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Reconstructed Fletcher Building faces stress test

Shoeshine

Friday 21st November 2003

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Calling an end to the Fletcher Building party is a hazardous occupation, as many an analyst will be able to attest.

Even the company itself has got it wrong. Back in February chief executive Ralph Waters warned demand for the company's products could peak in that quarter, adding it would be a big ask to achieve the same level of earnings in the traditionally higher-earning second half as it did in the first.

Analysts took what they thought was the hint and downgraded their forecasts, only to be berated by a frustrated Waters for reading too much into his comments.

Building in fact romped in with record annual ebitda (earnings before interest, tax, depreciation, and amortisation) of $331 million and the share price peaked at $4.44.

At the annual meeting last week Waters and chairman Roderick Deane both conceded the domestic construction market slowdown everybody had been expecting had not materialised.

Waters went on to make more bullish noises still. He told an NZX seminar in Wellington he would be "disappointed" if June 2004 ebitda didn't reach $400 million, prompting one fund manager of Shoeshine's acquaintance to question whether he and Waters were living on the same planet.

Analysts, a bit gun-shy perhaps from previous premature downgrades, don't seem to agree. Most estimates of the June 2004 ebitda are at least within striking distance of $400 million, although the financial year is still young.

One reason for Waters' optimism is that, even if the cycle turns tail sooner than expected, the impact won't be felt in this year's earnings as Building supplies materials in the actual construction phase and has a full order book for consents already issued.

Despite the rosy outlook, the share price has taken a turn for the worse lately, falling to just over $4.

The share price was also partly reacting to last month's tightening by the Reserve Bank of Australia, which again warned the housing market was getting overheated.

Also, analysts say, the market is looking through 2004 earnings and anticipating the 2005 year when, according to the pundits anyway, the party really will come to an end.

This week, for example, PMI Mortgage Insurance predicted house prices would start to cool from early 2005 as population growth eases and the building boom starts to catch up with demand.

The question then will be whether Building's earnings will simply drop away with the cycle as they have done in the past or whether the renovations Waters has overseen have made the company a more resilient structure.

Much depends, of course, on how the Australian market is faring.

Some observers were taken aback when Building bought Laminex in September 2002, arguing the acquisition was at the top of the market and worrying the company had taken on too much debt.

So much for that. Laminex has exceeded even Waters' estimates of 2003 earnings and Building has gladly handed over a further $A16 million for it, taking the total purchase price to $NZ759 million.

Fainter hearts fluttered again in August when Building paid $260 million for Tasman Building Products. As with Laminex, Building part-funded the acquisition by placing shares. The purchase took the ratio of debt to debt-plus-equity to just over 50% and the company plans to whittle that back down to pre-acquisition levels before the year is out.

Worries about Building's debt levels are misplaced.

Given the company is now earning double its cost of capital or better, the argument could be made that it's undergeared. But it has plainly chosen to take a conservative position, recognising construction on either side of the Tasman can't stay strong forever.

The point is that even if a pretty severe slowdown comes, the company is in a position to continue to create shareholder wealth, not destroy it. The share price will as ever ebb and flow according to the cycle but to investors, as opposed to speculators, that doesn't matter provided the long-term trend is upward.

A telling sign of investors' confidence in the company is the ease with which Building got away with share placements to fund its two Australian acquisitions.

Another is the dramatic growth of Australian institutional investors on the share register ­ from just 2% two years ago to nearly 27% in the latest annual report.

It's interesting to speculate to what extent that's because Building has an Australian chief executive with a well-known and respected track record across the Tasman.

It no doubt also reflects Building's increasing exposure to Australian assets.

Whatever, it's a level of interest no other New Zealand company, to the best of Shoeshine's knowledge, has ever been able to achieve.

Waters attributes Building's high return on investments to its vertical integration. Through the construction arm and the Placemakers trade and retail outlets it controls much of the distribution of its own products, allowing it to exert a considerable degree of margin control.

In that light Carter Holt Harvey's decision to sell off its tissues business, a high-margin consumer products outlet for its wood fibres and one of its highest-earning businesses, is truly perplexing. If tissues is non-core, what's core? Growing trees?

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