The next Rinker

What will be the next Rinker? I’ve had quite a few conversations with institutional investors over the past few days about which company could suffer a sudden 35% drop in its share price as analysts fall out of love with the company.

To find the next contender, we must first analyse what went wrong with Rinker. Put simply, the building materials analysts who cover Rinker made the fatal error of mistaking cyclical growth for structural growth. The cyclical earnings were capitalised as structural at the top of the US housing cycle. The price/earnings multiples (P/Es) and broker price targets expanded at the top of the US housing activity cycle.

For entertainment, I've re-read a few competitor reports on Rinker over the past three months and, quite frankly, they are laughable. They talk about how Rinker is positioned in structural growth states such as Florida, Texas, and Arizona, and how it would be in a strong position to grow earnings even though leading indicators of US housing activity were turning down.

The weakest recommendation from a broker I can find at Rinker’s share price peak was a "hold", while most wrote comments along the lines of "earnings and share price momentum to continue; Buy". Most analysts forecast earnings above the company's guidance range, and price targets were $25. The shares are now about $13, and the company has not changed its guidance. I think the shares are now good value.

I believe every industry is cyclical to some degree '” every company in every industry has some degree of cyclicality to its earnings. The biggest mistake you can make is to confuse cyclical earnings growth for structural earnings growth and then put a higher earnings multiple on that mistake.

Chasing momentum over the cliff

In the world in which we operate, all forms of above-market earnings growth, be they cyclical or structural, seem to attract a higher multiple due to the weight of money chasing earnings and share price momentum. I believe this leads to peak cycle cyclical earnings attracting higher P/E multiples, when multiples should be contracting as cycles peak.

The market capitalises each piece of cyclical earnings news as it is released, which I regard as the great flaw of quant-based momentum investing. I believe if the weight of earnings and share price momentum money in Australia wasn't so large then Rinker shares would never have traded at $22. They may have only ever reached $17 as the cycle peaked, and then retraced to where we are today.

So to find the next Rinker-style problem we must look for cyclical companies that are being priced (in P/E terms) as structural growth companies. The answer is clearly NOT in the resource sector, because single digit P/Es and consensus earnings that fall 50% over the next few years suggest that the market simply doesn't believe the current commodity price cycle is structural. I do believe the commodity cycle is structural, but the market clearly doesn't.

That means the next potential Rinker-style problem'” and I stress potential '” is among the industrials, a large-cap industrial cyclical company whose earnings are approaching peak cycle yet whose P/E is expanding as the market believes the growth is structural. In other words, the market is capitalising the earnings growth.

Let me just reinforce a couple of sectors that are cyclical; always have been, always will be: transport, investment banking, retailing, media, property development, building materials, basic manufacturing, steel, paper & packaging, telecommunications, market-linked earners, premium wine, healthcare, contractors, and industrial services.

The vast bulk of the leading stocks in the sectors I mention above are lowly rated, and have underperformed the market over recent years. However, there are clearly companies in the transport, investment banking, retail/consumer discretionary, market-linked earners, contractors and healthcare sectors who are seeing the P/E expansion at what could well prove to be the peak of the cyclical earnings and margin growth cycle for their industry.

Yes, these companies will report very strong earnings and dividends in the pending 2005-06 reporting season, but you really should be asking yourself whether it's as good as it gets, in P/E and earnings/margin growth terms, for cyclical companies operating in the six sectors I mention above. Stocks in these sectors that require you to be certain that it's "structural" rather than "cyclical", include the ASX, Macquarie Bank, Babcock & Brown, Computershare, CSL, Cochlear, Resmed, Toll Holdings, Brambles, Woolworths, Coles Myer, Aristocrat, WorleyParsons, Leighton Holdings, and United Group.

These companies are all priced as "structural growth" stocks and, yes, many will prove so due to industry structure alone. But some are clearly not, and you must remind yourself of the Rinker example and consider what would happen to the given company's share price if the market woke up one day and realised the earnings growth was cyclical, not structural.

Where is the love?

I'm just thinking aloud here, but at this stage of the earnings and share price cycle you really need to consider every day why you are holding a given stock, and why it is priced as it is. You have to consider the share price ramifications if the market falls out of love with a widely loved stock.

Just remember it gets harder to grow earnings from a higher base, yet the market currently adds P/E and adds expectation to those that are growing earnings to a high base. If the market (and the analysts who seem to be always in a contest to see who can have the highest earnings forecasts) are even marginally disappointed by the delivered growth, the ramifications for P/E and share price will be huge. Remember, Rinker never changed its guidance, but look what happened to the share price as the quant-based funds rushed the exit after analysts downgraded their excessively bullish expectations.

There have been a couple of pointers already from global resource stocks to what is coming from Australian resource stocks over the next month. Last week, for example, Freeport-McMoran doubled its second-quarter profit to $US367 million, or $1.74 a share, compared to $US175 million or 91¢ a share 12 months earlier. The analysts didn't quite get it right, with expectations of $1.45 a share, and their revenue forecasts were a tad off the mark with consensus at $US1.3 billion. There are earnings and cashflow surprises coming from the Australian resource sector, yet the key stocks are being priced on geopolitical risks. I smell opportunity, and I'm coming in to this reporting season "fully loaded" in our highest quality resource stocks.

BHP Billiton, the cash machine

My view remains that the market’s obsession about whether commodity prices are sustainable is taking the focus off the "company-changing" cash flows the resource sector is spitting out.

I believe these "super cash flows" are reducing the overall risk of the sector because management is showing discipline and using those "super cash flows" to either buy back large chunks of scrip, pay special dividends, or both. These super cash flows are being returned to shareholders, and I believe that will continue.

You don't even have to believe in a "super bull" commodity scenario to see BHP Billiton generate $US30 billion of free cash flow over the next three years '” yes, that's free cash flow after capital expenditure of $US30 billion.

My research colleague David Radclyffe ran some scenario analysis today, at commodity price forecasts that are far from "outrageous", and the results are that BHP Billiton could have up to $US30 billion of free cash flow over the next three financial years, which equates to $A7 a share (25% of the current market price).

Using an average oil price of $US60 a barrel, an average copper price of $US2 a pound, an average nickel price of $US8 a pound, iron ore up 10% and then staying flat, and flat coal prices for both thermal and coking, the calculation comes to $US30 billion of cumulative free cash flow over the next three years. Then you need to then consider what BHP will do with its huge free cashflow.

The Freeport McMoran quarterly highlights the return to shareholders when cash flows overwhelm allocated capital expenditure commitments. Freeport earned $US1.74 a share in the second quarter and paid a total dividend, including a special, of $US1.06. In the six months to June 30, the company earned net income of $US739 million and returned 61%, or $US452 million, in dividends and share buybacks. The Freeport result is an indication of the potential for BHP and Rio Tinto shareholders as capital expenditure starts to slow. As a reminder, last year BHP paid dividends of US42¢, or a yield of 1.4%.

As BHP turns down the capex/expansion/investment tap in 2007-08 and 2008-09, the free cash generation becomes enormous. This strong cash flow generation is expected to yield increased returns to shareholders through increased dividends and further buybacks (each $US2 billion equates to a return of about 1.6%).

So the "upside case" really isn't that optimistic, with many of our assumptions significantly below spot prices, but in line with futures curves. Let’s just say that if we used spot commodity prices and averaged them for the next three years, the free cash flow BHP spits out is obscene.

What will they do with all the money? Free cash flow of $US30 billion or potentially more is a very high-quality problem for a board to have. What a great strategic problem to have '” what to do with $US30 billion?

I've speculated aloud about BHP taking out Shell and bidding for Woodside Petroleum, but I suspect the more likely use of the free cash flow is a combination of huge buybacks and special dividends.

Bring it home, boys

If I sat on the BHP board I would be strongly considering how to unwind the dual-listing structure. My view remains that the dual-listing is actually playing a role in contributing to BHP's low P/E rating. The ever-widening discount the (UK-based) PLC shares command reinforces just how out-of-date the structure now is and why it needs unwinding.

I think the excess free cash flow should be used to buy back the entire PLC listing. Yes, buy back the entire thing over a three-year period. Buy out the hedge fund dominated register, and return BHP to its rightful spot as a purely Australian listed company.

The beauty of this idea is that you cancel 35% of the entire BHP Billiton register through time, and have an associated earnings per share uplift due to the number of shares on issue being lower. However, the good news is that the lower number of shares on issue in no way effects BHP ASX 200 index weighting of 10% as the UK shares are not included in the ASX calculations anyway.

If you offer the Poms a cash or scrip alternative at parity, and some choose scrip, the ASX 200 weighting will actually rise due more Australian dollar-denominated shares being on issue.

If I don't say so myself, the idea is a no-brainer. I can't see how this isn't in the long-term interests of the company and its long-term shareholders. The influential funds will continue to buy the buyback-generated earnings-per-share upgrades, while 10% of every Australian compulsory superannuation dollar that finds its way into Australian equities will find its way into BHP. That compulsory super flow can be tapped for growth capital if required, and buying back the UK listing in no way constrains BHP growth or acquisition options.

The other beauty of this idea is that it reduces risk, because BHP would be investing in the asset it knows best: itself. BHP has the greatest suite of mining assets in the world, yet the dual listing is contributing to those assets being priced as some of the cheapest in the world.

I know there are tax issues in unwinding the dual-listing structure, but I believe they could be overcome. I believe this must happen, and although I am out of line telling the BHP board what to do, I am certain that if they followed the advice above that BHP would be a $A50 stock in three years time, trading on P/E multiple of 13 times. Today, we have the greatest mining company in the world trading on a single-digit P/E, with that P/E actually contracting.

The stock is basically trading at net present value '” and that's in the middle of a commodity "super cycle". Action is required to rectify that ridiculously low rating, a rating that clearly doesn't reflect the quality or duration of the assets, the quality of the management and board, or the quality of the balance sheet and cash flows.

I'm a bit passionate about this because I believe there is huge value to be released here, and I believe a much better rating can be achieved for BHP Billiton. I'm certain BHP is considering all these options, I'm just urging directors to get on with it and back themselves. It's now or never boys, let’s take out the Poms and bring it home.