Brickworks: Interim result 2019

There has been no better time to be Australia's largest brickmaker than the past decade. A cracking construction boom has helped propel Brickworks' building material business from making very little money to making heaps of it.

Six years ago, the building products business generated operating profit of about $30m. In the first half of this year, the business almost equaled that, with an operating profit of $26m, despite a sharp 35% decline from last year when the construction cycle peaked.

Housing construction is slowing and so are brick sales; the business reported lower volumes in several states and higher energy prices across the board. 

Like all booms, this one won't last. These results suggest a slowdown is underway and the business is warning of lower domestic growth.

Bricks are, however, a small part of Brickwork's value. The business converts abandoned quarries into industrial property which are then managed in a joint venture with Goodman Group. 

Props to property

This is a wonderful business that has established a stable and growing annuity stream as well as recognising development profits and the value of rising land prices. Best of all, there is ample surplus land to launch years of growth. 

The property business recorded flattering headline profits over the first half, with earnings before interest and tax (EBIT) rising 167% to $132m.

However, that includes land sales which contributed $35m in EBIT and revaluations, driven by lower capitalisation rates, which contributed $67m. Rental income rose by 9% to $12m. 

This is still a healthy rise albeit not as spectacular as the headline numbers suggest. Brickworks' share of the property business now boasts a net asset value of $625m, a rise of 16% from the prior period. 

The largest source of value, however, is Brickworks' investment arm which owns a 39.4% stake in W.H Soul Pattinson (which, in turn, owns a stake in Brickworks). 

The investment arm has been a source of steady cash flow to offset the cyclicality of the building materials business and it has prevented a break-up of the carefully constructed structure of the group.

Although controversial, the investment has been a source of considerable value for shareholders. 

Over the past half century, Brickworks - which sounds about as uninspiring as a business name could be - has generated annual compound returns of 12.8%, a figure that would make most fund managers blush.

Changes

Yet change is underway. For the first time in 50 years, Brickworks sold a portion of its Soul Patts holding in the period, to raise over $200m. The proceeds went towards the company's first US acquisition.

The target was Glen Gery, the fourth largest brickmaker in the US, and management suggested that it could be the first of many acquisitions that grows the brick business in America.

There are good reasons for that. American costs - from labour, taxes and energy - are far lower than in Australia, so a lean successful survivor like Brickworks could do well. 

Glen Gery also resembles Brickworks in its focus on fashion and design for bricks. Brickworks could replicate its successful local strategy of rolling out design studios in US cities. Management has an outstanding track record and owns plenty of shares in the company. Despite the usual concerns over local businesses expanding overseas, they deserve to be given the benefit of doubt.

Worrywarts

Yet we worry. Brickworks has poured cash into its poorest business and promises to pour more. 

Making bricks isn't a great business; it is capital intensive, chronically cyclical and fiercely competitive. The US market is far more competitive than the duopoly in Australia.

Domestically, under the best conditions and a benign industry structure, the building materials business generated merely adequate returns on capital of just over 10%. Do we want this business to get any bigger?

The cyclicality that has boosted building materials over recent years is now subsiding. Construction activity is slowing dramatically, and domestic building profits will fall. Brickworks is lean and has adapted in a difficult industry but we wonder whether the US entry reflects frustration with the domestic market - the high energy prices, taxes and environmental regulation - as much as it does a bone fide opportunity.

Management has earned the right to some leeway, though, and we're happy to wait and see what comes of this new American foray. The stock is up some 28%, excluding juicy dividends, since our last upgrade in 2017 (see Building a case for Brickworks). Patience has paid off time and time again with this stock. We deploy it once more. HOLD.