All Eyes on Rinker

If history repeats itself this year, July should bring relief to a bruised and battered local sharemarket. History shows May and June are usually among the worst months for sharemarket returns, and this year has been no exception.

It used to be that June was the worse of the two, but the pattern has changed in recent years with May generating negative returns and June performing slightly positively. Equity strategists at GSJB Were suggested recently the change in pattern might be the result of investors trying to pre-empt the end of financial year dressing up of investment portfolios and starting to sell their loss-making investments in May.

Whatever the reason, a buoyant April tends to be followed by two months of subdued trading and that's exactly what has happened this year.

The good news is that July is usually one of the strongest-performing months of the year, vying with April for third place after the traditional rally months of December and January.

The news gets even better for investors in local equities, with technical analysts at Barclays Capital reporting this week the Australian sharemarket has historically been one of the best performers across the globe in July, with only the Hang Seng in Hong Kong performing better.

However, it is the upcoming results season that will determine the sharemarket’s direction in the coming year. Are analysts’ profit expectations too bullish? It is only human to err on the positive side in good times and to be too negative in the bad. History shows this is all too often the case.

After a few years of above-trend earnings growth, especially in sectors such as energy, metals and engineering, the risk is that securities analysts may have fallen into the habit of adding a dose of optimism to their numbers. The risk that expectations will have to be scaled back.

Several companies have already announced they won't meet prior profit guidance or market expectations for 2005-06, including the blue-chips Qantas (QAN), Ten Network (TEN), Aristocrat Leisure (ALL) and BlueScope Steel (BSL), as well as Repco (RCL), Nick Scali (NCK), Oroton Group (ORL), DCA Group (DVC), Coca-Cola Amatil (CCL) and several smaller caps.

All this is nothing unusual because the lead-up to reporting season always brings out both positive and negative revisions.

It is what happened to Rinker (RIN) this week that should have investors worried. Ever since Rinker was spun off from CSR (CSR) three years ago management has built up a reputation of exceeding its own guidance and market expectations, making Rinker a sharemarket darling over the past few years.

Until this week, Rinker was among the highest recommended stocks in Australia: nine out of 10 leading market experts rated it positively, with the average price target suggesting total investment return of about 35% over the coming 12 months.

In the space of a few days UBS and Credit Suisse downgraded the stock to neutral. More importantly, both brokers have reduced earnings forecasts and valuations for the shares by double digits. While others are still suggesting the shares will be trading at $22 and more next year, UBS and Credit Suisse have now set their targets at $17 and $19 respectively.

As a result of both downgrades Rinker shares fell below $16 this week, though they have recovered towards $17 again, indicating investors may still give management the benefit of the doubt.

Does this mean we should simply dismiss concerns at UBS and Credit Suisse?

Consensus earnings are currently for Rinker to report a net profit of about $US885 million, or US97¢ a share. Management's guidance for the year is for earnings per share (EPS) of US86–92¢ "pre and post both capital return and special dividend" which, on CS calculations, translates into an EPS range of US84–90¢ post capital management.

This means that even if the company meets its own guidance in August, it is likely to get hammered.

Credit Suisse forecasts a net profit of $US740.2 million, or an EPS of US80.2¢. Coincidentally, UBS has now pared back its forecasts to similar figures.

The difference between the consensus forecast for Rinker and what UBS and Credit Suisse now expect is 20%. Let's hope for Rinker shareholders that UBS and Credit Suisse are wrong '” and for the sake of the market that Rinker is not the harbinger of what is yet to come.

Higher costs will feature prominently in the upcoming results season. Slowing economic growth will be the next focus of investor attention, but it is likely to become more of a feature in next year's half-year results. Company leaders may, however, be more conservative when giving earnings guidance for the new year.

BHP Billiton's (BHP) recent carbon steel materials briefing (iron ore, coking coal and manganese) may serve as an indication of the magnitude in cost rises many companies are having to deal with. According to information provided at the recent presentation, operating costs for BHP's iron ore operations are up more than 100% from 2002-03, driven by freight (up 800%), contract mining costs (up 60%), royalties (up 100%) and diesel (up 200%).

Luckily for BHP shareholders, and not so lucky for steel manufacturers, the contract prices for iron ore went up by more than that.

Of course, just like any other results season, the upcoming one will be a combination of both positive and negative surprises. Speculation is already mounting that Telstra (TLS) will surprise on the positive side at what will be chief executive Sol Trujillo's first full-year result presentation.

Companies such as Oaks Hotels & Resorts (OAK) and Fone Zone (FZN) are expected to clearly beat previous guidance.