ZWU read this article from John Lawrence in the Tasmanian...

ZWU read this article from John Lawrence in the Tasmanian Times,sure it is a bit dated---but is relevent,the ASIC comment is a pearler




Gunns, FEA and insolvency

John Lawrence
21.09.09 5:42 am

Tas Times� stream-of-consciousness bloggers continue their unrelenting fascination with Gunns, its share price and solvency. Sometimes they end up a little astray from reality.

FEA is a much better illustrative example of the issues surrounding a company�s net asset position, its share price and its solvency.

There are two primary tests for determining insolvency, the balance sheet test and the cash flow test.

Under the balance sheet test a company is insolvent if total liabilities outweigh total assets.

With the cash flow test a company is regarded as insolvent if it is unable to pay debts when they fall due.

In Australia the relevant test is the cash flow test. This is backed by the statutory definition of insolvency in the Corporations Act 2001 (s 95) which says a company is solvent if and only if, the company is able to pay all its debts, as and when they become due and payable.

Personal insolvency is similarly defined.

There is a difference between solvency and a surplus of assets. A company may be at the same time insolvent and wealthy.

Perversely it was the same logic that ASIC used when a complaint was lodged that Great Southern were carrying on a Ponzi scheme. ASIC responded that it couldn�t have possibly been a Ponzi scheme because GSL had net assets at the time. So did Bernie Madoff. He had heaps, mainly other people�s.

Just because a company might have net assets they may nevertheless be insolvent pursuant to the statutory definition.

The nature of a company�s assets, and its ability to convert those assets into cash within a relatively short time, in order to meet its debts as and when they fall due, must be considered in determining solvency.

But the cash flow test for solvency does not mean that a company�s assets are irrelevant. The lines of credit available to the company are also taken into account to determine whether debts can be paid.

So how does this apply in practice?

Take Gunns for instance, the excess of asset over liabilities is $1.3 billion according to the latest financials. Excluding any intangible assets (such as goodwill for instance) gives a figure for net tangible assets of about $1.15 billion. Dividing this by the number of shares on issue (637 million) gives Gunns� net tangible assets per share (NTA) of $1.80. Yet the share price is about 40% below this figure.

A company�s share does not grant the owner a portion of each of the company�s assets. Rather it is a separate asset, a chose in action as the lawyers say, which grants the owner certain rights, to dividends to vote, etcetera.

There is no prima facie reason why the market value of a share will equal the NTA. Investors will rarely value a share on what the capital return might be in the event of liquidation, but rather on what they may earn from their share ownership, both from dividends and capital growth.

It is not in the least unusual for NTA to be below the prevailing share price. And a share price at a discount to NTA doesn�t indicate anything about the company�s solvency. To suggest otherwise is an exercise in self delusion.

Gunns are clearly solvent under the balance sheet test. Under the cash flow test they are also solvent. They may stretch out a few customers but there is no reason to conclude they will be unable to pay their debts. Claims about creative accounting are ill informed. In fact Gunns� full financials are well within the bands of normality when it comes to transparency and information provided in the accompanying notes.

Gunns is only a small company (outside the top 150 ASX listed companies) but they have strong institutional support. The recent capital raising saw 97% of their institutional shareholders cough up $114 million within 24 hours. The institutions represent over 80% of the shareholder base. It mightn�t be a great investment at this stage, but it�s unlikely they will lose control as happened with Great Southern shareholders for instance. Gunns is not likely to implode.

Great Southern did not have any major shareholders. Their biggest shareholder was a hedge fund which went belly up during the period leading to GSL�s demise.

Great Southern�s last set of financials indicated that the company had a positive NTA. At that time the Directors raised the possibility of not being able to continue as a going concern. Which meant there was a possibility that solvency pursuant to the cash flow test was suspect. The banks refused to advance further funds and they were unable to continue. Although at that point in time their assets probably exceeded their liabilities. Not anymore though, after the receivers take a cut and fire sale of assets occurs.

There are numerous examples of the cash flow solvency test causing problems when there are still plenty of net assets.

Take Centro Properties for example, in the few months preceding the ASX highs of November 2007. This was possibly the most public sign at the time of problems brewing in the economy. Their 2007 financials suggested a comfortable surplus of assets over liabilities. But then it was discovered that some of the long term liabilities were current (they had to be repaid within 12 months). Whoops! Once it became known that loans had to be repaid sooner, solvency issues surfaced. The company has just survived.

What about FEA?

Tas Times readers have already seen some evidence of the difficult transition from MIS company to fully integrated forest products company (Whither FEA?)

The half yearly result at December 2008 revealed cash flow problems but 75% of FEA�s $200 million debt was still classed as non current, as repayable at least 12 months in the future. But FEA clearly signalled its difficulties by reclassifying $59 million worth of land as a current asset, as land for resale, to help provide cash to survive.

On 17th July 2009 FEA issued a profit guide to the ASX, revealing an expected loss for the full year after tax of between $6 and $8 million. It turned out to be a loss of $14 million after tax. In the interim statements for the full year issued in August 2009, the bank debt of $200 million was reclassified as current, as repayable within 12 months. This is because FEA is now in breach of undertakings given to its lenders, which means that all loans are immediately repayable. The ball is in the banks� court.

This has brought into question FEA as a going concern, as being able to satisfy the cash flow solvency test.

FEA is not alone in this regard. There�s been much frantic activity this year with equity raisings as companies try to repair their balance sheets before issuing full financials and Directors signing the final accounts.

At 30th June 2009, FEA�s NTA was 71cents per share. Prior to the recent trading halt the market price was 18 cents. But with solvency being a serious issue they needed to fix up their balance sheet. They found some lads in Hong Kong who were granted back door admission onto the share register, taking up a 13% interest at only 7.5 cents per share. That�s an indication of how desperate FEA were to raise more funds. The concessional back door admission means that existing shareholders had the value of their holdings diluted by about 11%. A small price to pay if they live to fight another day, perhaps?

But the new allotment only raised $4.5 million. FEA needs much more than that. So a further capital raising via a 1 for 1 rights issue to all shareholders at 7.5 cents per share will raise another $35 million. Of the larger shareholders, Gunns� share will be about $5 million and Elders� share (via ITC Ltd) about $9 million. If none of the existing shareholders take up the offer, the suits from downtown Wan Chai, will step in, take up the offering and end up with 46 % of FEA.

Before the new share placement FEA�s NTA was 71 cents per share. The post placement NTA is 35 cents per share. In other words the net assets of FEA will increase slightly by the amount of the capital raising but will be spread over more than double the number of shares. The 7.5 cents per share placement represents a discount to NTA of 79%.

The total capital raising will be $39.5 million. All of this is earmarked for working capital purposes, not debt reduction. On this latter matter the banks �will review� their position. FEA are maintaining that sale of non core assets will be required to reduce debt. There is now $107 million of assets classified as �assets for resale�. The definition of a non core asset must have widened, as �For Sale� sign are now being displayed on existing plantations.

So FEA aren�t out of the woods yet but they will probably be able to satisfy the cash flow solvency test at this stage.

If any reminder is needed, FEA�s woes are clear evidence of how much more difficult life is after MISs.

And it also serves as a stark demonstration of the folly of MIS as an instrument of public policy. MIS policy has resulted in the massive subsidy of private benefits by the public purse. The resulting private assets that have survived the excesses and inefficiencies of the MIS system are now being sold to foreigners at a 79% discount because the MIS system which has led to the current mess is inherently unstable.

Like all Ponzi schemes new money is always needed for life support. Without it, look what happens.