Too cheap to ignore this ASX 200 stock with ‘compelling’ valuation: fundie

The cost of building a house is rising at the fastest rate since the introduction of GST in 2000. Interest rates are rising and housing prices are falling. Construction companies are collapsing due to labor shortages, lack of access to construction materials, and rising costs for these materials. And fewer and fewer people choose to build new houses, p approval down 14.4% in the last 12 months.

Yet fund manager Alan Gray says it’s a great time to buy this ASX 200 share in the construction play. This is a share Fletcher Building Limited (ASX: FBU).

Alan Gray managing director and chief investment officer Simon Mohini says Fletcher Building is trading “at a discount to fair value”:

Most investors shy away from buying companies that are likely to show declining earnings in the short term, regardless of the price at which the company is trading. This creates an opportunity for us
invest in companies at a discount to fair value. Fletcher Building Limited is one such company.

Why is this ASX 200 stock falling?

Fletcher Building shares were down 0.7% at $4.38 in mid-afternoon trading on Friday. The ASX 200 share is down 37.4% in 2022 so far and 36.5% over the past 12 months.

Alan Gray analyst Sudhir Kissoon says:

While we can’t be sure why Fletcher Building’s share price has been falling over the past year, the prospect of a downturn in construction activity is a likely explanation.

While it may be tempting to sit back and wait for the cycle to bottom, it is important to remember that stock markets are forward-looking.

Stock prices usually bottom long before the low of the cycle. In the case of Fletcher Building, its share price may already be a factor in the impact of a modest economic downturn.

“Compelling Opportunity”

In the September 2022 Quarterly Commentary, Alan Gray outlines the case for buying this ASX 200 stock.

First, Kison thinks the business metrics look good. By the way, these numbers are in New Zealand currency because Fletcher is headquartered in New Zealand.

Kissoon explains:

With a share price of NZ$5.16 per share at the time of writing in late September, Fletcher Building has a market value of NZ$4.0 billion. In addition to net debt of NZ$0.9 billion, the company has an enterprise value of NZ$4.9 billion.

…we estimate the lowest EBIT in 15 years to be around NZ$420 million (this is after adjusting for businesses that Fletcher Building has divested and therefore will not contribute to future earnings). The market values ​​the company at just under 12 times low EBIT.

Not only is this well below the broad market multiple of today’s market, but it is also likely that returns from this low will grow much faster than the market (and thus
guarantees a higher multiple than the market).

In our experience, a situation where the market offers us a company with a below-market multiple of diluted earnings has the makings of a compelling investment opportunity.

Is Fletcher Building’s share price a buy?

Kissoon says:

When we value cyclical companies, we try to estimate what the company can earn on average over the cycle, in good times and bad. We believe that mid-cycle sustainable EBIT for Fletcher Building should be around NZ$600m, almost 30% below management’s FY23 EBIT guidance of NZ$820m.

Mid-cycle EBIT of NZ$600 million would translate to net earnings after interest and tax of around NZ$400 million. It might not be unreasonable to attribute a price-to-earnings (P/E) multiple of 16 times to these mid-cycle earnings, which would equate to a market value of NZ$6.4 billion, or about NZ$8.15 per share. Compared to a share price of NZ$5.16, this represents upside potential of more than 50%.

Alan Gray Australian Equity Fund owns $61.7M worth of Fletcher Building shares.

The ASX 200 share represents 3% of the fund’s value as at 30 September.