Industrials move beyond metal bashing

It has been an extraordinary year for engineering groups. First, their cost-cutting efforts in 2009 proved more successful than anyone anticipated, pushing first-half profit margins strongly upwards. Second, sales volumes and orders rebounded impressively from their 2009 lows as business confidence gradually returned, particularly in Asia and South America.

Together, these two effects had an explosive impact on profits, share prices and the reputation of a sector that has for decades been trying to move beyond its metal bashing tag. There’s no sign of a slowdown yet, either, and the widely watched purchasing managers’ index (PMI) for UK manufacturing hit a 16-year high in December. But the sheer suddenness of sector’s transformation has raised doubts as to whether the high margins and share price ratings are sustainable. They show every sign of being so, but there are risks.

The greatest of these is, unfortunately, the hardest to assess: the direction of the global economy. Many engineers depend on capital spending by other companies, which can often be delayed in times of uncertainty. If the recovery story wobbles, or the Chinese authorities have to take robust measures to rein in inflation, managers may decide to delay orders.

A second risk is that input costs will rise. In many ways 2010 created perfect conditions for industry - labour and energy costs still low after the recession, and a resurgence in demand. But labour will feel entitled to a greater share of the profits this year, and metal costs are much higher now than they were a year ago. The December PMI survey found that average input prices were rising at their fastest rate in the survey’s 19-year history.

Yet most of the FTSE 350's engineers have strong enough market positions to pass rising costs on to their clients. They tend to make niche, yet process-critical, components for high-risk industries like oil and gas, mining and power generation. Most customers will accept a higher price for peace of mind. “It’s not like in the consumer world where you simply don’t have an option on pricing,” says Mark Wilson, an analyst at Collins Stewart.

Moreover, almost all the large UK engineering groups are geographically well-diversified, with exposure to emerging markets ranging between 20 and 40 per cent of sales. That should support the growth story even if areas like southern Europe continue to flounder. Sales are also still below their 2008 peaks in most cases. So the pattern of last year - margin improvements as volumes recover - should continue, albeit at a slower pace as the comparables become easier and costs are reintroduced.

Another theme is corporate activity. Ever since the colourful conglomerate Tomkins was bought by a private equity-led consortium last year, the rumour mill has speculated about who will be next. The most likely candidate is probably Invensys - now technically part of the software and computer services sector. Chief executive Ulf Henriksson openly angled for a Chinese bid in a Daily Telegraph interview in November. But a deal would be complicated - while Invensys’ rail division would be attractive to its joint-venture partner, China Southern Rail, it comes with two other businesses and a large pension-fund deficit.

Such complications explain the premium investors have to pay for the more focused engineering groups: Rotork, Spirax-Sarco and to an extent Weir, long seen as targets. These are impressively resilient companies that would fare better than most if global growth slipped.

COOKSON GROUP6541,80812.80.041.9
SMITH (DS)22698114.12.387.4
SMITHS GROUP1,2835,02317.92.726.9
WEIR GROUP1,7553,69922.41.3121.9
BBA AVIATION22597314.23.428.6
FORTH PORTS137162723.72.124.6
STOBART GROUP ORD.14638615.84.19.6

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