Built up too much?

Boral boss Mike Kane vented this week in a rare display of apparent frustration at the state of the economy and the impotence of monetary policy.

Green shoots? He hadn’t seen any in housing or construction, he said, and that was after 18 months and 175 basis points of interest rate cuts.

Maybe his rant was the tipping point for the Reserve Bank board which, the following day, delivered yet another cut, taking official cash rates to a historic low of 2.75%.

But for all the noise surrounding Kane’s 30% earnings downgrade – his finger pointing at everything from the weather to the economy – the massive earnings hit raises more questions than it answers. How much of Boral’s problems are cyclical, and how much is unique to the company?

From an investment perspective, Boral and other building materials supply companies have been bid aggressively higher on the expectation of a housing market recovery 12 to 18 months down the track.

The problem is, those expectations have been around for more than three years and, when it finally does arrive, will only serve to justify current earnings multiples.

When it comes to housing exposure, there are better investment opportunities among the developers and the REITs, with Lend Lease a clear winner.

Prior to the downgrade, Boral was priced at a little over 14 times next year’s projected earnings, making it one of the more sanely priced stocks in the sector. That blew out to 22 times after the downgrade, but since has dropped to 17 times as the stock price was thumped back to $4.50 levels.

As I pointed out last week (The housing stocks on the up and up), clear evidence now is emerging of a recovery in the Australian housing market. But it is patchy and tentative, with Sydney bouncing off a low base and Melbourne labouring under the weight of an oversupplied market while the March figures went backwards.

Despite housing affordability at its highest level in years, first home buyers are almost completely absent from the market as governments, both state and federal, have removed incentives.

In addition, new construction activity has been concentrated in medium to high density dwellings which, given the extent of common walls, require less material than detached housing. Renovations, meanwhile, are almost non-existent.

Kane this week referred to these factors. On top of that, the construction materials division had been hit by persistent wet weather in south-east Queensland along with delays to major projects in Victoria and Queensland that had contributed to a shortfall in third quarter earnings. All these things are cyclical and, clearly, out of the company’s control.

But the spectre of structural problems continues to dog the company. Kane’s predecessor Mark Selway was unceremoniously dumped last year, midway through a radical overhaul of the business.

Delivering power to the shop floor and out of senior management’s hands apparently put some noses out of joint. But it delivered huge increases in productivity, allowing Selway to shut down large slabs of redundant capacity in masonry, bricks and roofing.

While Kane continues to strip costs out of Boral, there are clear signs that the domestic business, particularly for building supplies and especially timber, are suffering from import competition related to the strength of the Australian dollar.

Boral’s gypsum business also is a serious underperformer. Selway bought out French group Lafarge in an Asian joint venture for a whopping $616 million. It seemed like a good deal at the time and probably will be in the longer term. But for now it is a major drag on earnings, although it is performing far better than the Australian arm.

On the positive side, Boral has around 11% of its revenue exposed to new housing starts in the US. Unfortunately, the US operation is a drag on earnings at the bottom line and this year is scheduled to lose more than $60 million.

But after more than five years in the gutter, the American housing market finally is showing signs of life and the division is expected to move into profit mode by 2015.

In terms of Australian housing starts, Boral is estimated to have a 35% revenue exposure to Australian housing starts.

After the cuts to official rates this week, the dollar headed lower; well, for a day or so. Kane would be praying for a sustained fall in the currency. It not only makes imports more expensive, but every 1c fall in the Australian dollar adds $2 million to Boral’s earnings before interest and tax as it repatriates its American income. That does not flow directly to the bottom line, however, as Boral’s US division has some unhedged US dollar denominated debt.

Among the analysts, opinion is deeply divided, although the optimists at this stage hold sway.

Despite this week’s downgrade, three major broking houses, Deutsche Bank, UBS and Credit Suisse, continue to rate the stock a buy, with target share prices ranging between $5.10 and $5.38.

JP Morgan upgraded its recommendation to hold in the wake of the announcement with a $4.40 price target while BA Merrill Lynch downgraded to a hold.

Those in the buy camp firmly believe that recovery in Boral’s key markets will fuel a sharp rise in earnings which, when coupled with the company’s strong focus on costs, will deliver the goods for shareholders.

And if this week’s interest rate cut has the desired effect, boosting housing and construction while weakening the dollar and improving Boral’s foreign earnings position, then the company may see serious benefits.

The most bearish is Citigroup. It has long had a sell recommendation on the stock, with a target price of $3.40.

While noting the cost savings program is well underway, the broker questions what the position would be like without it.

It adds that the key reasons for its negative view of Boral and the sector in general has been not just the weak housing market, but increased competition from existing and new entrants and from imports and the difficulty that will present in terms of future price rises.