The Shoeshine Column: Fingers tightly crossed over Fletcher Forests

Friday 14th July 2000

Down at Fletcher Forests there will be some nervous faces as the division prepares to cast off from the mother ship, Fletcher Challenge.

FCL has vowed to separate, in one way or another, all three remaining divisions by the end of this year and close the head office.

For Building, and especially for Energy, the process looks relatively painless - just a matter of seeing whether potential trade buyers put a higher value on the shares than the market does.

The FCL board is projecting a similarly relaxed attitude to the Forests separation. The reality is that Forests' debt situation is a millstone that could delay the whole carve-up.

The Big Mistake that got Forests into this situation was the decision, in September 1996, to buy the late Forestry Corporation's Central North Island forests from the Crown.

A consortium of FCL, Brierley Investments, and China's Citic paid just over $2 billion for the asset.

In strategic terms it was a smart move, concentrating Forests' operations in the North Island and furnishing big economies of scale in harvesting and transport.

The problem was financial. The acquisition was debt-funded to the tune of $US700 million as the partners were able to convince the banks they would be able to service the debt through rapid harvesting of Douglas fir from the CNI forests.

Then came the Asian crisis. Log prices plunged and cash flows from what harvesting there was almost dried up.

BIL sold out in 1998, booking a hefty loss on its investment, and the partners, now owning half each, went into a huddle with their bankers.

In return for a $US126 million cash injection from the partnership the banks agreed to suspend principal repayments until June 2000 to give log prices a chance to catch up.

They have, but not by enough to get Forests off the hook.

Interest payments, both on Forests' own $661 million of debt and CNI's $1.77 billion are being capitalised, meaning the debt mountain is growing higher by the day.

In the June 1999 year $56 million of interest was capitalised into Forests' own debt and $135 million into CNI's debt.

Against this the division generated net operating cash flows of only $69 million and an after-tax profit of $56 million.

In the first half of this year net profit, before an abnormal gain of $11 million from a Chilean fire insurance payout, was just $4 million and net operating cash flows were a wafer-thin $18 million.

All this, of course, doesn't mean Forests is about to fall over. One of the beauties of forestry is that you can always generate larger cash flows any time you want simply by cutting down more trees and selling them.

But at present that's not value-enhancing and Forests chooses not to do it. Log prices are forecast to keep rising on the back of a strong recovery in Asia and a global economy ticking along nicely.

Forests can't see the point of harvesting trees at current prices just to pay interest and its bankers are presumably comfortable with this.

But the situation is still pretty hairy. This year it will have to pay $26 million to the departing Paper division for FCL group tax benefits attributed to Paper that will go to Forests.

Principal repayments - in US dollars bought with New Zealand pesos - have restarted on the CNI debt. The banks won't forego their interest payments forever.

And the division needs cash to build more processing capacity.

So those log prices had better keep rising. The simple fact is FCL and its partners paid far too much for the CNI forests.

The question now is how much pain that mistake will inflict on the rest of the group before it is fully split up.

Plainly Forests can't stand alone without recapitalisation in some form. There are at least five scenarios.

One the FCL board will be praying for is the appearance of a major investor who is prepared to inject cash and take a sizeable equity stake.

That would dilute the minority shareholders but, given the untenable situation, they shouldn't complain too loudly.

Provided the injection was big enough to get debt down to a manageable level Forests would then be able to stand alone.

Secondly Citic could step in and buy Forests out of the CNI partnership. That would remove the debt problem but would leave Forests a far smaller entity.

Options three and four are a merger with another player or an outright sale, as with Paper.

This shouldn't be discounted. The division is one of the world's lowest-cost producers, partly because of those economies in the Central North Island. And a growing proportion of its revenue is coming from value-added processing and distribution rather than simple log sales.

But anyone merging or buying would have to assume Forests' $1.5 billion debt burden. Nobody should expect the shares to fetch the sort of premium to market prices Norske Skog paid for Paper.

Option five is asset sales - that is, selling whole forests rather than logging them. The easy sales have already been done. The East Coast forests raised $210 million, the South Auckland Forests went for $30 million, and the Nelson joint venture forests fetched $US185 million.

But these things take time and FCL has only five months until its self-imposed deadline for full separation. And Building and Energy are raring to go their own ways.

Given the relaxed attitude of the bankers Forests could possibly be separated as things stand as long as asset sales were promised.

The two other divisions will just have to keep their fingers crossed and hope those log prices keep rising until Forests is someone else's problem.

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