The Australian residential property market has been a major talking point in recent months, as the long awaited correction gathered pace. As many readers will be aware, a great deal of the economy relies on the residential property sector, from construction and building supplies companies, to entertainment and retail stores who benefit from the ‘wealth effect’ higher property values provides. The recent weakness has seen many associated sectors fall off heavily on the back of investors expecting lower profit growth; yet know that these corrections don’t impact all companies the same way and some can become oversold. In this edition of Under the Microscope, we try to determine whether Boral Ltd (BLD) is good value or has further to fall. As a note, Boral’s share price has fallen from a 12-month high of $8.22 to just $5.10, or 38%.
What is Boral?
The company was founded in 1946 as a group of investors sort to manufacture bitumen for the expanding Australian economy. Boral is an international building products and construction materials group with three divisions; Boral Australia, a construction material and building supplies business; USG Boral, an interior linings joint venture in Asia, Australia and the Middle East; and Boral North America, a growing building product and fly ash business in the US. The company acquired the US-based Headwaters for US$2.6bn in FY2017 as it attempts to expand its international footprint and reduce its reliance on the Australian building cycle.
Boral is among a handful of dominant building material players in Australia and has benefited from the recovering US economy through its acquisition of Headwaters. Management have been diversifying the business in recent years with revenue spread across Boral Australia ($3.59bn), USG Boral ($1.58bn) and Boral North America ($2.14bn). The Boral Australia business is Australia’s largest construction material and building product supplier focused around concrete, asphalt, cement, roof tiles and timber. Road, highways, subdivisions and bridges (RHS&B) represent 36% of revenue, following by non-residential and detached dwellings at 16% each; meaning the business is well diversified and not as reliant on residential property as the share price fall suggests. The USG Boral JV is a growing international business focused on the supply of plasterboard and internal linings across the growth economies Asia, with most revenue coming from Australia (37%) and South Korea (23%). The Boral North American business offers direct exposure to the US housing cycle, with around 80% of revenue coming from new and existing residential property, but a growing portion (13%) being sourced from infrastructure spending. It is the North America business that has been the key source of recent weakness, with a recent earning downgrade blamed on poor weather in the US.
Which Bucket does it fit in?
We believe BLD meets the requirements of the Value Bucket as it offers substantial earnings growth and currently trades at a heavily discounted valuation compared to this potential. The company has been sold off by close to 40% on the back of poor weather, but more so, concerns about their exposure to the US and Australian housing cycle. Yet, a closer look at Boral’s financials indicates that less than 50% of their total revenue comes form Australian and US residential housing construction, and they are in fact more directly exposed to the infrastructure spending boom than any company in Australia. The company has an oligopolistic position in the Australian concrete and infrastructure market but trades on a price-earnings ratio of just 12x and offers a 50% franked yield of 5.4% (6.6%). As a comparison, similar but less attractive competitors, Adelaide Brighton (16x) and Wagner’s (22x), trade on premium valuations but offer less exposure to the announced increases in infrastructure spending and more to the volatile residential property sector.
How do the financials look?
Boral announced a strong result for 2-18, with EBITDA up 47% on the previous year to $1.056bn and net profit up 38% to $473m. This result was supported by a full year of contributions from the Headwater’s business and hence appears stronger than it otherwise may be. Looking more closely, revenue in the Boral Australia division increased 9%, with scale supporting a 15% increase in division profit to $433m. From a macro view, further strength is supported by a 15% increase in the RHS&B building that occurred in 2018 and 13% in non-residential construction that is expected to continue. USG Boral detracted from performance in 2018, with income from the JV falling 9% and EBIT 10% down to $194m, as higher input costs and competitive pricing in Asia impacted on returns for the business. That being said, the business continues to grow from its small beginnings with EBIT now up 80% from day 1. The Boral North America delivered ahead of proforma expectations, reporting EBITDA of $368m compared to expectations of $345m and synergies from the acquisition are 10% ahead of their stated target. The result would have been stronger if not for adverse weather conditions impacting on construction projects. The strong results across the board resulting in a 20% increase in earnings per share and 10% to the dividend for the financial year.
The broker views on Boral are quite strong, with five buys and two holds from those who cover the stock and most have a target price in the $7’s suggesting upside of around 40% from its current level.
Wattle Partners view
The view of the Investment Committee is that BLD has been oversold due primarily to a misunderstanding of their revenue exposure. As all investors would know, mis-pricings can occur from time to time continue for extended periods, offering patient investors excellent opportunities. In Boral’s case, it appears that investors have assumed the company is more reliant on the Australian residential property sector, and subsequently that they have extrapolated a short period of US housing weakness into the future. US home building rebounded late in 2018, with November housing starts up 3.2% and building permits up 5.0%, with indications that rate hikes may be on hold likely to support further growth. As part of their ‘downgrade’ management reported expected growth in the North American business to be 20% in 2019, high single digits in the Australian business and 10% in the USG Boral joint venture.
In our view, BLD offers investors exposure to a company expected to continue growing earnings at a high single digit rate over the years ahead. The company is supported by three major tailwinds, firstly, the substantial pipeline of approved and funded infrastructure projects that require their concrete, bitumen and other material inputs (see the chart) as well as a renewed recovery of the US housing market and continued growth in Asian construction.
The companies US divisions are well placed to benefit from the stronger US economy and higher wages growth, which will contribute to higher property prices and greater spending on renovations. Management noted in 2018 that the supply of concrete and cement is likely to come under pressure in 2019 offering the potential for higher prices and greater profits. The US operations have benefitted from the announced corporate tax cuts whilst the future sale of land around existing quarries and operations in Australia may result in the payment of special dividends or other capital management initiatives. The property division has consistently delivered incremental profits to the business through a combination of rezoning and selling previous property assets or buying and redeveloping properties for their own use. Importantly, in a competitive sector Boral has committed $425m to capital expenditure focused around upgrades at their various plants and quarries around Australia and North America. Finally, the merger of Boral’s US JV partner, USG with Knauf, has triggered Boral’s option to buy 100% of this business, which will be determined based on the fair value which is expected in early 2019.
To summarise, in a world of overvalued, high growth, low profit technology companies, Boral may provide the complete opposite to investors; a profitable, diversified and growing business leveraged to the infrastructure cycle, that trades at a substantial discount to its fair value.