Property slump hits materials stocks

If you asked a university finance student how to value a stock, they would most likely tell you that some form of discounted cash flow would be the way to go (at least if they’d attended the lectures). But the real world of finance is a lot more practical than the storied halls of academia and many alternative valuation methods have been created over the years: some good, some bad; some easy, others complicated. Price-to-book ratios, price-to-earnings ratios (PERs) and dividend yields are just some of the techniques that have been devised to assist in valuing stocks.

One of the crudest methods of determining whether a stock might offer some value is to take a look at where its current price stands compared to its 12-month high and low prices. This technique has obvious flaws, as anyone buying HIH on the way down could testify.

Although deficient as a valuation technique, this process can at least provide a rough gauge of sentiment. When all the market can focus on is a stock’s blue sky prospects, then it’s likely to be close to its 12-month peak. Conversely, when gloom prevails, the stock is likely to be nearer its low. And as we note in this issue’s cover story, doom and gloom are more likely to produce value opportunities than a cheery consensus.

Negative sentiment

On that basis, now looks like a perfect time to reassess the building materials sector. With all the talk about falling property prices and declining approvals for new building developments, sentiment in the industry has turned negative—and most of the stocks in the sector are considerably closer to their 12-month lows than their highs.

The standout loser is Rinker, whose share price is now down 41% since it hit a peak of $22.22 in April this year. This stock provides an excellent example of the nefarious effect that sentiment can have on investment decisions. One local broker had been a cheerleader for Rinker for some time, having a buy rating on it during the period when it hit its 12-month high. Now that the fallout from the United States property market slowdown has started to hit, and after the stock has fallen through the floor, the broker has suddenly changed its recommendation to Sell.

The stock is now trading on a far more reasonable PER of 12. But, with earnings likely to decline this year, and perhaps stay down for years, we’re not willing to bet that we’ve seen the bottom yet. AVOID.

CSR is another stock plumbing new lows. It has lost 38% from its peak thanks largely to a profit downgrade earlier this month. This might have come as a surprise to the market, but it was met with more of a resigned sigh in our office.

No obvious advantage

In our last review of the stock we noted: ‘This is a cyclical business with no obvious competitive advantage, so we found it somewhat surprising that, at the AGM in July, management confidently predicted a 10% rise in operating profit for the 2007 financial year’. If there was an element of surprise on our behalf, it was because the profit warning was announced less than two months after the AGM. The stock is currently trading on a PER of about 10, which is pretty undemanding even for a company with poor businesses. The stock appears reasonably priced, but we believe there is BETTER VALUE ELSEWHERE.

Last on the list of biggest stock price losers is Boral, whose price has dropped 32% from its 12-month high. We could rabbit on about Boral’s troubles but we’ll save you (and ourselves) the trouble: the company’s suffering from the same problems as Rinker. AVOID.

Next on the list is James Hardie. Our past reviews have outlined why it’s among our least favoured stocks. It has an excellent business based on its fibre cement product, but this is overshadowed by the board’s apparent determination to push legal and ethical boundaries. AVOID.

Good news

Based on the above four stocks, you might be beginning to wonder if we would ever have a positive recommendation on a building materials stock. The good news is that there are a couple of stocks out there that, due to highly regarded management or impressive market positioning, we’d be keen to buy if the price was right.

The first stock on our watch list is Brickworks, and in our most recent review of the company, in issue 180/Jul 2005 (Avoid—$10.22), we tried to separate the company’s ancillary investments from its core brick-making business. An updated version of that exercise shows that when Brickworks’ investments in WH Soul Pattinson and Brickworks Investment Company, valued on the market at $839m and $59m respectively, are deducted from the company’s enterprise value of $1,821m, the implied value of the core brick and tile business and property development business comes in at $923m.

That works out as a multiple of more than 8 times earnings before interest, tax and amortisation (EBITA). We thought that multiple was expensive a year ago, so we’re not about to change tack now. Despite the company having impressive management we just can't recommend an investment in the company at this price. AVOID.

Favoured stock

The other building materials stock that has caught our attention in the past is Fletcher Building. The company increased profits again this year despite tough trading conditions and reported earnings per share of NZ$0.81, putting its stock on a PER of just over 10 at current prices.

There are a number of reasons why Fletcher Building stands out from other stocks in the sector. Firstly, we’ve always respected the management team at the company. However, the former chief executive, Ralph Waters, hung up his boots on 31 August this year, to be replaced by another Aussie, the former head of the company’s Australian laminate and panels group, Jonathan Ling.

We expect there was probably some heavy competition for the job. On Ling’s first day in the top role, the chief executive of the company’s building products division, Andrew Reding, tendered his resignation. The departure of two key executives in such a short space of time is a major concern for a company that faces a slowdown in building activity in its key markets of New Zealand and Australia.

The other main reason we’ve liked Fletcher Building in the past is the market dominance of many of its products in New Zealand, with some commanding market shares of more than 50%. Building materials companies might have average businesses, but figures like these can help overcome some of the sector’s frailties.

Management has admitted that 2007 will be challenging, although we expect the company to report earnings per share at least equalling 2006 levels. The stock looks reasonably priced, but the management changes and forecast tough market conditions for the next few years mean we’ll stick with HOLD for now.

Also on the list is Adelaide Brighton. We haven’t reviewed this stock since it looked like being swallowed up by Boral two years ago. The ACCC effectively killed that bid in what might have been a godsend for the company’s shareholders, with the stock price up sharply since. Despite the success of the past few years, Adelaide Brighton doesn’t excite us. The stock is unlikely to find its way onto our buy list any time soon and, on that basis, we’ve decided to CEASE COVERAGE.

Brad Newcombe