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Gunns - in the eye of a perfect storm

The headlines in the Australian press say it all - "Banks say Gunns almost out of Bullets", "Axe poised over Gunns head" or “Slash and burn: woodchipper clings to life as banks hover”. Gunns rocked the market recently announcing a loss of A$904 million but emphasized that it remains solvent. An A$355 million dollar loss was declared in the previous fiscal year. This latest news had no impact on the company stock price because it has been in a trading halt since March. At that time company stock was trading at 16 cents, a far cry from $3.57 in late 2007.

How did this long established company with its rather staid but reliable financial history get to this situation? Gunns opened for business in 1875 as a building company and entered the timber business in the 1890's. Perhaps it was the change from a private listing to public ownership in 1985 that set in train the events that have culminated in the current circumstance. Certainly public listing was the catalyst for rapid expansion of the company, which saw Gunns become the world's largest exporter of hardwood chips as well as a significant saw miller and very significant plantation owner.

Almost a decade ago Gunns made the decision to add value to its contracts to access native forests and its own plantations by investing in a Kraft pulp mill. From the outset there has been bitter and concerted opposition to the project from an array of antagonists. These were not just the "usual suspects", such as green and conservation groups but local residents and a bevy of scientists. This drew in a range of supporters across the nation and the world, many of whom probably had never been to the State of Tasmania, let alone to the mill site. Had they visited the site they would have quickly established that it was anything but pristine, located as it is adjacent to an Aluminum refinery and smelter, Manganese alloy smelter, 2 wood chip mills, and a power station.

A lot of the opposition was fueled by what was demonstrably deliberate misinformation about the environmental implications but also a growing national conscience about harvesting of mature native forests. It was also a reaction to an initial lack of public engagement in the early stages of the mill approval process. Instead Gunns took advantage of its long established status as a leading corporate citizen to achieve a political shortcut to approval of the mill and this was essentially delivered.

But there was a history of deep antagonism to pulp mills in Tasmania. In the late 1980's APPM, by then a subsidiary of mining giant North Ltd, in a joint venture with Canadian mining company Noranda had almost succeeded in building a pulp mill. This company saw forests as a renewable mining resource but had not anticipated the ferocious opposition of locals led by a lady who has since become a senator and leader of the Australian Greens Party.  Construction of the mill was thwarted when the Federal Government, for what were considered by many to be political reasons, effectively terminated that project by requiring a long and detailed study to establish discharge guidelines for bleached hardwood Kraft mills. Guidelines were eventually promulgated and were the basis for planning criteria for the proposed Gunns’ mill.

Fast forwarding to the current situation, Gunns have made considerable changes to their mill project to address many of the concerns raised by opponents. These included a commitment to use only plantation wood in the process and to agree to particularly tough limits for AOX discharge. However the fact that the proposed mill would be the world’s largest single line bleached kraft mill probably heightened public suspicions about the impact of the mill.

As it stands now Gunns have full State and Federal Government approval to construct the mill but this will not assuage the opposition. However, the impediments to the mill at the moment are not environmental but financial. Both issues are effectively related because it is known that the original banker for the pulp mill project withdrew funding because public customers had threatened withdrawing business if the mill proceeded.

Had funding been guaranteed earlier in the project development the mill may have been much further advanced and despite the other countervailing financial and economic forces there would be a more positive outlook than seems to be the case currently.

Australia for almost all of the years since World War II has enjoyed being a lucky country and was one of the few countries that avoided a recession during the GFC. It was against this utopian backdrop that Gunns built its business as an exporter of woodchips to satisfy a voracious demand for fiber from countries deficient in wood, initially from Japan and more recently from China. Although Australia escaped the GFC by mining its vast reserves of iron ore and coal to satisfy global demand, particularly from China, the world order is changing. China has become such a huge and dominant customer that any downturn in China transmits a pricing shockwave into the market. China has also encouraged the development of alternative suppliers of iron ore and coal to reduce its Australian dependency.

The high prices that were achieved for iron ore and coal drove much higher interest rates in Australia due to a strong economy. Combined with a Chinese currency pegged to US dollars, the exchange rate was significantly skewed, serving to significantly reduce revenue in Australian dollars as most commodities are sold in US dollars.

So it has been with wood chips. Demand has been impacted by declining pulp prices and Australia has more competitors as well as oversupply within Australia. From a standing start about ten years ago, Vietnam has now replaced Australia as the leading hardwood exporter and with a much lower cost base.

Of course Gunns had planned to effectively exit the chip market to feed their own pulp mill and the long term loss of the export chip markets was inconsequential. The problem has been with the timing. The pulp mill is nowhere in sight and less likely to eventuate because the Australian Dollar remains strong and pulp prices (mainly US dollar denominated) are falling.

The challenge is whether Gunns can survive long enough to build their mill or indeed whether the mill can be viable. When the mill was scoped no one was forecasting the dollar exchange rate being anything like it now is. Conventional economic forecasting assumed an exchange rate of 0.7 Australian dollars to a US dollar whereas it now seems entrenched above parity. The financial consequences are highly significant even with strong pulp prices. The mining boom in Australia caused construction costs to soar, offsetting any exchange rate advantage against the purchase cost of imported machinery. The good news for Gunns is that in just the last few weeks many major mining expansion projects have been shelved, which may take the heat off the construction market. Will it however be too little too late?

With all of these factors at play there is little appetite for investors to take a stake in the proposed Gunns mill. Gunns have sold just about everything that was not nailed down. However given the huge write down just revealed in their annual report, it is hard to see how Gunns can survive without significant equity investment or indeed capitulation, assuming someone would buy them. The vineyards and walnut farms are gone and in the fiscal year just completed Gunns sold two saw mills, the Triabunna woodchip mill and the Green Triangle forest estate from the Auspine business, which Gunns acquired in 2007. Subsequently even their corporate headquarters have been sold and the new chip loading complex in Victoria, albeit at a good price.

What Gunns do have left are significant forest assets; more than 200,000 Ha of company land and rights to a lot more. Much of the plantation estate was funded by the now discredited Managed Investment Schemes, which were the subject of a previous commentary and new funding has been turned off for some time now. The estate is financially underwater, with these plantations written down to a negative value on the basis of realizable revenue into the wood chip market only, because the Board was unable to reach a determination that the mill was "probable to proceed". Consequently almost a quarter billion dollars of project expenditure to date has also now been expensed. All of these financial decisions can be reversed if the pulp mill eventuates but the indicators are that the perfect storm is intensifying rather than abating. The problem is to find a buyer who would want the plantations without a pulp mill, given the precipitously declining wood chip prices.

Some years ago a respected financial analyst stated that the pulp mill would be built and would be a good long term investment but ultimately Gunns would not own it. He also said that stockholders would be well compensated for selling the asset. Now Gunns does look increasingly unlikely to own the mill but stockholders will not receive any reward, if indeed the mill ever eventuates.


UPDATE: In a statement to the Australian Securities Exchange, the board of Gunns said, “As previously announced by Gunns Limited, ongoing lender group support has been required in order to stabilise the company’s operations whilst discussions in relation to a potential capital raising, restructuring or alternative transaction proceed, and to retain proceeds from planned asset sales to meet the operational and working capital requirements of the business.

“The company now regretfully advises that the lender group has informed the company that the lenders will not permit the Company to retain further funds, which are necessary to meet the operational and working capital requirements of the business.

“As a result, the company is unable to continue trading and the directors are in the process of appointing an administrator. That appointment is expected to be made shortly.

“The company is disappointed that it will not be able to pursue the restructuring transaction, which it considers would have delivered a better outcome for the people who have a stake in the company’s past and future. The company is very grateful to all those people, especially employees, past and present, who worked hard to support the company’s strategy.

“This is a disappointment for them and those associated with the restructure of Gunns’ business to a plantation-based manufacturing industry in Tasmania.”

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