GWA Group

Theory says you should price cyclical companies on a relatively high price-earnings ratio at cyclical low points and a low PER at peaks, in anticipation of the upswing or the downswing to come. But it does rather beg the question of how you know there’s actually going to be an upswing or downswing.

It’s a pertinent question right now, with companies in many sectors enduring yet another year of weak conditions.

GWA Group, for example, saw its earnings per share peak at 23 cents way back in 2005, and this year they’re expected to hit their lowest in the current downswing (their lowest since 1997 in fact), at 12.4 cents.

All very neatly, the market is pricing in a recovery starting next year (to 15 cents in 2014 and 17 cents in 2015) – no doubt just as it has for the past few years. So the dizzying PER of 17.5 for this year’s earnings should fall to about 15 for next year and 13 for 2015. But what if the recovery doesn’t come, just as it hasn’t for the past six years?

There is some cause for optimism, with the company recently flagging an extra $4m of earnings before interest and tax in the current year (on top of about $61m) following a restructuring, and mentioning ‘some improvement’ in trading in October and November. But that follows a 41% fall in EBIT in the first quarter, so should be seen in context.

In its first quarter update on 19 October, management also explained that it wasn’t expecting a sales pick-up in the current year since demand for its bathroom, kitchen, door, and heating and cooling products typically lagged building approvals by 6-8 months. So, excepting an intervention from Dr Who, we suspect that any recent improvement is slight.

Right now it looks like the market is taking too much for granted for GWA. Even if the recovery does come through, a PER of almost 13 for earnings two years hence looks very steep for a company with returns on equity in the low teens despite a net debt to equity ratio of about 40%.

GWA has some okay brands and we've recommended it in the past, before selling on 6 Nov 08 (Sell – $2.90). We could be tempted if earnings looked set to improve markedly and/or if the valuation became a lot cheaper. In the meantime, we recommend you AVOID it.