Pop quiz: What’s the difference between cement and concrete? ‘Who cares?’, you might say, but the difference helps explain why Adelaide Brighton, Australia’s second largest cement manufacturer, is a better business than its ‘building materials’ classification suggests.
When mixed with water, cement is the glue that binds concrete together. It comprises only 10-20% of the volume of concrete although, as a vital but energy-intensive ingredient, it’s a greater proportion of the cost. The remaining components of concrete are aggregates such as sand and gravel or crushed stone.
If your eyes are starting to glaze over, perhaps a New Idea-like exposé of the inter-connected nature of the Australian cement industry will re-gain your attention. The industry is almost more incestuous than the ancient Egyptian royal family.
Favourable industry structure
Earnings supported by sequential booms
Very profitable lime business
Because cement is a key ingredient of concrete that’s usually uneconomic to transport long distances, Adelaide Brighton’s building materials competitors tend also to be customers and suppliers. The aggregates produced by major cement competitor Boral might be mixed with Adelaide Brighton’s cement to produce Boral concrete, for example.
Cement Australia, the nation’s largest cement manufacturer and a largely eastern states joint venture between European companies Heidelberg (Hanson) and LafargeHolcim, is a customer of Adelaide Brighton in South Australia and Western Australia. Then there’s the fact that Adelaide Brighton has a Victorian distribution joint venture with its 35% shareholder Barro Properties as well as a Queensland joint venture with Boral. It’s all very complicated.
As Cement Australia, Adelaide Brighton and Boral hold more than 90% of the cement manufacturing market – and rely on each other as suppliers and customers – the industry is probably best described as ‘gentlemanly’. The complementary nature of the materials required to produce concrete and the industry structure mean there is little incentive to engage in cutthroat competition.
No wonder the ACCC knocked back Boral’s $1.55 a share takeover bid for Adelaide Brighton back in 2004. If there was any industry where three players becoming two might lead to a ‘substantial lessening of competition’, it’s this one. Boral sold its 18% stake in Adelaide Brighton in 2009 at $1.95 a share but its corporate judgement has never been particularly astute. These days the stock is around $5.30.
Speaking of judgement, when it comes to Adelaide Brighton, our own hasn’t been any better. We’ve historically lumped Adelaide Brighton in with other building materials companies when, in truth, some are more equal than others. In our defence, though, unlike Boral we don’t live and breathe cement.
Our more recent analysis of the industry suggests that the previous Avoid recommendations on Adelaide Brighton – see this one from 26 March 2013, for example – have been too harsh. Since then the stock has risen a not inconsiderable 52%.
The long-term financial history of Adelaide Brighton – see Chart 1 – shows it to be a solid performer. Over the past ten years, earnings before interest and tax have risen steadily. The only time sales and earnings fell in that period was during the 2009 global financial crisis but it wasn’t a serious downturn. Margins actually rose.
In fact, operating margins have been surprisingly consistent at above 18% – high in this sector but the company’s lime business is extremely profitable (more on that shortly). Even free cash flow has been pretty decent over the years, mainly because cement manufacture doesn’t require significant new investment in plant or technology. In fact it hasn’t changed hugely since English bricklayer Joseph Aspdin took out a patent for manufacturing cement in 1824.
Adelaide Brighton’s consistency might suggest our previous concerns about an eventual cyclical downturn have been misplaced. Indeed, its financial history fits Peter Lynch’s definition of a ‘stalwart’ pretty nicely.
For all that, though, here’s our current view. Adelaide Brighton is still cyclical; it’s just that cement demand cycles have been obscured by a rolling series of booms over the past decade.
First up was the resources boom. As that petered out a few years back, the Reserve Bank engineered a switch to a housing construction boom. Now that the five-year long apartment construction boom is tailing off, some of the slack should be taken up by infrastructure development. Various road and rail projects are planned or underway around Australia – and they’ll need a lot of cement.
With this sort of demand – and growth? – baked in, it’s no wonder that Adelaide Brighton is trading on a 2016 forecast price-earnings ratio of 18 (it has a calendar year-end). But earnings are a little inflated by property profits – management forecasts property disposals will contribute $7m to the $190m-$200m net profit expected for the 2016 year.
With another $120m of property sales to support profits over the next decade, the company is also paying out special dividends – 13 cents over the past eighteen months. A time of buoyant conditions – which often goes hand in hand with special dividends – is not in our experience the time to be buying a building materials company, even a better than average one.
And Adelaide Brighton is better than average, partly because its business is not just building materials. The company is also Australia’s largest producer of industrial lime, which is used mainly in the alumina and gold industries.
Whilst the profitability of the lime business is not disclosed (it’s conveniently hidden within an obfuscatory ‘Cement, Lime, Concrete and Aggregates’ segment), it’s certainly a much greater proportion of earnings than its 12% of revenue would suggest. Hence why one of management’s three main growth strategies is to ‘grow the lime business’. This could be a significant source of earnings growth – and a high margin one at that (think 40% operating margins).
Adelaide Brighton has its attractions and may continue to defy the cycle for some time yet, but we can’t get comfortable with the price. It’s certainly not cheap at 18 times earnings and almost three times book value. International competitors such as LafargeHolcim and Heidelberg Cement trade at close to book value.
Our price guide is deliberately wide because the range of outcomes is too (we're likely to adjust the guide over time). Earnings might keep growing for a few years yet, but they could also be close to a peak if the infrastructure boom proves less profitable than the housing one.
In summary, the stock is closer to a Sell than a Buy, and it’s one where you should keep your portfolio weighting reasonable (we suggest no more than 4%). Adelaide Brighton is however a decent enough business to HOLD.