Fletcher Building paid US$700 million ($947m) to buy Formica Corp from private equity owners Cerberus Capital Management and Oaktree Capital Management in 2007. It may be a good time to sell a business that sits outside its core operations, says Morningstar.
In a note released after Fletcher announced wider losses in its construction business and breaches of lending covenants yesterday, the research firm said it anticipates "the divestiture of assets, especially those earning low returns with no synergies across the rest of the business".
"These should be the focus as long as they can be realised at attractive prices," Morningstar analysts said. "In our opinion, Formica fits the bill on both criteria."
In detailing further provisions at the Building + Interiors unit of the construction division, chief executive Ross Taylor said yesterday that he expected to unveil a revamped business strategy for Fletcher by June, including "what bits, if any, we want to trim".
The company expects to have negotiated new covenant terms on all of its funding lines by the end of March, having gained a waiver from its banking syndicate for breaches of conditions related to earnings ratios. It is also in talks with holders of its debt issued in the private placement market.
Yesterday's update brings two-year losses at B+I to $952m. Taylor said he is "quite convinced we've got these provisions right. Once we've confirmed that and got that monkey off our back ... we'll look at where we want to take Fletcher Building."
Former Fletcher CEO Jonathan Ling bought Formica in 2007, adding to the existing Laminex business in Australasia, with the aim of creating "a truly global laminates platform" and further diversifying the group's earnings exposure. Acquisition funding included a US$325m issue of notes in the US private placement market and about $328m raised from a share placement.
Cerberus and Oaktree had bought Formica out of Chapter 11 bankruptcy in the US and had chalked up three years of earnings growth before selling to Fletcher at 7.2 times forecast 2008 normalised earnings including expected synergy benefits, including rationalisation of Australasian manufacturing and streamlining of raw material procurement.
Formica sits in Fletcher's international division alongside Laminex and Roof Tile Group. Formica operating earnings before one-time items jumped 42 per cent to $88m in 2017, contributing to a 27 per cent gain in earnings for international as a whole.
In 2009, Fletcher cut the carrying value of Formica's goodwill by $56m and reported an impairment against the assets of Formica Europe of $65m.
Morningstar values the international division at $1.36 billion or 7.5 times estimated 2018 earnings before interest and tax.
"Applying these same multiples to just Formica, we think a sale of Formica alone would have to fetch $730 million to be neutral to our valuation and would also lead to lower gearing and provide greater certainty about the business."
It says Fletcher's focus should be on businesses where it has the strongest competitive advantage - building materials and distribution (which includes the Placemakers chain).
"A sale of the Formica business would achieve those goals as it earns a low return on capital and does not have any integration or synergy benefits from belonging to Fletcher's New Zealand and Australia focussed businesses," Morningstar said.
Return on capital employed in the international division at 8.7 per cent, is "a fraction below our cost of capital of 9.1 per cent. With current economic conditions in the US and Europe, now could be a fortuitous time to approach a sale".
Fletcher cancelled its interim dividend yesterday and said no decision had been made on whether to make a full-year payment. It would save $270m by omitting the full-year dividend, Morningstar says. A further $50m could be saved by cutting growth in capital expenditure to 1 per cent of sales, it said.
As at January 31, the company had borrowing headroom of $1b and said net debt is forecast to increase by about $250m this calendar year. Net debt stood at $2.1b with $173m of cash on hand.