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Fletcher Building at a Fork in the Road

Fletcher Building and investors alike find themselves at a fork in the road, facing a difficult decision about which direction to take.

Investors must decide whether to buy, sell or hold a stock where strong arguments could be made for all options.

Fletchers face a multitude of different choices to solve their current woes. These range from asset sales, to capital raisings, or merely renegotiating their debt to relax their covenants.

Before we explore Fletcher’s options, and the implications that would have on investors, we should have a look back at how Fletchers got into this mess in the first place.

The first whiff of the downgrades came from the February 2017 half year result, where the company noted that earnings from their construction division would be down 33% due to “losses incurred on a major construction project”. We have since learned that this project was the Justice Precinct in Christchurch (current forecast loss $156m). The share price was $10.21 prior to the result, and closed down 5.19% on the day.

Less than a month later Fletchers provided another update after a “thorough review” of the B&I (Building and Interiors) Business unit. The result was a $110m downgrade. Here we heard about another major project incurring a “provision for expected losses.” This was the SkyCity Convention Centre and Hotel (current forecast loss $410m). The share price was $9.22 prior to the update, and closed down 10.2% on the day.

Fast forward to July 20th 2017, and we saw the departure of CEO Mark Adamson, and another downgrade. Further losses on the two projects above, and “reduced profit expectation on smaller projects in the remainder of the B&I portfolio”, were the culprits (as well as write downs of the carrying value of Iplex Australia and Tradelink which resulted in an impairment of $220m). The share price was $8.09 prior to the update, and closed down 6.18% on the day.

3 Downgrades, and counting. Time to bring in the big guns. In September of 2017 KPMG are employed to review projects in the Construction division.

At the AGM in October 2017, we heard that the review looked at 4 projects, and in 3 out of the 4 projects the review considered that the “final margins in all three cases are expected to be positive.” One of these projects was Commercial Bay on Auckland’s waterfront (Fletchers have since “provisioned for contingencies” on the project). A further $125m of provisions was announced at the meeting. A new CEO, Ross Taylor, was also announced. The share price drops a further 10% over the next week to touch $7.

Heading into 2018 the share price had recovered nearer to $8 when it went into trading halt on the 8th of February citing further expected losses in the B&I business unit. This halt was extended on the 12th of February when the company disclosed that the downgrades will “result in a breach of one or more of the covenants in the Group’s financing arrangements.”

On the 14th of February Fletchers announced further expected losses of $486m, bringing total losses in the B&I division to $952m. The share price dropped another 10% over the next two trading days, back to $7 a share.

The share price dropped further 6.85% a week later when Fletchers announced their full year result, touching five year lows of $6.39 (down 37.4% over the course of the year detailed above).

 

IT IS WITHIN THIS RESULT WHERE INVESTORS SHOULD FOCUS. THIS IS WHERE THE KEY RISKS GOING FORWARD CAN BE FOUND.

The much publicised issues in the B&I division aside, the February half year result also included a provision of $12m for a loss on the Atlas Quarter apartment project in Christchurch’s Eastern Frame. Housing projects such as this are becoming a larger part of Fletchers earnings.

Investors will be hoping that the provision for loss on Atlas is not a sign of things to come.

Over the last couple of years, Fletchers benefited from sizable capital gains from property they have land banked in Auckland.

Given the softer property market over the last 12 months, it appears that these gains will be harder to achieve. A worst case scenario could see Fletchers holding fully developed projects on their books without suitable buyers.

The February result also showed a jump in funding costs compared to the previous corresponding year. This may rise further depending on the outcome of the negotiations underway with their debt holders (these are scheduled to be complete by the end of March).

Fletcher Building also announced that they would cease bidding for major construction projects in their B&I division. This certainly stems the bleeding in the short term, but will also result in lower volumes coming through their Building Products & Distribution business units. This will likely put downward pressure on margins. Some have also questioned what impact the loss of future potential work will have on sub-contractor and staff loyalty.

A shining light in the half year result was the performance of Formica. Operating earnings were up 24% to $42m. Ironically, this is the asset most touted for sale to plug the current gap on Fletcher’s balance sheet.

FLETCHER’S OPTIONS ARE THREE-FOLD

They are currently negotiating with their debt holders, the outcome of which will make things clearer from an investor’s perspective. The most likely outcome is probably a bump up in interest expense on the bulk of the $2.1b debt outstanding.

The company has already foregone their half year dividend in order to help sure up the balance sheet (and placate debt holders). Another alternative is to sell assets to improve their position, or potentially raise capital.

A capital raise is the worst case scenario for investors (leaving the incredibly unlikely chance of defaulting aside). This would likely take place at a reasonable discount to the market price. In most scenarios, the share price will drop down close to the capital raising price (as investors sell to take up their rights, for example).

An asset sale is possible. Although the impact on shareholders would depend on the asset sold, and the price achieved for investors.

SO GIVEN ALL OF THE ABOVE, WHAT SHOULD INVESTORS DO?

The answer to the above depends entirely on the level of risk an investor is comfortable with. Clearly there are some risks to navigate over the next few years, and there is potential for things to get worse before they get better (if they get better).

Investors need to consider whether they are happy to take those risks on. As with any investment, the right answer will come down to finding the right balance within your portfolio.

Filed under Grant Davies \ Newsletter

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