was a further $8 million worth of interest included in the capital costs of the pulp mill which increased from $205 million to $219 million over the half year. It is likely that displacement compensation paid to some of the recently departed pulp mill executives will also have been included in the capital costs of the pulp mill rather than included in the P&L.

The accounting treatment is correct, but reading the financial statements from the viewpoint of Gunns as a going concern, these non P&L outlays are relevant when assessing the operating cash flows from the cash flow statement.

In previous posts I have tried to explain that Gunns’ stated operating cash flow is overstated. In 2010 the adjusted operating cash flow was negative whereas the published cash flow statement reached a different conclusion.

At an analyst’s presentation in October 2010 Greg confirmed that Gunns’ cash flow was negative. It is safe to assume Greg was referring to operating cash flow.

The latest half yearly results state operating cash flow is $6 million. Since Gunns packaged up some of its MIS loans and sold them to Bendigo and Adelaide Bank, it acts a conduit for the receipt of loan payments from investors and their immediate remittance to the Bank. But the receipt of the loans is included as an operating cash inflow yet the payment to the Bank is treated as an investing cash outflow. Operating cash flow is therefore overstated in this instance by $16 million.

Operating cash flow also includes a tax refund of $13 million occasioned by a windfall gain when the ATO reassessed Gunns’ tax liabilities from prior years in 2010.

And then there is the interest paid that has been apportioned to the capital costs of the mill ($8 million referred to above) and the redundancy payments ($ unknown) to staff from the mill taskforce, possibly about $10 million in total.

Capital outlays usually form part of investing outflows but arguably in this case interest and redundancy costs have the character of operating outflows as a going concern struggles to survive and make the transition to a new stage.

Operating cash flow for the half year is probably closer to a negative $33 million.

That is why the proceeds of asset sales of $77 million have only managed to reduce bank debt by $29 million, from $659 million to $630 million.

Most of the balance was used to remain afloat, although some was needed to pay for the FEA sawmill. A part payment of $35 million was made for the mill in the period. Shareholders contributed $25 million so there was a small shortfall.

The gradual running down of sawmill inventory didn’t produce the expected boost to operating cash flows as customers just took longer to pay Gunns.

Back in October the plan was to sell the Green Triangle land and trees, the balance of unsold ex Auspine assets. Gunns still have these assets listed at a book value of $254 million and hinted they were likely to be sold before June 2011.

It would be a surprise if they fetched book value.

Back in October Gunns also talked about ‘vending’ the pulp mill assets (land trees and mill costs to date) into the pulp mill project. The latest option is to sell the land and trees with a book value of $826 million to institutional investors.

But a few problems may arise.

One problem is that the recent sale of Great Southern’s land suggests Gunns may have to accept a discount on disposal of 30% or about $250 million.

Another problem is that an institutional investor would want a return on its investment. The Canadian pension Fund which acquired Great Southern’s land was said to earn 12% pa across the board. That probably puts the price that Gunns would have to pay for a second rotation crop beyond the level required to operate a pulp mill and make money.

Gunns have also floated the possibility of selling its MIS assets of $400 million. The assets include future harvest commissions with a book value of $155 million and investor loans of $200 million.

It must be remembered that Gunns only paid $6 million for assets and rights to Great Southern crops (now booked at $50 million) so it’s a little inconceivable that someone else will pay $155 million to take over the burden of all GSL and GNS MIS schemes. The figure is likely to be closer to zero.

There is widespread reluctance to take over investor loans given the defaults that occur and given the legal hassles that are resulting from aggrieved investors taking action against MIS proponents and banks involved with investor loans. If Gunns get 30 cents in the $ for investor loans then they will be lucky.

There’s an element of desperation in Gunns floating the possibility of selling land trees and MIS assets. The recent experiences suggest that any prices achieved will be well below book value.

If Gunns sells land and trees then what is left? What will its contribution be to a pulp mill JV? The situation is beyond farce. Whilst it maintains the pretence that the mill will still go ahead, it appears that this is a way of maintaining it is still a going concern so that asset sales that are crucial to its survival can be conducted in a more orderly manner.

That is the task to which Greg has been entrusted. All the talk about seeking a social license is nonsense. The exit from native forests was needed for solvency purposes. If the pulp mill eventuates then that may be a feather in Greg’s cap but the first task is to survive.

Another small elephant has just entered the room. Its presence was noted in the Director’s Report.

Back in 2005 Gunns issued 1.2 million hybrid securities called FORESTS each with a face value of $100, for a total of $120 million. The securities are considered to be equity but pay an amount of interest each quarter. Initially the rate was 2.5% above the 90 day Bank Bill rate, about 7% in total. But it was paid as a franked dividend, which meant that about 5% was paid in cash with the balance paid with a franking credit. Gunns had plenty of franking credits in those days because it was a profitable company which paid regular amounts of tax thus giving rise to franking credits.

But the situation is now different. The interest rate margin is now 5% over the bank bill rate (making it about 10% to 11%) and the supply of franking credits must be about to end. Without franking credits the quarterly interest payment will have to be paid in full which makes it quite expensive money.

Gunns have floated the possibility of issuing shares in lieu of the FORESTS. At a market price of 50 cents, 240 million shares would be issued; at 25 cents 480 million shares. The existing 848 million shares will be flooded. Enough to make current shareholders nervous.

The alternative is to use some of the proceeds of asset sales to repurchase the securities.

Can Gunns afford to do this?

This is possibly why the sale of Tasmanian land and plantations has been raised for the first time. After the Green Triangle land and trees it’s all that’s left.

The half yearly results whilst producing an actual EBIT of a negative $5 million are nevertheless dressed up to show an underlying EBIT of $20 million. People who are willing to accept this view probably also believe in goblins.

The concept of an underlying profit for a business such as Gunns that is undergoing such radical surgery is a little fanciful. What is the underlying business? Softwood processing possibly? All the other areas are in transition.

That is why it is probably safer to try to ascertain what the actual operating cash flows are as the company struggles to keep afloat. These cash flows appear to be negative. It is likely that all segments of the business operated with negative cash flows. One segment, forest products made an accounting profit but this was only brought about by one of Greg’s $15 million book entries.

Gunns needs to find where it’s going pretty quickly. The half yearlys indicate that seasonality has disappeared from Gunns’ business with the decline of MISs, so the full year’s results are unlikely to show a huge improvement.

Half yearlys are much skimpier that full year’s statements. The latter will probably include revalued land trees and future commissions. There is no prima facie reason at this stage why these will increase and allow Greg to boost his bottom line with a few more book entries.

Even more chutzpah may be needed.

Postscript

Gunns’ ASX announcement on Tuesday explained he reason behind the trading halt.

``The company requested a trading halt last Friday due to an unexpected delay in finalising a financing facility. Revised cash flow modelling indicated the need to put in place temporary funding facilities as a result of the delay. These temporary facilities are now in place with re-payment to be made from the proceeds of asset sales or the completion of the planned financing.’‘

Wednesday’s AFR spilt the beans.

“It’s understood that late last week Investec pulled a $40 million line of credit after a promised sale-and-leaseback deal involving the sawmill fell over. This forced Gunns shares into a trading halt and meant the board had to delay the release of results while it persuaded long-time lender ANZ Banking Group to plug the gap”. Mmmmm. Sounds a little like the Directors were struggling to sign the solvency declaration.

First published: 2011-02-17 12:01 AM Tasmanian Times