Thinking through Forterra (FORT)

Looking at the big picture of a business

There is a very good interview (PDF) with Li Lu from 2013 in the Graham & Doddsville, the student newspaper of Columbia Business School. There he advises to understand one business thoroughly as if one owned it 100%.

So here is my view of one of the investments I hold which is Forterra (FORT.L)- a brick manufacturer in the UK. I’ll assume I’m the owner-operator.

We manufacture bricks in the UK. We’ve got a number of large production facilities (17) and we’ve also invested in a new large factory that will be the largest in Europe when it’s finished.

As an owner I want to generate the highest possible free cashflow on the capital invested in the company. This cash flow I want to invest most profitably in generating new cashflow going forward. So how are we doing at the moment?

We have about £230m book value - ie equity in the business. We have very little debt so I’m ignoring that part of the invested capital. If I look at the net working capital ie Current assets less Current liabilities + PPE I get approx. the same number.

We generated £70m EBITDA in 2021 and £50m in the 6 in 2021H1 - let’s assume we’ll make £80-90m in 2022. EBITDA adds back the amortisation and depreciation back onto operating profit. That’s misleading because it ignores how much we’ll need to invest into the business going forward - ie capital expenditure (capex). There are two aspects to capex - maintenance and growth - in our case we spend about £6m in maintenance and we’ve just spent £100m on building a new factory. I guess we’ll have to spend that amount every 5 years or so. So taken together and averaged (6 x 10) + 200 = 260 / 10 =26. So let’s say we make £26m capex investment in the business every year going forward.

That will leave us with some £55 - £65m in free cash every year. We don’t have much debt so we can largely ignore the interest on it. As the owner of the business I can just keep on banking this money and deploy somewhere else with better return on equity or reinvest in the business. But let’s say I keep it. How much money have I made over say 10 years? Let’s say it’s £500m - £600m. I know I should discount it with some discount rate but then the business will also grow a bit by inflating prices, new capacity etc so I’ll take it as is. Now, in ten years time I can sell the business for let’s say its current book value of £230m plus maybe some of the new PPE of say another £70m - ie £300m discounted at 7% so let’s say it’s £150m in current money. So all told I think the business is currently worth about £650m -£750m to me. Maybe less maybe more. Since it’s a hypothetical and I don’t really own all of it ;) you can actually buy it currently for £410m on the London Stock Exchange. In fact less as they have about £35m in cash so the enterprise value is £380m.

Why I bought the business is that it’s in an industry that is pretty stable - it’s expensive to transport, the cost per house is ~ 2%. Given this low proportion we may be able to raise prices without too much push-back. There is some tailwind in that there is a shortage of housing in the UK.

Is it going to be a better business in five years? I think with the new factory (which will increase capacity by ~ 20%) and other investments I’m more than 50% confident it will be better. How much better I don’t know.

How about our current management? The CEO has stepped down and a new CEO is coming in - he’s managed bigger businesses in the past and has experience in large capital projects. How is the management being incentivised? There is sadly not much inside ownership so very little skin in the game. The management got about £1.5m in salaries and bonuses which are tied to profit and strategic goals. The salaries constitute about 2.5% of the free cashflow so quite a bit.

So back to Return on capital - we’re getting £50 - £60m on capital of £230m so about 20-25% - not bad for an old industry.

What could go wrong? Obviously we consume a lot of energy - gas. We’ve fixed some of the prices using forward purchasing but it’s an unknown that could easily blow a big hole in our finances.

There is competition in this field - Ibstock Plc (IBST.L) is slightly larger but it’s return on equity is lower. However, they trade on a larger multiple than us.

Catalyst: Some improvement in the UK economy.