Gunns targets major expansion
Recommendation
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 doesn’t make the cut, we’d 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. We’ll start by looking at what’s 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, there’s about $360m of net debt, a pretty manageable figure given the group’s 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 Investor’s 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, it’s hard to tell how much of this is maintenance capital expenditure—a necessary evil—and 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 year’s figure. The more telling free cash flow multiple—with free cash flow defined as operating cash flow less maintenance capital expenditure—is somewhat higher, although it’s difficult to determine exactly how much higher.
The other main use of the company’s 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 stock’s 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 company’s land holdings, by $170m last financial year, and the NTA isn’t the picture of understatement it once was. And while the company’s past performance might suggest a premium price is warranted, there’s 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 group’s 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 stock’s risk.
Another concern is the financial impact of the company’s 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. It’s a risk that’s difficult to quantify, but it’s a risk nonetheless.
At the current price of $2.85, we can’t see any compelling value in Gunns. But the company does have a lot going for it, and we’d be more interested at a price that was closer to reported NTA. We don’t intend to cover the stock regularly unless the price becomes more tempting, though, because there’s BETTER VALUE ELSEWHERE.