Brickworks deconstructed

Brickworks should be viewed as an investment company that also controls some operating assets. The conventional measures we typically look at for pure operating businesses—price-earnings ratio, return on equity, free cash flow yields and the like—are next to useless for valuing this business as a whole.

Instead, we use a sum-of-the-parts analysis, using the appropriate analytical tools to understand each individual asset and then totting it all up.

In this case, we’ve provided two valuations for each of the key assets – one revolving around a ‘best estimate’ and the other around a ‘bargain estimate’.

Let’s start off with the Buildings Products division – the company’s heritage and the source of its name. Over the past 9 years, this division has provided annual earnings before interest and tax averaging more than $55m. Until 2012, the worst year in that period was 2009 when EBIT was $37m. In 2012, the division achieved EBIT of just $29m.

Bear market in building

Profits have suffered from the grindingly long contraction in new homebuilding in the company’s original home state of NSW, where new starts halved between 2004 and 2009 and have only recovered mildly since. The group has actively diversified into other markets over those years, only to see sharp slowdowns in those newer markets, particularly in Western Australia and Victoria.

Industry experts have claimed that Australia, and particularly NSW, have built far too few new dwellings to cater for its growing population. We have some sympathy with this view, notwithstanding our concerns about a potential house price bubble. If they’re right, the earnings from Buildings Products should eventually recover. Should they be wrong, however, we’re also comforted by the fact that the division sits on operating land (excluding the surplus developable land valued elsewhere in this review) of 3,843 hectares with a most recent valuation of $348m.

There’s a further $78m of buildings. There are a few provisions—approximately $50m—that should be deducted from any liquidation value. But our ‘bargain estimate’ of $250m, while a seemingly expensive 9 times EBIT, values this business so cheaply as to say that it’s worth more dead than alive. Our ‘best estimate’, at $350m, is also very conservatively couched against the hard assets of the business and the likely earnings potential should we see a decent pickup in homebuilding activity.

Next comes the company’s 42.72% stake in sister company Washington H. Soul Pattinson (Soul Pattinson is also the largest shareholder in Brickworks, through a long-standing cross shareholding structure). This is Brickworks’ most valuable asset.

Its 102.3m shares in Soul Pattinson have a current market value of almost $1.4bn, which we’ve used for our ‘best estimate’. For the ‘bargain estimate’, we’ve lopped off 25%. We actively cover Soul Pattinson and will be undertaking a full review in coming weeks. While we think that stock is currently trading at a mildly cheap price, there’s also the risk inherent in its substantial exposure to coal through Soul Pattinson’s stake in New Hope Corporation. We currently rate Soul Pattinson a Hold as a result.

Brickworks also owns a substantial portfolio of industrial property through a joint venture with Goodman Group. These large warehouses and distributions centres have been built on land sold to the joint venture from Brickworks’ surplus land assets. The great bulk of these properties sit near the intersection of the M4 and M7 motorways in western Sydney, a magnet for logistics-focused tenants that include Coles, Woolworths, Kimberly-Clark, Linfox, Toll Holdings and DHL.

With those assets valued at capitalisation rates of between 7.8%-8.5%, the value of Brickworks’ equity in the joint venture currently stands at $184.5m, making up our ‘best estimate’ valuation. For the bargain estimate, we’ve lopped 20% off the value of the joint venture’s assets, leading to a 35% discount for the equity.

Land holdings

Lastly comes the group’s surplus land bank, more than 1,000 hectares predominantly in outer suburban Melbourne and Sydney. These properties are either former Brickworks operating sites or sit on the edge of current operating sites, and are available for current or eventual sale. Some of this land is destined to be sold to the Brickworks/Goodman Group industrial property trust joint venture, but more of it will be sold to residential property developers.

Clearly, the same residential building slowdown that is affecting the Building Products division is also leading to a contraction in the pace of sale of this land, which has ground almost to a halt recently. Much of it will continue to sit on Brickworks’ books for many years.

It’s the hardest part of Brickworks to value. We think this land could ultimately prove to be worth substantially more than the ‘at least $340m’ management highlighted in the 2012 results presentation, ‘assuming [it is] rezoned and rehabilitated but [excluding any] development profit to BKW’. It could easily be worth double this amount. But, given the currently depressed nature of the new housing development market, we’ve let that figure guide our ‘best estimate’ and applied a harsh discount for the ‘bargain estimate’.

Adding it all up, and deducting a few necessary liabilities, leaves a ‘best estimate’ of more than $12 per share and a ‘bargain estimate’ of around $8.

Brickworks is not a bargain today. All things being equal, if it got down to $8 or so it would be, and we’d have an outright Buy, perhaps even a Strong Buy, on the stock. But does today’s price—up 8% since Brickworks: Result 2012 of 25 Sep 12 (Long Term Buy – $10.14)—justify a Long Term Buy recommendation?

We could have gone either way on this one, but have decided to downgrade. While Brickworks owns attractive assets and is most unlikely to prove a disaster for today’s buyer, it’s no Woolworths either.

Our ‘best estimate’ valuation is based on numbers that leave plenty of potential upside in the valuation for Building Products and the surplus land bank. But more than 60% of the valuation is dependent on the stake in Soul Pattinson, which we’ve valued at current market price rather than at a discount. There’s also the not insignificant exposure to coal through Soul Pattinson’s large stake in New Hope Corporation, a matter we’ll attend to in more detail in a coming review of Soul Patts.

The current Brickworks share price offers a 10% discount to our ‘best estimate’, a little too fine to be thoroughly deserving of a positive recommendation. The fully franked yield of 3.7% isn’t alone enough of a reason for excitement either. We’re downgrading to HOLD.

Note: The model Growth portfolio owns Brickworks shares.