Slower Going Seen Beyond FY17 For Brickworks

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Brickworks has raised expectations for its investment portfolio and expanded margins in building products but several brokers note that beyond FY17, the cycle is turning.

-Full order book currently and unprecedented activity in land and development
-Favourable east coast market but significant restructuring in Western Australian operations
-Despite investment portfolio, exposure to residential construction cycle is substantial
 

By Eva Brocklehurst

Brickworks ((BKW)) has laid a solid foundation in FY16, beating earnings and dividend expectations for its investment portfolio and expanding margins in building products. Management is positive regarding Australia's housing outlook but provided no formal guidance with the results.

Deutsche Bank notes the order book is full and there is an unprecedented level of activity in the property trust in terms of land and development. Given housing demand on the east coast is robust, the broker expects further FY17 EBIT (earnings before interest and tax) margin expansion of 290 basis points to 13%.

All states delivered an improvement except for Western Australia. Land and development was driven by revaluations and new developments in the trust are expected to contribute $16m in gross rental income per annum. The trust is also expected to generate sales from land of $90m in late 2017. The first section of Oakdale West is likely to be sold into the property trust in FY17 and Deutsche Bank believes further upside for the stock exists when the development application is approved.

Investment earnings beat Macquarie's estimates but the broker is preparing for the turn, expecting housing activity will slow over 2017 and weigh on demand going into FY18. The negative effect of a slowing cycle is likely to amplify the impact of rising energy costs on brick operations. Gas prices are an issue for 2018, the broker contends, with increases of around 30% expected. Gas contributes 20% to brick production costs and the volatility in the price represents a risk.

While the company's cash flow improvement is positive, it includes a substantial increase in the receipt of dividends and distributions and when this is excluded, Macquarie calculates receipts from customers net of payments to suppliers actually declined 15%. Meanwhile, the pipeline of property realisations and low volatility profits from investments should support the business in the medium term.

While favourable conditions prevail on the east coast, Brickworks has engaged in significant restructuring of its operations in the west, following a rapid downturn in market conditions. The less efficient Malaga plant will close and the Cardup plant will be re-commissioned.

Macquarie finds the specialised building systems business, which Brickworks has now established, is an interesting development which, although in its infancy, should bring more diversity to the portfolio. Brickworks is employing a distributor business model for a range of lightweight panels, sheets and facades.

While building products will continue to benefit from both volume growth and price rises in the short term, Morgans is conscious of the fact that a peak is near and, henceforth, there will eventually be a PE multiple de-rating across building product companies.

The broker acknowledges the company's cross-holding in WH Soul Pattinson ((SOL)) makes it more than just a building products business but, nevertheless, it has considerable exposure to residential construction and obtained good leverage to the cycle over the past few years. The broker believes, with the stock now trading at a 3.5% yield and at a FY17 price/earnings ratio of 14x, the top of the cycle is nigh and the positive outlook is factored into the share price.

Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, envisages continued growth over the medium term as Oakdale Central and Rochedale are completed, upgrading FY17 forecasts by 4.5% to reflect the near-term momentum in building products and contributions from the Oakdale estates. However, the broker downgrades its FY18 expectations to reflect softening building activity and increasing gas costs.

The broker's forecast contribution from the investments division for FY17 and FY18 is also lowered, largely on the back of lower expected contributions from TPG Telecom ((TPM)), offset a little by increases to New Hope Coal ((NHC)) forecasts. The broker has a Hold rating and $14.03 target.

Citi suspects there is increased risk of the share price underperforming in FY17, although the well documented spread between dwelling starts and completions means earnings should remain robust, supported by property development, especially in a low interest rate environment. Catalysts may come from the AGM in November, or a pick up in underlying new residential construction, as well as an improvement in the market value of WH Soul Pattinson, of which Brickworks owns 42.7%.

As an aside, Deutsche Bank observes the cross-claim brought by Perpetual ((PPT)) against Brickworks and WH Soul Pattinson continues. The discovery process has commenced and will take some time to be completed. Brickworks incurred $2m in costs in FY16 related to the Perpetual litigation.

The FNArena database shows one Buy (Deutsche Bank) and three Hold ratings. The consensus target is $15.09, suggesting 14.2% upside to the last share price. This compares with $16.45 ahead of the results. Targets range from $14.00 (Citi) to $17.53 (Deutsche Bank).
 

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