This is an extract from our September 2022 Quarterly Commentary and you can read the full Quarterly Commentary here.

Introduction by Simon Mawhinney, CFA, Managing Director and Chief Investment Officer

Accurate answers to questions about the precise trajectory of interest rates and their future impact on the economic cycle would be wonderful in our line of work. This perfect foresight would almost certainly result in us constructing a different portfolio to the one we have today. We would probably generate far better future returns for you than the ones we’ll ultimately deliver, too.

But an obsession with macroeconomic forecasting would introduce a near 100% likelihood that we would get these answers wrong. In the process, we would also be shifting from a contrarian investment philosophy to something more like a momentum-based strategy. Given today’s economic uncertainties, our portfolio would likely be filled with healthcare and supermarket shares whose earnings are unmistakably defensive and we’d ignore the astonishingly high multiples of current earnings that they cost at the moment. We would then devote our efforts to trying to time our rotation into the next hot stock so that we would be perfectly positioned to capitalise on the gathering momentum before the herd follows. Few do well from such a strategy and for those that do, we believe luck plays a far greater role than most would like to admit. Fewer still can consistently repeat the feat.

In our view, a far less risky way of generating consistently superior returns requires comparing the price of a security today to the likely future earnings one expects to derive from that security. The degree to which a company’s earnings are influenced by its point in the economic cycle is itself irrelevant, other than to the extent it will impact future earnings. All that matters is price and future earnings.

Today, the Allan Gray Australia Equity portfolio owns many companies whose earnings are likely to fall significantly in the years ahead, but whose price today is reasonable despite the economic headwinds that might unfold. Most investors shy away from buying companies that are likely to exhibit a decline in earnings in the short term, regardless of the price at which the company trades. This creates the opportunity for us to invest in companies at a discount to fair value. Fletcher Building Limited is one such company, which analyst Sudhir Kissun discusses below, and which the Equity portfolio has held for some time.

 

Fletcher Building Limited, by Sudhir Kissun, CFA, Analyst

Fletcher Building is a New Zealand-headquartered conglomerate that focuses on the building and construction sector, with half of its revenues coming from the residential building sector and the other half from the commercial and infrastructure sectors. Geographically, two-thirds of its revenue is from New Zealand and one-third from Australia.

Fletcher Building’s activities encompass almost a thousand operating sites, spanning the entire value chain from extraction through to manufacturing, distribution, development and construction. The company’s business segments are described below, and Graph 1 shows the contributions to revenue and operating profit from each of these.

• Building Products: Manufactures a range of building products, with plasterboard, insulation, pipes, steel roofing and sheds, and laminated panels for kitchen or bathroom benchtops and cabinets contributing most of the revenue.
• Distribution: Operates two retail store networks, one selling hardware products (the PlaceMakers store network) and the other selling bathroom and plumbing products (the Mico store network).
• Concrete: Owns and operates quarries from which it extracts limestone and aggregates. Converts limestone extracted from quarries into cement. Manufactures ready-mixed concrete, bagged concrete, concrete blocks, and concrete pavers.
• Australia: Encompasses a range of businesses across building products (laminates, insulation, pipes, and steel products), and distribution (bathroom and plumbing products within the Tradelink store network).
• Residential and Development: Develops, builds and sells homes and apartment buildings. Develops and sells surplus land owned by the company.
• Construction: Engages in construction of commercial and infrastructure projects. Also does civil engineering work and manufactures asphalt for roading work. This segment includes the troubled New Zealand International Convention Centre (NZICC) project that is not yet complete.

Graph 1 | Contribution to revenue and operating profit by business segment FY22

Source: Fletcher Building company reports, Allan Gray. May not total 100% due to rounding.

Are we nearing the peak in the current earnings cycle?

This company’s earnings are inherently cyclical, since building activity tends to rise and fall with the economic cycle. Fletcher Building’s earnings should rise at a faster rate than its revenue in an upturn and fall at a faster rate than its revenue in a downturn because its fixed costs, as the name suggests, remain relatively constant regardless of where we are in the cycle.

Graph 2 shows Fletcher Building’s earnings over the past 15 years, with the cyclicality and operating leverage evident. In the aftermath of the global financial crisis, for example, we estimate that Fletcher Building’s revenues fell 20% from peak to trough and the operating margin compressed by four percentage points, which nearly halved operating profits. During this period, dwelling consents in New Zealand almost halved, from 26,500 in financial year 2007 (FY07) to 13,500 in FY11.

Graph 2 | Fletcher Building’s earnings before interest and taxes (EBIT), adjusted*

Source: Fletcher Building company reports and commentary, Allan Gray. Note: *Estimated after adjusting for lease expenses, acquisitions, disposals, and the impacts of COVID-19.

Building activity levels in New Zealand and Australia have been elevated for the past few years. In New Zealand, dwelling consents in FY22 had risen to over 50,000 compared to the 30- year average of around 25,000 per year, while in Australia dwelling approvals in FY22 were a little over 200,000 compared to the 30-year average of around 175,000 per year. These elevated activity levels are reflected in Fletcher Building’s reported EBIT for FY22 and its guided EBIT for FY23. The cycle was strengthened after the onset of COVID-19 by the lowering of interest rates and the additional liquidity that governments injected into the economy in the form of wage subsidies and grants for new home construction and residential renovations. Now that these stimulus measures have been removed and interest rates are rising at pace, many investors (including us) are likely to conclude that we are at or near the peak in the building cycle. This would imply that a downturn is imminent.

The share price has come under pressure recently

Graph 3 shows Fletcher Building’s share price over time and how the Equity portfolio’s holding has changed. While we can’t be sure exactly why Fletcher Building’s share price has been falling for the past year, the prospect of a downturn in building activity is a likely explanation. Even though it might be tempting to sit on the sidelines and wait for the cycle to hit rock bottom, it is important to remember that sharemarkets are forward looking. Share prices usually hit the bottom well before the cycle is at its lowest. In the case of Fletcher Building, its share price may already factor in the impact of a modest economic downturn.

Graph 3 | Fletcher Building’s share price and the Allan Gray Australia Equity Fund’s holding

Source: FactSet, Allan Gray, as at 23 September 2022. The Allan Gray Australia Equity Fund is representative of the Equity portfolio, which includes institutional mandates that use the same strategy.

The valuation is compelling

With a share price at the time of writing in late-September of NZ$5.16 per share, Fletcher Building has a market value of NZ$4.0b. Added to its very manageable net debt of NZ$0.9b, its enterprise value is NZ$4.9b. As shown in Graph 2, we estimate that its lowest EBIT in the past 15 years was around NZ$420m (this is after adjusting for businesses that Fletcher Building has disposed of and therefore will not contribute to earnings in the future). The market is valuing the company at a little less than 12 times this depressed level of EBIT. Not only is this meaningfully below the broader sharemarket multiple today, but it is also likely that earnings from this depressed level would grow significantly faster than the market (and therefore warrant a higher multiple than the market). In our experience, this type of situation, in which the market is offering us a company at a lower-than-market multiple of depressed earnings, has the makings of a compelling investment opportunity.

When we value cyclical companies, we try to gauge what the company might earn on average through the cycle, across good times and bad. We believe a sustainable mid-cycle EBIT for Fletcher Building should be in the region of NZ$600m, which is almost 30% below management’s guided EBIT for FY23 of NZ$820m (the possible peak of the cycle, shown in Graph 2). Mid-cycle EBIT of NZ$600m would result in net earnings after interest and tax of approximately NZ$400m. It might not be unreasonable to ascribe a price-to-earnings (P/E) multiple of 16 times to these mid-cycle earnings, which would equate to a market value of NZ$6.4b or approximately NZ$8.15 per share. Compared to the share price of NZ$5.16, this represents potential upside of over 50%.

We were therefore loath to sit on our hands and pass up this opportunity in anticipation of a share price low that may never arrive.

Where might we be wrong?

There are a few issues that we worry about:

• Fletcher Building’s Construction division experienced significant cost overruns on a handful of fixed price contracts about five years ago, most notably the ill-fated NZICC project which is still underway and could incur further cost overruns. The large provisions the Construction division has taken to cover the additional costs of completing these projects have pretty much wiped out all the profits earned by this division over the past 20 years. If these types of cost blowouts are to be expected from time to time, it’s plausible this division may just about break even rather than earn the $25m of after-tax profit that we expect from it.
• It’s hard to know whether the Residential and Development business should be valued as an ongoing contributor to earnings or whether it has a finite lifespan, capped by the extent of the company’s current land bank. The company has been supplementing its historical land holdings with purchases of new land parcels over time and will also convert the quarries it owns into residential land once depleted. Our view is that a strong case can be made for this being an ongoing business and therefore a P/E ratio of 16 times would value the business at NZ$1.3b. Nevertheless, we are mindful that if we are wrong and this business has a finite lifespan, the company’s independent external valuer has placed a value of NZ$950m to NZ$1.05b on these property assets (in their current form).
• Fletcher Building has had a regular procession of restructuring charges over the years that have been a drag on after-tax cash flows to the tune of an average of NZ$30m per year. It’s possible that these sorts of costs could be a recurring feature going forward, during for example, future economic downturns.
• The company is planning to spend NZ$500m of capital expenditure (capex) on growth initiatives over the next three years, with a target return on capital of 15%. If it manages to meet its target, it would be an excellent outcome for shareholders. However, as prudent investors, we also need to consider what the impact might be if this capital generates a meagre return.

In Table 1, we provide a summary of our assessment of the share price impact of the concerns listed above.

Table 1 | Estimated share price impact of potential negative outcomes

Source: Allan Gray.

The estimated cumulative impact of all these negative outcomes transpiring would be around NZ$2.20 per share and would reduce the mid-cycle valuation from NZ$8.15 to just under NZ$6 per share. It is highly improbable that all these adverse outcomes would materialise simultaneously. However, even in the unlikely event that they do, compared to the share price of NZ$5.16, this would still leave us with potential upside of around 15%, which we regard as a good outcome.

There is a reasonable margin of safety

We have a high degree of conviction that, at the price the Allan Gray Australia Equity portfolio has paid, there is room for a lot to go wrong before the investment thesis for Fletcher Building is dealt a terminal blow. We are therefore comfortable to hold the current portfolio weight (or even increase it slightly) while we wait patiently for the value in this company to be recognised by the market.