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Morningstar | Improved Earnings in Challenging Fiscal 2018 For No-Moat Fletcher; Construction Outlook Lower

No-moat Fletcher Building delivered a satisfactory fiscal 2018 result in a challenging year, with underlying EBIT of NZD 710 million, up 35% on the prior year. Operating income was within the prior guided range of NZD 680 million–720 million and in line with our forecast of about NZD 710 million. While we've revised our near-term margin expectations lower, we still expect to see gradual margin improvement over the coming decade, to 9.5% in fiscal 2027 up from our forecast of 7.5% EBIT margins in fiscal 2019. We expect margins to widen slower than our prior expectations and we reduce our fair value estimate by 7% to NZD 6.50 per share (AUD 5.90), accordingly.

Following a strong New Zealand residential market in fiscal 2018, where consents climbed 8%, and a toppish but nonetheless persistent Australian market, the outlook for both markets is softer in fiscal 2019. The revenue headwind from lower residential construction will be compounded by Fletcher's wind down of their loss-making B+I business within the construction segment. We expect the B+I backlog of NZD 1,784 million in projects to gradually complete over the next several years. Providing some offset, however, is infrastructure and nonresidential spending, which are expected to strengthen. We now expect group sales growth to ease slightly from our prior forecasts, growing at a 10-year CAGR of 1.8% with the front end of the decade challenged by the aforementioned headwinds. We expect more normalised sales growth to eventuate in the latter five years of our forecast period, however, averaging 4.1% a year.

Fletcher expect fiscal 2019 earnings to be largely in line with fiscal 2018, excluding land development which is expected to deliver lower earnings. Thus, around NZD 700 million in EBIT is expected by management. We concur and expect operating income of NZD 708 million in fiscal 2019, reflecting softer EBIT margins of 7.5% and revenue easing by 0.9% to NZD 9.38 billion.

The New Zealand and Australian residential construction markets represent roughly 40% of group revenue, after adjusting for the planned divestiture of the formica and roof tile segments, and thus activity levels are major determinants of Fletcher's growth trajectory. The recent strong activity in these markets combined with tightening credit, and restrictions on foreign ownership in Australia drive our forecast for lower construction activity looking forward. 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.

Total capital expenditure in fiscal 2018 of NZD 304 million was in line with our outlook, and led free cash flow generation of NZD 250 million, including the negative impact from B&I and came in ahead of our expectations. Looking forward to fiscal 2019, Fletcher is guiding for capital expenditure, excluding formica and roof tile, of NZD 275 million to NZD 325 million or approximately 3.5% of sales, slightly above forecast of NZD 263 million or 2.8% of next year's sales.