In early May, CSR Limited (ASX:CSR) reported its results for the 12 months to 31 March 2023 (FY23). The result itself was slightly ahead of consensus expectations. Notably, there were stronger earnings from the core Building Products and Property division. Despite this, the shares were sold down. With this in mind, we recently researched CSR in The Dynamic Investor to assess whether the share price may have been oversold.

Overview of CSR

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 division has a portfolio of highly recognised, predominantly lightweight building products. The division 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 almost 80% of total EBIT in FY23.

The Company also generates additional earnings from its Property division, which focuses on maximising financial returns by developing surplus former manufacturing sites and industrial land.

CSR’s third division is Aluminium, which comprises the Company’s 25.2% interest in in the Tomago aluminium smelter, which is located near Newcastle, NSW. The smelter is a joint venture (JV) between Rio Tinto Alcan (51.55%), GAF (36.05%) and Hydro Aluminium (12.4%).

Key Fundamental Drivers

Volume Growth in Building Products Division

The expected rate of housing volume growth in FY24 is a key swing factor in terms of the outlook for the Building Products division. CSR is expected to benefit from the elevated pipeline of detached homes under construction. This is despite a challenging macro backdrop, namely a decline in housing starts and approvals). The Company expect that the pipeline should sustain demand for +6 months, with detached completions growth expected over the remainder of this calendar year.

Market estimates for underlying volume growth in FY24 range from flat growth to -4%. Having said that, there is downside risk to these estimates, as the financial position of building companies remains a risk. In particular, the number of construction companies entering administration has risen sharply over the last 12 months. In addition, cancellations have been rising, with some home builders even reporting post-contract cancellation or deferral. While some builders are extending their builds, others can’t afford to do so without facing further profitability impacts. The point is that while CSR see +6 months of sustained activity, the decline in volumes could occur sooner.

Further Asset Sales to Reduce Earnings Volatility

The earnings results for the Property division have exceeded expectations in recent years. This is due to the progressive sale of surplus land. The latter also reduces the volatility in earnings and supports the balance sheet. It also provides appropriate funding for an active capital management program, either via increased dividend payments and/or further share buybacks.

Aluminium Division Continues to Disappoint

EBIT for the Aluminium division in FY23 was at the low end of guidance and below consensus estimates. Tomago was impacted by higher raw material, freight, energy, labour and other costs. The operating segment result would have been worse had it not been for $13m Reliability & Energy Reserve Trader (RERT) payments received to support the stability of the national energy market.

Looking forward, cost volatility and unpredictability in energy and raw materials make this segment challenging. To mitigate the earnings impact, CSR appears to be hedging its aluminium opportunistically. This is to neutralise the risk of material potential losses, amid volatile and rising costs. The Aluminium division is expected to return to profit in FY25.

Notwithstanding that the Aluminium division only accounts for ~2% of group EBIT (down from 13% in FY22), we consider that a profitable sale of the division over the short-to-medium term would be well received by the market.

Strong Balance Sheet Continues to Support Capital Management

The Company is using it net cash balance to increase dividend payments. This is because disclosed land sales are expected out to FY24. Another use for the net cash balance is to undertake capital management via share buybacks.

While capital management is the current focus, it is worth noting that there is balance sheet scope to pursue potential Merger & Acquisition (M&A) opportunities. In recent years, M&A opportunities have been restricted by COVID-related challenges and elevated valuations for potential targets in light of the favourable market conditions. However, demand conditions are starting to ease, and there is increased pressure on smaller players, as evidenced by reported insolvencies and financial difficulties. In turn, this implies that M&A opportunities may become available over the short-to-medium term.

Fundamental View

The share price has recently been supported by two factors. Firstly, the possibility of strong price rises in key products. Secondly, the likelihood of a backlog in detached completions supporting near-term volumes. Having said that, we take a cautious view on CSR at current levels due to several factors:

i) Heightened downside earnings risk over FY24/25 from a more impactful decline in housing volumes (given the current weak forward indicators);
ii) A potentially larger impact to earnings for the Aluminium division from a high-cost operating environment;
iii) The expectation the Property earnings, while supporting CSR’s overall valuation, are unlikely to provide a positive offset and
iv) Based on current trading multiples, the shares are trading above its respective long-term averages.

Charting View

CSR remains in a slow uptrend since the June 2022 lows. However, the pullback since the May peak looks negative and the rally in June was on lower volumes. We would expect short-term weakness from here which could give investors a better entry point. A break under $4.60 support would be a negative for the overall trend.

 

Michael Gable is managing director of Fairmont Equities.

 

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