By George Whitehouse – StockVal Investment Analyst Brickworks (ASX:BKW) was founded in 1934 and listed on the ASX in 1962. BKW is a manufacturer and distributor of building products with operations in all states of Australia and New Zealand. It is Australia's largest manufacturer of bricks. BKW has extensive interests in property development as a result of legacy of brick pits that are now located in sought after locations in number of capital cities. The company has a 48% shareholding in Washington H. Soul Pattinson (ASX:SOL) which in turn has a 45% shareholding in BKW. Divisions Austral Bricks is the largest producer of pavers, bricks, building materials, façade systems and landscaping products in Australia. The success and size of this business has allowed it to be at the forefront of manufacturing technology. For example, the introduction of robotic brick handling equipment at plants around Australia has enabled reduced manufacturing costs and increased production flexibility. Austral Masonry was formed via the acquisition of a number of concrete masonry manufacturers. Through organic growth and acquisition Austral Masonry has become a significant player in the market for grey block building materials. Bristile Roofing was established in 1929 when Sir Lance Brisbane opened his first terracotta products factory in Perth. The division is now one of Australia's largest manufacturers of terracotta and concrete roof tiles. It was acquired by BKW from Futuris Corporation (now known as Elders Limited). Auswest Timbers manufactures a range of timber products including heavy structural timbers, roof tile battens through to floor boards and decking. The company has manufacturing plants in Western Australia, Victoria and the A.C.T. Brickworks Land and Development holds property through its Property Trust and Land & Development arms. In general when BKW develops a new quarry it is located on the outskirts of a city and operates for quite some time manufacturing product while the city grows. At the end of its life as a quarry it is generally surrounded by suburbs and the value of the land has significantly appreciated. At this point BKW sells or develops the site for residential or commercial/industrial use. Typically residential land is sold whilst industrial land is transferred into a trust that provides a rental income stream from the developed facilities. The property trust has grown into a solid long term income stream for BKW. Over time the property held on the balance sheet at cost is expected to be realized at multiples of its carrying value adding significant value to shareholders. The timing however is not possible to predict. Apart from the operating divisions BKW has a significant part of its equity invested in a long standing cross ownership arrangement with SOL. Brickworks owns 48.25% of SOL. In turn, SOL owns 44.6% of BKW along with investments in New Hope Corporation (60%) and investment bank Pitt Capital Partners (78%). SOL also holds significant stakes in Australian Pharmaceutical Industries (25%), TPG Telecom (28%) Clover Corporation (29%) and Ruralco Holdings (24%). In 2009 Brickworks investments made up 82.7% of the balance sheet equity. This is an increase from the 37% of balance sheet equity investments noted in 2000. The Outlook The use of bricks, blocks, roofing tiles and timber, in construction and building, is not likely to be substituted. Indeed increased use of clay bricks may eventuate as a result of housing regulations requiring higher thermal performances; a recent announcement by the Building Code of Australia notes a potential requirement of six star energy efficient housing from May 2011. A constant challenge for BKW is brick pricing. Most customers do not shop for brick products by brand name. Thus, they are bought largely by specifications and price. Generally with commodity type businesses, prices are determined by the lowest cost producer or the company most willing to buy market share. These particular commodities face intense competition when building activity contracts. BKW is fortunate in this regards as it is one of the lowest cost producers in the sector. Approximately 50% of BKW earnings are exposed to the residential building sector that is cyclical by nature. In the recent 2010 first half report, management noted that demand for building products had climbed strongly and the near term outlook is good. This is largely as a result of the government stimulus package. BKW recently re-commissioned a kiln in Western Sydney that had been closed for two and a half years. Management noted they expect solid returns from SOL in the near term. Over the last few years BKW has made several acquisitions, investing over $100m. Recently BKW has announced the acquisition of Sasso Precast Concrete for $35.25m. Sasso manufactures pre-cast concrete panels for the commercial, industrial and residential (high rise) markets. BKW has recently announced plans to double capacity at its Wollert plant in Victoria at a cost of around $65m. Upon completion of the expansion, BKW plans to close two other plants that were commissioned over thirty years ago. Once completed the land would be free for redevelopment. We would expect this will help BKW increase efficiency and reduce costs of supplying bricks to the Victorian market. Coupled with organic growth these acquisitions have resulted in a growing market share in a competitive industry. High market shares improve pricing power. Valuation
BKW displays the attributes of a sound business and has provided shareholders with a total return of 15.6% p.a. over the last decade, significantly higher than the 8.8% p.a. achieved by the All Ordinaries Accumulation index. At first such outperformance over a significant period appears unusual for a commodity type business. However BKW is more than just a building products business, it has a significant cross holding in SOL which in itself has produced a total return of 18.5% p.a. over the last decade. Management has used moderate levels of debt in the past and today has little debt with a Net Debt to Equity ratio of 12% after the sale of assets and a recent share purchase plan. It is appropriate for this business to have low gearing given its cyclical earnings and cash flows. Due to the investment portfolio and cyclical swings in building materials the business returns have been lumpy over the past decade. Excluding adjustments for one off gains the NROE has been as high as 28% in 2009 and as low as 9% in 2008. The average NROE from 1999 through to the end of the forecast period in 2012 is 15.5%. By comparison the All Ordinaries index has achieved an aggregate average NROE of 15.8% over the period March 1999 to March 2010. Conservatively we have selected a NROE of 13.5% as the Adopted Performance Forecast (APF) and a Required Return (RR) of 13%. When we adopt the same APF and RR our valuation will always be equal to the equity per share. Another way to think about it is if a business is producing the return we require for investing in that business the sensible price to pay is the equity per share employed by that business. When the business profitability is higher than our required return, we can pay a price higher than the equity per share and still achieve our required return. In this case our APF is marginally above our RR and as a result our valuation is marginally higher than the equity per share for the business. Using the above inputs and the equity per share StockVal produces the following values, The above valuations are based on analysts’ forecasts and are subject to change without notice. On a business rating scale from wonderful to poor the BKW business is around the middle. Investors can pay a premium for an outstanding business and still do well as typically the valuation grows quickly. We need to be rather careful with the price we pay for a business with average profitability as the valuation tends to grow slower. Potential investors also need to be comfortable with a significant investment in SOL that we will look at next week. Clime Asset Management and StockVal are part of Clime Investment Management (ASX:CIW).
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