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Morningstar | Infrastructure Outlook Remains Positive for Adelaide Brighton Despite Cautious 2019 Guidance

Narrow-moat Adelaide Brighton’s delivery of full-year 2018 net income of AUD 191 million was no surprise to the market. But cautious guidance and an underwhelming 2018 final dividend led investors to question whether the substantial pipeline of Australian infrastructure projects can offset declining demand from residential construction. Adelaide Brighton is guiding to flat volumes across cement, concrete, and aggregates in 2019. While the market reacted negatively, guidance largely tracks our expectations for a minor decline in construction material demand in 2019 before growth returns once more in 2020. We’ve marginally upgraded our five-year sales CAGR to 5.3% from 4.8% on account of expected positive mix shift. But with midcycle EBIT margins lowered by 1% to 15% due to rising energy costs, our fair value estimate of AUD 5.00 per share remains unchanged. Adelaide Brighton shares continue to screen as fairly valued, trading at a 5% discount to our valuation.

The Cement, Lime & Aggregates (CLC&A) segment, which accounts for 97% of earnings, experienced mix shift in 2018 that was more adverse than we’d expected. Significant volumes of low-value aggregates to early stage infrastructure projects continued through the second half of the year, while a greater proportion of cement sales into more competitive east coast markets also contributed to the negative mix effect. CLC&A margins correspondingly fell to 19.8% in 2018, down from 20.5% in 2017. While cement volumes were in line with our 1% forecast, concrete and aggregates volumes were surprisingly strong, up 14% and 10%, respectively, and provided for segment top-line growth of 4.4% despite the negative impact of sales mix. We expect mix shift to reverse course over the coming two years, while price increases act to largely offset rising input costs. Nonetheless, we see segment EBIT margins of 17.5% at midcycle, around 1% lower than prior estimates due to rising energy costs that may not be fully recovered.

We forecast a five-year sales CAGR of 6.1% for the CLC&A segment, with volumes to deliver around 2% of this growth as infrastructure projects pick up the slack from waning demand from residential construction. Remaining top-line growth will be delivered from positive movement in price and mix shift. Nearer term, we forecast segment top-line growth of 3.9% in 2019, delivered entirely from price increases with neither volumes nor mix shift to positively contribute. In fact, volumes are expected to recede by a marginal 0.3% in 2019 before returning to 1.4% growth in 2020 as demand from infrastructure projects gathers steam. Mix shift is expected to be neutral in 2019 before sales of higher value aggregates increase to infrastructure projects as they progress toward completion and recovery of cement volumes in South and Western Australia yield positive mix shift in 2020.

Considerable balance sheet flexibility remains in place for Adelaide Brighton, with net debt/EBITDA of 1.4 times at 2018 year-end. As such, capacity remains for further downstream quarry and concrete acquisitions, where the economics are favourable. Return of capital to shareholders remains an option in the absence of value accretive downstream M&A targets. Earnings quality was again robust in 2018, with net income well supported by operating cash flow. Specifically, net income (before depreciation) was 92% operating cash flow backed, up slightly on 89% in 2017.