Fletcher has untapped upside says broking firm

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Fletcher Building has as much as $100 million untapped upside in its operating earnings if it can return to the performance it produced in its core businesses before the 2008 financial crisis over the next three to four years, says analysis by broking firm First NZ Capital.

However, a combination of focus on its New Zealand manufacturing and distribution businesses and divestment of non-core or underperforming international assets could unlock significant additional value, FNZC analyst Kar Yue Yeo said in a note to clients.

"Our high-level analysis suggests it might be possible for FBU (Fletcher) to achieve a $900m-plus stretched ebit (earnings before interest and tax) target (25 per cent higher than the $720m financial year 2018 forecast consensus estimate) by retaining its existing portfolio over a three-to-four-year horizon.

"However, this is a high-input, higher-risk and potentially low-reward outcome. FBU's current portfolio of businesses is too wide in spectrum to be well-managed. The company's performance in the past 10 years is indicative of this."

The note comes ahead of an earnings outlook update, scheduled for October 25, and as the Fletcher board seeks a replacement for chief executive Mark Adamson, who departed under a cloud in July after announcing two substantial earnings downgrades in one year and the leak of a colourfully worded internal email criticising executives in Fletcher's building and interiors division.

The company reported a 23 per cent fall in ebit at $526m in the year to June 30, in part because of difficulties experienced on two very large New Zealand construction projects, thought to be the Christchurch justice precinct and the Auckland international convention centre.

Even without improved performance, FNZC forecasts that Fletcher's position will have improved to ebit of $783m by the 2019/20 financial year.

However, FNZC sees the new chief executive, which the company says could be appointed "in the next month or so" although there is no formal deadline, as having the opportunity to "redefine the playbook, financial targets and priorities for the team".

"Asset sale or a narrowing of FBU's existing portfolio in itself is not a panacea to FBU's financial performance, but it would certainly free up bandwidth to allow a stronger focus on core operations where management can add most value."

FNZC doesn't nominate specific assets for divestment, but analysis of its Australian and 'rest of world' portfolio leaves little doubt that it regards the Formica business as lacking strategic alignment, while some of the Australian units will require significant work to return to acceptable returns on funds employed.

"While Formica Group could offer ebit upside from further business improvement, it is inherently not an exposure to the building material sector, and does not add to the strength of FBU's building material business," FNZC says.

The note also appears to favour focus on Fletcher's manufacturing and distribution businesses over its construction and residential land development opportunities.

"FBU Construction provides some pull-through volume for FBU but its ownership is not essential to the success of the group's New Zealand manufacturing and distribution businesses," FNZC says.

Internal initiatives to improve performance and the recovery of the New Zealand construction market over the last five years have "led to positive operating leverage, margin recovery and ROFE in the last five years".

"However, FBU NZ current ebit, profitability and return on funds employed ... are still significantly short of the last peak in FY08A (the 2008 financial year) when industry volume was in fact at lower levels.

"We estimate this gap at $100m per annum", reflecting weaker pricing power.

"While FBU NZ may have ceded some share in certain categories in the supply and distribution of building materials over the last 10 years, we doubt this loss would be significant (if any) based on our understanding of FBU's share trend in plasterboard, insulation, cement, ready mix, concrete products, aggregates, steel distribution and building supplies distribution.

"In effect, FBU's NZ Manufacturing and Distribution business ebit margin over this period appears to have been eroded by higher cost inflation compared with product price inflation.

"There is still significant upside potential ... if the new CEO is able to drive further cost efficiency that commensurate with new realities of lower product pricing power environment in recent times."

Fletcher Building shares were trading this morning 0.8 per cent higher than on Friday, at $7.81 and have lost 27 per cent of their value in the year to date.

FNZC is rating the stock 'outperform' with a target price of $9.20.