Big Bottom

By David Dittman • July 20, 2012

What to Buy: CSR Ltd (ASX: CSR, OTC: CSRLF)

Why Now: CSR Ltd (ASX: CSR, OTC: CSRLF) is down about 90 percent from its all-time high on the Australian Securities Exchange (ASX), AUD12.47 in early 2006, and about 80 percent from the post-Great Financial Crisis high of AUD6 it hit on Aug. 28, 2009.

The stock closed at AUD1.17 per share on Jul. 17, 2012, in Sydney, an all-time low. And that’s saying something for a company that’s been listed on the ASX since 1962.

The company’s stock has been on a thrilling ride in the 21st century, topping out at AUD12.47 per share on the Australian Securities Exchange (ASX) on Mar. 31, 2006, as booming global demand for natural resources drove rapid domestic commercial and residential construction.

Like equities all over the world, however, 2008-09 was tough for CSR, as it hit an interim bottom of AUD2.85 on the ASX on Mar. 6, 2009, before beginning what looks like it could be a death dive to the final low of AUD1.17. As of this writing, during Jul. 19 trading Down Under in Sydney, CSR has ticked up from that price, at AUD1.22.

CSR more than doubled off its March 2009 low to a post-Great Financial Crisis high of AUD6 per share on Aug. 28, 2009. From there it’s been pretty much all downhill, as a sluggish global outlook and a stagnating domestic construction industry have taken a toll.

The company’s AUD1.2 billion acquisition of glassmaker Viridian in 2007 hasn’t worked out as hoped, coming as it did in the midst of a down turning market. A strong Australian dollar hasn’t helped, but management has initiated a program to cut what are high fixed costs at the unit.

CSR had already written down about AUD650 million of the book value of Viridian. The market was also uncomfortable with CSR’s sale of a 156-year old sugar business.

The stock’s steepening slide in 2012 is all about global prices for aluminum, with which it’s been closely correlated for the last six months. Aluminum has sold off from a near-term peak of USD2,650 per metric ton on Jul. 26, 2011, to a low of USD1,845 on Jun. 26, 2012. It closed at USD1,944 on Jul. 19.

With an annual dividend of AUD0.13 for fiscal 2012 and at a price of AUD1.185 per share as of this writing the 12-month net yield on the stock is 10.97 percent. That’s a big yield, and that’s what we’re hunting here.

But we’re not looking to throw money away. In addition to persistent rumors of potential interest from private equity players, which date at least a year back, to when the company was trading above AUD2.60 per share, CSR’s continuing business operations and strong balance sheet suggest there’s still long-term value here. Buy under USD1.35.

The Story

It’s increasingly difficult to spot double-digit yielders that actually have the stuff to maintain their businesses and sustain their dividends in the universe of stocks we cover in Utility Forecaster, Canadian Edge, MLP Profits and Australian Edge.

But that’s the mandate, and we’re going to follow it again this month.

Our prey for July–and at this point we’ll note that Big Yield Hunting’s Open Positions do not constitute a “portfolio” by any stretch of the imagination, just a collection of monthly recommendations for investors with the wherewithal and the stomach to make aggressive though informed bets on turnaround stories, underappreciated gems and outright speculations–comes from the Land Down Under.

And the operative word for this pick is “down,” as the stock, with a 50-year trading history, recently touched its all-time low. It may not be “the” bottom, but it clearly can’t go much lower.

The building products and aluminum operations are still generating positive cash flow, however, and the company recently eliminated all of its debt. Cash on the balance sheet and sufficient access to credit position it for an eventual stabilization of commercial and residential construction conditions.

And at these levels–a market cap of AUD602 million–it’s an easily digestible target for a strategic acquirer or for private equity interested in those cash flows. Down more than 90 percent from its all-time high and yielding nearly 11 percent, this stock is pricing in a lot of bad news.

But a case can be made that the current price doesn’t nearly reflect the value of the underlying business. Here goes.

David: So I’ve finally managed to work in a Spinal Tap reference to a Big Yield Hunting headline, though decorum prohibits a full explication.

Roger: I see that–congratulations–and I agree with your judgment on the decorum issue.

I agree too that the stock we’re talking about this month has achieved something like a “big bottom,” and that hopes for a turnaround rest on the Australian construction industry having found its low point as well.

David: Before we get into the issue for real I’d like to mention another point of pop-culture significance: The company we’re recommending this month is the villain in Australian band Midnight Oil’s song “Blue Sky Mine,” which deals with a mine this company operated between 1948 and 1966 at Wittenoom, Western Australia, that produced 161,000 tons of crocidolite fiber, a type of asbestos.

Thousands of workers and their families, visitors, tourists, consultants and government officials were exposed to potentially lethal levels of this blue asbestos.

Roger: Well, this explains too the “product liability” section of their recent investor presentation.

David: Yep, the company has about AUD450 million set aside to cover asbestos-related claims, and it makes payments of about AUD40 million a year to victims.

Roger: OK, so we’ve covered the “comedy” and the “tragedy.” Let’s move on to the substance behind this month’s pick.

David: Let’s start with the July issue of Australian Edge, where we calculated the “Graham Factor” for all 108 companies we track in How They Rate. The “Graham Factor” is the price-to-book value ratio (P/B) multiplied by the price-to-earnings ratio (P/E). Factors below 22.5 are recognized by value investing Hall of Famer Benjamin Graham–Warren Buffett’s guru–as potentially good buys.

That 22.5 product is based on Mr. Graham’s benchmark of 1.5 for a “value” P/B and 15 times earnings for a “value” P/E ratio.

Now these are just starting points. For the AE In Focus feature I included other key elements such as beta–which is a measure of volatility, not risk, it has to be said, which is different from volatility–as well as company scores under the AE Safety Rating System to narrow down to an actionable list of buy targets outside the Portfolio.

Roger: And…

David: And CSR Ltd (ASX: CSR, OTC: CSRLF) had the lowest Graham Factor among the 17 Australia-based companies we include in the Industrials section of How They Rate, 3.90, versus an average of 39.61 for the group. Its P/E ratio at the time I ran the numbers–about 10 days ago–was 7.95, its P/B ratio just 0.49. The average P/E for AE Industrials was 19.89, the average P/B 1.99.

Interestingly, its beta was 0.84, which means it’s been less volatile than the S&P/ASX 200 for the trailing two years. The average for Industrials in the AE coverage universe was 0.92.

Even more interestingly, its Safety Rating is “3,” based on the fact that it no debt and so has no maturities coming due before the end of 2013 and that it also boosted its final dividend for fiscal 2012 to AUD0.07 per share from the AUD0.053 paid for the final dividend for fiscal 2011.

It loses a point because of its aluminum exposure, because it has cut its payout during the past five years and because its payout ratio is outside our comfort zone for Industrials.

Roger: That’s a pretty compelling starting point, though I’d emphasize that it’s only a start. What about the underlying business? What’s CSR up to?

David: It’s a pure-play building products and aluminum producer based in Chatswood, New South Wales, Australia. Two years ago it sold a sugar business that generated nearly half of overall revenue for AUD1.75 billion.

Its remaining assets on  the building products side of the business include Bradford Insulation, which makes and markets thermal, acoustic and fire insulation; Gyprock, which makes plasterboard, or what we in the States call drywall; Viridian, which makes all types of glass for all types of construction projects; Ceilector, which manufactures ceilings; Hebel, which makes lightweight building material out of an aerated concrete material; Monier/Wunderlich, which makes roofing tile; PGH Bricks & Pavers, the name of which explains rather well what it does; and Cemintel, which makes weatherboard, planks and cladding panels, or siding, for commercial and residential construction projects.

CSR also owns 70 percent of Gove Aluminium Finance Ltd, which owns 36.05 percent of the Tomago aluminum smelter, near Newcastle in New South Wales, the second-largest smelter in Australia. It’s reputed to be one of the world’s lower-cost and more efficient aluminum smelters.

Roger: The aluminum exposure can’t be helping the stock price this year.

David: Although the whole decline from above AUD12 is about more than aluminum, for the last six months CSR has traded pretty much in lock-step with the commodity. Aluminum on the London Metals Exchange (LME) hit a high of USD2,353 per metric ton on Mar. 1, 2012, but has been in steady decline since, bouncing mildly of late off a Jun. 26 low of USD1,845.

CSR traded at its 2012 high earlier, in mid-January at AUD2.10, but has fallen sharply since.

Roger: I see that earnings from the Tomago smelter investment declined by 28 percent in fiscal 2012. But that’s not a CSR-specific thing: This decrease was primarily because the benchmark LME aluminum price declined almost 20 percent during the financial year in both US dollar and Australian dollar terms, while input costs, including petroleum coke, increased.

These are factors completely outside of management’s control. Australian and global peers have suffered similarly, and the Australian government has already taken steps to keep smelters open, such as kicking in AUD40 million to keep Alumina Ltd’s (ASX: AWC, NYSE: AWC) Port Henry facility open at least two more years and prevent layoffs.

David: Other smelters in Australia have already been shuttered, including Hydro Aluminuim’s Kurri Kurri facility in New South Wales. Stocks of aluminum companies around the world are under pressure, with Alcoa Inc (NYSE: AA), for example, down over 50 percent in the last year.

One research analyst’s study has concluded that at current levels the market is valuing CSR’s aluminum assets at zero.

Roger: But it’s pretty clear too that its main Australian residential and commercial construction markets under extreme pressure.

David: If you think about the “zero” valuation for the aluminum asset and the fact that it generated less than 30 percent of total revenue, even with the pressures the building products and glass divisions, which make up two-thirds of sales, this looks like a compelling bargain.

Operational issues I think have a lot to with fixed-cost pressures as well as slowing new construction; management has forecast new dwelling starts of 140,000 for 2013, down from a full-year forecast of about 148,000 for 2012. This 140,000 would mark a 15-year low.

Roger: So valuation metrics are interesting, and the stock is less volatile than the market, although that’s because it’s been moving steadily downward as opposed to making jagged moves down after short-lived rallies. Can management keep the dividend where it is?

David: I think so. A little more than two years ago, in March 2010, CSR sold Sucrogen, the largest raw sugar producer and refiner in Australia and the eighth-largest company of its type in the world, for AUD1.75 billion. The sale allowed the company to return a total of AUD800 million to shareholders in the form of a special distribution.

And CSR was also able to repay all of its outstanding debt. Because of this asset sale CSR ended fiscal 2012 (its fiscal year runs from Apr. 1 to Mar. 31) with a net cash position of AUD56 million.

The company still incurs financing costs related to the asbestos provisions and to maintain banking facilities, and Standard & Poor’s affirmed its BBB+ long-term corporate credit rating on Feb. 24, 2012.

Roger: So the balance sheet is in good shape.

David: Yes. And the payout ratio for fiscal 2012, based on earnings per share, was 86.1 percent. Management’s preferred metric is net profit after tax (NPAT) from continuing operations, on which basis the payout ratio was 72.6 percent. It’s management’s policy to pay out 60 percent to 80 percent of NPAT, pre-significant items.

Management continues to invest in the growth of the business, spending AUD16.1 million during fiscal 2012 on smaller-scale but accretive acquisitions in its building products business. Capital expenditure of AUD105.1 million was up 59 percent from fiscal 2011, AUD65.5 million for maintenance, AUD39.6 million for new growth and development efforts.

Management has said a phase of intense capital investment has wound up with the fiscal 2012 program, so CAPEX will come down in fiscal 2013 to around AUD85 million, AUD35 million for development.

Cash flow from operations was down to AUD171.3 million (before tax payments and significant items) from AUD230.8 million in fiscal 2011. But this figure still covered the annual dividend by 2.6 times. Operating cash flow of AUD103.3 million, down from fiscal 2011’s AUD171.6 million, covered the payout by 2.0 times.

Roger: A multitude of macro factors will influence what happens with the price of aluminum, but as you’ve noted it looks like the market has already zeroed out this segment for CSR. What’s the outlook for housing and construction in Australia?

David: The Housing Industry Association, Australia’s equivalent of the US’ National Association of Homebuilders, has forecast the decline in housing starts will turn around in 2012-13 and pick up steam in 2013-14, but that 2011-12 will be soft. Renovation is also slowing, but the HIA is confident this trend will reverse too.

On a financial year basis, housing starts are expected to bottom at a level of 135,280 in 2011-12 before posting a modest recovery to 141,870 starts in 2012-13 and 148,060 starts in 2013-14.

That’s not to say we’re looking for a return to early 2000s glory–the recovery will be to a level still many thousands of starts below the decade average.

Roger: It looks like management will make its next dividend declaration in early November, when it reports results for the first half of fiscal 2013.

David: And it won’t be paid until the middle of December. It’s likely we’ll see some play-out on the share-price drivers, such as aluminum and stabilizing domestic commercial and residential construction activity, in the meantime. We could see a double-digit capital return before we start collecting dividends, but waiting isn’t such a bad thing, and holding on longer–more than 12 months–means we wouldn’t have to pay short-term capital gains tax rates, which are normal rates as opposed to the 15 percent established by the 2003 Bush tax cuts.

Roger: Good points.

It looks analysts covering the stock are almost perfectly split: five rate it a “buy,” four rate it a “hold” and four rate it a “sell.” Even the three most recent analyses have been perfectly split: a “sell” reiteration with a price target of AUD1.30 from Commonwealth Bank of Australia, an “overweight” reiteration from JPMorgan with a target of AUD1.80 and a “neutral” reiteration from Macquarie with a target of AUD1.44.

The overall average 12-month target price among the analysts who provide such a figure (11 out of 13) is AUD1.47, about 20 percent above its Jul. 19 intraday quote on the ASX.

David: As difficult as it is to identify suitable stocks for the parameters we’ve laid down for Big Yield Hunting, I’d say CSR provides a pretty compelling opportunity–again, for investors with the wherewithal and the stomach to make aggressive though informed bets on turnaround stories, underappreciated gems and outright speculations.

Roger: Well said.

David: Merci, mon ami.

CSR is a buy under USD1.35 using the symbol CSR on the Australian Securities Exchange (ASX) or the symbol CSRLF on the US over-the-counter (OTC) market.

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