Plunging commodity prices and a global economic slowdown have dominated the headlines this winter, triggering substantial deratings for the more cyclical engineering groups. And things could go from bad to worse before improving if recent forecasts are anything to go by. The World Bank recently cut its forecast for growth in the global economy this year from 3.4 per cent to 3 per cent, citing anaemic eurozone growth, problems in emerging markets and the parlous state of Japan's finances.
Perhaps the single biggest concern for engineering groups is the low oil price. Announced reductions in capital spending by the oil majors have weighed heavily on the share prices of IMI (IMI), Rotork (ROR), Smiths (SMIN) and Weir (WEIR). So far there has been little impact on order intake - Weir's original equipment orders in the oil and gas sector were up 28 per cent year on year in the third quarter of 2014 - and exposure to less cyclical after-market revenues should ease the impact of capex cuts. But investor sentiment is still clearly bearish.
Yet a plummeting oil price isn't bad news for everyone. DS Smith (SMDS) and Bodycote (BOY) are among the largest users of energy in the sector, as is ceramics producer Vesuvius (VSVS). The molten-flow engineer's steel division could also benefit if the low oil price boosts consumer spending - on cars, for example. Bodycote and GKN (GKN) are also well positioned to profit from an increase in car production.
The prices of commodities other than oil have also taken a hit in recent months. This is bad news for Weir's already struggling mining unit, but could equally provide relief for consumers of raw materials. After a difficult trading period marred by soaring aluminium and energy prices, can-maker Rexam (REX) should be able to enjoy the fruits of lower input costs, for example. And rigid plastics supplier RPC Group (RPC) may be daunted by its exposure to the troubled eurozone, but it can at least count on a boost to profits from slumping polymer prices.
Winners and losers from the commodity slump aside, however, a low-growth environment is likely to remain the fundamental concern of many investors in the engineer space. That suggests the popularity of defensive companies with less cyclical track records, or companies with effective damage control mechanisms, is unlikely to wane.
Perhaps the best example of a traditionally defensive company is Spirax-Sarco (SPX). Despite weak industrial spending and falling energy prices, the steam-power specialist still emerged as one of last year's most resilient stock market performers. Its enviable track record of profit growth has presumably calmed investor nerves, but we remain unconvinced that steam power is the market to be in as energy prices fall. To our mind, the shares look fully valued on 22 times forecast earnings.
Melrose Industries' (MRO) buy-improve-sell business model, on the other hand, looks something of a safe haven. The unusual private-equity-style approach, which should help insulate the turnaround specialist from short-term end-market fluctuations, once again proved successful when it sold its holding Bridon in October after six years of ownership. Despite the global mining slowdown, the cable-making business fetched double the amount it cost, with £200m of the £365m proceeds now expected to be returned to shareholders in the form of a special dividend.
Alternatively, there are more orthodox strategies being implemented to boost growth in difficult markets. Bodycote, for example, has been focusing on product innovation to counteract pricing pressures. Investing in its niche technologies and services seems to have enabled the thermal processing specialist to boost margins and generate plenty of cash - some of which may be given back to shareholders this February. And DS Smith has ramped up the scale of services it offers to compensate for intense competition in Europe. In addition to corrugated boxes, the group now offers other packaging and logistic services to clients. So far this new business model has got off to a strong start, with a five-year contract as sole supplier to international food company Mondelez.
| Company name | Share price (p) | Market value (£bn) | PE ratio | Dividend yield (%) | 1-year performance (%) | Last IC View |
|---|---|---|---|---|---|---|
| Bodycote | 647 | 1.2 | 14.9 | 2.1 | -5.6 | Hold, 694p, 1 Aug 2014 |
| DS Smith | 330 | 3.1 | 14.3 | 3.2 | -3.3 | Buy, 305p, 4 Dec 2014 |
| GKN | 373 | 6.1 | 12.5 | 2.2 | -6.7 | Buy, 365p, 30 Jul 2014 |
| IMI | 1,274 | 3.5 | 16.8 | 2.8 | -16.4 | Hold, 1,429p, 4 Aug 2014 |
| Melrose Industries | 277 | 3.0 | 6.4 | 2.8 | -11.3 | Hold, 276p, 29 Aug 2014 |
| Mondi | 1,111 | 4.1 | 14.4 | 2.8 | 11.9 | Hold, 996p, 11 Aug 2014 |
| Rexam | 446 | 3.1 | 10.8 | 3.9 | -12.6 | Hold, 453p, 14 Nov 2014 |
| Rotork | 2,392 | 2.1 | 19.2 | 2.1 | -11.0 | Hold, 2,790p, 6 Aug 2014 |
| RPC Group | 541 | 1.4 | 13.6 | 3.0 | 1.8 | Buy, 577p, 27 Nov 2014 |
| Smiths Group | 1,082 | 4.3 | 13.2 | 3.7 | -29.1 | Sell, 1,093p, 15 Jan 2015 |
| Spirax-Sarco | 3,040 | 2.3 | 21.9 | 2.0 | 1.0 | Sell, 2,834p, 6 Nov 2014 |
| Vesuvius | 439 | 1.2 | 13.6 | 3.5 | -5.8 | Sell. 465p, 5 Aug 2014 |
| Weir | 1,688 | 3.6 | 12.0 | 2.9 | -22.4 | Sell, 1,789p, 18 Dec 2014 |
Favourites
Shares in DS Smith are up 92 per cent since our successful buy tip (167p, 23 Feb 2012), yet trade at 14 times forward earnings - a discount to peers. Given its strong market position and the success of its new business model, the group looks well placed to offset the challenges posed by a weaker European economy. We are also impressed with the countercyclical drivers in place at both Melrose Industries and Bodycote. Shares in both trade on about 16 times forward earnings, however, suggesting the potential has largely been priced in. Names to buy on weakness.
Outsiders
Shares in Weir are down 26 per cent since we turned sellers (2,208p, 23 Oct 2014) and look poised to slip even further as the oil price continues to plummet and sharp falls in the copper price add to concerns in the mining sector. We're also bearish on Smiths, even though it lost a quarter of its market value last year. Management changes, tight healthcare budgets and a low oil price paint an unpromising backdrop for profit growth
