gunns limited GNSPA
September 20, 2010 - 4:26pm EST by
2010 2011
Price: 0.63 EPS $0.00 $0.00
Shares Out. (in M): 807 P/E 0.0x 0.0x
Market Cap (in $M): 508 P/FCF 0.0x 0.0x
Net Debt (in $M): 772 EBIT 0 0
TEV ($): 1,280 TEV/EBIT 0.0x 0.0x

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I would like to make a second recommendation in an Australia listed company that has preference shares outstanding which i think has full downside protection, pays a 14% current yield at current prices, and has near-term catalysts which i think will re-rate the preference shares higher.
My recommendation is to investing in Gunns Limited's preference shares (Bloomberg: GNSPA AU). Gunns is an Australia-listed company which is involved in forest management and development, milling, processing, merchandising and exportation of wood products. As of September 17 201, the common shares are trading at A$0.63/share, and the preference shares are trading at A$70/share. I think the preference shares are a better risk-adjusted-return trade given that (i) conservative asset coverage assumes that the capital structure through the preference shares are fully secured, (ii) management has earmarked A$225mn to $275mn of non-core assset to sell immediately to delever the balance sheet which should be positive to the credit risk through the preference shares, (iii) 14% current yield to buffer any downside risk, (iv) potential A$2bn pulp mill project, which i am putting little weight on for my investment recommendation.
Please note all values listed below are in AUD. Conversion of AUD:USD is approximately 1 to 0.94. Lastly, fiscal year end in Australia is June.
Business Description:
Gunns, based in Tasmania, is one of Australia's oldest forestry enterprises. The Company manages 339,000ha of forestry land across Australia and is one of the major sources of employment in Tasmania. The Company ran into trouble during the GFC due to over-leverage and declining top-line. In addition, they expanded into non-core business segments, and is now in the midst of deleveraging through non-core asset sales and attempts to sell a minority stake in A$2bn pulp mill project, which has received strong opposition from Tasmania's environmentalists. The chairman John Gay recently resigned, which may actually be viewed as positive as his strong personality clashed with the environmentalists, which have a lot of power in Australia. With his departure, the likelihood of a pulp mill project getting approved may be higher (more on this later).
The Company's core business is in "forest products" (87% of FY10 EBIT, or $45mn) which is primarily woodchip exports to Japan, making up 75% to 80% of Gunns' total woodchip exports. Majority of Asia-Pacific's woodchip demand is made up of hardwood chips. Of the 2009 Asia-Pacific woodchips traded (~14mn bdmt), Japan imported >70%. Japan's pulp mills are the major destination for the world's woodchip vessels. The country imported ~53% of globally traded hardwood chips and ~15% of softwood chips. Other countries in Asia (China, Taiwan, S. Korea) accounted for ~12% of global traded wood chip demand. Most imported woodchips to Japan are for domestic consumption in producing high quality pulp, to produce premium graphic paper. Japan's demand for high quality fiber has increased over time, hence Australia's share of supply to the Japanese market has increased from 31% of the Japanese market in 1995 to almost 40% in 2008. Nonetheless, the rate of increase has slowed / been decreasing as Japan's domestic consumption requirements have stagnated. Asia-Pacific woodchip demand declined significantly as a result of the financial crisis and reduced demand for paper products...with the exception of China. Woodchip imports into China is expected to grow even further, with a series of major new pulp mills which have been built, and several others expected to come online in the next few years. China has historically relied heavily on waste paper for its pulp mill fiber requirements, but hardwood chips importation is starting to take off. Vietnam is currently China's largest woodchip supplier, followed by Australia. In the long run, Australia shoudl benefit from China's appettie for wood chips, although to-date, China's new pulp mills have not been focused on quality fo fiber purchased, but more on price, making current margins for wood chip sold from Australia very thin.
Australia has become the world's largest exporter of wood chips, supplying approximately 33% of Asia's total hardwood demand. Gunns is a leading supplier of imported hardwood fiber to pulp and paper manufacturers in the Asia-Pacific region, representing ~35% of Australia's total exports. Volume exports to Japan have reduced these years because (i) contracted export hardwood fiber to Japan is denominated in A$. The appreciation of the AUD agains the USD has made Gunn's export comparativley expensive when set against supply from countries such as THailand, Vietnam and even South America, (ii) Gunns' intention to build a pulp mill may have caused some concern among Japanese buyers about the future reliability of supply, causing them to seek alternative supply strategies, (iii) Japanese production capacity has fallen by approximately 20%
Gunns' second major business driver is its "sawn timber" division (31% of FY10 EBIT, or $16mn) which is one of Australia's leading manufacturers of value-added hardwood and softwood products for the building products market. Production facilities include 8 hardwood sawmills throughout Tasmania, Victoria and Western Australia, two softwood samills in Tasmania and Southern Australia and one decorative veneer facility along with major distribution centers in every state of Australia. This business is levered to Australia's residential housing starts.
The remaining business segments (-17% of FY10 EBIT, or -$9mn) mainly consists of corporate expenses, and loss-making operations which Gunns deems non-core and will discontinue in the future. The major contributor is the Managed Investment Schemes ("MIS"). These are tax-deferral, long term investment options for Australia residents. Investors pay an upfront fee, contribute to ongoing management fees for the life of the project, and then share in the ultimate proceeds from the agriculture produce. Gunns' MIS consists of an investment portfolio in wood plantations, winegrapes, and walnuts. The Company acts as a responsible entity to establish, maintain, and operate the scheme, and makes money from ongoing harvest and management fees.
Australia has seen its fair share of failed forestry companies (i.e. Great Southern Group, Timbercorp) after the recent financial crisis. Most of these failed enterprises relied heavily on the upfront cash received from selling MIS plans (Wikipedia has a good summary of the history of Great Southern and further detailed explanation of MIS schemes). Since the global meltdown, and the failure of these schemes, appetite for MIS schemes has significantly dwindled. Gunns does not expect to sell any more MIS schemes in the future; as such, cash proceeds from this business segment is expected to be negligible in the future.
As of September 17 2010, the Company's market capitalization was $512mn
$2bn Bell Bay Pulp Mill:
Gunns has been planning to build a pulp mill in Tamar Valley (Tasmania), which will also consist of a warehouse and wharf, chemical producing plant and wood fired power plant. In 2007, the project was approved by the Tasmanian government but has met strong opposition from environmental, social activists and poltiical groups for the past several years. Strategically, the project makes sense given the management's negative near term view on the Japanese market's demand for Gunns' woodchips absent any Forest Certification System certificate (a gold standard in the industry), which they currently do not have due to the fact that they continue to harvest wood from natural forst sources. The Chinese market is just not mature yet to absorb the vacant demand expected form Japanese declining demand. Secondly, the rationale ot build the pulp mill is to move up the value chain. Gunns currently has access to a large wood resource and is well positioned geographically. Both these factors, combined with a global shortage in pulp which allows for pricing power, puts Gunns in a very good position to build and take advantage of a pulp mill and target selling into the Asian market.
To date, Gunns has invested over A$200mn in the pulp mill but the Company still requires a third party investor and project loans to finance the full transaction. Total cost expected to be ~A$2bn, split between equipment ($730mn), erection cost ($400mn), civil & engineering ($700mn), and other miscellaneous costs ($170mn). Nonetheless, the important factor now is to get the environmentalists' blessing on restarting this project. With the removal of John Gay and the Company's commitment to end logging of old growth forests, management seems to be moving in the right political direction in getting an approval, which will be vital the business' future cashflow.
Capital Structure:
As of June 30 2010, the Company's capital structure was as follows:
$380mn senior facility, maturing January 2012
$108mn working capital facility, which is reviewed annually
$12mn forestry land rust, due for review in June 2013
$76mn securitized loan facility, of which $41mn is due Dec 2011
$83mn lease facility
$120mn preference shares
--> total debt + preference shares = $779mn
The Company is quite levered at 9.2x net debt + preference shares to FY10A EBITDA. Multiples look even scarier at 15.8x EV to FY11E EBITDA (which management has guided to be ~A$80mn). Nonetheless, the balance sheet is asset heavy and has $1.62 per share of net tangible asset to common equity, which has given equity investors to-date some comfort to the asset coverage.
$120mn Preference Shares:
Management to date has insisted that they will continue paying the preferred dividends for the next 12 months. I think this is helpful in cushioning any downside if the thesis does not work out, since the preferred shares pay a 14% current yield (at $70/share)
In October 2005, Gunns issued $120mn of preferred equity, which are perpetual, non-cumulative, quarterly paying securities which rank above Gunns' common equity. They currently pay Australia swap rates + 5% margin =  all in rate of ~10%. These securities can be converted to equity at a 2.5% discount or redeemed at anytime at PAR.
The Australia preference equity market has historically been dominated by retail investors, family offices, small prop desks, and high yield funds; a combination of both buy-and-hold, as well as trading type investors. This space has been overlooked by many outside participants, hence also adds to the mispricing which can be very attractive for value investors. This market intiially came about for Australia banks to access cheap source of financing (rather than having to issue equity). Industrial companies jumped ot the party and started issuing these securities in 2005 to 2006; it was a dream financing option for them -  cheap equity with no upside sharing. You can think of these securities as having no protection (similar to equity).
Financials & Valuation:
As noted earlier, Gunns' current core business is in woodchip exports to the Japanese market. Woodchip volumes have never fully recovered from the global financial crisis, and forward guidance on the woodchip business continues to point to difficult recovery of the export woodchip market. EBITDA next year should be ~$80mn, which is flat relative to last year. Guidance has not moved higher, because management is forced to sell more woodchips at lower prices into non-Japanese markets (mainly China) which will impact margins and explains their low guidance of $50-60mn EBIT.
Nonetheless, the investment thesis is predicated on Gunns' ability to delever its balance sheet. To date, the Company has been disciplined with asset sales. Management has specifically stated in the last earnings call that they are looking to sell their remaining non-core assets in the next 12 months, which they think can reap:
1. Walnut assets & pine estate = $150mn to $200mn guidance
2. Native forest land sales = $25mn
3. Non-core commercial properties = $20mn
4. Wine operations = $30mn
--> Total of $225 to $275mn of non-core asset sales
I've taken a more conservative approach and believe the Company can sell these assets at $180mn (haircuts on native forest and walnut & pine estate sales), bringing down the total debt + preference shares level to $598mn outstanding.
In addition, I've analyzed several other core balance sheet items which i think provide me with more comfort that the debt + preferred are fully covered by Gunns' balance sheet assets:
1. Gunns owns 65,000ha of unencumbered land & trees, which are valued at $4,450/ha on its books. I've assumed these assest are valued at $2,000/ha, which is reasonable considering there have been several land/timber deals this year which have transacted above those levels
2. Gunns currently manages 106,000ha of land which has MIS-investors' timber harvests planted on them. These are encumbered assets. The land title reverts back to Gunns after the 1st harvest of the MIS-investors' timber. Given the encumbered nature, i've assumed a lower valuation for this land at A$1,000/ha
3. $141mn fair value on its existing road infrastructure, which is used to access Gunns' plantation & native forest. There's no signficant value to this asset besides to Gunns' benefit and access to its assets. As such, I've assumed a 40% discount to fair value (i.e. $85mn)
4. Of the $338mn long term receivables, ~$273mn is owed by MIS investors. Gunns previously provided upfront financing to these MIS investors, which Gunns expects to get repaid upon timber harvest which it helps manage. Since there is an uncertainty level around what yields can be obtains from these future harvests, i've assumed a 50% discount on these MIS receivables (i.e. $137mn). Nonetheless, bear in mind that Gunns will be managing the harvest process, so any default on these receivables by an investor can immediately be recouped with the harvest proceeds which was expected for that investor
5. $190mn inventory value, which is related to its timber products ($154mn), forest products ($39mn), and others ($9mn). As i understand, this is mainly woodchip and saw timber related inventory. The selling value of these products is somewhat predictable since they're ready for sale, but i've taken a conservative 75% discount to this inventory (i.e. $47mn)
6. $377mn biological assets (i.e. timber) of which a portion is owed by MIS investors. I have no idea the state and maturity of these trees, and do not fully trust the book value of these assets. As such, i've taken a conservative 75% discount on these assets (i.e. $94mn)
If you add up the core assets ($600mn) and non-core assets ($181mn) you have enough asset coverage through the preference shares ($779mn) to recover at PAR. I believe these assumptions are conservative enough as i have assumed:
- No value to cash ($7mn) and current receivables ($129mn)
- Land value at significant discount to carrying value ($761mn)
- No value to the ex-Great Southern woodlot projects which are now managed by Gunns (130,000ha)
- No value to any of the mills
- There have been rumors and news reports that there may be a compensation package of up to $200mn given to Gunns upon their agreement to suspend harvesting on their existing native forest agreements. These discussions must involve the Tasmania government & Wildnerness Society. There is a lack of clarity on how this compensation will work (logically it doesn't make sense to me). As such, i've assumed no value to these rumors
- Right now the plans for the pulp mill are still very ambiguous given the lack of approvals. I do not see any potential investor wanting to invest in such a project without the government & environmentalists' approvals required. Any sale of a minority stake in the project will go towards deleveraging the balance sheet. I have not fully priced this into the investing strategy, although anything positive will have significant upside to the prices of the common stock and preferred equity
Lastly, assuming that only the non-core asset sales come through in the next 12 months, i believe there will still be enough cash to service the preference shares. Simple back-of-envelope math suggests:
- EBITDA = $80mn
- No WC changes
- No tax expenses (carry forwarded losses from prior years)
- Interest expense = -$33mn (approx 7% interest cost)
- Net Capex = -$30mn (management guidance)
--> Cashflow available for preference dividend payments = $17mn (vs. preference share dividend payments of ~$12mn assuming 10% of $120mn face value)
I suggest using the next 12 months to allow the Company time to delever the balance sheet. I believe these positive motions will help rerate the preference shares from its current levels (14% current yield). I've already discussed the conservative asset coverage, which provides further downside protection. During the next 12 months, the company has time to clarify to the market their pulp mill intentions and other future strategy. If no successful news comes out of these "upside events", you would have still made a healthy 14% yield and have the option to reassess the situation after 12 months


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