Shares digital

A weak pound brings mixed blessings to a sector that has outperformed all others over the past 12 hard months, with more competitive exports set against pension fund problems. The sector report this week weighs up the pros and cons, and looks at some companies to watch

Industrial engineering stands out as the best-performing sector this year but is barely changed on a 12-month view. An average price earnings ratio (PE) of 14.5 for the major players suggests this sub-sector is neither particularly cheap nor expensive; but it is a different story for the smaller fry – many of them are on single-digit PEs, although their prospects are much less assured and earnings forecasts at greater risk.

A weaker pound is a plus but falling stock markets mean rising pension deficits for many firms, so balance sheets may not be as sound as they look. In the event of a marked global economic downturn – there is plenty of evidence available which supports such a view – then engineering will be the last domino to fall, assuming the fat backlogs of the oil equipment & services sector also succumb.

A final problem is just how well the sector has already done. Not only is it the top performer so far in 2008, it has the most enduring fanclub. Shares research could find just six ‘sell’ or ‘underweight’ ratings on engineering stocks – one each on Manganese Bronze (MNGS) and Weir (WEIR) from Arden and a quartet of them on Rotork (ROR) from Kepler, Investec, Arburthnot and Royal Bank of Scotland (RBS). This compares with 83 ‘buy’ or ‘overweight’ ratings, suggesting the sector may be an over-loved last stand so far as equity bulls are concerned. It is therefore easy to see how this sector could disappoint if the economy really does come a cropper, so exposure should be very selective. Hill & Smith (HILS) and Hamworthy (HMY) still look solid, while Rotork and Energetix (EGX:AIM) look too expensive to be worth the risk at this delicate stage of the cycle.

Best of British

Many British engineering firms have become mean and lean world-class competitors. They had to change simply to survive. After the Second World War, the majority of engineering companies involved in mining and ship building simply collapsed. Many others fell by the wayside, hamstrung by poor management, under-investment, poor products and often trades union demands that rendered cost bases uncompetitive.

Those engineers left today are generally in fine fettle, with profits, for the most part, expected to carry on rising. A recent report by Global Insight, the US-based consultancy, shows the UK is still the sixth largest manufacturer worldwide and, though it is expected to slip further to ninth spot in 2025 will still command 2.3% of the value of manufactured goods globally.

The key to short-term performance over the next 12 months is whether emerging markets, and particularly Brazil, Russia, India and China – the BRIC countries – will decouple from the West and remain buoyant or see their economic growth rates dragged down. Longer term, the BRIC countries will almost certainly top the list of fastest-growing economies but there could be a slowdown in the offing after several years of remarkable growth. Just last week the Reserve Bank of India cut its 2008 GDP growth forecast to 7.7%, from the 9.0% seen last year

Most UK engineers sell far more overseas than at home and on average still sell around 70% of output in the EU and US and so they could face problems if these trading blocs head into a prolonged downturn. The overall picture from the G7 is far from encouraging: only the US, at 1.9%, grew GDP in the second quarter, helped by a $100 billion rebate for consumers. The UK came in flat, while Canada, France, Germany, Italy and Japan all exhibited quarter-on-quarter declines in GDP.

This sector is one of the furthest removed from the consumer, who is cutting back spending sharply in many countries, yet the downturn in property has started to affect construction-related groups such as structural steel expert Severfield-Rowen (SFR).

Investment bank Citigroup expects economic weakness to spread into more general industrial areas such as automation.

Currency boost

Sterling’s fall against all the major currencies is a useful prop as many engineers still manufacture a big proportion of their products in the UK. The pound has crashed by almost a quarter against the euro in the past year and has slipped by 12% against the dollar since it peaked at $2.108.

Broker Numis highlights Renishaw (RSW), Bodycote (BOY), Charter (CHTR), Cookson (CKSN), IMI (IMI) and Hamworthy as prime beneficiaries of sterling’s weakness against the dollar.

The current rate of e1.26 against the pound is some 13% higher than the 2007 average of e1.46. If this rate is maintained through the rest of 2008 there will be some useful profit upgrades.

Following the acquisition of Foseco last year Cookson now sells 60% of its goods to mainland Europe. Around a third of Hamworthy’s profits are in euros, mainly from its water services business in Germany. Bodycote, Rotork and IMI have over a third of sales in Europe.

Sterling has also fallen by 9% against the Chinese renminbi. Chief exporters to China are Rotork, which derives 28% of its sales from the PRC and Cookson with 25%, and Charter with 15% of their respective revenues.

Hamworthy and Weir are least exposed to the dollar but each 1c movement still adds 1.5% to profits, according to Numis.

The downside of sterling’s slump is energy, transport and raw material price rises have been exacerbated with higher costs, probably removing a quarter of the gain.

The picture will become a lot clearer after companies report on fourth-quarter trading, after the summer shutdowns, early in 2009. But the market appears sceptical about current consensus earnings forecasts. The sector’s valuation looks relatively unchallenging on the basis of PEs but analysts at Citigroup are not convinced. A look back at valuation trading ranges over previous economic downturns shows the sector is definitely at the lower end of its range on an absolute basis. But its valuation relative to the broader UK equity market remains nearer the upper end of its 18-year range.

The market’s lack of belief in earnings forecasts undermines the validity of any assertion the sector is cheap on a PE basis. A better measure might be enterprise value (defined as market capitalisation plus net debt or minus net cash) as a percentage of turnover. This provides a useful valuation comparison tool for, while profits can shrink significantly, any variation in top-line performance is usually much less pronounced.

On a total sector view the EV/Sales metric shows the sector at a mid-point in its historic trading range, so providing only limited valuation support. This is in contrast to the 2003 low, when the sector approached its early-1990s troughs.

With economic uncertainty set to continue and with possible negative earnings momentum the picture is likely to be one of continued share price volatility.

A further point to note is the issue of pension deficits. As UK engineers tend to be among the oldest listed companies, and have often shrunk in size, they are among the most vulnerable to this financial burden. The slump in the stock market this year has undone much of the strengthening in balance sheets experienced since 2003.

Companies are having to spend around 10% of their profits topping up their pension schemes.

Companies with year-end pension liabilities larger than their market capitalisations include Avon Rubber (AVON), Scapa (SCPA:AIM) and GKN (GKN). This means they are more likely to have to resort to placings or rights issues if the stock market continues to fall.

Analysts at broker Arden Partners say: ‘Companies are acutely aware of the volatility of pension funding and are actively working to reduce risks, in particular the potential requirement to make additional contributions in future.

‘A good example of this is Avon Rubber. An improved funding position has allowed the company to make a major shift in its investment strategy towards liability matching investments. While this is clearly a sensible move it has reduced expected pension finance credits’.

Big is best

In such an uncertain environment big is generally best and certainly safest. There are four industrial engineers with market caps over £1 billion, although commercial kitchen and cooking equipment maker Enodis has been snapped up by US group Manitowoc after a bid battle pushed the price up 15% to £1.2 billion. Enodis (ENO) shares will cease to trade on 27 October.

The largest of the remaining trio is Weir Group, which reported first-half profits ahead 80% and the order book up a third. Broker Landsbanki likes the stock, saying: ‘While mining capex has grown significantly over the past five years, there appears no need for it to fall any time soon (or indeed stop growing). Weir represents one of the few ways UK investors can play global mining capex, courtesy of its slurry pumps business. In our view, Weir shares are being re-rated by investors, recognising the group looks increasingly like an oil equipment & services company rather than a machinery one. Under this hypothesis there may well be further to go.’

Second largest IMI is a company of two halves. The pumps and fluid controls arm is going reasonably well but the drinks dispensers business is suffering. The shares have underperformed the market by 5% over the past three months.

Third largest, Charter, has underperformed by 9% despite its single-figure PE rating. Markets are worried it will go ex-growth next year after an excellent period of rapid growth selling welding and gas-handling equipment.

Rotork, which lies just outside the premier division with a market value of £900 million, is a highly rated manufacturer of controls, but its share price is too rich, says Investec. Its historic rating is 24 times while the prospective PE of 19.5 does look full.

At the other end of the spectrum there are 18 industrial engineers with a market value under £10 million with two, Associated British Engineering (ASBE) and Jarlway Holdings (JWY:AIM) under £1 million.

Few companies in this segment look good buys, though those smart enough to have snapped up Associated British Engineering and slighter larger tiddlers Imagelinx (ILI:AIM) and Surface Transforms (SCE:AIM) in mid-May have seen these shares top the sector by rallying over 70% in the past three months.

There is a host of excellent companies in the second division with a market valuation of between £20 million and £100 million.

From the smallest upwards Hydro International (HYD:AIM) is a world leader in water management, making products that clean and manage storm waters. Gas Turbine Efficiency (GTE) is a fast-growth specialist in cleaning turbines on both planes and power generation to cut fuel costs.

Gooch & Housego (GHH:AIM) is a world leader in making switches for lasers. Renold (RNO) has just won a $17 million contract to supply couplings and gearboxes for the New York City underground. Goodwin (GDWN) is a highly successful family-controlled maker of advanced pumps and valves and radar antennae.

In the £100 million-and-above zone Manganese Bronze has struck a deal to make its trademark black London taxis in China and export them worldwide. Pursuit Dynamics (PDX:AIM) hopes its innovative PDX technology will enable it to profit from fire suppression equipment and more efficient manufacture of bio-ethanol. Vitec (VTC) has a good record making lots of money supplying broadcasting and photographic equipment to both big companies, professionals and amateurs.

Finally, there are two juicy plums worth just over £200 million apiece. Hamworthy did brilliantly after it was floated four years ago, more than doubling after it was flagged as a Shares (19 Aug ’04) Play of the Week with its pumps and fresh water products for ships and reliquification technology going great guns. Fenner (FENR) overtook US giant Goodrich several years ago to become the world number one in making conveyor belts for mining companies and is currently the subject of takeover speculation. Several UK engineers have been picked off over the past couple of decades and many of those mentioned above could well follow suit.

CONCLUSIONS: Industrial Engineering

Risk to earnings forecasts: 2 (5=upside risk, 1=downside risk)

Earnings predictability: 3 (5=very high, 1=very low)

Valuation: 3 (5=cheap, 1=expensive)

Balance sheet strength: 3 (5=cash rich, 1=heavily indebted)

Cashflow: 4 (5=very strong, 1=very weak)

Over-owned? 1 (5=all brokers negative, 1=all positive)

TOTAL: 16/30

Stocks to buy: Hamworthy, Charter, Hill & Smith Holdings

Stocks to avoid: Manganese Bronze, Energetix Group, Rotork

Total Broker Buy Ratings on Stocks: 83

Total Broker Hold Ratings on Stocks: 28

Total Broker Sell Ratings on Stocks: 6

SHARES RATING: NEUTRAL

SECTOR SPOTLIGHT

Weir Group pumped for action

How chief executive Mark Selway has made his company top dog in the sector

A set of sparkling interim results, published a fortnight ago, again emphasised how Mark Selway’s tenure as Weir (WEIR) chief executive demands attention. He has done a remarkable job revitalising and enlarging the company since he was appointed to the top job in 2001. In the five years to 2008 sales and profits will just about have doubled.

Today, Weir is ‘pumped for action’ as Harry Philips of Evolution headed his positive note on the stock a fortnight ago.

Top dog in the pecking order of industrial engineers, in terms of market valuation, Weir is also one of the best run with one of the most impressive product ranges. The £1.8 billion cap has developed into a focused infrastructure play operating on a global platform, says Philips. It deserves a higher rating because it is really a mining, oil and gas services business which would command a loftier multiple were it to be found in resources-based sectors such as oil equipment & services.

Earnings are forecast to grow strongly until at least 2010. Weir’s order book stands at £734 million, compared to a full-year sales forecast of £1.3 billion for 2008 and £1.4 billion in 2009. Some 40% of that backlog comes from the minerals sector, 28% from oil and gas, and 18% from power. The remainder is industrial, water and naval.

Best of all Selway has moved Weir away from just supplying product to becoming a higher margin services company. Half of sales are now regular after market items with the other half original equipment.

King of the hill

The size and pace of Selway’s acquisition and disposal strategy took some market experts by surprise but he has hardly put a foot wrong. The best part of £1 billion was spent buying SPM, Warman and Gabbioneta in the US with a big chunk recouped by the sale of DML, Strachan & Henshaw and Weir Pumps.

More acquisitions are expected but of a smaller bolt-on nature costing maybe $60 million a pop.

The largest division, minerals, is underpinned by an 18- month order book and a market share of over 30% compared with the next player at 6%. This is a big competitive advantage. Margins could rise a little from the current 16% on the back of 10% per annum sales growth.

Oil and gas is also supported by a strong order book with the US building more gas storage plants. SPM is busy supplying well-service pumps and flow control equipment to the oil and gas industry. Sales growth should rise by around 4% with margins near 25%.

Rising demand for refining capacity is good news for Gabbioneta where revenue has doubled to £60 million since Weir bought the business in 2005. Two recent purchases add some breadth to this division with Mesa, a Texan pump business costing $40 million which will slot into SPM, and the purchase of 75% of Standard Oil Services in Azerbaijan paves the way to the buoyant Caspian Sea sales area.

Power and industrial should benefit from the UK’s decision to build at least eight new nuclear power stations plus huge opportunities around the world like China where a £20 million contract was won a few months ago.

Order input jumped 52% and could continue rising at this rate for another couple of years. Margins are only running at 8%.

Evolution expects the remaining bits of Weir – Weir LGE, the Canadian distribution business and Weir Materials and Foundries in Manchester – to be sold. They might fetch £50 million to £100 million between them.

Clouds on the horizon

One negative is an interim pension deficit of £19 million, which compares with a surplus of £37 million at the end of last year. But Weir has taken out two Legal & General (LGEN) policies which substantially reduce the company’s exposure to future investment and mortality movements. It also lowers the group’s total pension exposure from £626 million to £276 million.

Evolution’s Harry Philips has lifted his price target from 740p to £10 for 14% upside. This looks perfectly feasible given the markets in which Weir operates and it has reasonable valuation, on a prospective PE of 14 and 2.3% yield.

Gearing is no problem at 31% and the banks are happy to lend the group up to £550 million against current debt of £171 million providing a war chest up to £300 million for more acquisitions.

Selway has almost completed the transformation of Weir from sleepy Glasgow group in slow growth sectors to a dynamic global player in energy engineering.

CONCLUSION: WEIR GROUP (WEIR) 879.5p

Risk to earnings forecasts: 2 (5=upside risk, 1=downside risk)

Earnings predictability: 4 (5=very high, 1=very low)

Valuation: 3 (5=cheap, 1=expensive)

Balance sheet strength: 3 (5=cash rich, 1=heavily indebted)

Cashflow: 4 (5=very strong, 1=very weak)

Over-owned? 2 (5=all brokers negative, 1=all positive)

TOTAL: 18/30

RATING: BUY

TRADES TO MAKE THIS WEEK - BUYS

Order of the day

Hamworthy (HMY) 475p

A fat order book, reasonable valuation and leading technology all mean a dive in Hamworthy’s shares from 665p last November to 475p looks to have provided a good entry point into the stock.

Hamworthy is a world leader in the design and manufacture of a raft of pump and water systems for ships plus its patented liquid natural gas reliquefaction systems.

Last week its shares jumped on the news of an order breakthrough for the first ethylene reliquefaction system sales to four dual fuel diesel electric powered ships and two gas carriers worth a total of £13 million. This order for BG Group (BG.) expands its sales by 8% and will probably lead to other orders being won before long.

The company has already won over a dozen orders for reliquefaction systems on slow speed diesel engine liquefied natural gas (LNG) carriers.

Hamworthy’s technology slashes fuel costs for big vessels which used to burn off some of the LNG they were transporting to power the ship. The reliquefaction system cuts fuel costs by over £1 million a year by retaining the LNG in its compressed or frozen state and using cheaper diesel engines to power the ship. Hamworthy is keen to sell its systems to other gas-related industries.

An order book of £285 million compares to forecast sales for the year to March 2009 of £251 million and should help profits surge from £17.4 million to £20 million this year and to almost £24 million in 2010. On a prospective PE of 13.5 the shares look good value.

The people’s choice

Charter (CHTR) 788p

First half results are due in just over a fortnight and could surprise on the upside. Since the dark days in the early years of this decade the group has become a sleek and profitable world leader with its ESAB and Howden welding operations and air & gas handling equipment companies.

Despite the slowdown in the important Chinese market the company thinks it will still grow sales there and Brazil by over 10%. Chief executive Michael Foster is upbeat saying ‘there are positive long-term dynamics in key end-user segments of both ESAB and Howden such as power, oil and gas, petrochemicals and shipbuilding.’

Charter is starting to generate large amounts of cash rising from £107 million to £149 million last year with around £175 million expected this year. So despite much higher capital expenditure there is now over £100 million in cash on the balance sheet, and this will provide plenty of firepower for any acquisitions.

The only cloud is Charter’s enduring popularity. All ten brokers who follow the stock carry a ‘buy’ or ‘overweight’ rating and this looks a touch dangerous, especially as the stock’s momentum has begun to flag – the London firm has underperformed the FTSE All-Share by 8.4% over the last three months. That said a prospective PE of 8.2 this year and 7.9 in 2009 looks decent value, especially when combined with a near 3% yield.

Sector dynamo

Hill & Smith Holdings (HILS) 314p

Infrastructure exposure and a lowly valuation point the way at Hill & Smith, which looks attractive on a prospective PE of 10 with a 3.4% yield.

Last week’s results from the Solihull firm surprised on the upside as underlying pre-tax profits surged 46% to £21 million on sales up 50% at £264 million. Even allowing half this came from acquisitions, underlying earnings per share still grew by 22%. Dynamic chief executive Derek Muir is absolutely confident sales and profits will carry on growing next year and probably the year after.

This is because the company is a prime contractor for road improvements with its signage, fencing and other infrastructure products for the oil and gas, and power sectors. It also supplies innovative waste water and Topdeck car parking systems, as well as operating the lowest cost galvanising operations in the UK and France.

The decision by the Highways Agency last month to roll out the variable message sign active traffic management scheme will mean millions of pounds of orders for H & S’s Techspan operation. The new Zoneguard safety barrier will be launched in the US next year.

TRADES TO MAKE THIS WEEK - SELLS

Will the Chinese bet pay off?

Manganese Bronze Hds. (MNGS) 421p

The maker of the famous London black cab has gone for the biggest gamble in its lengthy history.

It has entered into a deal with big Chinese car manufacturer Geeley to produce the London taxi in Shanghai. Geeley gets all the profits from selling in China while Manganese Bronze pockets all of the earnings generated outside the People’s Republic.

But will there be significant overseas sales? Even Manganese Bronze does not yet know the answer to this one. Realistically the black cab might strike a few sales in Anglophile places such as former British colonies but it will have a lot of trouble eating into sales of Japanese workhorses that double up as taxis but cost a lot less.

Commercial production in China should start at the end of this year after testing is completed.

The shares raced up to 950p just over a year ago as bulls dreamt of colossal profits coming from the Far East. But the bears chased the shares down to 277p a few weeks ago and it would be no surprise if they returned there before long, after their recent rally back north of 400p.

Still waiting for big profits

Energetix Group (EGX:AIM) 85p

Energetix is great at talking the talk but so far has not delivered the promised goods. Sales last year came to £55,000, a figure dwarfed by the firm’s £48 million market cap. At least Energetix has £12.8 million in cash in the kitty, but it will be several years before the company makes a profit, and the stock market environment is not the best at the moment for such a blue sky firm.

That is not to say Energetix will fail to establish itself, but for any company commercialising intellectual property the reality can be tough. A new wall-mounted gas boiler saving over £100 a year compared with current models should be on the market next year. The distributed generation and energy storage expert has signed collaboration agreements with utility giant E.ON, Dutch manufacturer Daalderop and another unnamed company. Energetix is also planning to sell other alternative energy products such as a small generator powered by compressed air.

High rating, higher price

Rotork (ROR) £10.75p

Rotork is a leading maker of control and fluid systems and its products are highly rated, but unfortunately so are its shares. A historic PE of 24 and a prospective rating for 2008 of around 20 look rich in the current environment. Rotork is a good play on more infrastructure spending in Europe and the rest of the world but Weir (WEIR) is much cheaper and growing at around the same speed.

Investec took issue with this lofty valuation when it issued a ‘sell’ note after last month’s interim results this month with a 900p target price. The broker argued the boom will not last forever and a slowdown from 20%-plus annual earnings growth back to single-digit growth looks likely within a couple of years, especially if the water sector starts to slow down.

Investec believes a 40% valuation premium to the sector is fair but a 60% premium looks excessive. Underlying half-year profits and sales both rose by 18% and the order book grew by 38% to £135 million but prospects of any big upgrades look limited unless margins rise faster than expected.

TREND SPOTTING

The sector that roared back

Tame the volatility of industrial engineering and bumper returns could be yours

by Simon Griffin

Industrial engineering could be in the process of forming a bull flag pattern. This would suggest further gains toward a test of the bear trend line that joins the peaks seen since last July but such a move will require the index to break decisively above resistance at 3,605 and importantly the 50-day average, which has capped recent gains.

In the event of further weakness a re-test of mid-July’s low of 3,254 would be expected with a move lower still toward the channel base line support expected to be close to previous significant support and resistance at 3,135 – some 11% below current levels.

The FTSE 350 Industrial Engineering sector has offered investors a roller-coaster ride in the last 12 months. The grouping rose by 246% during the 2003 to 2007 bull market and outperformed the wider UK market by a thumping 70%. It was one of the earliest sectors to recover from the 2000 to 2003 downturn and it then settled into a broad bull channel, which might still be influencing the sector even now.

Having peaked in mid-July last year, with a move that saw the index breakout above the channel upper return line, a sharp dive between late October and the end of January saw the sector index lose some 36% of its value.

If that was not enough volatility, the sector shot back up 54% to almost equal its October highs just four months later in mid-May, only to then rotate southward once more, retrace 50% of this last up move and then in turn recover 50% of that final sell off. If correctly traded using just the 50-day average, these dramatic swings would have returned investors a 62% profit since last November.

Fenner (FENR)

SELL - 232p

TARGET - 165p

STOP LOSS - 249p

The writing seems to be on the wall for Fenner, the reinforced polymer specialist. After a sector-busting six-fold increase during the bull market of 2003 to 2007, which saw the stock outperform its peers by almost 100% in that time, the bull trend line that had supported most of the rise finally gave way last November. The attempted recovery in February stalled out as the same trend line was tested for resistance.

The shares have now developed a ‘broken back’ pattern on the chart with successive rises making lower major highs. Support in the 215p to 220p zone is coming under increasing pressure and resistance close to 270p has capped the upside.

A minor bear trend has developed since June and despite some positive indications from rising volume and minor bullish momentum divergence, this suggests the shares will find it hard to break above 240p, a necessary move if bearish portents are to be scotched.

The shares appear to be in the process of completing a large top, culminating in a downward sloping right angle triangle. This itself signals a move lower toward 165p via possible support close to the 194p level which supported the shares for most of 2006. This bearish stance is reinforced by the key 50- and 200-day moving averages crossing in a true dead cross formation at the end of the first week in August.

Corac Group (CRA:AIM)

BUY - 70p

TARGET - 108p

STOP LOSS - 61p

A call on this column favourite at 56.5p (Shares 10 Jan ‘08) has already made a 40% profit but there could still be more to go for. The company is involved in developing an innovative ‘down the hole’ gas compressor to potentially increase recoverable reserves from gas fields by over 40%. Should the technology prove itself, if will be very valuable, hence the volatility of the share price chart.

The big picture shows a long run bull channel whose origin is the 2002 13p low. In late June the shares topped out on a re-test of their post-launch highs of 92p, almost hitting the channel return line. Equally evident is a broadening or ‘megaphone’ pattern that has defined price action over the last 12 months.

With the 200-day average and the base of this latter pattern close by, support is expected at 62p and until this lower support level gives out, it offers an opportunity for a bull trade.

This trade seeks a resurgence of the uptrend targeting the post flotation intra-day high of 108p. The risk is recent activity is actually a bear pennant that portends of a sharp fall below 40p so that stop at 61p might well be a stop and reverse for the more adventurous trader.