Adelaide Brighton Stirs Cement Speculation

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-Uncertainty over supply networks
-Pressure on market share in SA?
 

By Eva Brocklehurst

A single contract supply agreement in the cement industry will be terminated at the end of this year. The announcement has sparked speculation over a complex chain reaction among cement suppliers which is difficult to quantify. For the moment, Adelaide Brighton's ((ABC)) major cement customer in South Australia and Western Australia, Cement Australia, is not expected to extend the current SA supply agreement beyond the end of 2014. Instead, Cement Australia intends to expand facilities in Osbourne, South Australia, and bring in its own volumes.

Currently, Cement Australia brings 500,000 tonnes from Railton, Tasmania, to Sydney. The demand in Sydney can now be met from the grinding facility expansion at Port Kembla – where Cement Australia has recently taken delivery of the first clinkers. Cement Australia plans to move some of the previous supply that was going from Railton to Sydney, to Adelaide. The logistics of moving some of the Tasmanian supply to Victoria are also featuring in broker considerations regarding the chain reaction in the cement industry.

Cement Australia's plans are expected to have a material impact on Adelaide Brighton's 2016 earnings. The company expects a loss of the 120,000t currently delivered on that contract to reduce 2016 earnings by $15m. Morgan Stanley observes that flow-through pricing in the SA market could be negative, should Cement Australia choose to import more than the required volumes into that market. Having said that, the broker notes that Adelaide Brighton has a cost advantage in the South Australian market and is well placed to defend market share.

The broker is not sure of the import volume restrictions in Melbourne but estimates Cement Australia's volumes could increase in that port by up to 260,000t, putting further pressure on pricing. Then, again, Adelaide Brighton may seek to use the expansion of import facilities in Newcastle, NSW, to put pressure on the market in both Victoria and NSW, in terms of margins. Morgan Stanley still perceives Adelaide Brighton's pay-out ratio over three years of 120% is possible. Nevertheless, the broker is cautious and presumes a 90% ratio. On that basis the 2015 yield is still attractive. The broker thinks the stock price reaction now more than accounts for earnings risk and retains an Overweight rating.

BA-Merrill Lynch also thinks margin pressure may ensue in South Australia. Cement Australia could also target the remainder of Adelaide Brighton's business there. The broker thinks Adelaide Brighton's earnings have been flat for four years now and the relative growth comparison to other stocks in the sector, combined with the premium to valuation at which the stock is trading, forms the basis of an Underperform rating.

Uncertainty prevails and other players may be affected as well. According to Macquarie, game theory will dominate the cement industry. The broker observes the stated impact of a $15m reduction to earnings in 2016 is made under a very defined set of market outcomes. This includes the loss of 120,000t of SA supply, that Cement Australia takes no more than its current volumes into the state, and that Adelaide Brighton does not try to mitigate the loss by raising the volumes it sends to other regions. The broker notes Boral ((BLD)) has been selling 150,000t of NSW cement to Cement Australia and, with Boral committing to run its Berrima plant at full capacity, this would suggest a substantial volume of cement is now looking for other markets. Macquarie has reduced earnings forecasts by the stated amount, but will evaluate the impact further depending on how the strategic positioning plays out.

UBS observes Cement Australia already took 50% of its Western Australia contract away from Adelaide Brighton in 2010, at a cost of $10m pre-tax. The broker believes Adelaide Brighton will try to ship its over-capacity in South Australia to other markets and this could lead to price competition, benefitting independent concrete producers in NSW and Queensland. Adelaide Brighton could even contemplate shipping cement to Auckland, New Zealand, where Holcim – one of the partners in Cement Australia – is considering building new import clinker grinding facilities. The balance sheet is under-geared, in UBS' view, but the broker has removed the 3c special dividends forecast for 2014 and 2015, while reducing 2016 dividend by 0.5c.

JP Morgan thinks this is the opening salvo in a re-positioning of the southern Australian marketplace and Adelaide Brighton is the first "victim" of the soon-to-be commissioned Port Kembla grinding mill. The new SA facility could be built by the end of this year but Adelaide Brighton expects it more likely next year. As South Australia is one of Adelaide Brighton's highest margin markets, JP Morgan wonders whether Cement Australia will try to take market share in South Australia, or Victoria, from Adelaide Brighton to fill the excess capacity coming from Railton.

As Cement Australia owns the land and a port at Osbourne, Deutsche Bank thinks the construction of the facilities is relatively inexpensive and straight forward and could feasibly be completed at the end of this year. Hence, the broker reduces 2015 profit assumptions by 15%. Further contract losses may be possible but Deutsche Bank does not think Cement Australia will look to import more cement into Western Australia as it lacks the necessary land and port facilities, or a cement grinding facility for that matter.

The market has over-reacted. That's CIMB's take. The broker suspects that Adelaide Brighton may have alternatives for mitigating the impact of the contract loss. The timing of the new facilities to be constructed by Cement Australia is uncertain and the $15m profit decline forecast for 2016 is a "worst case" scenario, in the broker's view, which assumes all volume currently associated – around 120,000t – is lost. As the stock is now fairly valued CIMB has upgraded the rating to Hold from Reduce.

There are two Buy ratings, four Hold and one Sell on the FNArena database. The consensus target is $3.87, suggesting 3.1% upside to the last share price. This target compares with $4.03 ahead of the announcement. The dividend yield on 2014 earnings forecasts is 5.9% and on 2015 it's 6.0%. Price targets range from $3.50 (Merrills) to $4.25 (Credit Suisse).
 

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