Is It Too Early, Too Soon For James Hardie?

This story features JAMES HARDIE INDUSTRIES PLC. For more info SHARE ANALYSIS: JHX

The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Chris Shaw

As the US housing market has been in bad shape for some time it came as little surprise James Hardie ((JHX)) reported a modest FY09 profit of US$96.9 million, while as UBS notes it is also no surprise earnings in FY10 are likely to be even lower at somewhere around the US$60-$70 million level.

The key in terms of the company’s share price will be how fast the US housing market turns around and here the market is divided. Deutsche Bank analysts believe most investors are expecting a “V” shaped recovery as this is what has historically happened when a “U” shaped turnaround is more likely to be the case in the current cycle.

This means any significant recovery is unlikely until FY11 at best in the broker’s view given the amount of inventory remaining in the US market. This limits earnings upside given housing starts are now expected to be less than 500,000 this year. As Credit Suisse notes, this represents only 25-35% of through the cycle activity levels.

Assuming Deutsche Bank’s assessment of the US market is correct then it is simply too early to be in James Hardie given its share price has historically had an 85% correlation to US homebuilders, especially as its market penetration rate in the repair and remodel segment of the market has slowed in the downturn. The broker’s Sell rating reflects these concerns.

JP Morgan agrees, seeing the combination of the weak US market and the re-emergence of some asbestos related issues for the company as a combination investors don’t need to pay up for in the current market environment. With respect to the asbestos fund the broker sees a risk the company cannot make a major contribution in FY11, increasing the chances it is under-funded by FY12.

But as Credit Suisse counters, a major attraction of the company is the strength of its market positions means margins are quite high and should in theory go higher as activity in the sector recovers. As an example, the broker notes margin targets stand currently at 20-25% but these are likely to be exceeded relatively easily when market conditions become more favourable.

The other attraction of the stock is earnings leverage, Macquarie noting group earnings are very much dependent on housing starts and should the company’s capacity utilisation increase to 45% in FY11 from around 35% now, this would add about US$48 million to earnings, all else being equal. Volumes are far more important than prices, the broker estimating a 10% increase in prices would only add around US$14 million to earnings.

While there remain short-term risks in the market, Macquarie takes the view a bottom must be near and as this becomes apparent the risk-reward scenario turns back in the stock’s favour. To reflect this, the broker has upgraded to Neutral from Underperform. Macquarie does agree with the likes of Deutsche and JP Morgan though a sustainable pick up in volumes for US housing construction should not be expected anytime soon.

RBS Australia makes a similar shift in recommendation given it too sees signs of a stabilisation in the US market, though the broker is similarly not really in a hurry to get back into the stock as it suggests to clients the group’s margin expectations may prove optimistic and the full impact of the housing recovery may not be felt until FY12.

Post the result, the FNArena database now shows James Hardie rated as Hold eight times and Sell twice, compared to a six/four split prior to the result. The average share price target is $4.14, up from $3.88, thanks largely to increases from Macquarie and RBS Australia in support of their rating upgrades.

Shares in James Hardie today are weaker in line with the overall market and as at 11.10am the stock was down 15c or 3.3% at $4.35. This compares to a trading range over the past year of $2.89 to $6.09.

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