We recently researched Fletcher Building (ASX:FBU) after the Company provided a trading update and outlined targets to expand margin for each of its segments over the next two years. Investors appear divided over whether the targeted margin expansion can be achieved and are factoring in a slower earnings growth given that the New Zealand residential market appears to have matured.
Accordingly, we assess whether there is validity in these investor concerns. However, the key consideration as to whether positive investment sentiment towards FBU can return is whether there are any mitigating factors and to what extent these would allow the Company to achieve its targets.
About Fletcher Building
Fletcher Building is the largest materials company in NZ, with a diverse portfolio of businesses that include concrete, building products, distribution, residential & land development, and steel in its core NZ market. FBU also has an Australian business, which is a smaller contributor to group earnings. The Company’s revenue and earnings base is linked to the housing construction cycle in NZ and Australia.
Key Fundamental Drivers
Margin Target Ambitious but Achievable
The Company is targeting an expansion in group EBIT from ~8.2% in FY21 to 10% by FY23. If achieved, this would equate to a ~20% increase in the revenue base from FY21 to FY23, assuming an EBIT base of ~$NZ660m in FY21 and a group revenue base of ~NZ$7.3b.
FBU has outlined the expansion/trajectory in margin required for each segment in order to achieve the 10% EBIT margin target by FY23:
• Margins for the Australia segment to rise from ~3.6% in FY21 to 5-7% in FY23.
• Construction margins to rise from ~2.2% in FY21 to the bottom of the margin range of 3-5% by FY22, underpinned by changes to the order book.
• NZ ‘Core’ (i.e. Building Products) margins are expected to expand slightly as a result of operating leverage; and
• Residential and Development margins: to maintain margins above 15%.
The greatest challenge for FBU to achieve the expansion in EBIT margin to 10% is the Australia and Construction segments. The desired EBIT margin target of 5-7% for the Australia segment requires at least a 140 basis point improvement from the 3.7% EBIT margin delivered in FY21. It is worth noting that while initiatives to pivot towards the more profitable SME channel, private label and site optimisation appear logical, the Australia segment has not been able to achieve an EBIT margin of ~5% since FY16 – at a time when activity levels were peaking.
The Construction segment has faced challenges from its loss-making buildings and interior business. However, the Company is working to wind-down its backlog of these projects. The Company expect EBIT margin to be bottom of margin range (3-5% by FY22) as order book replaces nil margin legacy work. However, there is upside to this, as recent backlog additions appear to be at higher margins than this range as they entail lower-risk contract models.
Over the medium term, profitability is likely to be driven by higher-margin, lower-risk infrastructure projects. The Construction segment continues to rebuild its forward order book and recent work won by the Construction segment has been of this nature. In particular, only 1/3rd is higher-risk lump sum/development & Construction work, while the remainder of new work won is evenly split between alliance/maintenance-style work.
Growth Opportunities in Land Development
The Residential & Land Development Segment acquires large tracts of land, or rehabilitates former industrial sites, to convert into housing estates. While the revenue base is small, it is a typically higher-margin business and as such, is a material contributor to group EBIT (i.e. ~20%).
FBU has raised their development guidance from 700-800 unit sales to 850 unit sales in FY21. The Company previously had a target of 800-900 unit sales, however the impact of COVID-19 in FY20 means that these unit sales will be completed in FY21. Beyond FY21, the Company has highlighted growth to 1,000 unit sales by FY23, with additional growth planned in subsequent years. Growth opportunities include scaling up offsite manufacturing and apartments, as well as expanding the retirement offer in existing communities.
Balance Sheet Expected to Remain Strong Over the Medium Term
Gearing (on a net debt to EBITDA basis) is expected to be ~0.3x as at 30 June 2021. Accordingly, the strong balance sheet position has enabled the Company to undertake an on-market share buyback of up to NZ$300m over 12 months (which commenced in June 2021) and resume paying dividends in line with its dividend policy.
The Company expects gearing to step up from FY21 levels as a result of increased investment over FY22 and FY23, the share buyback (which will be debt-funded) as well as cash outlays related to legacy projects in the Construction segment. Importantly, while the gearing level is expected to rise to ~0.7x in FY22 and FY23, it would remain below the target gearing range of 1-2x.
Accordingly, over the medium term, the balance sheet is expected to remain in a position to continue capital management. In particular, further share buybacks (aside from the one recently announced) may be possible, however these are more likely to be in the form of special dividends as the Company returns to tax-paying position in NZ.
The shares are currently trading on a 1-year forward P/E multiple of ~16x. Notwithstanding the improvement in the share price since our recent analysis in The Dynamic Investor report, this multiple remains un-demanding in the context of mid- to high-single digit EPS growth in FY22 and FY23 (supported by the share buyback). Further, the potential for construction activity in the core NZ market to hold up better than expected is a key catalyst for the shares.
To this end, forward indicators for the NZ residential market point to continued robust volume growth, with ongoing structural undersupply of housing in NZ (housing undersupply of 40,000 dwellings) and the industry operating at or near capacity in certain areas. Regarding the Australian residential market, volumes are expected to remain robust through FY23.
While we acknowledge the likelihood that the turnaround in the Australia segment may not be strong enough to support the targeted margin expansion (i.e. to 5-7%), this factor is mitigated by: i) Potential for operating leverage in the core NZ segment, ii) Growth opportunities in the residential & land development segment, iii) Balance sheet optionality and iv) Longer-term margin expansion opportunities – namely a new Winstone Wallboards plant which will be operational from FY24 and expected to yield transport efficiencies, specialty export product opportunities and unlock existing high utilisation constraints.
FBU has been trending well over the last year. In late June it broke the uptrend line, retested the underneath of it, and then continued to fall. However, when it got near major support near $6.65 at the May low, it managed to hold on and bounce off. For now it looks like FBU should continue to trend higher from here.
Michael Gable is managing director of Fairmont Equities.
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