Adelaide Brighton multiplies its returns

Boral, Brickworks and CSR are suffering from the reverse multiplier effect, but ABC isn’t.

PORTFOLIO POINT: Adelaide Brighton’s return on equity is about three-times that of its industry peers, although it is trading above its intrinsic value.

Extra income leads to more spending, which creates more income, and when this income is spent, this spending becomes someone else’s income, and so on.

The effect is known as the multiplier effect. If consumers spend 80 cents of every extra dollar of income, the multiplier effect would be a five-fold increase in income.

The multiplier effect refers to the increase in final income arising from any new injection of spending.

But a bit of night-time reading has revealed there are sectors of the Australian economy where the multiplier effect is working in reverse. The Australian Bureau of Statistics’ release of housing starts data showed the number of houses built in NSW in the March 2012 quarter was 5,158, seasonally adjusted. This was more than 40% lower than the previous corresponding quarter and '¦ wait for it '¦ the worst quarter since 1951.

Big falls were also recorded in the ACT (-41%), Tasmania (-16%) and Victoria (-8%), and they combined to deliver a 13% national decline. Analysis of total unit dwellings commenced (houses plus flats) reveals a 25% decline on the March 2011 quarter.

And here’s the multiplier effect in reverse.

It starts with administrators being called into St Hilliers, Reed Construction Australia and the century old Kell & Rigby.

Insolvency firms are seeing many building businesses crawl through their doors. To keep cash flowing through the door, these builders competed for jobs with little or no margin.

Their closure then causes builders, tradesmen, manufacturers of building materials and retailers of anything housing-related to pull their hair out, if not pull up stumps too.

Investors must realise that the impacts of these events cannot be quarantined. Like a pebble dropped in the middle of a pond, the ripples eventually touch every corner of, and every community in, that pond. And as the ripples expand, each wave leaves opportunity in its wake.

While the value of work done in residential construction – accounting for around 23% of the $200 billion per annum construction industry – is declining, the Australian construction industry continues to grow at 15%, thanks to the Aussie resource sector. So investors must differentiate between exposure to residential and other construction. The first major question, among many on my mind however, is, are either any good?

Analysis of the ASX-listed building materials stocks is generally not good reading. Each of Boral, Brickworks and CSR are expected to deliver their shareholders an estimated 5% to 6% normalised return on equity for fiscal 2012 and fiscal 2013.

But these rates of profitability are about half their average return on equity over the past decade and hardly worth the risk of owning such a business. This raises two further questions. First, given these three companies are under-earning relative to their 10-year average annual return on equity of 10% to 12%, is the current slump in their earnings structural or cyclical? If it’s structural, walk away and ask no more. If it’s cyclical, do they warrant further scrutiny or are they simply bad businesses?

Second, why is Adelaide Brighton Cement (ABC) an outlier with its 10-year average return on equity at 16%, and its forecast return on equity for fiscal 2013 at 17%, approximately three times that of Boral, Brickworks or CSR?

Answering question two first; Adelaide Brighton Cement is engaged in the manufacturing and distribution of cement, lime, premixed concrete, aggregates, sand and concrete products. Its differentiated positioning is the source of its higher returns.

While its end-use markets include residential and non-residential construction, engineering construction, alumina and steel production, it is also focused on mining. And in South Australia, Western Australia and the Northern Territory, its cement and lime production has limited competition, allowing it to reap higher returns.

Fig 1. Skaffold Quality Scores for ABC 2002 -2011

Over a decade to December 2011, Adelaide Brighton Cement’s revenue has grown consistently from $486 million to $1,100 million, a compound average annual growth rate of 8.5%. Over the same period, pre-tax earnings have jumped from $67 million to $206 million and pre-tax profit to sales margins have improved by 5% to 18.7%. The company has also done this while maintaining its return on equity.

The only blemish is the tendency of the company to bite off a bit more than it can chew. The 2011 results were typical. The company generated cash flow from its operations of $155 million. It then invested $134 million in itself and/or acquisitions. This left the company with $20 million of surplus cash for dividends. Instead, the company paid $120 million in dividends. The result? An additional $109 million of borrowings.

The debt suggests management is switched on to their profitability responsibilities and, over time, even though share-on-issue increases (the company has paid a little more for additions to PP&E than it can afford to – or is it dividends?) have been consistent, the company has maintained the return on the additional equity capital.

The only thing I don’t like is that the share price, supported by the excessive dividend (it cannot keep biting off more than it can chew), has been persistently above the intrinsic value of the company on a per share basis. Indeed since 2006 the shares have only traded below intrinsic value once and that was during the depths of the GFC. See Fig 2.

Fig 2. Skaffold Line chart of ABC

Analysis of the activities of Boral, Brickworks and CSR, on the other hand, suggests they might be attempting to be all things to their customer base. Their varied activities include the production and distribution of bricks, blocks, pavers, fly ash, plasterboard, concrete, quarries, pipes, roof tiles, precast walling and flooring panels, masonry and timber products as well as the sale of land and investments. Such strategies succeeded in ensuring market share but at what cost? Large market shares in a small country like Australia typically make it more difficult to grow faster than the market.

I believe the depressed Australian house building cycle means that Boral, Brickworks and CSR are indeed probably under-earning – that is, earning below their long-term average rates of return – but a counter cyclical strategy we won’t adopt. This is partly because none of the listed companies meet all of our criteria and also because we doubt the conditions in the foreseeable future will return that could see them collectively double their return on equity to their long-term average of 10% to 12%.

Irrespective of the business cycle, I will only invest in stocks capable of delivering a high return on equity, and when they’re trading at meaningful discounts to intrinsic value. The last time Adelaide Brighton Cement offered a sufficient margin of safety however was some time ago. What we need is a reverse multiplier effect in Adelaide Brighton Cement.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.

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