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Buffett's acquisition highlights the allure of unloved industrials

The master investor's new recruit, Precision Castparts, throws up parallels with a number of unloved, yet similarly attractive UK industrial engineering companies
September 18, 2015

Warren Buffett's decision to buy a struggling US engineering group in the biggest "elephant" deal of his decorated career made for interesting reading. The master investor spent $32.5bn (£21.3bn) on a precision manufacturer of metal components for industrial gas turbines in a period when global industrial growth is sluggish and commodity prices are in meltdown. Normally, we would dismiss this type of behaviour as idiotic, particularly as his vehicle Berkshire Hathaway paid a 21 per cent premium for the shares. But Mr Buffett's track record isn't to be sniffed at, and neither is Precision Castparts ' (US:PCP) dominant market position and strong pricing power.

In fact, this latest move could serve as a reminder to investors that regularly overlooked industrial companies make attractive propositions. True, tepid industrial growth, emerging markets uncertainty and commodity price chaos aren't great selling points. But as sentiment wanes and valuations edge down off mass sell-offs, this panic-stricken scenario has also created some interesting long-term buying opportunities in some of Britain's best companies.

 

A clear attraction of Precision Castparts is its exposure to the burgeoning aerospace industry. Regardless of industrial cycle swings, the world's population is travelling more, hence why Airbus (Fr:AIR) and Boeing (US:BA) boast a combined order book of 12,000-plus aircraft. Investors keen to emulate Mr Buffett's bet on soaring air travel without paying through the nose can find plenty of options in Blighty, too, including one in components and sub-systems manufacturer Meggitt (MGGT).

 

Aerospace shares to soar?

This Dorset-based engineer suddenly has the wind behind its sails, evidenced by surging revenue and underlying profit growth in the first half of the year. But despite boasting some mouthwatering prospects, created mainly by its civil aerospace segment, shares in the revitalised group trade at a discount to lower cash-profit margin peers on 13 times forecast earnings.

Part of the engineer's strategy is to supply new aircraft equipment for free in order to generate more aftermarket revenue. That policy may sound bizarre at first, yet it actually enables Meggitt to make a killing from higher-margin parts and repair work. Those prospects should be further enhanced by a big investment programme designed to transform the group into a supplier of choice. So far the recently implemented "gold-standard" service has improved the quality of products by 86 per cent, while boosting the number of deliveries made on time by a tenth.

Cobham (COB) also merits close attention. Military cuts and chunky one-off costs from the bumper $1.5bn acquisition of New York-based wireless communications expert Aeroflex have weighed on sentiment, yet first-half results for 2015 offer sufficient encouragement to suggest the group's downtrodden shares are in the midst of a turnaround. Aeroflex, with its exposure to high-growth areas such as commercial space, avionics, wireless communications and the medical sector, has hit the ground running. That lessens Cobham's reliance on tepid energy markets and volatile defence spending, which itself is again on the rise as president Obama responds to an increasing number of geopolitical tensions.

Like Precision Castparts, plenty of the UK's big aeroplane suppliers also happen to manufacture goods for troubled energy markets. That, together with similar capital investment cuts in mining and hefty costs implementing new aerospace programmes, has certainly put the brakes on shares in Hertfordshire headquartered Senior (SNR). Speculation that Airbus and Boeing are driving a hard bargain additionally hasn't helped, although with 40 per cent of sales generated from aeroplane parts some may see this moment of weakness as an ideal buying opportunity.

Pricing pressures in aerospace have equally dampened confidence in GKN (GKN). But that's not the main reason why the shares have tumbled 19 per cent this past year to trade on just 10 times forecast earnings. The emerging markets slowdown has created all kinds of problems for its farming and mining equipment business, so much so that management is reportedly now considering selling it. Weak trading there has overshadowed excellent progress in its core auto segment. And with appetite for commercial aircraft parts likely to grow, value investors may be tempted to stomach the group's remaining issues in a bid to get cheap exposure to two sectors at cyclical highs.

Could the same be said for Rolls-Royce (RR.)? The £13bn giant has posted three profit warnings in 18 months of worsening conditions in offshore marine markets, leaving the shares in one of Britain's most respected companies down 30 per cent in the past year to trade on 12 times forward earnings. That may look like good value, but sadly even its usually dependable civil aerospace operation has struggled to meet expectations. The transition from the group's disappointing Trent 700 engine to the replacement Trent 7000 proved more difficult than expected. Yet amid this turmoil, management remains confident that the troubled engineer can still snatch a 50 per cent share of engines installed in long-range passenger aircraft.

 

Self-help revival

Alternatively, there are plenty of smaller, unloved industrial engineers out there that have done a sterling job of growing profits in the face of weak top-line growth. By focusing on the basics, such as cost-cutting, customer service, efficiency and moving out of commoditised markets, several names have delivered remarkable bottom-line growth against all odds. Two companies that fit this bill yet continue to go under the radar are carbon and ceramic manufacturer Morgan Advanced Materials (MGAM) and industrial chains and power transmission group Renold (RNO).

Bodycote (BOY) also deserves an honourable mention. Like Precision Castparts, the heat treatment specialist has been hit by both menacing oil and gas markets and concerns over aerospace orders. But the engineer is now much better at negotiating downturns after management embarked on a clean-up mission that consisted of successfully exiting lower-value services, opening communication channels with customers and branching out into more profitable specialist technologies. That's mitigated the eroding effect a low oil price has had on group margins and contributed towards strong cash conversion.

 

Favourites

Virtually all the names mentioned can be categorised as potential value investments, although there are a select few that currently stand out from the rest. For example, Meggitt's unjustified discount to peers and aftermarket prospects in aerospace certainly make it an attractive proposition, with its strong pricing power placing it in a similar mould to Warren Buffett's Precision Castparts. We're additionally very keen on Morgan Advanced Materials' transformation over the years, and believe its entrance into higher-growth sectors, coupled with the arrival of an exciting new chief executive, could be a catalyst for share price upside.

 

Outsiders

Despite the share price tanking hard over the past 12 months, it's still hard to present a feasible buy case for Weir (WEIR). The Scottish supplier of equipment to the mining, oil and gas, and power industries has suddenly found all its end markets in turmoil. Drastic cost-cutting activities should at least help to ease the blow, although judging by recent events we don't expect the group to bounce back to previous glories anytime soon.

 

IC VIEW: Various factors, such as weak global industrial growth, tepid oil and mining markets and the all-important slowdown of emerging markets economies, mean that virtually all of the names mentioned above currently trade below historic averages on low forward PE multiples. In some cases that's justified and in others less so, as some management teams have done a spectacular job of extracting growth from difficult sectors without getting the recognition they deserve from investors. Particularly impressive have been those moving away from commoditised products after recognising that countries in emerging markets can do it at a lower price. Defensive companies make great long-term investments, and plenty of buying opportunities have emerged in them as many who made the change are still often mistakenly tagged as cyclical. Pricing power is key for those keen to follow Mr Buffett's foray into the highs of aerospace, as simply making parts for a booming sector isn't always a recipe for success.

 

Broker's view

Not so long ago, the entire industrials sector was generally known as 'cyclical', a slightly disparaging title suggesting that the companies in the sector could do little more than bob around in the economic surf of greater macro forces. Over the past 20-plus years, we have seen many of the companies in the sector - and new ones created - exert much effort to strategically adapt and position themselves outside the 'cyclical' tent. Classic strategies include aggressively developing recurring revenue through offering services on an original equipment installed base and moving up the 'value chain' by dropping commodity products and focusing on highly engineered, bespoke products with new technology. Focusing on regions offering much better growth potential than home markets, or on market segments offering structural and localising manufacturing to avoid the swings in profitability associated with being an exporter from a country with a currency - such as sterling - has also been important.

This is all well and good, but what happens when these companies are faced with strong headwinds on virtually every strategic front? We can only conclude that with a backdrop of lacklustre developed markets, softening emerging markets, strong sterling (versus the euro) and very difficult niches such as oil and gas, even those companies that have strategically moved a long way from being 'cyclical' are going to struggle to generate top-line growth and expand margins in this environment. As a result, we continue to favour companies that can remain master of their own destiny through actioning strategic points.

The collapse in the oil price last year has already placed pressure on orders and trading for companies exposed to this area. Weir, as one of the most exposed, saw a 23 per cent decline in order intake in its oil and gas segment in the first quarter. However, the oil and gas picture is probably a little more nuanced than the shock decline in Weir's orders might suggest. In its half-year results, IMI (IMI) highlighted that its oil and gas aftermarket segment actually saw a rise in orders. Others such as Bodycote also comment that subsea demand remains firm.

Commercial aerospace remains a solid area, as confirmed by Bodycote, GKN and Rolls-Royce. However, this remains platform specific with Rolls and GKN both warning on the production slowdown on the Airbus A330 during late 2015-16. Conversely, there is positive momentum from the ramp up in A350 production and ongoing strength in regional aircraft.

David Buxton and Raymond Greaves are analysts at finnCap