Ann: Fletcher Building Market Update, page-63

@noomx,

Apologies for the slow response but in recent weeks I have been conducting a "deep dive" (a cheezy phrase, but it works) and wanted to complete the exercise before commenting.


"but would you agree that all the points you have identified above justifies that FBU is not a buy and hold forever stock?"

That's moot, because there has been no mention by me of it being a buy-and-hold forever stock.


"but would you also agree that that points 1 and 4 relate to the cyclical nature of the the underlying business?"

No, I would not agree.
Points 1 to 4 are defined structurally, not cyclically:

1. It's a poor business model:
Low GP Margin (~30%), high fixed-cost manufacturer and distributor of mostly commoditised products, rendering limited pricing power.

2. Its balance sheet is in poor shape due to structural reasons, namely that it is capital-intensive with no organic growth, which means it has had to make acquisitions and fund significant working capital in order to grow (as it happens, the core business has gone backwards over time, given the business today makes less than it 15 years ago, despite having made a net total of $1.4bn in acquisitions ($3.1bn in acquisitions less $1.7bn in asset sales).

3. Its managers have been poor strategically and in terms of allocating and managing the business's capital. Not only have acquisitions been value-destructive, but working capital management has been sloppy: there has been a $500m working capital impost (a big number in the context of a $4.5bn EV) over the past three years, despite Revenue being flat. Working Cap-to-Sales is knocking up close to 20% currently, the highest level since just after the GFC when liquidity conditions were far looser than they are today.

4. A bad industry structure is a bad industry structure; it doesn't ebb and flow from bad to good on a cyclical basis. (In fact, if anything, when business conditions are favourable that's when competitor behaviour becomes undisciplined).


That all said, having rummaged through the entrails of this near-carcass of a company, I think there is an investment opportunity here; a low-conviction one (*), if not for any greater reason other than the paucity of value to be found elsewhere in the market, combined with the fact that I hold more cash than I have done for many years.

Because while I don't think that the top-line is going to up in a hurry, the key performance metrics, namely operating margins, are proving to be resilient. The GP Margin is holding up particularly well, although this might be due to a bit of accounting origami, because CoDB -to-Sales is broadly tracking the GP Margin.

Point is that the EBIT margin has been holding up fine (well, until the most recent interim result, that is), despite the inflationary pressures on the input side of the business:




But I believe the big problem with FBU, which has played a large part in the acute de-rating of the stock, is to be found in its changed Free Cash Flow attributes in recent years.

As the graph below shows, FBU used to be a prolific FCF generator until around 2017 (as shown by the dark grey columns), which made it the darling of many "value" fund managers (notably PPT).

But since then, for some reason the business has become a capital hog (represented by the light grey columns), generating zero cumulative FCF:




The ~$1.7bn of capital returns to shareholders over the past 7 years (~$1.3bn in dividends and $400m in share buybacks) were effectively funded by a $750m rights issue (2018) and monetisation of Formica ($1.2bn in 2019).

So, they've basically been giving shareholders' money back to them. But, disconcertingly, none of the capital returns were backed by FCF.

There's a lot more to unpack that brevity doesn't permit, but clearly the overarching picture is not an endearing one.

The catalyst for the stock is that it regains the FCF attributes it once had. I think there is a chance of this occurring - if only to a modest extent - over the next result or two, because I think the working capital account is excessively bloated to the tune of at least a couple of hundreds of millions of dollars (31 Dec 2023 Working Capital was $1.6bn, which is obscene).

So, I expect that, at least optically, it will look to the broader market like things are turning around in terms of FCF generation, which will almost surely present a share price catalyst (after all, that will be the reversal of the thing that pushed the share price into the gutter).

In summary, prima facie, it's a cheap stock (see graph below) for which a catalyst can be identified.



Not the most elegant investment, I concede, but my assessment is that the stock has been sold off in anticipation of an equity raising; one which is by no means a certainty given the balance sheet appears to be pregnant with some sort of capital release. (And even if an equity raising happens - perhaps because FBU's bankers press the board for it - any raising needs to be only modest in size, in my view.)


(*) There is, in my mind, an increasing likelihood of stagflation taking root in developing countries, including Australia and NZ, an outworking of demand-side focused fiscal policies at the expense of attending to constrained economic capacity (I don't see is a political leader alive today who is even remotely familiar with the determinants of supply-side economics, let alone proficient in the concept.)