| High earnings risk in cyclical sectors such as construction, packaging and airlines |
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| John Mattimoe’s three sectors of building materials & construction, airlines, and paper & packaging share one thing in common: they are cyclicals. Hence they offer good upside ‘for the rally that will follow’. However, he also says that although valuation levels have become quite attractive, the market continues to face challenges in the coming year, particularly in the first half. |
After a difficult 2007, when the ISEQ fell by 26 per cent, what now are the prospects for the Irish equity market? Although valuation levels have become quite attractive, the market continues to face challenges in the coming year, particularly in the first half.
Last year, the principal concern was the slowdown in the Irish housing market, and the impact that this would have on the wider economy. Today, the potential investor in Irish equities continues to be concerned about this, but with added fears over the international economy – whether the sub-prime crisis will tip the US economy into recession, and the impact this and the ongoing credit crunch might have on the broader global economy. Into the mix add US dollar weakness and higher energy prices. For Ireland, the implications of an international slowdown add to the impact of the housing market correction. As a result, earnings risk in equities is currently high. As the three sectors I research are cyclical industries, these face clear challenges.
In building materials and construction, CRH faces a slowing US economy (where it earns a little under 50 per cent of its operating profits) and its US profits will be translated at a weaker rate - its challenge is whether this can be more than offset by positive pricing trends in its cement and aggregates businesses and through continued successful acquisition development (which is supported by a strong balance sheet).
For Kingspan, the question is how much of the benefits of conversion of its markets to higher specification insulation will be eroded by slowing commercial and industrial building activity, particularly in the UK. Grafton will be impacted by lower Irish housing activity in 2008, while the softening UK consumer poses risks to its UK business, although it should be underpinned by strong intrinsic cash generation characteristics and a valuable strategic position in the UK. The housebuilders face the obvious challenges of achieving a reasonable level of sales volumes while protecting margins as best they can in tougher demand conditions.
The greatest challenge for the airline sector is how it manages the increase in oil prices, by far its largest cost. Compounding this, the ability of airlines to recoup this through higher fares will be constrained by softening economic and consumer conditions.
In paper and packaging, Smurfit Kappa will again have to deal with higher input costs and a weaker US dollar. A favourable supply/demand balance in its industry over the past two years has allowed positive momentum which has more than offset these challenges. If slowing economic growth rates in 2008 or supply additions in late 2009 affect the pace of price momentum, then it will be important for SKG to realise its cash generation ambitions.
While the cyclical challenges have increased, valuations have become quite attractive and already discount much of the risk. Such valuations do represent attractive entry points for long-term investors, however, near-term sentiment is likely to remain negative. If economic uncertainty increases and/or earnings downgrades are realised it is likely that valuation levels go lower before they go higher. If that is the case, it is likely to present a great opportunity for investors to position themselves in Irish equities, at a low valuation multiple, for the rally that will follow as and when economic newsflow improves and earnings risk diminishes - be that later in 2008 or during 2009. |
John Mattimoe is senior equity analyst at Merrion Stockbrokers.
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| Article appeared in the February 2008 issue.
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