gnspa, page-89

a bit of research from feb this year.. but some key points are still valid (note: GNSPA was trading at $79 at the time)..



The balance sheet continues to improve, albeit not as much as we would have hoped on the back of assets sales and a $25m capital raising. Net debt for the period decreased from $652.1m to $627.4m. Importantly, the core corporate debt of the company continues to decline and now stands at just $370m. The remaining debt comprises a working capital facility ($115m), a MIS securitised loan facility ($65m) and various lease and land trust facilities ($81m).

The company did however purchase an existing Bell Bay pulp mill from the receiver of Forest Enterprises Australia during the period and continues to spend money on its proposed major development, also at Bell Bay. This was a big reason that property, plant and equipment on the company’s books increased by $61.9m during the period and net debt wasn’t reduced more.

By far the most important part of the result though was the announcement that Gunns is looking to convert/buyback the GNSPA in the first quarter of the 2012 calendar year. The relevant quote from the company was,

The Directors have reviewed the status of the Forests note issue. Whilst the note is structured as a perpetual instrument, the Directors expect to either convert the Forests to ordinary equity or undertake an on or off market purchase of the Forests at or around the then current market price following completion of restructuring and refinancing transactions. The transactions are expected to be finalised in the first quarter of the 2012 calendar year. Further guidance in respect of the Forests note will be provided as these transactions are progressed.

This indication that the company is looking to deal with the Gunns Forests (GNSPA) should push the security price closer to its face value of $100. We already view the security as cheap on a perpetual basis with it paying a coupon margin of 5.00% above the bank bill swap rate (BBSW) and with Gunns looking to deal with the security in the next year, this effectively puts a finite maturity date on the Forests.

Further Debt Reduction
The catalyst for the conversion/buy-back of the GNSPA is the continued debt reduction of the Forests. The company only has core debt $370.0m and it isn’t hard to see scenarios where this amount is repaid in full with plenty leftover for a buy-back of the $120.0m face value of GNSPA by the end of 2011.

The company has already flagged that it is looking to sell parts of its land and forest assets which have a balance sheet book value of $1.5bn. Gunns has already appointed an adviser to sell the Green Triangle pine plantation estate with a book value of $254.0m. The company expects bids for this estate to be received by mid February with contract execution by 31 March. While we believe the company would likely incur a discount to book value for the sale of this asset, any proceeds would still make a sizeable dent on the company’s core debt.

Another asset that could be sold is parts or all of the MIS business. This business currently has net assets of $400.0m ($420.0m of assets and $20.0m of liabilities). The main asset is the loan book of $265.0m of which $65.0m is funded by securitisation facilities (mentioned in the net debt above). The company also has $155.0m in woodlot maintenance facilities.

Again, the company would likely incur a loss on the book value of these assets if sold. The loan book is the most saleable portion of the MIS operation but we wouldn’t rule a sale of the entire business. A sale of the Green Triangle assets and the loan book alone would come close to wiping out the company’s corporate debt with the additional sale of the MIS receivables likely eliminating corporate debt entirely and having cash left over.

To illustrate just how asset rich Gunns is, another option for the company would be to sell the Tasmanian plantation forest assets which have a book value of $826.0m. Ideally, the company would like to retain these assets to vend into the pulp mill joint venture but if need be, they could sell down the equity in these plantations to institutional investors to raise cash.

Refinance Risk
Of course there is always a risk that the company cannot achieve the desired pricing/timing for the sale of assets that it requires. If the company fails to do so then it may experience difficulty in refinancing this debt when it is due in January 2012.

In fact this risk was even flagged by the auditors who drew attention to the refinancing risk the company faces.

However, we regard this note from the auditors as more procedural than anything else with the company already in advanced stages of addressing these issues.

Essentially, the company has flagged that it is the process of selling non-core assets to repay its corporate debt. Further, Gunns has more than sufficient assets to eliminate its corporate debt entirely with money left over to fund a buy-back of the GNSPA.

Conversion/Buy-Back Outcomes
For GNSPA investors, they can now look forward to their securities being converted into ordinary shares or bought back in the first three months of 2012 giving them an expected maturity date of approximately a year. While there are still some risks involved about this process occurring, this leaves some substantial upside based on a current price of around $79.

Conversion in the GNSPA would result in ordinary shares being issued at a 2.50% discount to the 20 day weighted average price. This equates to $102.56 of Gunns shares been issued to GNSPA investors for a security that is currently trading at a significant discount to this price.

There are some risks with a conversion to ordinary share though. Firstly, there is a floor price for the ordinary shares so that any conversion is limited to 400 ordinary shares for each Gunns Forest security. This equates to an equivalent floor price of $0.25 cents per ordinary share. If the ordinary securities were to fall below this price then GNSPA investors would share in any downside. While we think the risk of this outcome eventuating is unlikely, it remains a possibility with the ordinary shares currently trading around $0.51.

The other main risk is the dilutionary impact that a conversion of the $120m of GNSPA would have on the ordinary shares of Gunns. Based on current share prices, this would create approximately an additional 28% of ordinary shares to the company’s register.

The reason the company offers a 2.50% discount on conversion to ordinary shares which isn’t offered for a cash redemption is to allow for investors to exit the ordinary share register while allowing for a slight decline in price while selling out. However, this clause normally assumes a few percent of additional shares will be issued, not 28% and there is a risk that on conversion that investors all rush for the exits on receiving their ordinary shares and force the price down. Alternatively, if they continue to hold the shares, they are exposed to the ongoing equity risk of Gunns.

Buy-Back a Better Option
The other stated option would be for the company to buy-back the GNSPA either on or off market at around the then prevailing market price. With the securities currently trading around $79, this might appear to be the less palatable proposal, however in all likelihood could be the less risky and more profitable result.

We believe the main reason the security is currently trading at a discount to face value is credit risk concerns. However, the company will only conduct a buy-back of the GNSPA if debt has been substantially diminished (an outcome we regard as likely based on the above analysis) and the balance sheet is in an improved position.

If that were to occur we would expect that the GNSPA will be trading at close to face value of $100 at such a time. By comparison, the similarly structured stepped-up hybrid issued by Ramsay Health Care (RHCPA) which is a relatively low credit risk is currently trading at close to $100 (clean price) despite paying a coupon margin of 4.85% over BBSW compared with 5.00% over BBSW for the GNSPA.

While the company has indicated that it will conduct an on or off market buy-back at such a time we still wouldn’t rule out a cash redemption of the securities in the first quarter of 2012. If the company is in a financial position to make a cash payout at this point in time then it is likely the GNSPA will be trading at close to face value. The redemption option would then be more practical from the company’s perspective as it accounts for the full $120m of securities rather than try to mop up small parcels at a time via a buy-back.

Summary
Gunns has delivered another messy financial result for the first half of 2011, albeit an expected one. Despite the company reporting a headline net loss, underlying earnings were in line with expectations.
Importantly though the company continues to flag plans to reduce its debt levels by the continued sell down of assets. While a failure to complete these asset sales could result in the company breaching covenants and/or failing to refinance its debts, the abundance of assets the company owns makes this outcome unlikely.
If the sell down of assets occurs as planned it will be in a financial position to either convert the hybrids to ordinary shares or buy-back the securities in the first quarter of 2011. Either of these alternatives would likely see investors realise approximately face value for the GNSPA.

There remains risk with the GNSPA, specifically the possibility that the company will breach covenants and/or be unable to refinance its debt facility in January 2012. However, we regard this prospect as low and with the potential for substantial upside over the next 12 months we retain our high risk BUY recommendation.