Bricks & Mortar – Part 1 Grafton Group plc.

I keep seeing large numbers of the same building and construction stocks coming up in the many value based scrrens that I run. Whether I run magic formula, Graham & Dodd screens or P/B type screens, the same stocks seem to appear with great regularity. Of the construction oriented stocks that are appearing I decided to do some work on Grafton Group plc, Morgan Sindall plc, Abbey plc and Barrett Development plc. These firms are all UK or Irish based but are predominantly exposed to construction or builders merchanting in the UK. At a later stage I will also look at Titan Cement in Greece.

Grafton PLC

Listed on the Irish Stock Exchange, Grafton PLC is a building materials group whose main markets are the UK and Ireland. The company has strong positions in the builders and plumbers merchanting in the UK and Ireland, as well as being the largest DIY retailer in Ireland. The company’s principal competitors would be Travis Perkins plc, Wosleley plc and Saint Gobain SA. 

The share price reached a share price peak of €13.10 during early 2007, fuelled by investor appetite for anything related to the property booms in the UK and Ireland. Since then the stock has predictably been crushed whilst margins have been under consuderable pressure. To put it in context the stock is 80% off its highs and the 2010 EBIT margin of 1.6% is significantly below the 20 year average margin of 6.5%. Revenue has fallen 37% from the peak.

Market reaction to the collapse in sales and profitabilty has left Graftons stock (€2.70) trading at a particularly low level of valuation.

  • P/E: 9.4x trailing earnings
  • Graham & Dodd P/E: 5.8
  • P/B: 0.61
  • P/S: 0.30

Since 1989, the average P/B value for Grafton plc has been 1.6x, and for much of this period it has traded in excess of book value.

Interstingly, the valuation argument is not as clearcut when looking at P/S. The present level of 0.3x is in the middle of the range achieved prior to the heady days of the construction and building related boom of the 2000’s in both Ireland and the UK. To be fair this is on revenue that is almost 33% of the highs achieved in 2007.

I think one of the main question for any potential investor or speculator to ask, is, Are margins permanently impaired?

Grafton Groups website is a mine of information and has data on the company going back to 1988. I am inclinded to think that have averaged 6.5% operating margins over 20 years that the most performance of 3.7%, 0.2% and 1.6% from 2008-2010 is due to the considerable downturn in building related activity in the UK and Ireland. I have no insight into when this will recover, but I would be of a view that any meaningful recovery is simply not priced into the shares at present.

 

Furthermore, the low price to book is in my view extrapolating the present low returns indefinitely. This is a company that has a reasonably long history of double digit ROE combined with a moderate level of leverage and consistency of freecash generation.

 I am not presupposing that asset turn over and margins will suddely leap forward to rebase returns to more ‘normalised’ levels, however no recovery is being implied in the present valuation. For me that presents more opportunity than threat.

The Piotroski F-Score  based on the 2010 annual accounts is 6, yet on the basis of the most recent interims this has improved to a score of 7, with the usual caveat of unaudited half year results applying. At the half year stage, revenue has posted a 3% gain leading to an improvement in asset turnover to 1.01 (from 0.99). Operating margins of 2.1% are well ahead of margins at a full year or interim basis in the past two years.

Disappointingly for me, the gloss has been taken off this much improved operating performance by a step up in financing costs. The net interest cost has grown 350% on a balance sheet that has a gearing of 26% verus 29% on a lower absolute amount of net debt outstanding. The company puts this down to the margins paid on bank lending facilities refinanced during August 2010, when compared with the rather generous margins that the company enjoyed from its banks prior to the credit crisis. It doesnt derail the investment thesis for me, but it does I feel delay the eventual improvement in profitability and returns.

IT should be no surprise that margins in the UK business units have improved so much more than those of the Irish units. The moost recent operating margin in the UK business of 4.5% was above the margin generated for all of last year. The longer term range of UK margins has been 3.2% – 7.8%. Historically the margins on the Irish business were significantly larger than in the UK, with operating margins regularly fluctuating between 10.7% and 13.0%. Since 2008 margins in the Irish business units have compressed significantly. The unit is presently loss making, but the margin has improved year on year to -0.4% from -1.4% a year ago. It is likely that the company is facing a prolonged period where margins in Ireland fail to regain double digits.

So while peak margins are unattainable, I do believe that further margin improvement is likely. On a back of the envelope type of scenario analysis, I calculate that a 5% margin in the UK (below the 6.5% average) along with a 5% margin in Ireland (less than half the long term average), would lead to the stock trading on 8x earnings and a ROE of 7.7%. Pretty much a static analysis, so make of it what you will.

I have admired the chairman of Grafton, Michael Chadwick for a long time. He has been a shrewd and somewhat parsimonious manager of the business. He is after all one of  the principal shareholder in the business. For me this is the type of business that I want to own in my portfolio. I am interested in the potential in the Irish business. I have a sense that the Irish economy has hit the bottom. Not being a believer in sustainable V-shaped recoveries it would not surprise me if the Irish economy remains at this floor for a prolonged period of time. As such, while Grafton offers good value, I am not willing to pull the trigger and invest immediately.

I want a larger margin of safety on this one. In the past it has traded down to below 0.5x book and 0.2x P/S. For the moment I will wait in the anticipation that I can pick up a position at a more attractiive entry point. I spend a reasonable amount of time studying stock charts as well as valuation and balance sheets. To my mind, it seems that the line of least resistance is downward, with support kicking in between €2.20 – €2.40. Hopefully it will travel toward there. If so, I will re-evaluate.

Call me greedy, but thats what I am. I want to maximise my returns, so my aim is to pay as little as possible as I build up this portfolio. If I had more confidence that margins would improve to allow a realistation of the historical norm of double digit ROE’s then I would invest presently – I do not have that confidence as of yet.

The secular bear market of the past 11 years has not yet ended in my estimation. I will take my time to invest, and with 10% exposure to equities after 6 weeks that is a position that I am content with for the moment. There are many other construction related equities that I am presently working on. I will publish on those when time allows.

From what I can see at present, in terms of sector valuations, the only real value lies in Financials, Contruction, Retail, Utilities and Pharmaceuticals. There are obvious quality and leverage detractions with some of these sectors. My goal would be to double my investment in 5 years. That being, I need to seek out areas whereby I can speculate on a combination of margin improvement & valuation expansion without the need to spend too much time deleveraging. 

As usual, comments and critiques are welcome.

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