Safe as houses

PORTFOLIO POINT: Investors looking to build up a holding that has good upside should consider Brickworks.

There was some welcome good news for Australian building supply companies this week with the NSW state government budget “first home buyer initiatives”.

This followed supportive policy initiatives announced by the Victorian government for development of more public housing.

The NSW budget proposes a comprehensive package to stimulate the housing sector after many years of underperformance in NSW. The Building the State package provides $561 million for additional infrastructure that accelerates the delivery of up to 76,000 more properties to significantly boost housing supply in NSW. There will be fast-track approvals for major projects to clear the backlog of stalled approvals and redirect financial incentives to new housing. Under this package, NSW first home buyers will benefit from a generous support scheme. The scheme provides an extra $19,245 in grants and concessions for first home buyers.

You can see from the following chart that monthly building approvals have plummeted towards the cyclical lows last seen in the GFC (mid-2008). The recent peaks of 16,000 monthly approvals in early 2010 were a direct result of the federal first home buyers’ assistance initiative.

Chart 1: Australian building approvals
Source: IRESS

The NSW government announcement is welcome news for Brickworks Limited (BKW), which sits in our growth portfolio and which trades below our assessment of value. This valuation is supported by the observation that BKW shares are trading in the market at a significant discount to stated equity. Further, the stated equity in the BKW balance sheet is well below market and replacement value.

The share price has been under pressure, as the recent return on equity has been below what is an acceptable return. The chart below shows this clearly and it does underline that the building industry has been operating at cyclical lows.

Chart 2: Brickworks performance

BKW is a manufacturer and distributor of building products, with operations in all states of Australia and New Zealand. It is Australia’s largest manufacturer of bricks and has extensive property developments and, as a result, the legacy brick pits are located near a number of capital cities. This provides attractive redevelopment opportunities.

BKW listed on the ASX in 1962, has paid a dividend every year, and has had only one capital raising from shareholders.

Chart 3: Brickworks operations
Source: Australian Bureau of Statistics; BKW: Results Presentation 2011

Shareholders in BKW are also shareholders in Soul Pattinson Limited (SOL) and therefore New Hope Limited (NHC). This gives BKW shareholders a diversified investment across:

• Brick and building materials operations;
• Land holdings and residential development joint ventures;
• Long-term equity investment portfolios direct and through investment companies (BKI);
• Strategic business ownership of pharmaceutical (API), retail outlets, healthcare, telecommunications (TPM), Rural distribution, seed and grain, rural financing and fertiliser distribution (RHL); and
• Coal mining, port facilities and $3 billion of cash (NHC).

The chart below shows the extent of the cross-ownership and explains why Perpetual Funds Management, as a major shareholder, has suggested that the group consider the unwinding of the cross ownership to unlock the latent value of the group.

Chart 4: Brickworks cross ownership structure
Source: MyClime Brickworks report

The cross-shareholdings between BKW and SOL have existed for about 40 years and were ostensibly established to allow each company to invest and grow without an individual threat of takeover. As asset rich companies, taking a long-term investment approach, they were clearly vulnerable to the asset strippers of the late 1970s and early 1980s. Interested readers may like to Google: 'Slater Walker asset stripping activities'.

Today both companies have grown immense asset bases. For instance, if we add up all the value the market ascribes to SOL’s holdings and exclude $350 million in costs such as liabilities and operating costs, the total value comes to just over $4 billion. This equates to a per share asset value of about $17. Obviously an owner of BKW also owns these undervalued SOL assets. Indeed, it is observable that the current market capitalisation of BKW represents its investment in SOL. Thus, the building assets and property holdings plus joint ventures have no value in the BKW share price. There lies both the opportunity and the frustration.

Increase value

We noted above that recently Perpetual Funds Management (a large minority shareholder in BKW) proposed a scheme whereby BKW sold its holding in SOL. This was reviewed by the SOL board, who noted a major capital gains tax issue in the selldown.

Thus, a logical counter proposal would be for SOL to undertake on-market purchases of BKW shares. SOL directly, and indirectly through NHC, has over $1.5 billion in cash (equity accounted) and thus plenty of capacity to acquire more shares. Indeed, the purchase of BKW shares by SOL at current market prices is akin to SOL buying its own shares at a fraction of their value. Further, the circular nature of the structure also suggests that it would mean that BKW would be effectively buying its shares back for half value.

Buybacks that are conducted at expensive prices serve to reward leaving shareholders at the expense of remaining shareholders and destroy value. Buybacks conducted at prices lower than value add value to remaining shareholders at the expense of leaving shareholders. In this situation the purchase of BKW shares by SOL would replace cash (low earning asset) with an attractive asset consisting of the underlying assets of the whole group.

Thus, at current market prices there may indeed be a fiduciary duty for the directors of SOL and BKW to consider the purchasing of more shares in each other, rather than the sale of each other’s shares. So is there an impediment to this happening?

The answer to this is complicated from an outsider perspective. There may be unforeseen tax consequences which require an expert review. Further, there is a view that the Australian Securities and Investment Commission (ASIC) has restrained SOL or BKW from undertaking such purchases. My review of public announcements has not uncovered any support for this contention and indeed it would be extraordinary if ASIC is directly restricting the creation of value for shareholders. To clear the air, maybe a shareholders’ meeting to approve the purchase of shares, say under the 3% creep rules, would resolve this issue. After all, it should ultimately be the decision of shareholders to decide what is in their interests.

For the above reasons BKW sits nicely in our growth portfolio.

Growth Model Portfolio

-Clime Model Growth Portfolio (prices as at June 14, 2012)
Company	Code	Purchase Price	Market Price	June 2012 Value	Safety Margin	GU Yield	Total Return
BHP Billiton	BHP	35.5	31.80	47.69	49.97%	4.63%	-10.42%
Commonwealth Bank	CBA	50.78	50.57	58.94	16.55%	8.93%	-0.41%
Westpac	WBC	22.02	20.29	27.57	35.88%	10.49%	-4.13%
Blackmores	BKL	27.55	25.41	28.33	11.49%	0.62%	-7.77%
Woolworths	WOW	25.85	26.39	31.53	19.48%	6.55%	2.09%
Iress	IRE	6.75	6.21	7.28	17.23%	8.36%	-8.00%
The Reject Shop	TRS	12.04	9.51	12.56	32.07%	4.66%	-21.01%
Brickworks	BKW	10.45	10.25	12.33	20.29%	5.71%	-1.91%
McMillan Shakespeare	MMS	11.01	11.15	11.42	2.42%	4.74%	1.27%
Mineral Resources	MIN	11.77	9.24	14.00	51.52%	6.34%	-21.50%
Rio Tinto	RIO	66.6	54.27	84.06	54.89%	3.13%	-18.51%
OrotonGroup	ORL	8.64	7.40	9.48	28.11%	9.65%	-14.35%
* Market prices as at close June 14, 2012

Access a full research report on Brickworks and Soul Pattinson (plus many others) on MyClime. Register for a free trial to MyClime, our stock valuation and research platform.