Analysts expect WA pipes will cost Fletcher more

Analysts think the leaky plumbing pipes problem in Perth is going to cost Fletcher Building a lot more than its existing $16 million provision, irrespective of who's right or wrong about what caused pipes manufactured by its Iplex unit to burst.

They also expect it will likely take a number of years to resolve the issues.

Forsyth Barr analyst Rohan Koreman-Smit has written an A$100 million cash cost estimate into his earnings forecasts for the full years ending 2024 to 2026 but said “the range of outcomes is wide and highly uncertain.”

Craigs Investment Partners analyst Cameron Parker estimates that the rot could stop at Fletcher's existing provisions, but could also end up costing the company up to $2 billion if a full product recall is required.

“We think a provision, (to be established over time), is more likely than not to be at the lower end of the range,” Parker said, noting a $250 million liability would cost 20 cents per share.

Perth-based building firm BGC has called for a full product recall and estimated that would cost about A$1.8 billion, although both it and Fletcher have said the industry doesn't have the required capacity.

Fletcher estimate

Fletcher has argued that cost estimate is “sensational,” that a product recall isn't warranted, and that the total cost of repairs to the wider industry will be between $50 million and $100 million.

Jarden analyst Grant Swanepoel has also assumed a range of potential outcomes but estimates only a 5% probability of a full recall.

He estimates that would cost about $1.38 per share.

But neither can he completely buy Fletcher's assertion that it was poor installation practices and not the pipes themselves, that caused the problems.

The evidence just doesn't add up for Swanepoel.

On the one hand, while building firm BGC, whose houses account for about two-thirds of the leaks discovered to date, has asserted that there are leaks elsewhere in Australia, Swanepoel is having a hard job of buying this.

Fletcher has said about 15,000 homes on Australia's east coast were built using the Iplex pipes, with 55% of these built by only four building firms, and that the failure rate has been negligible – Fletcher put the number at 28 affected homes and only one was the result of a product defect.

“On this evidence, it is hard to put a material probability on an ex-Western Australia issue,” Swanepoel said.

Anomalies beyond coincidence

However, he is equally puzzled about why the pipes started leaking after mid-2017, and appeared to have stopped leaking in 2021, if shoddy workmanship was the cause.

If one accepted Fletcher's data, “you would need to believe that installation practices in Perth were fine in the lead up to 2017, deteriorated briefly in 2017, improved in 2018, then deteriorated sharply in 2019 and 2020 before improving in 2021,” Swanepoel said.

He describes the situation as “a data anomaly that looks beyond coincidence.”

Parker estimates the cost to Fletcher could be anywhere up to $1.36 per share but hasn't yet factored anything beyond the existing provision into his 12-month target price of $5.36 per share.

“Resolution of any type appears fanciful in the near term, particulaly given each party's estimated total remediation costs vary wildly,” Parker said, describing both Fletcher's and BGC's presentations as “robust.”

“Without getting bogged down in the murkiness of the claims and counterclaims, what is clear is that the most likely outcome will be a drawn out process of leak repairs and cost, data collection, reporting to regulators and, potentially, litigation as a means to an end.”

Sharp share price fall

The share market appears to have taken an each-way bet, driving the shares down 14.5% to $4.19 early on, before ending Monday at $4.33 from $4.90 when trading in the shares was suspended last Wednesday.

But the current price weakness “may present a good buy opportunity,” based on Fletcher's numbers, Parker said.

One reason the market reaction was as strong as it was comes down to Fletcher's credibility issues.

“Its recent track record of estimating costs has been poor,” ForBarr's Koreman-Smit noted.

“Given the entrenched positions on both sides, it is likely this resolution of the issue will be drawn out and litigious,” he said.

One thing investors will be watching for is the outcome of joint inspections of affected homes by both Fletcher and the Western Australian regulator, the Department of Mines, Industry Regulation and Safety (DMIRS), which are about to begin.

DMIRS' current position is that the problem lies with the pipes themselves – Koreman-Smit said his understanding is that “DMIRS' initial view was based on BGC's findings only. We note that the DMIRS is conflicted, given it is the entity who should ensure that failures of the nature identified by Fletcher should not be occurring.”

However, the fact that DMIRS has agreed to the joint inspections does suggest it is at least somewhat open to changing its view.

In his presentation on Friday, Fletcher chief executive Ross Taylor noted that in Western Australia plumbing installations are self-certified by the plumber, whereas in Queensland, every plumbing installation is inspected.

Improving outlook

Whatever the impact of the pipes problem, Parker's view of the wider Fletcher outlook has become a little brighter.

He has raised his forecast for the company's earnings before interest and tax (ebit) by 1.7% to $675 million for the year ending June 2024, by 3.6% to $684 million for the following year, and by 2.2% to $748 million for the year ending June 2026.

For the year ended June this year, Fletcher reported normalised ebit of $798 million, up 6% from the previous year.

The increases “reflects our moderating view of the impact from the current down-cycle on Fletcher's materials and distribution divisions,” Parker said.

“Recent channel checks, along with the potential tailwinds from a change to a centre-right government and continuing strong net migration numbers suggest an increase in work put in place is possible from early calendar year 2024,” he said.

StatsNZ provisional data put the annual net migration gain in the year ended August at 110,200 people.

But until he gets better visibility on the data, his forecasts for Fletcher's other divisions remain unchanged and he noted that his medium-term group ebit forecasts are between 1% and 3% below consensus.

Parker has a “neutral” rating on the stock while Jarden has maintained its “buy” recommendation and ForBarr expects the shares to “outperform.”