Shares in brick manufacturer Forterra (LON:FORT) dropped modestly today as a trading update revealed that a decrease in demand would lead to a small reduction in profit on a year-to-year basis. The shares dropped in early trade:
At under 7%, this is a much smaller downgrade than what we have seen for other companies, around 30% seems the average these days for a profit miss. There can be said to be some mitigating factors: the decrease in profits seem small, the shares already traded on a modest valuation, and a slowdown in building may only be cyclical and new properties will still be needed in the future.
Forterra may be one of the exceptions to the rule and that it has performed very well for those who purchased in the IPO in 2016. Although the price fell sharply from its 180p initial price, the performance has then since been steady and before todays warning the price was 300p, which is a great return even before considering roughly 30p in dividends have been paid in the meantime.
What’s gone wrong at Forterra?
The bad news comes in a trading update today. The commentary reveals some quite common themes which may not be a surprise to anyone reading them:
While volumes into the new build housing market have remained broadly in line with plan, trading in relation to distributors and non-residential applications has slowed. Key indicators such as UK national brick sales volumes, construction output, new housing starts, housing transactions and consumer confidence also point to further uncertainty in macroeconomic conditions.
We also get another common cause of profit warnings: these macro factors manifesting themselves in a delay to contracts:
The Group’s sales volumes have been affected by this recent weakening of activity, with brick and block volumes down in line with the overall market. Precast concrete sales have slowed in recent weeks despite good growth earlier in the year. Whilst a sustained improvement in productivity has now been achieved, the Bison precast business is unlikely to deliver the level of margin growth anticipated in the second half as a result of delays in a number of large contracts.
We have this quantified, although this is not an exact science:
As a result of the above factors, and recognising the current macroeconomic uncertainty, the Board now expects profit before tax to be modestly below last year’s result (2018: £64.8m).
Forterra: Built on solid foundations
A surprise when looking at Forterra’s figures is that their share price performance over the past couple of years is built on good foundations and is not based on a ‘jam tomorrow’ forecast. Growth here has been strong over the past couple of years as these figures from Stockopedia show:
This has been achieved without the need for large-scale acquisitions, which might have been a temptation. Intangibles and goodwill are very small (£17.3m out of £289m total assets), which leaves the business in a strong net tangible asset position. IPO proceeds have appeared to gone towards reducing the debt pile. At the last account net debt stood at £38.8m, which is roughly half of profit before tax.
This debt was refinanced in the past year and appears to be comfortable, a £150m revolving credit facility and a £50m accordion shows plenty of headroom. Cash collection appears to be strong, with average receivables period of just over a month. There are no updated broker notes available today, but the last one (available on Research Tree) projects debt to increase slightly over the next couple of years due to a large-scale investment in manufacturing facilities.
Strong margins, or efficiencies?
One of the most pleasing aspects of the business is the strong returns. We could assume that bricks and concrete are mere commodities and priced as such, but in the past few years operating margins have been at 18%. Profits have also jumped at a faster rate than turnover, so these factors could indicate either a strategic advantage in its products, or operational gearing where fixed cost proportions drop on increased production.
Perhaps both could be viable: Forterra are the only producer of the ‘London Brick’, which apparently features in approximately a quarter of UK housing stock. It is also possible to envisage that the marginal cost of producing one of these is pretty small, which explains the expansion in their Desford plant to boost capacities.
It seems that management have been performing well here. Whilst growth has stalled a little, the business is more efficient than before, is financed fairly conservatively and pays sustainable dividends relative to free cash flow.
Is there a bear case for Forterra?
Arguably the factors facing Forterra is well known and have been baked into the price for a long time. The share price in January this year was a mere 240p, which priced the business on a single digit P/E ratio. However, it should be noted that many businesses related to housebuilding such as the builders and contractors were similarly priced (or cheaper), with the markets expecting a crunch.
The annual report points out another risk, that the fortunes of Forterra are very much tied to what happens in the UK. Geographically, the UK means that export of bricks to Europe is made more difficult due to their low value relative to weight and that there are few barriers to a manufacturing facility to be built elsewhere. This also cuts both ways, and could even represent an opportunity. The number of bricks the UK imports has been rising over the last couple of years, and this demand could be fulfilled.
Another potential weakness is that the Bespoke part of the business operates at much smaller profit margins than the Bricks part. This was mentioned in the annual report last year so it is of some concern that these problems are still persisting, and it is this part of the business that will be more vulnerable to project delays.
I get the impression this is a nice business to be involved in. There are good margins, stable supply of raw product, a good market position, and an inventory which is unlikely to depreciate too much over time, given how bricks are designed to last and are unlikely to go out of fashion. Performance since the IPO has also been shareholder friendly, and the dividend going forward looks quite sustainable at current business performance.
The most obvious thing going against it is that sentiment in the sector is poor and Forterra are almost entirely dependent on the UK situation. However, in the medium term it seems likely that this will recover, and it would take a big change in the political winds for a downturn to persist. However, with operational gearing as it is, Forterra could be badly hurt if this happened.
The share price hasn’t fell too far today perhaps because the company is already quite cheap on conventional metrics. Had the price declined by 30% to the 220p levels seen at the start of the year I think this would have gotten a top rating, but it falls a little short. It is not quite at a bargain price, but overall the rewards still outweigh the risks in my view. 4/5.Like this? Share on social media: