Friday 9th February 2018
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Any buyer for Fletcher Building's construction division would likely want a discount for losses at its building and interiors (B+I) unit, according to analysts at Morningstar, but the company's existing Spanish partner says it isn't interested.
The Auckland-based company has scheduled briefings on Monday to update the market on "further material losses" at B+I that would cause it to breach debt covenants. A halt in its stock at the same time as the profit warning this week prevented the company being punished by the market, having fallen 23 percent this year. Morningstar says there's a high level of uncertainty about the stock's fair value, which it puts at $7.80, and it won't make any adjustments before Monday's big reveal.
Acciona, which is in a design and build joint venture with Fletcher Construction for the 18.5-kilometre Puhoi-to-Warkworth extension of Auckland's Northern Motorway, says it has no interest in acquiring Fletcher assets. "We're not looking at buying anything," said Acciona Australia head of communications Julian Elliott. He declined to comment on whether there were other commercial arrangements with Fletcher that may be in the wings.
“We are not currently looking for acquisitions in the New Zealand market, instead preferring organic growth," the company said in an emailed statement. "We already have a strong working relationship with Fletcher, but any potential collaboration between our companies on future opportunities remains confidential for commercial reasons."
Puhoi-to-Warkworth is a public-private partnership (PPP) under which the Northern Express Group, which includes Fletcher, Acciona, the Accident Compensation Corp and a Morrison & Co fund, finance, design, construct, manage and maintain the motorway for 25 years. Fletcher says Spain's Acciona is "a leader in the development and management of infrastructure, renewable energy, water and services," according to its website entry on the motorway.
While Construction may or may not be for sale, Morningstar says it would be a positive outcome for the company to offload the business "given Fletcher's lack of expertise in managing large, complex construction projects." The firm's model assumes a valuation for Fletcher Construction of $550 million "but given the uncertainty around the ultimate size of the losses from B&I, any sale would probably come at a discount to our estimate."
Before 2017's losses, construction had contributed about 11 percent of annual ebit, although Morningstar's valuation equates to just 7.9 percent of the building company's market capitalisation of $6.97 billion.
Before this week's disclosures, Morningstar had been forecasting Fletcher's net debt/trailing ebitda ratio to reach 2.9 times. "These further losses clearly tip Fletcher to a level above 3 times ebitda, which we assume is the covenant level that, one of its covenant ratios," it says.
It describes Fletcher as still being "hostage to the construction cycle" despite its diversity and scale. At the group level "returns are below the cost of capital as the firm has made poor acquisitions in adjacent segments and new geographies and suffered execution issues in the Construction division. This has obscured the impact of a very strong housing construction cycle - an environment in which Fletcher should be generating good earnings growth."
Fletcher chair Ralph Norris apologised to shareholders in October for the company's mistakes as the company took a further $125 million provision against problematic construction contracts including the Convention Centre and the Justice Precinct in Christchurch and said its B&I unit would report a full-year loss of $160 million for 2018.
Its 2018 full-year earnings guidance, excluding B+I loss, is $680 million to $720 million, suggesting full-year earnings including B+I could be as low as $520 million. Morningstar analysts say they aren't confident Fletcher will be able to sustainably keep its return on invested capital above its cost of capital even with "steady ebit growth across most divisions."
Across its five divisions, Morningstar gave mixed reviews. Distribution, which includes "crown jewel" PlaceMakers, makes up a third of sales and a quarter of profit, and is expected to produce ebit margins reaching 5.5 percent over the medium term. International has Formica and Laminex and roof tiles - products with low pricing power but may generate long-term ebit growth of about 6 percent.
Construction offers "profitable growth driven by higher-margin, lower-risk infrastructure projects" Morningstar says. It assumes any further losses on the Convention Centre and Justice Precinct contracts are now fully provided for in the first-half 2018 results "but until these projects are complete we cannot be certain." With the addition of the Higgins infrastructure business, the analytics firm "expect Fletcher to win a high share of new projects contributing to long-term ebit."
Morningstar has a 'neutral'rating on the stock and a fair-value estimate of $7.80, just north of the $7.77 it traded at before being halted. Fletcher faces the challenge of either improving returns from under-performing businesses "or divest non-core operations and concentrate on where it has the strongest competitive advantage. Bigger is not always better".
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