SPECIAL REPORT. Juicy fruit in the MIS garden MAY 2007/MIS REVIEW R E P O R T

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1 SPECAL REPORT SPECAL Juicy fruit in the MS garden This sector has copped a hammering over the past six months. n this special report we go searching for some value. The managed investment scheme (MS) industry has had more highs and lows than Argentine football legend Diego Maradona over the past decade. Also like Maradona, currently in hospital trying to overcome an alcohol addiction, the industry is, once again, on its knees. Are the current problems permanent? Or is this another chance to make three or four times our money, as we did from the opportunity that presented itself in 2003? Answering that question is what this special report is all about. But before we kick off, let s take a look at the industry and some of the problems it s currently facing. The five companies in this report Timbercorp, Select Harvests, Great Southern Plantations, Forest Enterprises and Willmott Forests are all in the business of selling agricultural tax deductions. They might try to pretend otherwise, but the fact is that the vast majority of people who invest in these companies schemes do so because they get a tax deduction for the whole amount of their investment. Astonishing growth Agricultural tax products have been around for a long time. Formerly the domain of the mega-rich prepared to take a risk with the tax office, they began to gain wider appeal as MSs in the mid-1990s. The growth since then has been astonishing. Adviser Edge estimates that the industry attracted $1.2bn in funds in the tax year. Originally, your options were limited to timber plantations but, whilst timber products are still in the majority, there is now a bewildering array of options available from almonds and olives to avocados and cattle. Contrary to popular opinion, it wasn t a change in the law or the Government s 2020 vision that sparked Chainsaw massacre the explosive growth and associated rural disquiet. nstead, the tax office only has itself to blame. n the old days, punters would simply make their agricultural investment, put the deduction in their tax return and hope for the best. But in 1998, the tax office introduced a system of tax rulings, whereby investors could get certainty about the tax treatment of an investment before they invested. The promoter lodges a prospectus with the tax office, then the tax office issues a ruling stipulating how that particular product will be treated for tax purposes FEA GTP GTP SHV WFL TM FEA SHV TM WFL Base = 100 Apr 03 Apr 04 A green light from the tax office made the MS products attractive to thousands of investors that would never have considered tax minimisation in the past. Property booms, stockmarket booms and the lowest unemployment rate in 40 years have given these investors plenty of taxable income that needs minimising, and the industry has grown from virtually nothing to a $1.2bn a year, highly profitable sector. From small farmers angry that they can t compete for land to those, like us, who think MS investors have Buckley s chance of earning a decent return from some of these projects, the industry has always had its detractors. Now, as a result of a series of enquiries by the Federal Minister for Revenue, Peter Dutton, the tax office has joined the fray (a few tax office announcements threw the industry into disarray in 2001, but this time it s serious). About face The tax commissioner has about-faced and decided that, due to some undisclosed change in circumstances, investors in these MS schemes shouldn t really be able to claim a deduction after all. Since the Government still wants people to plant trees and meet the objectives of the 2020 vision, it has enacted a law specifically to exempt timber investors from the changing interpretation. But, from 1 July 2008, the tax office won t be issuing product rulings for non-timber MS products. That s a big blow, especially to the two biggest players, Apr 05 Apr 06 Apr 07 Timbercorp and Great Southern. And, as you can see from the share price graph, investors have thrown them back into the rehab clinic. We think this reaction has been overdone. These businesses all have their problems if the tax office hadn t got there first, potentially appalling returns to early investors could have done a job on future sales anyway. But there s enough asset value and locked-in revenue in these businesses to provide healthy returns, even under some pretty pessimistic assumptions. And, if history is a guide, there s a decent chance the tax office doesn t have a leg to stand on. Our favourite in the sector is undoubtedly Timbercorp, but you could probably buy widely and do well. f we find a cheap sector, our preferred approach is to focus on the best opportunity. But each investor is different and, by the time you get to the end of page 8, you ll be able to make up your own mind. R E P O R T MAY 2007/MS REVEW

2 SPECAL REPORT/MS REVEW MAY 07 Timbercorp ripe for picking Sensible management, a growing annuity stream and a dirt-cheap share price make the first opportunity in this special report the best. TMBERCORP (TM) $1.905 MARKET CAPTALSATON $581m HSTORCAL 12-MONTH PRCE RANGE $4.10 $1.76 FUNDAMENTAL RSK 3 out of 5 SHARE PRCE RSK 3 out of 5 OUR VEW STRONG BUY f you have a short attention span, we can sum up this opportunity in a paragraph. With 73% of its operating earnings coming from non-forestry products, the tax office clampdown will effect Timbercorp more than its competitors. Mr Market has overreacted, though, and in a big way. The stock is now trading on a PER of around 7, but the company has locked-in future revenue increases, related to past sales, that will almost offset the loss of income elsewhere. t looks dirt cheap and is getting back towards the level where we first recommended it, at $1.85, as our first Strong Buy in a long time. Timbercorp started out selling hardwood timber plantations and, like Great Southern Plantations (see page 6), grew very quickly through the late 1990s. The two companies business models were always slightly different, land, plant some trees and still have some cash left over. But, to develop a one-hectare block of almond trees, the company needs to spend approximately $50,000 (the land is only a small fraction of this amount, the vast majority relates to water rights and irrigation systems), more than four times the investor s $12,000 upfront contribution ($3,000 per 1/4 hectare block). The investor then pays an annual rent which equates to an annual return of about 11% on Timbercorp s investment. This is a crucial point. After the initial sale and establishment costs, the company is more an agricultural property trust than a tax scheme promoter. llustrating this, Timbercorp has created the separately listed Timbercorp Primary nfrastructure Fund, to which it has sold land and passes on associated rent. The shift away from timber plantations means Timbercorp has a lot more to lose from the tax office changes, but it also makes for a more robust business. There is plenty of future revenue headed Timbercorp s way whether the tax office wins its case or not. And that s why we like it. Annuity stream locked in An almond project runs for 27 years and an olive project for 23 years (compared with 10 years for your average timber plantation). Almond trees don t start producing until their third year of life and they don t reach maturity until their fourth or fifth year, and Timbercorp receives rent and Figure 1: Money grows on trees $0.30 Earnings per share $0.25 $0.20 $0.15 $0.10 $0.05 Figure 2: Frostbite $5.00 $4.00 $3.00 $2.00 $1.00 Figure 3: n the pipeline 20,000 Non-forestry hectares under management 15,000 10,000 5,000 FY 03 FY 04 FY 05 FY 06 in that Great Southern required investors to pay 100% of their contributions upfront, whereas Timbercorp required a smaller upfront payment but additional annual rent and management fees. But in 2001 their paths diverged significantly. Timbercorp announced its intention to diversify into non-timber (horticulture) products because land prices for timber plantations had risen to unsustainably high levels. And diversify it did. n the seven years since, while Great Southern has been paying all sorts of crazy prices for plantation land, Timbercorp has been selling thousands of horticulture products to the point where plantation timber is now a relatively small part of its business. t should probably change its name. An agricultural property trust The economics of the new projects, mostly almonds and olives, are very different to the economics of the timber plantations. n the old days, Timbercorp could sell its timber projects at a price that would allow it to buy a block of $0 Apr 03 Apr 04 Apr 05 Apr 06 Apr management fees that escalate as the trees reach maturity. So, whilst upfront profits represent a large portion of total profits right now, there s an annuity stream locked in that will last more than 20 years. Now take a look at Figure 3. Over the past few years, horticulture products have been selling like hot cakes and the annuity revenue from these projects is yet to start flowing. t s like the property trust has been building office blocks but the tenants are yet to move in. n 2006, annuitystyle profit from the horticulture business was $29m. That will more than double over the next few years. By 2009, this part of the business will be generating more than $70m in profit or about $49m after tax and it s locked in for the next 20 years. At the end of the project, the cash will stop flowing from investors, but Timbercorp will be left owning land, irrigation and water rights. t can either find a new tenant or farm the land itself. And don t forget that all deductions will be allowed on projects bought before 1 July 2008, which gives Timbercorp another two financial years to sell new products. f it 2 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au

3 matches last year s sales, as indicated by management at the half-year results briefing, that would be $158m in pretax profits about $111m after tax plus a significant addition to the annuity stream. This is why Timbercorp is cheap. t s being priced as if this division is going to disappear. Yet there are still two years of (probably) growing profits to come and, by the time the rules change, the annuity revenue will have grown to the point that, overall, the company won t be earning much less than it is today. We value Timbercorp s horticulture business at $600m. t s comprised of $110m for the post-tax earnings over the next two years plus $490m for the ongoing business including a $49m annuity stream for the next 23 years and the value of the land, infrastructure and water at the end. Horticulture pain, forestry gain Then there s still the business specifically excluded from the tax office s change in interpretation. Timbercorp owns 91,700 hectares of land on which it manages hardwood timber plantations (the woodchip used to make paper). The company intends to maintain a plantation of approximately this size (90, ,000 hectares) on a year rotation. n other words, it intends to sell 8,000 10,000 hectares of new projects every year, forever. That should generate an annual profit of around $22m or $15m after tax which, using a post-tax multiple of 10, would be worth $150m. While there will probably be more demand for the timber products once the non-timber projects get shut down, we ve got our doubts about this part of the business as we pointed out on page 1. However, the $257m of net assets employed in the forestry division mostly land bought many years ago gives us confidence that our $150m valuation is conservative. The majority of investors borrow most, if not all, of the money needed to make their investment from Timbercorp (you wouldn t expect to pay for the tax deduction, would you?). Figure 4: Adding it all up BUSNESS Whilst that, combined with the upfront capital requirements we mentioned earlier, has caused the company plenty of cash flow problems over the years, it now has a loan book worth $329m, on which it earns very acceptable rates of interest. But the loans are offset by a large pile of Timbercorp s own debt. n fact, at 30 September 2006, the $565m of debt more than offset the company s combined loan book and cash, to the tune of $87m. So that s $87m we need to subtract from our valuation. There s risk lending to the rich There is a risk here. You would think that people with tax problems would have high incomes and would therefore be a good credit risk. But the provision for doubtful debts (an estimate of the percentage of loans that aren t expected to be repaid) jumped from 0.8% to 2.1% last year. No doubt investors aren t too happy about paying loans back if the associated investments aren t providing adequate returns. We ll have more to say about this in a moment but, as we don t think the projects have much chance of providing an adequate return, it s no surprise bad debts are on the rise (although one or two large defaults can make this number swing around from year to year). A significant rise in default rates would put a dent, though not a fatal one, in our valuation. Other odds and ends On top of the traditional MS business, Timbercorp has been building an industrial business to process and sell the produce from the timber and olive projects. Revenue from this business will double to more than $100m this year and it will contribute a few million to earnings. Management tells us the returns have been low because they ve been paying early investors above-market rates, but that they expect to start generating pre-tax margins of 12 18%. We ll believe that when we see it and have put a value of $40m on this part of the business, but it s potentially worth significantly more. Finally, as you can see in Table 4, we need to add in Timbercorp s $47m stake in the listed company Select Harvests (which manages all of the almond projects see page 4). Subtract the corporate overheads and you end up with a per share value of $2.52. There have been a few changes since the last reporting date, including the acquisition of Chiquita Brands and the conversion of preference shares into ordinary shares, but they don t make a significant difference to the per share value. VALUE So, as it stands today, the stock is at a 24% discount to our conservative appraisal of the company s value. Horticulture business ($m) 600 Forestry business ($m) 150 ndustrial ($m) 40 Select Harvests ($m) 47 Net Debt ($m) 87 Corporate overheads ($m) 50 Total ($m) 700 Shares on issue at 30 Sept. (m) 278 Value per share ($) 2.52 Significant upside The biggest swing factor in our valuation is the final outcome of the tax office clampdown. As we indicated on page 1, there s a reasonable chance of the non-forestry MS industry eventually resuming with similar restrictions as those applied to the forestry industry. That would add dollars per share to the valuation. A few more years of record sales could make our estimate of the annuity stream seriously undercooked. Management s estimate of the annuity stream, as things stand, is significantly above our own, and the industrial business could be much more valuable than we ve estimated. n short, if a few things go the company s way, the value could be multiples of the current share price. Even if the whole MS sector comes to a screaming halt as investors realise the error of their ways, Timbercorp has ridden the wave to become one of the major landowners and farmers in Australia. t is going to continue making money for a long time to come. With the share price down 4% since 18 May 07 (BUY $1.98), we re happy to once again upgrade to a STRONG BUY. Disclosure: Staff members own shares in Timbercorp, but they don t include the author, Steve Johnson. SPECAL REPORT/MS REVEW MAY 07 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au 3

4 SPECAL REPORT/MS REVEW MAY 07 MS makes for a Select Harvest This almond grower has been an incredible growth story for more than a decade. The future is unlikely to be as good. SELECT HARVESTS (SHV) $10.80 MARKET CAPTALSATON $420m HSTORCAL 12-MONTH PRCE RANGE $13.80 $9.37 FUNDAMENTAL RSK 3.5 out of 5 SHARE PRCE RSK 3.5 out of 5 OUR VEW HOLD Select Harvests is not an MS company, strictly speaking. But it has hitched its wagon to the MS boom to such an extent that we ve included it in this report. The company has three businesses, all related to the almond market: it owns 2,500 hectares of its own almond orchards, it farms 35,000 hectares of orchards on behalf of others (mostly Timbercorp s MS investors) and it has a substantial processing and marketing business selling almonds and other nuts to retail and wholesale customers. We ll come to each of these businesses in turn, but first let s take a quick look at the almond market. Of all the MS options available, almond projects look like the ones most likely to generate decent returns. The almond industry is not a new one in this country South Australia s Riverland Almonds was founded in mportantly, whilst production has taken off in recent years and we re about to become the second-largest exporter of almonds in the world, providing 3% of the world export market, Australia is still a minnow compared to the US (California grows more than 80% of the world s export market). Australia also has some genuine advantages over the US: we re counter-seasonal and we re closer to ndia, one of the world s largest importers. The global almond market has been growing strongly in recent years at around 20% per year. And although the future is probably not quite as rosy as the Timbercorp product disclosure statements would have you believe, growing disposable incomes in Asia and increasing awareness of the health benefits of eating nuts are expected to Earnings go nuts ensure continuing growth. This rising demand has coincided with a replanting phase in California, driving up prices and resulting in some good returns for Select and its early investors. But while prices will remain high for the next few years, while the Californian orchards are replanted, a return to historical levels probably isn t far away. Genuine industry n contrast to the pulp timber schemes, though, it looks like there s a genuine industry here. Despite the rapid growth of recent years, Australia is not going to flood the market the way it could in the forestry industry, and it s possible that growers will actually get some decent returns. n short, Select has a more sustainable business Jun 97 EPS Pre abs (LHS, cents) Return on equity (RHS, %) Jun 98 Jun 99 Jun 00 Jun 01 model than other MS participants. Listed since 1983, Select originally grew its own almonds and seems to have done a reasonable, if not spectacular, job of it. n 1997, though, the company announced a change of strategy to diversify its earnings stream and increase profitability. One half of the strategy, managing orchards on behalf of third parties, turned out to be a stroke of genius. The other half, establishing the company as a food processor and marketer, is shaping up as a disaster. Whether through good luck or good management, though, the good has far outweighed the bad. Despite earning reasonable returns on its own orchards, Select has hardly planted a tree of its own for eight years. n August 2000, it struck a deal with Timbercorp (which is Select s second-largest shareholder with an 11.3% stake), whereby Timbercorp sells MS almond projects and Select manages them. Timbercorp owns the land and receives rent, Select manages the orchards and receives a management fee, and they split the upfront profit between them. The basic details are similar to those for a timber plantation. nvestors lease a quarter-hectare block of land to grow their crop, but they don t receive the proceeds from their particular block; instead the project is grouped with others in one large plot and investors get a pro rata allocation of the net proceeds. Selling like hotcakes These almond projects have been selling like hotcakes. Like Timbercorp, Select has been banking the upfront profits, but the ongoing management fees don t kick in until the trees reach production. When they do, however, Select can look forward to a minimum 20-year annuity stream of management fees. n 2006, the company harvested 6,200 tonnes of Jun 02 Jun 03 Jun 04 Jun 05 Jun almonds, including its own. Once the current plantings reach maturity, Select will be harvesting more than 45,000 tonnes per year and it will need to invest $32m in a new processing facility just to deal with the increase. The result will be a massive increase in annuity-style revenue. With very little of its own capital required to generate exceptionally good profits, it s easy to see why the company has been focused on this side of the business rather than planting its own trees. Even so, the company s own orchards have generated a decent return on invested capital over the years. From 2005, the annual report combined this division with the managed services division, which makes it difficult to value separately, but we ve assumed that its future profits will match 2004 s $8.8m operating profit. t s a pretty solid little operation and is no doubt receiving some benefit from the massive ramp up in operations and associated economies of scale. So the economics of Select s almond growing business, both for others and for itself, vary from pretty good to excellent. The rest of the business drags the average down 4 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au

5 and, unfortunately, that s where a lot of the profits are being reinvested. Food products squeezed Select has been pouring millions of dollars into the last piece of its integrated business jigsaw processed food and marketing. t s been gobbling up businesses over the past 10 years and it now owns a number of food manufacturing businesses including Lucky, Sunsol, Nu-Vit, Meriram, Soland and Temptations. Most of the products are nuts or nut-related products like muesli. f you produce all the nuts, why not package them in bags and grab a bit more of the profit as well? Unfortunately, things haven t worked out so simply. The main sales channel is through the supermarkets, and Coles and Woolies have been squeezing Select along with the rest of their suppliers. The returns on invested capital have been poor and profits from the division fell 15% in the latest half-year. Unfortunately, management has described the division as an integral part of the business, so it looks like we re stuck with it. Table 1: Valuation FOOD PROCESSNG OWN ORCHARDS MNGMT CORPORATE TOTAL 2006 EBT ($m) Multiple high N/A 10 Multiple low 6 8 N/A 10 Value high ($m) Value low ($m) Shares on issue (m) Per share value (high) Per share value (low) 7.26 t s hard to fathom this obsession with an integrated model. n the near future, Select will be controlling more than 60% of Australia s almond production you would think they d be better off throwing their weight around at the production end of the process. t s difficult to know what to make of this management team: they look like geniuses for jumping on the MS bandwagon but the subsequent capital-allocation decisions have been poor. Risk of water shortage Whilst Select is one of the stronger businesses in this report, it s still exposed to the same risks as the others a high-profile MS wipeout, stagnating stock and property markets reducing the demand for MS products, and the usual operational risks. n addition, this company needs water from the Murray River lots of it. As the honourable member for Bennelong has informed us in no uncertain terms, one of this country s worst ever droughts means water allocations on the Murray will, most likely, be zero at the start of the next financial year. The Prime Minister neglected to add that allocations at that time of year, in the Robinvale area of Victoria where Select grows its almonds, are normally close to zero. t s typical for allocations to be 10% at the start of the year and, as the inflows to the system become known, allocations are made accordingly. So, while there s no doubt that a full-year zero allocation would be an absolute disaster, the chances of that are slim even in a drought the magnitude of the current one. Lack of water is a long-term risk that should be high on your list of things to worry about, but it s not a show stopper just yet. That s especially so if you can buy the business cheaply enough. So what s it worth? Even if the tax office wins its test case, Select will still have two more financial years of MS sales, which makes our valuation a very similar process to the one we used on Timbercorp a few years upfront profit and a growing annuity stream. There are a couple of important differences, though. Select is currently debt-free so we don t have to worry about a loan book or any debt. And, most importantly, Select doesn t need to invest mountains of additional capital to add to its annuity stream. The $32m new processing plant should meet its needs for a long time to come. You can see our range of valuations in Table 1. We ve applied some simple multiples to the two non-ms businesses and performed a slightly more complicated calculation for the MS-related revenue (the high valuation is based on a successful test case regarding tax deductibility, while the low valuation is based on sales ceasing 1 July 2008). n a pessimistic scenario assuming MS sales come to a screeching halt, almond prices fall significantly and the food processing division continues to suffer at the hands of Coles and Woolies we reckon it s worth around $7 a share. But zero water allocations for a number of years would make it worth a lot less than that. Potential for big returns f the MS changes don t make it through the courts and Select keeps selling to investors, it s probably worth more than $16 a share. Continuing new sales revenue on top of the rising annuity revenue would translate into some very handsome returns for shareholders. There are a range of scenarios in between which involve Select finding a way to sell similar projects to institutional investors not driven by the tax benefits. That game won t be anywhere near as profitable as the current one, but the relatively attractive economics of the almond business, at least for the time being, make this scenario a distinct possibility. Table 2: Key almond growing statistics Approx no. of trees per hectare 250 Average life Typical yield per hectare (4 years old) Typical yield per hectare (8 years old) Typical price per tonne High (past decade) Low (past decade) 27 years 1.3 tonnes 2.7 tonnes US$5,000 US$9,000 US$2,600 Our conclusion is that if you can pick Select Harvests up at anything less than $8 a share, then a lot of the risks we ve highlighted could arise and you d still do all right. At less than $10, a price we have seen on a few occasions over the past 12 months, the odds are probably in your favour. Right now, though, the downside is a little too large and likely for us. We re commencing coverage with a recommendation of HOLD. Steve Johnson SPECAL REPORT/MS REVEW MAY 07 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au 5

6 SPECAL REPORT/MS REVEW MAY 07 Great Southern stripped bare Since our review of Timbercorp everyone wants to know why not Great Southern? Well, why not? GREAT SOUTH. PLANTATONS (GTP) $2.35 MARKET CAPTALSATON $741m HSTORCAL 12-MONTH PRCE RANGE $4.04 $1.87 FUNDAMENTAL RSK 3.5 out of 5 SHARE PRCE RSK 3.5 out of 5 OUR VEW HOLD Let s just sort out any potential confusion right now Timbercorp and Great Southern are very different companies. They are both in the MS business, sure, just as Pavarotti and Britney Spears are both in the entertainment business. Great Southern s upfront model made it the ideal play in the big industry upswing earlier this decade, and we happily participated in the bounty. But with the industry s early offerings maturing and showing horrible returns, the Government and the tax office more prepared to consider the negatives of the industry, and the incredible growth in forestry MSs forcing newer plantations onto less suitable land, we re now much more comfortable with Timbercorp s Heading south annuity-style model. $5.00 Bottom line difference We devote a large amount of our time to looking at the downside of investment opportunities. Entertain our nightmares for a moment, and let s imagine the Government does a backflip and bans all MS tax deductibility from 30 June 2008, including timber. n the $4.00 $3.00 $2.00 $1.00 following year, Timbercorp s revenue would likely be more than $300m, while Great Southern s would be negligible. That s case closed on why we prefer Timbercorp. Now let s put on our rose-coloured glasses and imagine the opposite, with tax deductibility on all products, including non-timber MS, beyond This would be great for both companies, and it s a scenario that s worth considering as it could indeed happen. We d put the chances of the nontimber MS business being allowed to continue in a format similar to today s as somewhere north of 20%. Both stocks would likely soar, but we think Timbercorp with its significant non-timber business would be best placed to benefit. The grey area So, in a worst and best case, Timbercorp wins. Of course, that ignores the grey area in between, which is where the industry currently stands. f everything went according to Peter Dutton s plans, then non-timber MSs would be obliterated, while the timber business would likely get a boost. This would theoretically be better for Great Southern, because it s more focused on the timber business. But its main advantage would be its more aggressive nature, as it s the one more likely to continue selling woodlots once $0 Apr 03 Apr 04 the supply of ideal land has run out, by continuing to plant in marginal areas. This offers us little comfort. We re not experts in this field, but we ve got a strong hunch that Timbercorp forestry MS investors are, on the whole, in for a less unpleasant experience that those who purchased Great Southern timber lots. And that factor will make Timbercorp s forestry business more sustainable. But it s not our job to protect MS investors from themselves. We d happily buy Great Southern at the right price. t s just that we d require a bigger margin of safety since it doesn t offer the same downside protection. So this isn t an attempt to put a fair value on Great Southern; we feel no compulsion to do so. nstead, we ll put a ruthlessly conservative valuation on it and see if it still stacks up. Rising price of land One of the major issues in recent years has been the rising price of suitable land in the Green Triangle of Victoria and South Australia, and southern Western Australia, the two traditional areas of forestry MS operation. Great Southern has been selling woodlots for $3,000 for a 1/3 hectare block for many years, or $9,000 for a hectare. Go back five years or more, when the company could buy a hectare of land for $2,000 or less, and the economics of this business were mouth-watering, even after taking into account that some of that land must lie redundant. But in the period to 30 September 2006, the company acquired 3,000 hectares of land for $21m, or $7,000 per hectare. And our Apr 05 Apr 06 Apr 07 research suggests that many newer purchases are less suitable land than what was available at a fraction of the price a few years ago. This hunch is further supported by note 4(ii)(a) to the recent half-yearly report to 31 March 2007, if you want to do more of your own digging. At these inflated land prices, the business becomes much tougher. Of course, Great Southern has a massive land bank to recycle for future MS offerings, but we won t value its 250,000 hectares of plantation land at anything close to $7,000 a hectare. Without the bidding war of MS companies in these regions, prices would be a lot lower. For our ruthless valuation, we ll stick with the number we used back on 18 Sep 05 (HOLD $2.88) $1,500 per hectare. We ll then discount the value of that land to account for the fact that it s encumbered, without earning rent, for anywhere between one and eleven years. Rather than wade knee-deep into mathematical formulae, we ll just lop off a third to account for that fact. At $1,000 per hectare, that s $250m for the land. Cash and cows Another major asset on the books is cash, which stood at $93m at 31 March Other tangible assets totalled a little over $700m, including loan receivables, pastoral leases and biological assets including a bunch of cows. Many of 6 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au

7 these assets will eventually be converted to cash so we re happy to include them in our valuation, lopping off 10% in the interest of conservatism. By our ruthless reckoning, the company has at least $970m of tangible assets. From this, we ll deduct all of the company s liabilities except the $140m in deferred revenue. Deducting the $730m of remaining liabilities, mostly debts, leaves net tangible assets of $240m. This, it should be stated, is an almost laughably conservative valuation for the company s net assets, but just joke along with us for now. Next comes the 5.5% clip Great Southern stands to collect on the proceeds of each project on maturity, ostensibly for management and rental expenses. But it looks like pure profit to us. f the net present value of this isn t at least $50m, we ll eat our Fire sale valuation $m hats. t could end up being worth Land 250 multiples of this figure. Cash 93 So if Great Southern was to shut its doors today and never sell another MS Other tangible assets 630 product, it d still be worth at least 5.5% fee 50 $290m in a fire sale. Of course, the Liabilities 730 company isn t having a fire sale, and Valuation 293 the recent word from that grasscovered bunker in Canberra suggests that tax deductibility for forestry MS Conservative ongoing valuation $m products is much safer than we thought Sales business 450 when downgrading the stock on 5 Dec 5.5% fee (SELL $2.97). That said, it s worth bearing in mind Biological assets 100 that Cirque du Soleil couldn t match Excess cash 50 the number of regulatory backflips this Valuation 650 industry has seen over the years. And it still faces a backlash when project returns continue to disappoint as we expect them to do. So the ongoing forestry business has an intrinsic worth, but is it enough to justify Great Southern s $740m market capitalisation? A different path through the woods Let s look at it from another, slightly less ruthless, angle. The net assets of the business are a necessary investment and so we ll ignore their fire-sale value and instead focus on the earnings they might generate over the next decade. The company has 250,000 hectares of land at its disposal that, as the current projects mature over the next decade, will be reusable for future offerings with minimal further investment. After accounting for the 40% of land that generally cannot be utilised, the company can create 150,000 hectares of new plantations, or some 450,000 individual 1/3 hectare woodlots. So, on an admittedly lumpy average, it ll be able to sell 45,000 woodlots per year without significant capital investment. This may seem an unnecessarily conservative number, considering that in the past few years the company sold more than twice as many woodlots. But, as we ve explained, with land prices so inflated, sales of woodlots beyond this point won t be particularly lucrative, so we ll ignore them for now. Breaking down the business Working out Great Southern s profit from the sale of an individual woodlot isn t easy nowadays, as the company doesn t break down its costs to reveal what comes from planting trees and what expenses come from cattle, olive or grape projects. But we did take a stab a few years ago, when the business was predominately forestry MS. Those numbers, presented on 13 Sep 05 (HOLD $2.88), remain our best guess. We arrived at a profit per woodlot, before land rental, of $1,790. We won t deduct land rental this time, as we ll exclude the land from our valuation. But we will lop off 20% to be conservative, and then from that figure another 30% for taxation, to arrive at a post-tax profit of $1,000 per woodlot. So the sales business should be able to generate post-tax earnings of $45m per annum. Putting that on a multiple of 10 gives us a valuation of $450m for the sales business. This should prove conservative, perhaps very much so. But we can also imagine a world where things are worse, so we re not prepared to go any higher. To this figure, we can add the $50m net present valuation for the 5.5% fee on maturity, and another $100m or so for biological assets, which are surplus assets if Great Southern is getting out of the non-timber MS business and should be converted to cash over the next few years. We ll also add $50m, being our estimate of the company s excess cash position. Not quite there Our conservative estimate for the ongoing timber business, then, comes in at $650m, which equates to about $2.05 per share. We re not going to recommend the shares because, for a raft of reasons already discussed, we prefer Timbercorp s. But at prices below $2.00, Great Southern shares start to drift into the no brainer category. There ll always be risks surrounding the company s model and modus operandi, but a cheap enough price will outweigh such concerns. For now, though, we re upgrading our recommendation a notch from 7 Feb 07 (SELL $2.19), to HOLD. Disclosure: Staff members own shares in Great Southern, but they don t include the author, Gareth Brown. SPECAL REPORT/MS REVEW MAY 07 WARNNG This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. The ntelligent nvestor and associated websites are published by The ntelligent nvestor Publishing Pty Ltd (Australian Financial Services Licence number ). DSCLAMER This publication has been prepared from a wide variety of sources, which The ntelligent nvestor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRGHT The ntelligent nvestor Publishing Pty Ltd No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for members only. DSCLOSURE At the time of publishing in-house staff held shares in: AEA, AHC, ANZ, ARP, CBA, CHF, COH, COS, CRS, CXP, DBS, FLT, GFF, GLB, GNC, GTP, HHV, HHVO, HVN, AS, FL, FM, VC, JBH, JST, KRS, LMC, LWB, MBL, MLB, MMA, MRC, NABHA, OEQ, ORL, PBL, PTM, QMT, ROC, SFC, SFH, SGB, SGN, SOE, SOF, SOL, SPT, STO, TGR, TM, TLS, TLSCA, TRS, WAL, WBC, WDC and WPL. This is not a recommendation. Prices correct as at date of publication, 31 May The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au 7

8 SPECAL REPORT/MS REVEW MAY 07 No value hiding in the Forests Forest Enterprises and Willmott Forests don t offer as much value as their larger counterparts, but they re worth a dot on the radar screen. Both of these companies operate in the forestry MS business, but they re very different to Great Southern Plantations and Timbercorp. We ll start with Forest Enterprises, which is one that will be familiar to a few members. t was bombed out and unwanted when we first recommended it on 8 Mar 02 (SPECULATVE BUY $0.12), starting our review with the ominous words: This company could go broke. Share price information their plans. The valuation isn t stretched and they re yet to make an obvious mistake. The stock is down 4% since our last mention on 26 Mar 07 (HOLD $0.74) and our recommendation remains HOLD. Willmott s long-term offering Willmott Forests differs from the other companies in this report in that it sells MS products for softwood timbers destined to become sawn timber. That means pine trees rather than eucalyptus, which the company grows mostly around Bombala and Tumut in south-eastern NSW. The plantings also take more like 25 years to mature compared COMPANY ASX CODE PRCE ($) BUSNESS RSK SHARE PRCE RSK OUR VEW Forest Enterprises FEA Hold Willmott Forests WFL No View But the business has changed very significantly since then. As we wrote on 10 May 06 (HOLD $0.58), we ve been impressed by many of the changes implemented under Andrew White, such as the development of longer-rotation eucalyptus offerings destined for sawn timber rather than woodchip and pulp. This potentially offers the company an attractive niche in an industry otherwise destined for domination by bigger players with deeper pockets, like Great Southern. With the share price up since then, our enthusiasm has waned. The group recently announced a 1-for-4 rights issue at $0.70, and the business is proving to be more of a consumer than a generator of cash. Apparently, proceeds of the rights issue are to be used for two purposes, neither of which looks very promising to us. Much less attractive The first is to fund the further acquisition of land suitable for lease to growers in the Group s upcoming woodlot projects. As we explained in our review of Great Southern, this business becomes much less attractive when land prices get too high. And this development suggests that land prices in northern Tasmania are now high enough that the company has to issue new shares to grow its business. The dilutionary effect of such efforts can be akin to shooting yourself in the foot to relieve an itch. Even less appealing is the proposed use of the new money to allow capacity for continued growth in the Group in other related vertical integration activities including the new sawmill at Bell Bay. We find the term vertical integration activities about as appealing as a soggy spam sandwich. The supposed efficiency gains from vertical integration are rarely forthcoming, and in any case we re very sceptical that the timber processing business will prove to be as lucrative as the forestry MS funds management business. The stock doesn t look compelling on an assets valuation or an earnings valuation, and we re not thrilled with the direction it s taking. But, given what s happened at this company over the past four years, we will allow Andrew White and major investor Futuris some slack to implement to 10 years for hardwood woodchip offerings. But you get a much higher value product on maturity. The problem has been that most MS investors don t seem to be very concerned with the value on maturity, and are instead focused on the tax deduction on commencement. So 10-year offerings have captured the lion s share of the market, because you (hopefully) get your dough back quicker. But we think what Willmott does is much more sustainable, and in Australia s economic interests, than woodchip offerings. At the moment, if you invest in a product you have to hold it until maturity. But new rules announced by the Government will allow a secondary market where you can sell your project investment after a minimum of four years and still keep the tax deduction. That could reduce the handicap that Willmott faces with its very long-term offering. Shares marked up Of course, that fact isn t lost on the market, which has marked the shares up more than 10% since the announcement. The company currently manages some 30,000 hectares of plantations, which it s increasing by approximately 6,000 hectares per annum. But growing the business won t require huge wads of capital, because it s now allowing someone else to own that land and lease it to MS investors. Unfortunately, though, Willmott also feels the need to vertically integrate, investing in downstream processing and even renewable fuels. Perhaps forest litter and wood waste will be useful in biofuel production, but why not let someone else find that out and, if they re successful, just sell them the biomass? On an assets basis, Willmott doesn t strike us as particularly cheap. t has net assets of $89m compared to a market capitalisation of $98m. And it hasn t yet proved that it can generate decent free cash flow, or indeed any at all. That should change, but we d rather see the runs on the board before considering an investment, so we won t be issuing a recommendation at this stage. We ll keep a spare eye on it, though, for any future opportunity. Gareth Brown 8 The ntelligent nvestor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) Fax: (02) info@intelligentinvestor.com.au