Join our community of smart investors

FTSE 350: Engineers in recovery mode

Macro uncertainties persist for the FTSE engineers, although capital budgets within the extractive industries may have troughed
January 26, 2017

A year ago, when reviewing the FTSE 350 engineers, we wondered if markets had become guilty of “irrationally selling off stocks without taking into account individual prospects”. But you couldn’t blame investors for so doing, given the battering that sector constituents had taken as a result of the oil price slump over the preceding 18 months. It was also unsettling that many of the engineers were trading on forward earnings ratios well in excess of historic multiples seen when the market was at a low ebb. In the event, the FTSE 350 industrial engineering index was just about to reach its five-year low following the publication of last year’s review.

You would be hard pressed to find a better example of the havoc that oil price exposure has wrought on the sector than the experience of Weir (WEIR), a Glasgow-based manufacturer of valves and pumps used in the energy and mining industries. Demand at the engineer’s key pressure control and services division all but dried up after the rotary rig count in North America – Weir’s biggest market – fell by 63 per cent in 2015. The end result: a 43 per cent fall in operating profit for the year to January 2016 and a 510 basis point reduction in the underlying margin.

The gradual recovery – or perhaps stabilisation – in energy and mineral markets through 2016 has seen the engineer’s share price double over the year, and perhaps Weir’s rollercoaster ride shows why investors need to be prepared to ride out periodic volatility for stocks that demonstrate a high correlation to commodity cycles. Rotork (ROR) was another engineer that saw sharp declines in profitability and underlying margins through its exposure to energy markets, although the group, the world’s leading supplier of actuators, actively pursued strategic buying opportunities – not a bad idea when the cyclical markets you serve are in a downtrend and asset prices in retreat. By broadening its capacity, Rotork is now better positioned to benefit from any nascent recovery in energy markets.

The slump in crude prices had a pronounced effect because of the disproportionate exposure of the FTSE 350 engineering constituents to natural resource markets. The retracement in share values among the engineers suggests that capital budgets within the extractive industries probably troughed in the early part of 2016. Although this would undoubtedly be favourable for the likes of Weir and Rotork, there are other considerations to take on board.

There’s no avoiding President Donald Trump. On the one hand, if the new US administration manages to make good on campaign pledges linked to tax cuts and infrastructure spending, it could drive US growth and dollar strength, with positive implications for UK engineers such as GKN (GKN) and Smiths (SMIN) that have a substantial degree of exposure across the Atlantic. However, pledges made during the febrile atmosphere of an election campaign rarely take account of Congressional oversight, so the new leader may have to tailor his spending plans to assuage a fiscally conservative Republican majority.

Price (p) Market value (£m)PE (x)Yield (%)1-year change (%)Last IC view
Bodycote6401,22417.52.425.3Buy, 585p, 17 Nov 2016
GKN3405,82129.82.620.6Buy, 297.7p, 26 Jul 2016
Hill & Smith1,18392920.31.959.2Buy, 1,223p, 25 Aug 2016
IMI1,0712,913193.636.4Hold, 1,056p, 01 Aug 2016
Rotork2612,27422.91.964.3Hold, 204p, 02 Aug 2016
Smiths Group1,4945,90822.82.869.4Hold, 1,424p, 28 Sep 2016
Spirax-Sarco Engineering4,2593,13127.41.746.1Sell, 4,275p, 11 Aug 2016
Vesuvius4401,19317.73.750.0Buy, 355p, 29 Jul 2016
Weir2,0284,41629.42.2144.2Sell, 1,493p, 28 Jul 2017

Sterling’s depreciation in the wake of June’s referendum vote has boosted UK exports. Activity in the UK’s manufacturing sector grew at the fastest pace for two-and-a-half years in December, while industry order books remain above historical norms, according to a recent CBI survey. The competitiveness of FTSE 350 engineers should continue to benefit from a weak pound and it has even prompted Weir to examine whether reshoring production of some engineering components from overseas to the UK is a viable option.

We also previously flagged concerns that the pace of economic growth in China could further weigh on industrial and commodity markets. That certainly played out early in 2016, although the outlook became more favourable as the year progressed. However, the ability of the country to support global industrial demand could be imperilled by the country’s opaque debt markets and high inventories.

 

Favourites: Although Bodycote (BOY) has fairly limited exposure to energy markets – around 11 per cent of revenue – we think the transformation of the business mix in favour of more profitable technologies has put the group on a solid footing. The group’s business has been rebalanced towards higher-added-value services in an attempt to generate more consistent returns throughout the cycle. The share price has moved up nicely since our November buy call, but the shares still look decent value when set against their historic enterprise-value-to-cash-profit rating.

Outsiders: We were forced to eat humble pie after we mistimed a sell recommendation on Rotork last January, although our misgivings on the group’s prospects were perhaps understandable given its heavy exposure to energy markets. On the bright side, the group has subsequently made some headway in reducing this reliance and the order book strengthened in the first half of 2016, while the balance sheet remains in decent shape.