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The First Axe Falls On Darling Rinker

Australia | Jun 28 2006

By Greg Peel

"Earnings revisions are the most important driver of [Rinker] RIN’s share price, in our view. Those earnings revisions are a function of changes in the supply demand balance in RIN’s key products, readymix concrete, crushed stone and cement in Florida (Fl). At the moment demand exceeds supply providing RIN with strong product pricing power leading to ongoing positive earnings revisions, increasing returns on capital and an ever improving balance sheet." – UBS, 13th April 2006.

"Profit revisions are typically far more powerful than multiples in explaining share price movements in building materials stocks. The reason is that most valuations are related to expected earnings growth, and building materials stocks have low earnings visibility. For instance consensus estimates of RIN earnings two years out show an average error of over 30% for the three years since RIN has been listed." – UBS, 28th June 2006.

And with that, the axe fell.

Rinker (RIN) has been a market darling for some time now. Prior to today, 8 out of 9 brokers in the FN Arena database rated the stock a Buy. SB Citigroup was the only dissenter, rating Rinker a Hold despite its last report (April 7) being a very positive one. On that day, Citi lifted its target to the level the stock was actually trading at – hence the Hold.

As can be discerned from the statement above, UBS has now pulled its rating for Rinker in from Buy to Neutral. The analysts have also sliced the price target from $25.00 to $17.55. Rinker closed yesterday at $16.80.

On April 13, UBS upgraded Rinker from Neutral to Buy, lifting the price target from $18.50 to $25.00. Rinker had closed the day before at $20.95. One week before, the exasperated analysts noted "Following recent upgrades from US peers, RIN has moved to upgrade guidance for YEM’06E [US fiscal year to March 2006 estimation] one last time". Rinker had upgraded five times in the year, and it had a track record of exceeding guidance. Could this company do no wrong?

Around the same time, the warning bells had been sounding for the US residential housing market. As Sydney and London had experienced earlier, the US housing market had taken off previously but had begun to decidedly cool. Economists were very worried. The US current account deficit being the way it was, any collapse in housing could cascade with devastating consequences.

However, when it came to Rinker, brokers were not concerned. FN Arena’s Broker Call carries the following entries as an example:

"The analysts acknowledge volumes are slowing in the US housing market but they add any weakness should be more than offset by non-residential and infrastructure activity plus some material price increases." Credit Suisse, June 9.

"The stock has been hammered on fears of a US housing slowdown, and the broker suggests the market is right to be cautious. However, the broker feels valuation parameters are compelling, and that RIN is cheap compared to Australian and US peers." Macquarie, June 8.

Economists globally are concerned about a slowdown in the US economy. Forget inflation, they say, as a slowing economy will put a lid on inflation soon anyway. Of more concern is a predicted slowing in US consumption levels, and part of this is due to a fall in housing prices. It won’t be a crash, but it will make a difference, they chant.

UBS reports that US demand for concrete as of March 2006 was running at an annualised rate of 12.5 mt – an increase of 40% over the past three years. The compound growth since 1995 has been about 7% so UBS suggests it’s unsurprising that profits have also been strong. However, UBS also believes demand cannot be expected to grow at 10% or even at a 7% pace in the medium term. Population growth is around 2.4%, the analysts note, and adding in 1% for bigger buildings, more roads and so on, that is more concrete consumption per person, only gets us to 3.5% growth. Compound growth from 1995 through to 2002 was only 4.6%.

In other words, something had to give. At what point did the UBS analysts actually wake up to these figures?

Rinker’s concrete division has grown since 2004 at a level that has provided returns on equity exceeding 30%. Says UBS: "A return to more normal returns was, in our opinion, always on the cards. What’s different is that we now expect that return more quickly than previously, and that’s because the fall in the leading indicators of housing, at least nationally, is more dramatic than we had anticipated".

That’s a big difference. Big enough to take a target from $18.50 to $25.00 and back to $17.55 in the space of two months. Recent data from McGraw Hill, reports UBS, shows an anticipated 23% decline in 2006-07 for Florida housing, leading to an 18% decline in total construction. UBS claims such data is hard to come by.

UBS also notes that a look back into Rinker’s history suggests margins are presently well above historical levels (about $30 for every $100 of concrete sold). "Arguably this simply reflects nothing more than the cement shortage that has existed for the last couple of years", says UBS, "As the supply-and-demand balance returns to ‘normal’, the risk is that so do margins".

This all seems like a very sudden revelation.

The risk for Rinker investors now is that UBS’ downgrade is a trickle that sets off a flood. Rinker has fallen some 20% from its highs, along with the rest of the market in the current correction. The average target in the FN Arena database is still $22.59, some 34% above yesterday’s close, and that’s after we take UBS’ drop from $25.00 to $18.50 into consideration!

Either Rinker now becomes the greatest Buy of all time, or the brokers will begin to fall like nine-pins. Hold is always a much safer place to be when you hate to admit defeat.

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