The shaky isles

About half of Fletcher Building’s business is sourced in New Zealand with most of the rest in Australia. The Christchurch earthquake could eventually be a strong source of demand as rebuilding efforts will eventually create demand around the city. It is too early to estimate the damage bill but the repair bill should be a boost for construction material demand.

“Without appearing to be mercenary, Fletcher Building has a great opportunity to help the Christchurch region in a substantial way”

Fletcher’s recently released 2010 profit result showed an encouraging second half improvement after a difficult first half year. At NZ$301 million excluding unusual items, the net profit for the year was only slightly lower than the prior year at NZ$314 million. Operating earnings of NZ$521 million was also down on the previous year and operating cash flow was also slightly down. The company declared a fully franked final dividend of 15 cents per share bringing the full year total to 29 cents per share.

Throughout June to early August, Fletcher Building had declined sharply which saw the RSI dip into deeply oversold levels. The intraday low printed was $5.61 on August 17. Due to the oversold nature, strong buying pressure emerged, which resulted in a strong upward move, breaking above both the 50 (green line) and 200 (period moving averages). This is an indication of a change of trend to the upside.

The rapid appreciation in price has now seen the RSI reach overbought territory, which is indicative of an exhaustive move to the upside. We would expect a countertrend move lower in the near term, which should find support at the 200 period moving average at $6.29, before a resumption of the upward move.

In a year of ups and downs at the divisional level, Laminates & Panels almost doubled while the Steel division lagged the strong prior year result. Overall, the group result was boosted by cost reduction initiatives and improved trading conditions in New Zealand and Australian residential housing.

Government infrastructure spending has been more difficult to pin down but remains a positive factor for future demand across the next two years. It is likely that demand will get another kicker from last week’s 7.1 magnitude Christchurch earthquake, depending on the willingness of the government to act quickly on crucial projects.

Christchurch earthquake

Fletcher Building was quick off the mark with a $1 million donation to the relief fund and this has been nudged up by the NZ government’s $5 million pledge. But this money is a fraction of the total repair bill that is likely to be required.

So far, the Earthquake Commission in New Zealand has received over 15,000 claims from local residences as the aftershocks (at least 58 so far) are still rumbling through the region. The Prime Minister has said that over 100,000 homes have been damaged in the quake. More than 500 buildings in the central city are damaged, 90 of them significantly and will likely need to be demolished and rebuilt. Roads and other core infrastructure will take much longer to assess. Even if the damage is immediately obvious, the cost and estimated time for repair will take weeks and months to calculate.

Our early guess at the final bill is simply based on local press reports which put the figure around NZ$ 2 billion.

Without appearing to be mercenary, Fletcher Building has a great opportunity to help the Christchurch region in a substantial way. It is supremely positioned to help get people’s lives back together, even if it does have an obvious pecuniary interest in doing so. The company is a New Zealand icon and will be bending over backwards to break out the no. 8 fencing wire attitude to getting its back yard into order.

2010 review

The following table shows the earnings by division for the 2010 year.

Building Products sales growth was up due to the Australian government’s insulation program although this was terminated early in February leaving a large amount of unsold inventory. A restructuring charge of $18 million was incurred as a consequence of the suspension of operations at the Sydney and Melbourne glass wool manufacturing plants. Government stimulus in New Zealand also helped this division. Plasterboard and roof tile sales were weaker during the year.

Flat sales in the Distribution division masked the stronger sales momentum in the second half of the year. The Placemakers business is the equivalent of Wesfarmers’ Bunnings business and is equally as dominant in NZ. The 9.6% sales decline in the first half was more than offset by the 10.2% recovery in the second half. It is this momentum that could begin to see Fletcher’s earnings begin to head back to mid-cycle normality and is one of the reasons behind our preference for this stock as a recovery play on New Zealand as well as the Australasian housing markets.

Residential building consents have increased 13% in New Zealand but are still lower than normal activity. The New Zealand housing market should eventually recover to around 21,000 starts per annum from the current low level of about 16,000 in 2010. The timing of this recovery is perhaps the more difficult aspect to gauge.

Concrete sales were down on New Zealand as weakness in the commercial construction market continued. This factor is taking longer to recover and makes the government infrastructure spending more important for the intervening period. Construction billings were up on the prior year, however, as the backlog of work begins to accumulate.

Steel sales were down for similar reasons as lower demand affected volumes and prices.

Earnings from Laminates & Panels of $141 million was much better than FY09 but included some one-off gains. Nonetheless, earnings from Laminates was up 63%. Pricing of product was flat as competition for volume heated up throughout the year. During the year, Fletcher’s closed some of its capacity to align with market demand and has taken some significant cost out of the division. This will set the business up with greater operating leverage when conditions improve. The remaining facilities are now running at full capacity except for the Melbourne plant. The Queensland medium density fibreboard plant is due to be commissioned in late 2011 so group capacity still has some upside when demand picks up.

Geographically, Fletcher’s earnings are dominated by New Zealand and Australia as shown in the table below:

In this regard, the company is less exposed to the weak American and European economies. We see this as a tactical advantage given the probability that the Australasian building and construction markets could recover sooner than other markets.

Fletcher Building had $1,219 million of drawn debt and ample capacity for other funding requirements. About 93% of debt is at fixed rates of 7.5% and an average maturity of 4.4 years. Interest cover for the year was 4.9 times.

Cash flow of $522 million for the year funded $191 million of capital expenditure compared to $289 million in FY09. About $137 million is estimated to be ‘stay in business’ capital expenditure.

Fletcher is continually seeking to align its capacity both geographically and according to industry demand. Operational efficiencies are helping to provide a better profit outcome which will be strongly demonstrated in any cyclical upturn.

Looking at the weekly chart, Fletcher is currently trading in a wide consolidation in between support at the 23.6% Fibonacci retracement of $5.81 and resistance at the 38.2% Fibonacci level of $6.99. An accelerated move higher will result in a convincing break above the $6.99 high. Should this occur, the potential move higher could target the 50% Fibonacci resistance level of around the $7.94 region over the longer term.

The company is obviously still cautious about the outlook for the current year. The pace of the residential and commercial building activity in New Zealand and Australia remains slow, supported to some extent by government spending. The latter is expected to slow in 2011 in New Zealand but pick up again into 2012.

We think Fletcher Building is still well placed to benefit from a construction upturn and a recovery in the New Zealand market. The FY10 result showed that sales and earnings momentum is returning, albeit slowly.

We will continue to hold Fletcher Building in the Fat Prophets Portfolio.