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FTSE 350: Headwinds for UK industrials

A series of recent profit warnings from the UK's leading industrials suggests even the champions of British manufacturing aren't immune to stagnant global economic growth
January 28, 2016

An industrial recession triggered by sluggish global economic growth continues to undermine prospects for the nation's best-loved engineers. Slowing US momentum, combined with mounting evidence of a hard landing in China, has seen the sector's shares take a hammering throughout the year.

As the world's second-largest economy and home to a fifth of its population, fears over waning prosperity in China have fed a bearish market. The country is the world's biggest consumer of commodities, meaning signs of sluggishness there generally trigger sell-offs in not only resources companies, but also capital goods. Add into the mix the effect this is having on an already fragile US economy, and it's little surprise that markets are in panic mode.

 

Oil's not well

The biggest concern remains the tumbling oil price. Whereas not too long ago supplying substantial quantities of high-value mission-critical pumps, valves, pipework, metering equipment and control systems was extremely profitable business, economic uncertainty has since suffocated demand.

Bulls insisted this drought wouldn't last, yet as we enter 2016 Brent crude looks set to continue plummeting in value as appetite slumps and supply from the US, Russia and sanction-free Iran soars. Indeed, investment bank Goldman Sachs thinks prices could drop to as a little as $20 (£14) a barrel. While this forecast may prove extreme, we share the view that 2016 looks set to be another difficult year for this market.

Further reduction in capital spending by the oil majors represents particularly bad news for industrial valve specialists Rotork (ROR) and Weir (WEIR), both of which banked heavily on emerging economy infrastructure projects. The others aren't immune, either, with Bodycote (BOY), IMI (IMI), Melrose (MRO) and Spirax-Sarco (SPX) also having a foothold in this once highly profitable sector.

What's more, concerns about the pace of economic growth in China could further weigh on mining and steel markets in the year ahead. Glasgow-based Weir again stands out as one of the biggest losers, together with molten metal flow engineer Vesuvius (VSVS).

 

Can shares fall any further?

Given the already drastic falls and increasingly gloomy sentiment, it could be argued that markets have reached the point of irrationally selling off stocks without taking into account individual prospects. Such flagrant panic can often yield value opportunities for investors with long-term horizons, although this is a risky strategy.

According to analysts at Barclays, in difficult times the sector historically trades on a single-digit forward earnings ratio. Based on current valuations, this suggests that more downside could be in store, and that investors keen to 'buy the dips' should maybe wait for ratings to fall further before topping up on holdings.

That point certainly resonates with global economic forecasts for the year ahead. Most analysts expect only western Europe and - of the Bric nations - India to show signs of recovery. Given the low-growth environment, the impact of lower commodity prices and overall industrial recession, this ultimately means that pricing pressures look likely to persist.

 

Room for optimism?

But not everyone is bearish. For example, analysts at Haitong reckon investors have overreacted to China's struggles, pointing out that the domestic stock market is in fact not a good indicator of the nation's economic health. Moreover, the bank's panel of experts notes that Chinese industrial production is stabilising, as the government offers subsidies for home sales and property prices stop falling. Importantly, an eventual recovery in the construction market there would present a big lift for commodity prices.

Meanwhile, Liberum's European capital goods analyst Daniel Cunliffe is confident that the US recession currently affecting the world's equipment and machinery makers could be shortlived. According to the broker's early cycle indicator data, the ratio of new orders to inventories across the pond has staged a recovery in the past few months. Based on past indicators, Mr Cunliffe says this suggests an imminent rise in orders.

 Price (p) Market cap (£m)PE (x)DY (%)1-year change (%)Last IC view:
BODYCOTE          520                       996 12.22.8-19.1Hold, 675p, 02 Aug 2015
GKN          287                    4,914 31.93.0-21.6Hold, 292p, 27 Oct 2015
IMI          793                    2,156 10.84.8-36.3Hold, 1,069p, 02 Aug 2015
MELROSE INDUSTRIES ORD          277                    2,752 1.72.92.1Hold, 280p, 29 July 2015
ROTORK          161                    1,396 12.53.1-32.6Sell, 162p, 21 Jan 2016
SMITHS GROUP          890                    3,514 14.34.6-17.8Buy, 930p, 17 Dec 2015
SPIRAX-SARCO ENGR.       2,947                    2,163 21.22.3-2.4Hold, 3,311p, 05 Aug 2015
VESUVIUS          292                       791 8.85.6-32.1Hold, 413.3p, 31 Jul 2015
WEIR GROUP          841                    1,798 7.15.2-50.4Sell, 1,181p, 05 Nov 2015
 

Favourites

While there might not be too much light on the horizon, it's fair to say that panic over prospects has triggered one or two buying opportunities. Most interesting are those with low ratings and decent, reasonably covered yields, such as Smiths (SMIN). We recently turned buyers after the maker of everything from industrial valves to X-ray scanners offered more optimism on trading conditions in medical and detection markets. News that the pension deficit will no longer be a major constraint on strategy offers hope that the big dividend is safe, while hinting at the possibility of a long awaited, value-enhancing break-up. These plus points help to compensate for the devastating impact depressed oil prices are having on Smiths' John Crane operations.

Outsiders

Order intake at Rotork is tumbling as project deferrals and cancellations in the oil industry take their toll. This difficult backdrop has darkened prospects for the valve maker, which is renowned as a market leader in controlling the flow of gases and liquids. While the instrument division, a growing product range and cost-cutting measures are helping to offset the damage caused by falling energy prices, we are no longer convinced that Rotork merits a premium rating.