By Forests we mean a toxic hybrid issue concocted by Gunns bankers JPMorgan and Macquarie three years ago whose conversion threatens large-scale share dilution.

Forests stands for Frankable Optionally Redeemable Equity Settleable Transferable Securities. No, this is not a joke. Surely a box of Monte Christo cigars will have been bestowed upon the banker who dreamt up this acronym.

Anyway, Gunns is looking to wrap up its $430 million capital raising by early October, before the interest rate on its Forests resets on October 14 to an expensive 12.5%. Management said it intends to pay the 250 point step-up and then redeem the hybrids in the second half of 2009.

Despite the mooted 35% to 40% dilution from this capital raising, Gunns major shareholders such as CBA and Perpetual have agreed to tip in for their entitlements. They have little choice. Already overstretched with $1 billion in debt, Gunns itself faces being pulped into oblivion if it doesn't get the capital raising away.

Like so many other companies in the present downturn the timber group procrastinated about raising equity, punting the market would recover while its stock price was slowly being felled by opportunistic shorts and anxious investors. In so doing, it watched its cost of capital rise.

What happened? A good old acquisition binge and debt splurge by chairman John Gay and his cohorts. A few numbers tell the story: Gunns spent $52 million on acquisitions in 2007 and $221 million in 2008 as it sought to swallow South Australian softwood group Auspine.

In the same time frame, they chewed through $129 million and $131 million in working capital. Capex rose from $81 million to $105 million and proceeds from borrowing were $665 million and $560 million in 2007 and 2008 respectively, surpassing repayments in both years.

Poor management, full-stop. Interest cover is roughly 1.7x and even leveraged buy-out merchants insist on a respectable 2x interest coverage. The interest bill last year at $72 million was higher than the $69.5 million in net operating cash-flow.

As for the pulp mill, a new $2 billion spend is an extreme long-shot as Leighton's boss Wal King noted the other day. Now there is talk of a Swedish partner coming to the table, although green groups have been searching high and low for the candidate and found no one who would fess up to it.

Without a partner, the mill is dead. That Gunns is on its knees and desperate for capital does not help sentiment but the $85 million interest bill this year on debt of $1 billion and a market cap of $672 million simply does not stack up.

On the operational front, the news is better. Japanese demand for woodchips is firming. Woodchip volumes had been down four years on the trot till 2007 but are now recovering. Hardwood chip earnings were up 30% last year thanks to demand from Japan and China.

This will help get the issue away. Tomorrow is the key day as the institutional bookbuild will determine the price. A three-for-four issue priced at $1.40 would raise the full $430 million. On ABN's numbers, gearing would fall from 104% to 46% though EPS would also fall by 17% and 27% in 2009 and 2010.

These numbers assume the full amount is raised. The retail component is yet to come with the pricing period due to close on September 24. Wisely, Gunns has set no definitive target on this so it cannot be hit with a shortfall.

Meanwhile, the pricing period for the Forests runs from September 16 through October 13 and the conversion price ratio naturally depends on the price of Gunns shares so there promises to be much volatility in the stock.

Whether there is any goodwill among investors to support John Gay on the expansion trail once again, via the pulp mill funding (it may require more equity), is doubtful.

The former sawmiller got a taste for acquisitions when Gunns bought Tasmania Board Mills from Boral for $23 million in 1999. Gay was also at the helm when Gunns acquired Boral's Tasmanian forests and chipping operations in 2000 for $72 million.

It was the ambitious deal to buy North Forest Products for $335 million the following year which catapulted Gay into the big time. It was a risky play which doubled the size of the company and came off well.

Spending four times your market cap on a pulp mill expansion though is another matter when your existing business needs to be rescued by its shareholders.

mwest@fairfax.com.au

BusinessDay