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Morningstar | Cyclical Peak in Fiscal 2018 for No-Moat Brickworks

A resilient detached housing market saw no-moat Brickworks deliver adjusted EBIT of AUD 280 million in fiscal 2018, 6% ahead of our expectations and also ahead of market consensus. In spite of this, shares traded approximately 5% lower on the result, with management’s outlook for the building products segment clearly disappointing a market that was overly optimistic about the durability of the current housing cycle. While the business is tracking largely in line with our expectations, we place Brickworks under review pending the transition of coverage to a new analyst this coming week.

Building products segment EBIT grew 16.8% year on year to AUD 76 million, slightly ahead of our expectation for AUD 73 million, on segment revenue growth of 7.4% to AUD 820 million. Bricks, the largest division within the segment, delivered the lion’s share of revenue growth, growing 8% to AUD 447 million. While total housing commencements fell 1.6% in fiscal 2018 from unprecedented levels, a brick industry that has been operating at full capacity on the East Coast since fiscal 2017 provided for a backlog of work that has offset the easing of construction activity during the year. Sales volumes thus grew and drove revenue growth in fiscal 2018. Looking forward, we expect softer volumes to drive an approximate 3.5% reduction in building materials revenue to AUD 792 million in fiscal 2019, while increased energy prices and the unwinding of manufacturing operating leverage influence our fiscal 2019 EBIT margins forecast of 7.5%, down from 9.3% in the prior year.

Meanwhile, Brickworks’ investment in Soul Patts delivered EBIT of AUD 122 million in fiscal 2018, up 19% from the prior year. Increased earnings from its largest investment, New Hope Coal, was the primary driver of the improvement. The property segment also delivered improved earnings, with segment EBIT up 4% to AUD 94 million.

Conditions remained subdued in Western Australia, or WA, but restructuring activities in the WA bricks operations led to a reduction of losses in this geography and saw the building products segment EBIT grow ahead of segment revenue. Segment EBIT margins thus widened to 9.3%, up from 8.5% a year earlier. While smaller contributors to segment revenue at 17% and 13% of segment sales, respectively, roofing and masonry also made meaningful contributions to revenue growth. Revenue for the two divisions grew 6.6% and 23.3%, respectively. Meanwhile, precast sales fell 8.5% to AUD 73 million due to the closure of the Melbourne plant, while timber sales were also lower, falling 5.1% to AUD 45 million.

Management acknowledges that residential construction activity will decline in East Coast markets, in line with our view. Sales into the Sydney multifamily dwelling market have been particularly soft in early fiscal 2019, and Brickworks expects construction activity to fall around 10% over the next two years to approximately 180,000 dwelling completions. While we agree in directional terms, this forecast remains ahead of our own. We still expect completions to fall to roughly 170,000 completions in fiscal 2023 before staging a recovery thereafter. Further, management have conceded that the previously announced energy price increases, to take effect in January 2019, will not be fully recovered in selling prices, given challenges in a declining market. Margins will therefore be affected in the near term with little opportunity to recoup lost margin as the cycle turns. We therefore see EBIT margins softening to 7.5% in fiscal 2019, with lower brick demand resulting in lower operating leverage and also contributing to contracting margins. On a positive note, the previously announced industrial action by unionised NSW Austral Bricks workers has been resolved, and no disruption to operations or sales impact are expected.

A lack of undeveloped land sales in the property segment in fiscal 2018 saw profits from this source come in materially lower than the prior year. Offsetting this were strong revaluation gains and earnings from the announced sale of the Oakdale South development in Western Sydney, while development profits of AUD 29 million relating to the completion of assets at Oakdale Central and Rochedale provided further one-time upside. Net trust income, which represents the stable, recurring rental earnings stream from the property segment, grew 20% to AUD 22 million. In line with expectations for growth in rental receipts, we expect trust income to grow at a five-year CAGR of 2.2% to AUD 26 million over the forecast period.

The balance sheet remains strong, with net debt/equity at 15% at year-end fiscal 2018, unchanged from a year ago and comfortably below the group’s upper gearing limit of 20%. Despite the housing cycle now turning, we see gearing reducing over medium term to below 10% with less cyclical earnings from the investments segment providing free cash for debt reduction.