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Morningstar | Fletcher Building Returns to Profitability, but End-Market Weakness Will Drive Near-Term Challenges

No-moat Fletcher Building’s first-half results were slightly below our expectations, with profitability pressure from weaker Australian markets, heightened competition, and input cost inflation. While we’re encouraged operating profits returned to positive levels versus a loss in the previous corresponding period, or pcp, the firm’s EBIT margin of 6% trails our full-year 7% forecast. Nonetheless, management’s updated outlook for the year for EBIT in a range of NZD 650 million to NZD 700 million tracks our projection of NZD 662 million, which increases NZD 20 million on the back of lower noncash depreciation expenses stemming from the upcoming sale of Fletcher’s Formica business. We continue to expect further top-line pressure from weaker Australian residential construction and easing New Zealand results, but also forecast profitability expansion toward a midcycle level of just over 9%. We maintain our NZD 6.70 fair value estimate, but our ASX-traded valuation rises to AUD 6.50 on the back of a stronger New Zealand dollar.

Revenue in the period fell 2.8% versus the pcp, in line with our full-year forecast, primarily due to declines in New Zealand construction as project backlog is worked off, weak building products revenue, a cement mill outage on New Zealand’s north island, and weakening Australian housing construction conditions. We expect further top-line pressure over the next several years. Together, the New Zealand and Australian residential construction markets represent roughly 40% of group revenue, after adjusting for the divestiture of the formica and roof tile segments, and we expect near-term weakness in both markets. Moreover, despite our forecast for rising infrastructure spend, we also anticipate weakening nonresidential commercial markets.

Supporting our opinion, management noted while New Zealand housing consents remain elevated, prices in the key markets of Auckland and Christchurch in New Zealand are flat to slightly declining, and lower average floor space in new approvals is leading to flat year-over-year total performance. Meanwhile, falling Australian residential consents--down 5.6% in calendar 2018--tracks our expectations. We expect New Zealand household consents to fall over the fiscal 2019-fiscal 2021 period, before returning to modest growth in fiscal 2022. We have similar expectations in Australia, and expect reductions in residential construction activity in Australia through to fiscal 2023 before returning to growth once more in fiscal 2024. And management also noted it is seeing growth rates easing in commercial activity. Including the impact of the divested segments, we forecast revenue falling at nearly 4% per year through fiscal 2023.

Conversely, we expect profitability to improve in the coming years. Fletcher felt a pinch in the first half from higher electricity and raw material costs, increased competition in a weaker Australian construction market, and one-time issues associated with the cement mill outage. Nonetheless, we foresee price increases to offset a portion of the rising costs, and along with restructuring in the Australian business, operating leverage in the distribution division, and a higher mix of infrastructure projects relative to commercial projects, anticipate EBIT margins climbing to 8% by fiscal 2024 and 9% over the next 10 years.

Fletcher’s balance sheet is in a considerably better position to weather the near-term top-line challenges. The firm finished the half with net debt/EBITDA of 1.7 times, markedly improved from 4.8 times in June 2018 following a sizable charge in the buildings and interiors business. We also see substantial deleveraging opportunity following the sale of the formica unit late in fiscal 2019, which should garner Fletcher NZD 1.1 billion in net proceeds. As such, the company reinstated its dividend in the period, declaring NZD 8 cents per share, unfranked, with an intention to pay out 50% to 75% of NPAT going forward.