We revisit CSR Limited (ASX:CSR) after the Company reported its results for the 12 months to 31 March 2021 (FY21) and as a follow-up to our previous BUY recommendation. With the shares having since gained ~25% due to continued strong operating conditions in the key Building Products division and upward property revaluations – is there scope for further upside in the shares?
CSR is a leading building products company in Australia and NZ. The majority of group revenue and earnings are generated from the Building Products division. This comprises three business units: Interior Systems (e.g. gyprock), Masonry & Insulation, and Construction Systems (e.g. external cladding). EBIT for the Building Products division accounted for ~70% of total EBIT in FY21. The Company also generates additional earnings from its Property division. This division focuses on maximising financial returns by developing surplus former manufacturing sites and industrial land.
CSR’s third division is Aluminium. This comprises the Company’s 25% interest in in the Tomago aluminium smelter, which is located near Newcastle, NSW.
Key Fundamental Drivers
Favourable Demand Environment for Building Products
The demand environment for CSR is very favourable. This is evidenced by single-family housing approvals rising 48% over the past six months and given the fact that CSR’s products are sold within the second half of the construction process, there is typically a two-quarter lag between demand and actual sales.
A key driver of the strong uplift in single-family housing approvals have come from the HomeBuilder program. The Company is confident that it can service this demand and the fact that HomeBuilder starts have been extended over 18 months does meaningfully aid in flattening (and spreading) the demand curve.
Looking back at past housing cycles, CSR has demonstrated a strong record of being able to deliver when the cycle is favourable. In the most recent upturn, housing starts began improving from FY13 through to FY18. This saw CSR expand Building Product EBIT margins from 7% to 12%, and EBIT more than doubling from $67m to $201m over this same period. Most notably, CSR managed to deliver sales growth of 20% and EBIT growth of 30% in FY18, at a time when the housing market was nearing a peak.
Operating Leverage Expected to Increase
EBIT growth of 10% in FY21 against a 2% decline in revenue points to evidence of significant operating leverage in the Building Products division. In particular, EBIT margin in 2H21 increased by 200 basis points, as the benefits from the HomeBuilder program have started flowing through to increased levels of activity.
Operating leverage is likely to continue over the short term, given that the HomeBuilder program has recently commenced. Further, CSR has emerged from COVID-19 with a structurally lower cost base as a result of the organisational restructure and operating efficiencies. This was partially driven by COVID-19, which will somewhat be retained over the next 12 months. As a result, operating leverage is likely to improve in FY22 and could even be higher as CSR intends to push through price increases given the strong demand environment. However, there is a risk that price increases may be mitigated by the fact that many builders have already forward-sold future capacity.
In a normal cycle, this improvement in operating leverage typically builds over multiple years. In FY23, operating leverage is expected to moderate as operating costs begin to rise.
Increased Earnings Contribution from Property Division
The Company has 457ha of existing land holdings that are leveraged to key Western Sydney locations that are set to benefit from structural tailwinds. These include a new Western Sydney Airport, surging e-commerce activity and strong demand for distribution centres. These factors are supporting the industrial aspect of the property business.
Earnings for the Property division can be volatile, and difficult to predict. However, CSR’s Horsley Park development is near completion, with transactions secured underpinning $88m in EBIT over the next three years.
Importantly, there has been an acceleration in valuations for industrial property assets over the last 12 months. This is because the onset of COVID-19 has accelerated the structural shift of online. The revised independent expert’s valuation for the “as-is” valuation of the Western Sydney Property portfolio is now $900m and well ahead of the $500m provided in November 2019.
Strong Balance Sheet Position Supports Further Capital Management
With an effective net cash position of $134m and proceeds from CSR’s disclosed land sales expected to be received between FY21-24, capital management is expected to continue. This is mainly via special dividends given that the Company has an adequate franking credit balance.
Whilst there is balance sheet scope – and intention – to pursue potential Merger & Acquisition opportunities in conjunction with the above-mentioned capital management initiatives, it is worth noting that valuations for potential targets have recently risen in light of the favourable market conditions. Accordingly, the Company’s focus over the short term is likely to be on pursuing organic growth.
From current levels, the valuation appears stretched. In particular, the shares currently trading on a 1-year forward P/E multiple of ~16.5x, compared to EPS growth of ~7% over FY21-24 on a CAGR basis.
Having said that, positive catalysts for the shares include: i) Further details on the potential costs savings in relation to the supply chain transformation project and ii) A potential exit of the Aluminium division.
CSR has been trending well since the middle of 2020. It still remains in an uptrend, but at the moment it seems to be hitting a brick wall at current levels. If we can see it start pushing higher towards $6.50 again, then we can be confident that it should just continue trending. Otherwise a dip back towards $5.50 would be a better buying opportunity. Any weakness will need to stay above the April low near $5.50 though for the uptrend to remain intact.
Michael Gable is managing director of Fairmont Equities.
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