EUR 850.00 For Business Accounts Only

Morningstar | Formica Divestment Yields Balance Sheet Flexibility for Fletcher; FVE Unchanged on Analyst Transfer. See Updated Analyst Note from 14 Jun 2019

We retain our fair value estimate of NZD 6.70/AUD 6.50 per share for no-moat Fletcher, following a transfer to another analyst. Expectations for Fletcher are largely unchanged. Shares continue to screen as cheap, trading at about 24% discount to fair value. We continue to expect the top line to grow at a 10-year CAGR of 0.5%, with the divestment of Roof Tile Group (RTG) and Formica Business contributing to the flat top line. We expect EBIT margins to rise to a midcycle level of just over 7.4%, excluding joint venture, or JV, profits, up from a nadir of 0.3% in fiscal 2018. Tighter control of costs, operating leverage in the distribution division, and a higher mix of infrastructure construction projects relative to commercial projects will all contribute to an improvement in the margin. We expect EBIT of NZD 643 million, inclusive of JV profits, in fiscal 2019, up significantly from NZD 50 million in fiscal 2018.

We retain our no-moat and high uncertainty ratings. Following the substantial losses sustained in its construction segment in fiscal 2018, Fletcher has taken corrective action--divesting its global Formica business and backing away from commercial construction projects. But we would have liked to have seen a more comprehensive restructure, involving a marked reduction in the group’s level of diversification. We advocate that Fletcher refocus the group’s attention on its businesses, which are well positioned competitively. T he potential for management to create value for shareholders increases when it's f ree from the distraction that comes with the ownership of a plethora of disparate businesses.

The dividend was suspended in fiscal 2018 but management reinstated dividends in first half fiscal 2019. The company looks to pay out between 50% and 75% as dividends and we expect a full-year dividend of NZD 0.28 cents (fully franked to New Zealand shareholders) in fiscal 2019, as gearing falls well below target gearing range of 1.5-2.0 times net debt/EBITDA.

Fletcher Building does not possess an economic moat in our view. The company is highly diversified across a range of product segments and end markets, with a large number of subsidiaries. While a limited number of Fletcher’s businesses do possess competitive advantages, about 60% of group earnings are derived from the manufacture of building products, which lack material differentiation in the marketplace, and from construction activities in which Fletcher lacks sustainable advantages. By division, distribution appears to have an economic moat based on intangible assets, namely the brand and the service levels the PlaceMakers chain has built with its core base of small and medium-size builder clients and is reflected in the high return on funds employed in that segment. Certain segments in the building products division, such as its plasterboard business Winstone Wallboards, also appear to have a narrow economic moat. But the lack of a moat at group level is apparent with the company’s historical returns on invested capital, or ROICs, after reaching an average 5.4% for the past five years and 5.9% over the past decade, comparing unfavourably with the cost of capital, estimated at 9.1%. With divestment of the International Formica business now complete, we expect group ROICs to improve marginally to an average 6.4% over the next five years, but will remain sub-cost of capital.