Bottom Line: Tarmac challenge is just beginning

THE transformation of Tarmac has been as dramatic as the revival of its share price over the past 18 months, and chief executive Neville Simms should be congratulated on undoing the ravages of the previous regime, which culminated in 1992's pounds 350m loss.

But he is honest enough to realise that reducing debt from 63 per cent to 18 per cent and refocusing the group on house building, quarrying and construction is just a beginning. A threefold increase in the shares to 179p since September 1992 suggests the market is expecting much more of the same.

The challenge now is to return Tarmac to a reasonable level of profitability. This means a return on sales of 15 per cent from homes and aggregates and maybe 4 per cent from contracting, or double the margins achieved last year.

The markets are moving in the right direction. Prices for quarry products climbed by up to 10 per cent over the year and bricks were selling for 16 per cent more than in December 1992.

But with construction unlikely to excite this year, the key is housing. The good news is that two- thirds of the land that was written down in 1992 to a level at which it provides no profits has now been used up. The elimination of zero- margin sales will itself give profits a substantial boost.

But analysts who have pencilled in a further quadrupling of group profits from pounds 50m to pounds 200m over the next three years are taking a rosy view of the risks inherent in a short land-bank builder trying to increase stocks in the face of silly asking prices for housing land.

With land representing a chunky 23 per cent of estimated selling prices, Tarmac will have to buy very wisely if it is to get up to 8,500 house sales a year and still maintain a healthy margin.

Even if it does, the performance of the shares depends on how quickly the stock market shifts its sector rating from the current recovery p/e to the discount that should be expected as the building cycle peaks in, say, two years' time.

At 12.3 times expected earnings for 1996, the shares stand at a 12 per cent premium to the market. That is unlikely to continue for long and the shares, down 7p yesterday, are still expensive.