What's new?

With the focus on volatile resources and financials, the past few weeks and months have been hectic in the markets, so we thought we'd slow things down this week with a look at a relatively staid industry - building materials.

Fletcher Building is a New Zealand-based manufacturer and distributor of building materials. The company has a number of divisions, including Building Products (supplying plasterboard, insulation and metal roof tiles); Infrastructure (aggregates, cement and concrete); Laminates and Panels; Steel; and Distribution in NZ, which moves Fletcher's various products around the country.

Fletcher's markets are economically sensitive and right now economics and finance are front-page news. Throw in the fact Fletcher derives about 65 per cent of its operational earnings from the recessionary NZ economy and it's little wonder the share price has been heading south this year.

Notwithstanding these difficult conditions, Fletcher is a highly profitable business. In past years, the company has consistently generated a return on funds invested about 25 per cent. In the 2008 financial year, however, the return dropped to 19 per cent. While weaker markets can be partly blamed, the poorly timed Formica acquisition in May last year, costing $US700 million, also accounts for the lower levels of profitability.

Formica is a global manufacturer and distributor of decorative surfacing products with businesses in Asia, Europe and North America. It now forms part of the Laminates and Panels division, Fletcher's weakest in terms of profitability. In 2008, the division generated a return on funds invested of less than 7 per cent. So in effect, Fletcher pumped shareholder funds into a low-return business, bringing average profitability down.

The outlook

An improvement in the Formica integration will no doubt go some way towards improving overall profitability. The bigger question, though, is how lengthy the present slowdown will be. All areas of Fletcher's operations - NZ, Australia, the US and Europe - are in various stages of economic contraction. On the plus side, the company does generate about 40 per cent of its operational earnings from the Infrastructure division, which relies largely on government spending programs. So while Fletcher's outlook is finely balanced, it's not precarious.

Price

Fletcher's share price has been marked down heavily on the weaker economic outlook and the dubious Formica acquisition. However, as shown in the graph, at the time of the acquisition the market celebrated and pushed the stock to more than $11.50. But that was in the bull market. Bear markets induce realistic analysis and the stock now trades about $6.

Worth buying?

Investors have already factored lower 2009 earnings into the share price. The time to buy cyclical businesses is at cycle lows. We might not be at that point yet but we're getting close. With volatility expected to continue for some time, accumulating the stock under $6 would be a prudent way to gain exposure. Using Bloomberg consensus estimates, Fletcher trades on a price-to-earnings ratio of about 10 times and a dividend yield of more than 6.5 per cent.