Hidden mill investment exposures!

Reading this could save you a lot of money…

We are entering an unstable investment environment created by a combination of the unravelling US sub-prime crisis, extreme weather events, fuel availability concerns and an on-going drought in Australia.

This is the environment in which Finnish supplier Poyry is selling Gunns a $1.x billion pulp mill that they'll have to go into deep debt to purchase. Gunns is also paying Poyry as consultants to guide them through the project. Years ago, it was Poyry that 'advised' Australian government to get into tree plantations and recommended that Tasmania was a suitable location for a world scale pulp mill...and it was Poyry again, (according to insiders) that created all of the financial inputs for Gunns IIS.

Make no mistake, Poyry is writing Gunns script and there has been no independent verification of their claims whatsoever.

Repaying the debt and earning profits in such an unpredictable environment could be very problematic, not least because Gunns has ignored so many obvious threats to their business.

Leaving threats to your business out of your plans is a recipe for sudden surprises and disasters.

One threat stems from the total of taxpayer subsidies and cost relief that Gunns enjoys, which ranges between $150 million and $250 million per year. As the company only posts profits in the order of $80 million per year, it means their management cannot make a profit in the commodity business and needs subsidies to cover their losses and keep them in 'business'.

CONCLUSION: Gunns survival depends entirely on taxpayer subsidies.

Subsidies are good news in good times, but in difficult times they expose the company to huge losses when subsidised activities suddenly become a cost.

Subsidies also cushion management from needing to perform, make them lazy and out of touch with the realities of free markets. Gunns chairman Gay has been called a 'cowboy', 'inarticulate' and, a 'patsy'. Subsidies and protection from the free market allow that quality of management - at the expense of efficiency and competitiveness.

Hot issue

One question for investors is whether they really believe that governments will continue to justify around $200 million per year as subsidies, when social pressures are calling for greater government investments in health, education, aged care etc.

Gunns has chosen a high volume/low value commodity approach to business that relied on subsidies to keep it at a profit. High value woods like sassafras and celery top from public forests are run through the chipper to produce paper. This is not a business of the 21st century, it does nothing to address any of our important problems, the reverse. We conclude that this commodity business does not 'fit' our times and hence is likely to be unsustainable.

For Gunns, the inconvenient facts are that:

1) Gunns does not know, or has not reported, the impact of sensitive variables on their proposed pulp business (sensitivity analysis). Such variables include:-

• Cost and availability of water for plantation growth
  
• Changes in fuel costs (e.g. ships bunker fuel)
  
• End market changes (e.g. polymer papers from plastic waste)
• Pulp price collapses (forecast 2010 glut)
• Adverse carbon credit findings leading to new costs
  
• Input losses due to fires and firestorms (each 100 ha lost = $3.2 million of pulp)
  
• Plantation investor revolt (e.g. Class action)
• Catastrophic event at pulp mill (e.g. ClO2 explosion, black liquor boiler explosion)
• Odours from mill disrupting other Tamar businesses
  

2) The IIS did not recognise existing subsidies or the impacts of their cessation such as:

• Federal MIS schemes
• Roads & bridge maintenance
• Charges for water used by plantation

With those subsidy levels, Gunns has been effectively making losses for years and has only been posting a profit thanks to taxpayer subsidies or cost relief.

3) When critical variables are not well understood, or worse deliberately ignored, that implies a deficient business plan and therefore a deficient business.

Gunns should make its economic assumptions and models available to all shareholders now so that they can decide what level of protection there is from threats presented by those types of variables (e.g. fire, drought, subsidy losses).

Facts and implications for investors

1) Gunns is operating in the dark because no-one, including Gunns or their shareholders, understands the potential impacts of changes in business sensitive variables (for reasons, see consultant statements at bottom of this post).

• What happens if tree growth is stunted by drought? Or fire storms destroy plantations?
• If Peak Oil is real, could ships' bunker fuel prices cripple competitive exports?
• What exposures exist from further overseas market changes (e.g. polymer papers)?
• Pulp market forecasts describe a glut of pulp by 2010. What impact might this have on pulp prices and profitability?
• If Gunns is seen as an emitter of carbon, how might the extra costs affect Gunns bottom line.
• Plantation investors pay around $7,000 per ha to own the trees. Since each hectare produces between 150 – 200 tonnes then investors will expect between $35 - $46 per tonne to break even. Gunns can now buy timber from Forestry Tas for $16 per tonne, delivered to the mill, so investors are in for a very rough ride when they try to sell to the only buyer - Gunns! Expect the outcome to be strongly politicised.

2) Gunns business is highly exposed to subsidy reductions:-

• For each hectare of plantation established by Gunns, they receive over $3,000 of taxpayer money via MIS. To increase their plantation estate, Gunns needs more land. The mill seems to need a minimum of 400,000 ha of plantation, an increase of 200,000 ha from current levels. That growth would represent further federal subsidies of $640 million. If that scheme is stopped (and there are many farming and community groups fighting it), then plantation estate increases would be curtailed. That would cap inputs and lower income significantly.
• Road and bridge repairs are conducted at ratepayer expense. The weight of modern log trucks creates disproportionate damage and total cost relief for this item has been estimated at about $20 million per year across Tasmania. Councils are already crying poor, how long before this subsidy comes under serious question?
• Plantation trees consume a lot of water (reported as averaging 2 Ml/ha/yr more than grasslands for grazing) for which plantation operators do not pay. Tasmania is in drought status right now, rainfall has been diminishing for 10 years and reservoirs are at record lows. Pressure from farmers and communities down catchment could easily change government policy on water charges for trees. The 400 Gl currently calculated for Gunns plantation, at $100 Ml, represents $40 million dollars of foregone State revenue per year.
• Additional subsidies in the forms of cash payments and cost relief have also been made available to Gunns (e.g. forest agreements etc) to the value of over $300 million in the last 3 years

3) This is a long and inflexible project that forces Gunns to operate at specific levels for many years to pay off the costs of the investment. Given the rate of change in the markets today, we should ask whether we want long-term, inflexible investments or short term flexible arrangements.

If you're going to be locked into something that relies on long term stability, you really need to know what could go wrong so you can assess the risk.

Any prudent investor must surely ask why none of the sensitivity analysis has been published, disclosed or discussed.

What is Gunns trying to hide?

If the pulp mill business needs annual injections of the order of $200 million, surely there should be a fixed contract with government to assure those payments? If they suddenly show up as costs, it's almost impossible to see how Gunns can stay in profit.

Hot issue

If Gunns insurance is as tenuous as insiders report, then shareholders could be severely exposed in the event a major mill accident or a class action against the company.

Our take on the risks with Gunns is that they are real, severe and considerable, particularly if the problems occur in multiples which seems quite likely.

We cannot understand how the company's management can leave the company and shareholders, so exposed by keeping us ignorant of so many critical factors that would affect our perceptions of value and risk. Drought risks alone include stunting plantation growth, firestorms and new charges being levied for tree plantation water use. Risks that surely merit discussion with shareholders before the company plunges itself into the unknown.

Frankly, after we'd reviewed everything that Gunns has hidden, we decided to EXIT.

The only thing that would have stopped us exiting our position would be a change of management coupled with a focus on high value/high margin business to replace the low value/low margin commodity business which is exposed to global competition and uncontrollable events.

Key lesson

If you convert high value, differentiated timbers into low value, commodity wood chips, you'll need subsidies so that you can pretend its a business.

Our advice?....It was great while it lasted but from here on in....

...we're out of here!


This way to the EXIT everyone....asx.com.au

INSIGHT: Competent executives? Due diligence?

The sworn statement by Jonathan Stanford, a consultant chosen by Gunns Ltd., is filled with proofs that Gunns wrote it's own financial forecasts. In his sworn witness statement for the RPDC Mr Stanford writes…

“The main input for the economic modelling was the financial model supplied by Gunns….on a strict commercial-in-confidence basis”

It seems that there has been no independent validation of Gunns figures. Who in Gunns could have supplied economic models for a pulp mill? Their paid 'consultants'...Jaakko Poyry...the people selling them a pulp mill!

From this we can conclude that Gunns intends to rely on Poyry's financial forecasts, with no independent verification, to support their acquisition of an unpopular 'world scale' pulp mill that will place a massive debt burden on the company but handsomely reward Poyry, certain Gunns directors and whoever finds the finance.

Back to Mr Stanford on public concerns about environmental costs (e.g. water, fires)

“We did not model the economic impact of any significant adverse environmental impacts because we were not advised that there would be any such impacts.”

Mr Stanford on concerns about project risks

“I have never included an analysis of project risks when evaluating and reporting the economic outcomes.”

These are the sworn statements of the man that Gunns used to do their economic modelling.

It's pretty obvious that Mr Stanford only did what he was told, only used information provided by Gunns and did no risk analysis whatsoever.

Professional? You be the judge at...Jonathan Stanford sworn witness statement
Mr Stanford is now, worryingly, a partner at Deloitte.


See also Dani Ecuyer's (investment analyst) analysis

You'll find more information about the risks in Foresty actuary's RPDC submission
Chris Lang also provides a good and detailed alternative overview of the pulp business