Are Fletcher Building’s Losses Under Control?

This story features FLETCHER BUILDING LIMITED. For more info SHARE ANALYSIS: FBU

Fletcher Building has revealed further construction losses and downgraded FY17 guidance. Brokers believe the market will take time to be convinced the issues are under control.

-Management downplays further systemic issues in its work book
-Other businesses appear to be tracking in line with expectations
-Although Macquarie raises the spectre of further fixed-price risk
 

By Eva Brocklehurst

Fletcher Building ((FBU)) has revealed further construction losses after reviewing current contracts, downgrading FY17 estimates just four weeks after affirming prior guidance. Targets in other divisions remain in line with guidance provided at the first half results.

In the first half result a loss of -NZ$30m was realised on a major project and at the time management signalled the loss was very specific to that job. Now, a -NZ$110m downgrade to guidance is partly driven by further losses in this project as well as a loss on another current major project.

Risks of further downgrades in this division exist and it is difficult, in Morgan Stanley's opinion, to form a strong view because of the opaque nature of the business. Nevertheless, management has an incentive to hit FY18 targets and the broker suspects a worse outcome has been taken in FY17 to safeguard FY18 expectations.

The broker finds the value of the stock compelling and retains a Overweight rating. The company continues to be exposed to a recovery in the New Zealand housing market and is considered a leading player through its vertical construction offering.

Period Of Uncertainty

Several brokers expect a period of uncertainty until the market can be convinced that the company's construction problems are fully understood. RBC Capital Markets believes the current issue is a one-off and the impact over-represented in the share price, upgrading the stock to Outperform. The broker, not one of the eight monitored daily on the FNArena database, has a price target of NZ$9.50.

The company has announced a reduction in the FY17 EBIT guidance range to NZ$610-650m from NZ$720-760m. This equates to a downgrade of -15% at the mid point of the respective ranges. The broker estimates that roughly half of the downgrade relates to the problem contract that was flagged and accounted for at the first half result. One other project accounts for the majority of the remaining impact.

While this may raise questions around the company's tendering and project design methodology, management has downplayed any further systemic issues in its book. This broker also expects the issues to be contained in FY17 and therefore considers the impact on valuation limited.

Deutsche Bank agrees the risks are currently priced in and maintains a Buy recommendation, lowering the target to NZ$10.15 from NZ$11.67. The broker suspects the construction related losses largely relate to the Justice Precinct project in Canterbury and the Sky City development in Auckland. Assuming FY18 earnings estimates at global multiples the broker notes there remains 11% potential upside to the current share price.

The downgrade may be unwelcome but Credit Suisse is sufficiently comforted by the detail shared during the conference call. The broker observes occasional losses in the sector are unavoidable, but the company has assured investors a loss of this magnitude should not be repeated.

The broker believes the issue is not systemic, and entirely unrelated to cycle risk, but has brought the stock price to compelling levels where the rewards are worth the risks. Accordingly, the broker upgrades to Outperform from Neutral. Target is revised down to NZ$9.80 from NZ$10.10.

The company represents a broad-based exposure to the Australasian building and construction sector with approximately 66% of operating earnings sourced from New Zealand. Brokers project further earnings growth given the ongoing strength of the NZ building and construction sector.

Other Businesses

Credit Suisse notes, beyond the initial negative response to the announcement, the company has always been, and still is, a large manufacturer and distributor of building products with a relatively small construction business. Other businesses, including Higgins and South Pacific, within the construction division continue to track in line with expectations.

Citi also downgrades its target, to NZ$10.20 from NZ$11.40. The broker expects investor confidence will be dampened by the outcome of the review and the market may take a wait-and-see approach. Nonetheless, with the majority of the business portfolio operating in line with expectations and management's incentive to deliver NZ$820m in EBIT in FY18, the broker expects considerable negatives are already reflected in the share price.

UBS observes the main issues driving the over-run on costs were design complexity, higher subcontractor costs and time delays. Of the company's construction backlog of NZ$2.7bn around NZ$1.5bn is under a price guarantee, and the vast majority likely relates to the Sky City development.

UBS also believes the sell-off in the stock provides a favourable entry point, especially with construction losses most likely being one-off in nature, but concedes a re-rating may take time as investor confidence is re-built.

Further Risks?

Macquarie is one broker raining on the parade, with a Underperform rating. Macquarie's target is NZ$7.87. The broker retains a view that the loss identified back in February was not a "one-off". The company's construction backlog has grown to three times the level experienced at the previous cycle peak and the broker notes its presence as a builder had historically always been about exerting control over the channel to market for competing products.

Macquarie believes the review, being confined to one vertical segment, contains the inference that the horizontal businesses do not bear the same level of complexity or fixed-price risk. The broker is sceptical, observing that many public-private partnerships are fixed-price in nature and many road projects around New Zealand over the last few years have pushed into geotechnically challenging areas.

Macquarie believes the review should have covered the residential and land development division, given the company's ambitions are similarly large in the residential segment and there is fixed-price risk across some of this work. All up, there are additional downside risks around the horizontal work-in-progress and upstream margins that the broker takes into account.

FNArena's database shows five Buy ratings and one Sell (Macquarie). The dividend yield on FY17 and FY18 forecasts on present FX values is 4.8% and 5.1% respectively.

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