Fletcher plays chicken as bank deadline looms

By Nick Stride

Friday 17th November 2000

In the elaborate game of chicken being played out between Fletcher Challenge and China's Citic, road space is running out fast - but both sides are determined not to blink first.

Unless the two can agree to stump up, by December 31, several hundred million dollars, their joint venture, Central North Island Forests Partnership, is likely to breach at least two important covenants on its $1.6 billion of bank debt.

If that happens the so-called crown jewel of New Zealand's forestry estate could wind up in the banks' hands.

FCL is playing down the likelihood of that happening. Seizing the forests, spokeswoman Ginny Radford has pointed out, is only one of the actions the banks could take.

Even so, the language of this week's prospectus for the Fletcher Forests division's rights issue makes it clear the possibility should be taken seriously.

"It is likely the banks will require, as a condition to the grant of any waiver of any such default, a further equity contribution to be made by the partners into the CNIF Partnership to fund a reduction in the senior (bank) debt," the document notes.

"Only if Fletcher Challenge Forests is satisfied that it is economically appropriate to do so, and its 50% partner Citic does likewise, and FCF reaches satisfactory arrangements with the banks, will FCF be willing to invest further equity."

The solution seems simple: the partners front up with more cash and business goes on.

The trouble is they can't agree on how much needs to be injected or on what terms. It's not even clear Fletcher Forests will be able to come up with enough cash to put the partnership back on a sound footing. According to ABN Amro analyst Dennis Lee the recapitalisation under way at Fletcher Forests is $300 million to $400 million short of what is needed.

At the heart of their argument is the simple-sounding question: how much are the CNI forests worth?

FCL, Citic and Brierley Investments bought Forestry Corporation's estate from the government in 1996 for just over $2 billion. At that time the US dollar, in which all the debt is denominated, was worth $NZ1.43.

At the equity level, in New Zealand dollar terms, FCL has pumped in $617 million and Citic $650 million. Above that Fletcher Forests has lent the partnership around $610 million of junior debt. Ranking above that is around $1.6 billion of bank debt.

But the slide in log prices triggered by the Asian financial crisis of 1997 has cut severely into the asset's value. By most reckonings the partnership's equity is now worthless.

Citic New Zealand's vice-president of finance Michael Kidd says the consensus of analysts' and consultants' valuations of the partnership's assets is about $1.7 billion. The recent range has been between $1.4 billion and $1.8 billion. If the assets were sold off for $1.7 billion the banks would get all their money back but FCL would get only $100 million for its $610 million of junior debt.

Citic's dilemma, Mr Kidd says, is that if it puts in more cash that cash would push up the value of FCL's junior debt without providing any value for Citic. In effect it would be a wealth transfer from Citic to FCL.

"We've stated we won't put in equity that ranks behind their subordinated debt," says Citic's Greg Molloy.

Citic thinks the only fair solution is for FCL to write off its junior debt or convert it into another form of equity.

Fletcher Forests' new chief executive, Terry McFadgen, has acknowledged Citic's position, admitting "every dollar they put in benefits us rather than them." Even so, says Citic's Greg Molloy, "FCL hasn't come back to us with any response whatsoever."

Citic has offered to buy FCL out of the partnership. FCL rejected the $218 million offer as "significantly too low." FCL's insistence the Forests' division is worth no less than 100c a share implies it thinks the partnership's value is above that level - $2.2 billion - at which the equity the partners have pumped in has value.

But that's above what the partners paid in 1996, when log prices were at a cyclical high. FCL chairman Roderick Deane has himself conceded "we paid too much."

At least two independent analysts agree.

In a report dated October 1 JB Were's Doug Smaill said Citic's offer valued the partnership at $1.8 billion, at the top end of his range of $US600 million to $US700 million.

ABN Amro's Dennis Lee says accepting Citic's offer would imply a fair value, after the rights issue, of 33c a share for Fletcher Forests, against 31c as things stand.

Were the banks to call in the receivers - the "worst case scenario" - Lee says Forests shares could be worth as little as 10c.

Dr Deane has also rejected as far too high Citic's claim the partners will need to inject $US200 million ($500 million, or $250 million each) to restore the partnership's gearing to a level the banks can live with. Mr Kidd says he finds this puzzling.

Worldwide the industry norm for gearing is equity of 60% to 70% and debt of 30% to 40%.

If the asset's worth is $1.7 billion, then a 40% debt level would be $680 million. The partners would have to repay $1.02 billion ($US408 million).

Even if the enterprise value is $2.2 billion, as FCL seems to be claiming, the repayment would still be $880 million ($US352 million).

With the consensus valuation hanging just above the $1.6 billion value of the senior debt the partnership's banks are likely to be well outside their comfort zone. One concern is the "Wall of Wood" - New Zealand's annual tree harvest is forecast to double over the next three years.

Log prices are forecast to stay flat for at least that period, suggesting the partnership's financiers can't bank on much upside in forestry valuations.

And, although the partnership's loans are without recourse against Fletcher Forests, one of the provisions of the original financing agreement was that the division stays part of the FCL group. The group's break-up will remove from the picture the strength and diversity of FCL's cashflows.

What will break the impasse? Citic's Mr Kidd says the ball is now squarely in FCL's court.

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