Pulp Fact As Gunns Goes Through The Mill

The Age

Wednesday September 3, 2008

Michael West

Gunns needs to raise cash to get its balance sheet in better shape, but investors may be wary as market volatility lops its share price.

ENVIRONMENTALISTS will be happy to know that Gunns is in danger of being chopped down by its own "Forests". In fact, the timber group will have to take care of its Forests before it even contemplates erecting a pulp mill in the Tamar Valley.

By Forests we mean a toxic hybrid issue concocted by Gunns' bankers JPMorgan and Macquarie three years ago, whose conversion threatens large-scale share dilution.

Forests stands for Frankable Optionally Redeemable Equity Settleable Transferable Securities. No, this is not a joke. Surely a box of Montecristo cigars will have been bestowed on the banker who dreamt up this acronym.

Anyway, Gunns is looking to wrap up its $430 million capital raising by early October, before the interest rate on its Forests resets on October 14 to an expensive 12.5%. Management says it intends to pay the 250-point step-up and then redeem the hybrids in the second half of 2009.

Despite the mooted 35-40% dilution from this capital raising, Gunns' major shareholders, such as Commonwealth Bank and Perpetual, have agreed to tip in for their entitlements. They have little choice. Already overstretched with $1 billion in debt, Gunns faces being pulped into oblivion if it doesn't get the capital raising away.

Like so many other companies in the present downturn, the timber group procrastinated about raising equity, punting that the market would recover while its stock price was slowly being felled by opportunistic shorts and anxious investors. In so doing, it watched its cost of capital rise.

What happened? A good old acquisition binge and debt splurge by chairman John Gay and his cohorts. A few numbers tell the story: Gunns spent $52 million on acquisitions in 2007 and $221 million in 2008 as it sought to swallow South Australian softwood group Auspine.

At the same time, it chewed through $129 million and $131million in working capital. Capital expenditure rose from $81 million to $105 million and proceeds from borrowing were $665 million and $560 million in 2007 and 2008 respectively.

Poor management, full stop. Interest cover is roughly 1.7 times and even leveraged buy-out merchants insist on a respectable two times interest coverage. The interest bill last year at $72 million was higher than the $69.5 million in net operating cash flow.

As for the pulp mill, a new $2 billion spend is an extreme long shot as Leighton's boss, Wal King, noted the other day. Now there is talk of a Swedish partner coming to the table.

Without a partner, the mill is dead. That Gunns is on its knees and desperate for capital does not help sentiment, but the $85 million interest bill this year on debt of $1 billion and a market cap of $672 million simply does not stack up.

Gunns always needed to do a raising to pay off the Auspine bridge-financing and fund its MIS (managed investment scheme) finance receivables.

As the pulp mill permits and approvals got closer, the "optionality" was to have been reflected in a higher share price and the equity raisings would be less dilutive.

Pulp prices were also moving in the right direction, which supported the project's returns - but who would know what the returns would actually be when the mill came on line. If pulp prices were US$500, returns were marginal, but if they were US$1200, then the returns would be handsome.

Japanese demand for woodchips has been firming. Woodchip volumes had been down four years on the trot until last year but are now in recovery. Hardwood chip earnings were up 30% last year, thanks to demand from Japan and China.

This pulp mill was always a bit of a "bet the balance sheet" affair, a plan right in sync with chairman John Gay's aggressive corporate manoeuvrings of past years.

Gay had gone out on a limb before when he went after North's Tasmanian assets, so why not again? A $2 billion pulp mill in the Tamar Valley was too hairy chested for many in the market but not for the true believers. That he had no experience running a huge pulp mill did not seem to matter.

Former sawmiller Gay had got a taste for acquisitions when Gunns bought Tasmanian Board Mills from Boral for $23 million in 1999. He was also at the helm when Gunns acquired Boral's Tasmanian forests and chipping operations in 2000 for $72 million.

It was the ambitious deal to buy North Forest Products for $335 million the following year that catapulted Gay into the big time though. A risky play, it came off and doubled the size of the company.

Unfortunately, credit markets iced over last year and pulp mill politics deteriorated. People became increasingly worried about Gunns' debt and interest coverage, and hedge funds started to short the stock.

It is clear from the financial engineers' experience that the market has little tolerance for aggressive growth plays that gear up and blow up. Recovery prospects recede once a stock price falls to such a level that confidence and access to capital is gone.

For Gunns, however - unless it kept funding MIS sales off its balance sheet and never collected the receivables - there is a solid underlying business in 4 million tonnes a year of woodchips being sold to the Japanese.

They make a margin of $30 a tonne, from which it is easy to generate $120 a tonne from woodchips and other logs. (The whole idea of the pulp mill was to make a margin of $90 a tonne for pulp.)

Any talk from Gunns of going it alone on the pulp mill will not help this issue get away. Hence the gossip about the Swedish partner, which helps. Gay has not committed to his entitlement.

Tomorrow is the key day as the institutional book-build will determine the price. A 3-for-4 issue priced at $1.40 would raise the full $430million.

Meanwhile, the pricing period for the Forests runs from September 16 until October 13 and the conversion price ratio naturally depends on the price of Gunns shares, so there promises to be much volatility in the stock.

Balance sheet repair is one thing. Whether there is enough goodwill among investors to support John Gay on the expansion trail once again - via a pulp mill three times the size of Gunns' market value and requiring the injection of even more equity at some point - is entirely another.

© 2008 The Age

Back to News Index | Back to Home