Adelaide Brighton: Result 2017

All the signs of a cyclical boom in the Australian cement market – at least outside Western Australia and the Northern Territory – are there. Adelaide Brighton's managing director Martin Brydon said as much on the 2017 results conference call: ‘the pricing environment on the east coast is as good as I can remember'.

Exhibit B for cyclical strength: Wagners Holding Company – a cement manufacturer based in south-east Queensland – listed on the ASX in December.

The boom looks like it might persist for a few years yet too.

As highlighted in Adelaide Brighton: laying foundations a year ago, cement demand appears to be gradually pivoting away from residential construction and towards infrastructure. The share price reflects ongoing buoyant conditions, which management says should continue for at least another 2–3 years. The stock has now risen 30% over the past year.

When it comes to Adelaide Brighton's recent results, however, you might wonder what all the fuss is about. While revenues for the year to 31 December 2017 rose 12% to $1,560m, half of that growth came from several small acquisitions.

Operating profit was flat at $267m, while net profit fell 2% to $182m. So where was the evidence for a cyclical boom? Normally you'd expect margins to expand in the good times, whereas in fact the opposite happened; the group operating margin fell from 19% to 17%.

One-offs?

Removing various ‘one-offs', management's definition of ‘underlying' operating profit was up by 8%. But unless they are truly one-offs, we're usually reluctant to deem them so.

These additional costs that hit profit in 2017 were mainly $5m of expenses related to acquisitions and a $17m provision for doubtful debts, relating to some systemic underpayments by customers (internal controls have been strengthened apparently).

Property disposals will continue to be a feature of Adelaide Brighton's results too. In the 2017 result, land sales generated $8.4m of net profit, on top of the $7.9m for 2017.

As they will be an ongoing source of profits over the next decade, management includes land sale profits in its definition of underlying earnings. This management team's pretty good and there's no obfuscation, but there's always a level of judgement required as to what's a ‘normal' part of earnings.

According to management, 2018 will be another strong year on top of a strong 2017. Market expectations are for around 32 cents per share in earnings – with no property profits this time – which places the stock on a forecast price-earnings ratio of 22. That seems high for a cyclical business, even if the demand outlook remains favourable for a few years yet.

As we said in Adelaide Brighton: laying foundations, however, the industry structure makes the company a better business than its ‘building materials' classification might suggest. This, and the company's historical ability to produce strong free cash flow, means it deserves a premium multiple – at least on earnings ‘across the cycle'.

Peak cement?

Given management's expectation that strength will continue into the medium term, it seems reasonable that we're not at the peak yet.

It's not our role to predict the peak of course. Rather, we try to identify value – and there's not much of it about at Adelaide Brighton. The stock looks on the expensive side and, as we've recommended before, you should be selling down if your holding exceeds the 4% suggested maximum weighting.

Premium stock prices always look deserved until there are problems. The cyclical boom could end abruptly, or imports might threaten Adelaide Brighton's highly profitable lime business. Indeed, management pointed to some likely weakness in lime volumes this year.

Shareholders can, however, take some comfort from the fact major shareholder Barro Properties continues to creep up the register. Barro has acquired 6% of Adelaide Brighton's stock over the past year under the ‘creep provisions' of the Corporations Act (which allow a major shareholder to acquire 3% of a company every six months).

Barro now owns 41% of Adelaide Brighton and will probably bid for the remainder eventually. However, its average entry price remains less than half of today's share price so its most recent acquisition of 19.5m shares at $6.75 isn't necessarily indicative of ‘value'.

We're prepared to allow Adelaide Brighton a little leeway given its long-term record. With that in mind we're lifting our Buy and Sell prices to $4.50 and $7.50 respectively. However, we highlight that the stock looks fairly expensive and we have misgivings about the long-term outlook. HOLD.