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By Leo Sek, Clime Asset Management

Crane Group Limited (ASX:CRG) is a diversified plumbing and related building materials business.

The company operates through three divisions:

– Pipelines representing 58% of EBIT

– Trade distribution 36% of EBIT

– Industrial products 6% of EBIT

(a) Pipelines

CRG manufactures and distributes plastic pipes and pipe fittings through brands such as Iplex and Key Plastics in Australia, New Zealand, Singapore, Malaysia and Indonesia.

(b) Trade Distribution

The trade distribution division is a wholesale and retail distributor of plumbing and electrical supplies, sanitary and taps ware and bathroom fittings. It operates through two businesses – Tradelink (220 outlets in Australia) and CDNZ (127 outlets in New Zealand).

(c) Industrial Products

This division sources and distributes copper, copper alloy, aluminum and stainless steel products to customers in the manufacturing industry through Austral Wright Metals in Australia and Mico Metals in New Zealand. It also operates a copper tube manufacturing facility in Australia.

The charts below show the end uses of the pipes and the customer base for the trade distribution and industrial products divisions:

 

Key Investment Issues

Australian and New Zealand building cycle

75% of CRG’s sales are leveraged to the Australian and New Zealand building cycle.

Australian dwelling units approved have risen since June 2009 as illustrated below, which a positive sign for CRG. It is expected that first home buyer dwelling approvals will decline following the First Home Owners Grant which expires on 31 December 2009. However, the level of new dwelling construction has been below the long term average of 150,000 per annum and there is perceived to be a shortage of dwellings in Australia at present.

On the other hand, the value of non-residential building approvals has declined sharply from an excessive level in 2007. This is likely to plateau around current levels before recommencing growth in 2010.

Looking forward, the Construction Forecasting Council forecasts a decline in the value of residential, non-residential and engineering work in FY 2010 before a recovery in FY 2011.

In support of this, CRG management does not expect any recovery in Australian building demand to positively impact profit until at least the second half of FY 2010. Civil and water infrastructure forward orders are still contracting and management does not expect to see an improvement until the fourth quarter FY 2010.

In the medium term, CRG should benefit from fiscal spending on schools, public and defence housing and roads. However, profit margins are lower on sales to the project sector.

Resin prices

PVC and PE resin are key cost inputs into the plastic pipes manufactured by the pipelines division. If prices increase and CRG cannot recover this in their sale prices then this will affect operating margins.

Valuation

Over the last five years the return on equity has averaged a modest 15% and in recent years has steadily declined. This trend is attributable to the business’ mediocre return on new equity raised from shareholders for bolt on acquisitions. We can see this by noting that:

a.    Profit has risen from $38.7 million in 2005 to $43.6 million in 2009;

b.    The company has retained $66.7 million of equity and raised $216.1 million of new capital amounting to $282.7 million of increased equity over five years;

c.    This has resulted in normalized ROE falling from 15.4% to 10.1%; and

d.    Equity per share of $8.35 is made up of about $4.00 of goodwill.

Although gearing as measured by net debt per equity is low at 33.6%, this was achieved by raising equity over each of the last three years. The equity raised during 2009 was used to repay $62.8 million of debt accumulated from previous acquisitions. The return on this new equity is limited to the cost of interest saved and thus has dragged down the profitability of the company.

We believe that the building cycle in Australia has bottomed. Growth driven by population and GDP growth will ensure growth in profits and a rising level of profitability over the next few years.

We have adopted a required return for CRG of 13.6% and we regard this as appropriate given the cyclical nature of the earnings.

The adopted profitability forecast of 12% is regarded as conservative. However a return to 15% profitability is required by CRG to justify its current price in the market.  

In the main we regard the company’s recent returns as being pedestrian and justify our view that prices closer to $7.00 are required for us to get very interested in acquiring CRG shares.

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