Gunns’ hybrid holders take a bullet


The venerable Tasmanian forestry company, Gunns (ASX: GNS) released its preliminary final report on the last day of the 2012 reporting season and it was a shocker.

The headline loss of $904m included impairment expenses of $583m in forestry assets and, with further reductions in reserves, the company now has only $24m in net assets on the balance sheet, down from $1,054m twelve months ago. The report is preliminary, unaudited and contains warnings that the company must rely on its lenders’ support to continue as a going concern.

Gunns shares remain suspended from trading so any existing shareholders have no options open to them but are there lessons here that we can learn as Foolish investors?

One is to avoid anything like the general disaster that was investing  in timber and agricultural assets over the last few years, especially any tax-driven, managed investment schemes – think Great Southern and Timbercorp; both long since liquidated.

Perhaps more pertinently, we should look at the treatment by Gunns of their hybrid issue, labelled  “FOREST”, bearing in mind the current crop of hybrids and notes from our major banks and from household names such as Caltex (ASX: CTX), Tabcorp (ASX: TAH) and Crown (ASX: CWN).

ASIC recently issued warnings about this whole area, with commissioner John Price quoted in the Sydney Morning Herald as saying, “Some hybrid securities and notes are highly risky investments” and the Gunns experience certainly illustrates this.

First a bit of history: the FOREST (ASX: GNSPA) notes were issued in October 2005 at $100 and paid a margin of 2.5% over the variable bank interest rate plus franking. In October 2008, they were to be redeemed or the interest margin went up to 5%. This interest increase is what happened and, until April this year, Gunns continued to pay the quarterly distributions. Since the shares were trading on the ASX at well below their $100 face value (the last trade before suspension was at $45), the yield had rocketed up to over 20%. The company appeared to have considerable assets which far outstripped its debts, so the investment case was appealing and the notes continued to be recommended as part of a diversified portfolio by a number of advisers.

Fast forward to today and the outlook for holders is bleak as they have just been told that their notes will be converted into ordinary shares in October. This was always a clause in the issue documents, as it is with many hybrids, but was not the expected outcome. To add insult to injury, this conversion invokes a maximum share clause which means that the holders only get 421.7 shares per note.

When  the ordinary shares were suspended,  they traded at $0.16, and if this were still the case, the conversion would represent $67 worth, not such a bad result if you bought for $45. However, the company is facing possible liquidation and the net tangible asset per share, after the hybrid conversion, is only about $0.018. If note holders got that, then the $100 original investment would have returned $7.59 but, if liquidation really does happen, the more realistic expected return for any equity holder is a big, fat zero.

When the company got into trouble, it decided it didn’t owe these investors money and wasn’t going to treat them as debtors, instead the owners of these notes are now down at the bottom of the pile alongside ordinary shareholders. So the reality is that they have always had all the equity risk but none of the upside. Real shareholders might see capital gains of any amount whereas the note holders were never going to get back any more than $100. All risk and no reward for a bit higher yield.

Foolish takeaway

There are a lot of hybrids being issued at the moment. If you are considering any of these, tread very carefully and closely examine all the clauses and conditions. Many hybrids are constructed to have sufficient equity-like behaviour that they don’t count as debt on the balance sheet and remember, equity holders are the last in line in times of trouble.

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Motley Fool contributor Tony Reardon owns various Gunns hybrid securities. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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