Stock in Focus: Is now the right time to buy Forterra?

Market conditions mean that I’m struggling to find new stocks to add to my screen-based Stock in Focus portfolio system.

As I write, just eight stocks qualify for my buying screen. Of these, four are already in the portfolio and three are ruled out for various other reasons. That leaves one company, FTSE 250 firm Forterra.

Forterra (LON:FORT)

This brick-and-block maker was founded as part of Hanson in the 1960s. Hanson was acquired by Heidelberg Cement Group in 2007.

Hanson’s UK building products division was then sold to private equity in 2015 and rebranded as Forterra. A London IPO followed in 2016, hot on the heels of rival Ibstock (LON:IBST) in 2015.

Both firms’ private equity owners were keen to cash in on surging demand for new homes, aided by the Help to Buy scheme.

Forterra shares have delivered reasonably good returns for shareholders who have caught the lows, but performance has otherwise been somewhat rangebound:

Performance against key UK rivals has also been middling. Forterra has outperformed larger Ibstock (LON:IBST) but has lagged behind premium brick specialist Michelmersh Brick Holdings (LON:MBH) on a five-year view:

Looking ahead, I think it’s fair to assume that market conditions could get tougher. Rising interest rates, surging inflation and the possibility of a recession could all have a negative impact on construction activity.

This could provide an interesting backdrop for the opening of Forterra’s £95m new factory in Desford, which is due in 2023. Management say the new plant could boost profits by a third from current levels by 2025, assuming demand remains stable.

The risk is that this extra capacity will come onstream just as demand eases. That could weaken Forterra’s pricing power, although I’d guess the initial impact would be to displace imported bricks.

Fortunately, it’s not my job to make macroeconomic predictions. I’m just here to review the numbers, which look quite positive to me.

Forterra passes all of my screening tests with ease, and also scores well with Stockopedia’s algorithms:

As usual, I’ll examine Forterra by looking at its value, quality and momentum metrics, highlighting those which seem significant to me.

Value: better than it looks?

ValueRank: 53

Forterra’s ValueRank is by far the stock’s weakest factor score. The shares don’t score very well on several key metrics used in the ValueRank calculation (circled):

Price to book: a high price/book ratio can sometimes be a sign of a weak balance sheet. Too much debt or too little liquidity, for example. In this case I don’t see any serious problems. Forterra ended last year with net cash of £24m and adequate liquidity, in my view.

Instead, I think the explanation is that Forterra’s high P/B ratio reflects the group’s strong profitability. More on that in a moment.

Price to free cash flow: by inverting Forterra’s P/FCF of 18.7 we get the stock’s free cash flow yield of 5.3%. That’s enough to cover last year’s 3.5% dividend comfortably, but it doesn’t seem especially cheap to me.

However, Forterra is investing in a new factory, so I’d expect some pressure on free cash flow.

Price to earnings: the stock’s trailing P/E of 16.6 does not seem obviously cheap, but after-tax earnings were depressed last year by a £10.8m (non-cash) tax charge to reflect next year’s increase in corporation tax from 19% to 25%.

Earnings yield: I think we can get a more objective measure of valuation by looking at Forterra’s earnings yield (EBIT/EV). This comes in at a very attractive 10%, comfortably above the 8% minimum required by my screen.

Earnings yield was made popular by US value investor Joel Greenblatt and has the benefit of neutralising the impact of changing tax rates and debt levels.

My view: Based on recent performance, I think Forterra could be quite reasonably priced.

Quality: strong profitability

QualityRank: 95

A high QualityRank is generally an indicator of a profitable and improving business. The StockReport provides us with a quick view of all the factors that lie behind the quality score.

Profitability: I mentioned Forterra’s strong profitability in the value section. Here we can see that the numbers look very good indeed. Forterra’s high operating margin and return on capital employed suggest to me that it benefits from economies of scale and decent pricing power.

Fundamental health: the F-Score tests a range of fundamental factors such as cash generation, profitability and liquidity to see whether they are improving or not. A high score generally means that a company’s financial health is improving.

Safety: the Bankruptcy and Earnings Manipulation Risk scores are intended to flag up companies whose accounting may mask serious problems. These measures aren’t foolproof but negative results are worth investigating, in my view. Fortunately, no risks are flagged up here.

My view: Forterra appears to be a very profitable and healthy business. Once again, the main risks I can see are cyclical. Any reduction in demand or failure to pass on cost increases could hit the group’s profitability.

Momentum: still motoring

MomentumRank: 88

If a construction market slowdown is on the horizon, City analysts have not yet decided to acknowledge it. Nor have investors, who have pushed Forterra’s share price up by nearly 20% since the start of April.

Forterra’s MomentumRank of 88 seems to suggest further gains may be possible. Let’s take a closer look at the two main factors which lie behind this score.

Price momentum: these technical metrics show that Forterra shares have outperformed the market over the last year (relative strength) and are now trading in a uptrend, close to their 52-week high.

Earnings estimate: Broker earnings estimates for 2022 and 2023 have risen steadily over the last 12 months.

2022 earnings estimates were upgraded in May after the company said it expected 2022 results to be “materially ahead of its previous expectations.”

However, the two blue lines on the chart above have got closer together recently. This tells us that earnings growth could slow next year. Understandably, City analysts are not yet willing to extrapolate the bullish outlook for 2022 into 2023.

Forecast valuation: Forterra’s forecast growth and valuation metrics look potentially attractive to me:

The P/E ratio is highlighted as red (i.e. expensive) against industry peers. However, I think this is due to the mix of companies listed in the Construction Materials sector. Some of these are overseas companies that aren’t relevant comparisons.

I estimate a UK sector-average rolling forecast P/E of 11, in line with Forterra’s valuation.

My view: As things stand today, Forterra’s momentum certainly appears strong to me. But I think there’s a risk the outlook could deteriorate quite fast.

My decision

Buying Forterra may carry some cyclical risks, but I think there’s a fair chance the shares could be a good investment from current levels.

However, I’m not going to add Forterra to the portfolio for diversification reasons.

I already hold property developer Watkin Jones (LON:WJG) in SIF. Comparing the share prices of Watkin Jones and Forterra shows an alarming degree of correlation since 2016. More than I expected, to be honest:

I don’t think it makes sense to double up on property risk when these shares have moved so closely in the past. I’m cautiously optimistic about Forterra, but I won’t be buying.

Disclosure: Roland owns shares of Watkin Jones.