Shares in CSR Limited (CSR) have declined from recent highs of around $6.00 in early May this year. As expected, the more challenging conditions for housing in light of higher interest rates and lower consumer spending have weighed on sentiment. Accordingly, we recently researched the Company to assess the prospect for a further recovery in the share price. The key factors to consider include: i) The extent to which the Company’s end market exposure can mitigate the more challenging macro conditions, ii) Balance sheet optionality and iii) Potential for further valuation uplift in the Property division.
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 over 70% of total EBIT in FY22. The Company also generates additional earnings from its Property division. This 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% interest in in the Tomago aluminium smelter. This is located near Newcastle, NSW.
Key Fundamental Drivers
Operating Leverage for Building Products Division Likely to Reverse
EBIT margin for the Building Products division in FY22 increased by 210 basis points to 14.1% compared to FY21. While this points to improved operating leverage, a key area of focus is the lower-than-expected rate of revenue growth achieved in FY22. This is important from the viewpoint of the changing macro environment.
CSR has emerged from COVID with a structurally lower cost base. This was as a result of an organisational restructure and operating efficiencies, partially driven by COVID (marketing, restrictions). However, the FY23 EBIT margin for Building Products is expected to fall to <14%, as:
i. Some of these COVID-related costs are returning,
ii. While CSR has achieved improvements to the supply chain, the Company is yet to yield the anticipated benefits from system and capability investment.
iii. Builder insolvencies are rising and while another builder is typically assigned to a failed project, there is a risk of rising costs across the industry.
How CSR Can Overcome More Challenging Macro Conditions
Housing starts in Australia are expected to slow further in FY23 and FY24, as the full impact from interest rates hikes begin to impact the market (3-4 quarter lag). A recovery is expected in FY25, as population growth returns to full capacity. On the positive side, the rate of decline in Australian housing starts (>20%) is unlikely to be as much as the declines evident in past cycles of -25% to -45%.
One of the factors supporting the lower-than-historical rate of decline is household formation. Further, CSR has signalled a strong pipeline of detached housing projects which extends until calendar year 2023. In particular, i) The Company typically has a late cycle exposure (normally a two-quarter lag) to the construction process and ii) Comments from the Housing Industry Association indicate that supply chain challenges and acute labour capacity shortages have added 50% to home building cycle times.
In addition to an extended cycle for detached housing, Company management also noted some improvement in multi-family and non-residential construction (which were delayed through COVID). In addition to the price/mix benefit in these sectors (in particular, a higher value product mix and improved pricing discipline contributed to margin improvement for the Interior Systems business in 2H22), recovery in these volumes may help soften the anticipated impact from the decline in detached housing in FY24.
Property Division Demonstrating Earnings Stability & Higher Valuation
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 has underpinning increased EBIT certainty over the next three years, given that there is a high level of contracted transactions.
There has been an acceleration in valuations for industrial property assets over the last 24 months, as the onset of COVID-19 has accelerated the structural shift of online. The group’s latest independent valuation of its Western Sydney sites has increased to $1.1b as at 31 March 2022, up from $0.9b in FY21.
Strong Balance Sheet Continues to Support Capital Management
The balance sheet remains in a very strong position, with net cash as at 31 March 2022 sitting at $177.7m. The Company is using the available cash balance to increase dividend payments (as disclosed land sales are expected out to FY24) and 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. Over the last 1-2 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, with demand conditions starting to ease, and pressure becoming evident on smaller players (i.e., insolvencies/financial difficulty), M&A opportunities may become available over the short-to-medium term.
Market concerns about declining housing starts from FY24 now see CSR shares are currently trading on a 1-year forward P/E multiple of ~11x, compared to ~12.5x at the time of the FY22 results release in May and ~17x around 12 months ago.
Overall, we see potential for further upside in CSR shares over the short term. Notwithstanding the moderate EPS growth profile of +4% over FY22-35 on a CAGR basis, the shares are trading at a significant gap to the average valuation of ~$5.60 per share. Importantly, while there is downside risk to the valuation for the Building Products division, overall group valuation is likely to be supported by the Property division, which is now comprising a greater portion of the group’s valuation (currently accounting for ~1/3rd of the group enterprise value).
After falling heavily in May-June, CSR then traded sideways to form an ascending triangle. It broke higher in mid-July on good volume. So far we have CSR respecting the breakout as it continues to climb higher. Momentum looks good and the share price is likely to continue rallying.
Michael Gable is managing director of Fairmont Equities.
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