Intelligent Investor 2005issue 189 Stocks in Detail | Blue Chip...

Intelligent Investor 2005
issue 189

Stocks in Detail | Blue Chip Industrial



Gunns targets major expansion
23 Nov 05 | Issue 189


This forestry company is betting its entire value on a new mill, and its share price allows little room for error.
From a personal point of view, this particular analyst wouldnt touch Tasmanian forestry company Gunns no matter how cheap it was. Logging some of the worlds tallest and most pristine forests in Tasmania is something he feels future generations wont forgive us for. But thats a personal point of view, so pleaseno hate mail. Our task isnt to decide whats right for our subscribers ethically; its just to tell them whats cheap financially.



Superficially, at least, Gunns does look cheap at 9.5 times 2005 earnings. So we took a closer look but found plenty of reasons to steer clear. When a stock doesnt make the cut, wed normally have a think about the price at which it might stack up, put the research file away and keep one eye on the share price, just in case it gets into bargain territory. But we thought a review of Gunns might provide an interesting window on our investment process. Well start by looking at whats there.



As well as access to significant tracts of natural forests, Gunns owns 180,000 hectares of freehold land, which is valued on the books at $472m. It owns standing timber with a book value of $265m, and other hard assets, such as buildings and timber processing plants, worth another couple of hundred million dollars. Against this, theres about $360m of net debt, a pretty manageable figure given the groups earnings and assets. It all adds up to net tangible assets (NTA) of $1.97 per share.



Money growing on trees



On those assets, Gunns managed a profit in the year to 30 June of $101m, which translates to earnings per share of 29.9 cents. But that number is boosted by accounting for self-generating and regenerating assets (SGARA), a topic we tackled in the Investors College of issue 182/Aug 05. Basically, SGARA accounting requires a profit to be recorded for the natural increase in the value of trees growing in the forest. While a tree adding another ring to its width and growing a little taller ensures revenue down the track, dividends today can only be paid from profits obtained by cutting and processing timber.



So operating cash flow is a better guide to economic reality in this case. Last year, this figure amounted to $80m and, over the past three years, it has averaged $100m per annum. From this, the group has made capital expenditure of approximately $70m per year. However, its hard to tell how much of this is maintenance capital expenditurea necessary eviland how much is expansionary capital expenditure, which should result in larger profits in the years ahead.



So Gunns, with a market capitalisation of almost $1bn, is trading on a price to operating cash flow multiple of less than 10 times, using average cash flow over the past three years, or 12 times this years figure. The more telling free cash flow multiplewith free cash flow defined as operating cash flow less maintenance capital expenditureis somewhat higher, although its difficult to determine exactly how much higher.



The other main use of the companys cash flow has been dividends, which have averaged $38m a year over the past three years. And, last year, it paid out 12.5 cents in fully franked dividends, equating to a yield of 4.4%.



Billion dollar mill



Given the stocks 45% premium to NTA, price to free cash flow multiple of more than 12, and a reasonable but not compelling dividend yield, the stock is probably fairly, rather than cheaply, priced. Add to this a significant upward revaluation of the companys land holdings, by $170m last financial year, and the NTA isnt the picture of understatement it once was. And while the companys past performance might suggest a premium price is warranted, theres reason to believe that the situation might be changing.



Gunns is planning to build a bleached kraft pulp mill in northern Tasmania, a huge project that will cost more than a billion dollars, which exceeds the groups market capitalisation, and is more than



20 years worth



of dividends at the current rate. Perhaps it will turn out to be a veritable gold mine, but it means that more of Gunns assets will be of the depreciating type, rather than the appreciating forestry assets that we prefer, financially-speaking. It also adds to the stocks risk.



Another concern is the financial impact of the companys environmental issues. Gunns is often in court seeking a gag order on someone or other, and green groups are learning to bite back in the courts. Something big could hit from left field one day. Its a risk thats difficult to quantify, but its a risk nonetheless.



At the current price of $2.85, we cant see any compelling value in Gunns. But the company does have a lot going for it, and wed be more interested at a price that was closer to reported NTA. We dont intend to cover the stock regularly unless the price becomes more tempting, though, because theres BETTER VALUE ELSEWHERE.