Join our community of smart investors

Bodycote self-help to pay off

'Self help' measures have placed the industrial heat treatment specialist back in the buyers' circle
November 17, 2016

We think Bodycote (BOY) is a self-help story well worth considering. Having stayed on the sidelines with a 'hold' recommendation at the half-year stage, we now feel the transformation of the group's business mix in favour of its more profitable technologies has put the group on a firmer footing. A more flexible and pro-active stance by management should also help shore up margins. Meanwhile, the engineering group's strong balance sheet means shareholders should stand to benefit from either acquisitions, more special dividends or both. And from a valuation perspective, the shares look cheap against peers, having lagged the sector in 2016.

IC TIP: Buy at 585p
Tip style
Value
Risk rating
Medium
Timescale
Medium Term
Bull points
  • Low valuation relative to peers
  • Reacting faster to demand trends
  • Potential for acquisitions and special dividends
  • Higher added-value business mix
Bear points
  • Pressure on energy sector budgets
  • Sensitivity to economic cycle

Bodycote's specialist coatings are utilised across a broad range of industries, including the aerospace and defence (24 per cent of sales), energy (12 per cent), automotive (27 per cent) and general industrial (37 per cent). So there's an unavoidable correlation to general industrial demand driven by the global economic cycle. What's more, order visibility is limited and many costs are relatively fixed in nature. This makes margins vulnerable to turns in end markets. A recent case in point has been the collapse in demand from the oil and gas sector, which accounts for about 5 per cent of overall sales. In the first half, on the back of spending cuts linked to the fall in the oil price, sales plummeted by almost a half.

 

 

What's impressive is the speed and decisiveness with which management reacted, illustrating a more forward-looking approach from the group than has historically been the case. A rationalisation programme was implemented at the 2015 half year, successfully exiting underperforming businesses in Brazil and India and closing a handful of facilities and consolidating poorly-performing activities elsewhere in the portfolio. The speed of management's response meant that the group sustained a headline operating margin of 18 per cent at the 2015 year-end and the margin is forecast by broker JPMorgan to still be close to 17 per cent this year before beginning to bound back up.

Pressure on energy sector budgets remains intense for now, but some areas of the business, most notably Bodycote's sales linked to the automotive sector, will have benefited from recent levels of activity in European auto markets, which has been strong through 2016. And sterling's relative decline subsequent to the EU referendum could even help to trigger the long-awaited cyclical bounce in manufacturing.

Management has deliberately rebalanced the group's business mix towards higher added-value services in an attempt to generate more consistent returns throughout the cycle. This has been pursued in tandem with moves to free up cash flows and improve the flexibility of the group's cost base, partly achieved by the increased use of temporary contract labour which can be reduced at little or no cost to suit the prevailing workload. These measures have been undertaken to limit the impact of fixed costs on profitability when demand slows, which was the cause of a devastating drop in earnings in 2009.

Bodycote's balance sheet strength also provides it with the potential to boost shareholder returns. It has paid special dividends to reflect the year-end net cash positions in 2013 (10p), 2014 (20p) and 2015 (10p), which are not included in our accompanying table. Management has stated that where there is net cash on the balance sheet at the year-end, any excess cash will be returned to shareholders. We're not pitching Bodycote principally as an income play, but if you factor in those special dividends its yield moves beyond 4 per cent. Perhaps more significantly, in a slow-growth environment, having the fire-power to make acquisitions can be viewed as a very attractive quality.

The prospect of any improvement to forecast earnings from a shrewd deployment of cash hardly seems factored in at the moment. Indeed, the shares look cheap against other engineers with the group's enterprise-value-to-cash-profit rating of seven times representing a one-third discount to where it has traded at over the last two years relative to the peer group, based on Bloomberg data.

BODYCOTE (BOY)
ORD PRICE:585pMARKET VALUE:£1.12bn
TOUCH:585-586p12-MONTH HIGH:645pLOW: 482p
FORWARD DIVIDEND YIELD:2.8%FORWARD PE RATIO:16
NET ASSET VALUE:310p*NET DEBT:1%

Year to 31 DecTurnover (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
201362098.038.613.5
201460910441.714.4
201556775.029.615.1
2016**58391.034.915.8
2017**60999.037.016.6
% change+4+9+6+5

Normal market size: 3,000

Matched bargain trading

Beta: 0.93

*Includes intangible assets of £184m, or 96p a share **JPMorgan Cazenove forecasts