Bodycote has lost its flame

The share price of heat-treatment specialist Bodycote has roughly doubled since late 2008. That’s not as good as it sounds in the industrial machinery sector - many of its peers have performed even better - but it still caught many analysts off guard, and our sell tip last July proved really badly timed. Yet now shares in the infamously volatile group are now highly rated, leaving them looking especially vulnerable. As more bears emerge from the woodwork, we reiterate our sell advice.

Investors bought Bodycote shares for two reasons. First, it has been a takeover target ever since Swiss industrial group Sulzer made a number of offers in early 2007, finishing at 332p per share. These were rejected by management at the time as “undervaluing the business” and have not been repeated. But on a PE ratio of 20 times for this year and 12 times for 2011 - both above the engineering sector average - the shares still seem to price in dreamy hopes of a top-of-the-market takeover battle.

They're also pricing in a rapid bounce in earnings. Bodycote is one of the most operationally geared companies on the London market, with high fixed costs that make its profits very sensitive to variations in demand. Crudely speaking, Bodycote strengthens metal components by baking them in vast kilns that require a constant stream of energy and human attention no matter how much or little material goes in. The bulls are therefore hoping for radical upgrades as Bodycote reaps disproportionate rewards from a recovery in its end markets.

In the short run, this may happen, but more thanks to Bodycote’s savage cost-cutting programme than to growing demand. Management has reduced the company’s headcount by an extraordinary 29 per cent over the past two years, closing 25 factories and mothballing product lines at the remaining ones. The measures, which cost £103m to implement, should boost profits by £43m this year.

But such severe cost-cutting is disruptive and provides no answer to Bodycote’s long-term problems. The company still operates in a cyclical business with high fixed costs. It’s also not positioned where the growth is, with just 9 per cent of sales coming from emerging markets - far lower than most UK-listed engineers. Management wants to migrate factories further east, but this is likely to be a long-term game because thermal processing equipment is both heavy and expensive.

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A simple 'V-shaped' recovery in its end markets is far from guaranteed. Bodycote is best known for treating steel for the world’s major car makers, who have ramped up production significantly over the past year. Bodycote's sales have swelled accordingly, and were up 9.6 per cent year on year in the first quarter of 2010. But the outlook now looks dull, as car registrations in western Europe - which accounts for 72 per cent of sales in Bodycote’s automotive and general industrial division - have been falling since April, when scrappage schemes expired.

The company’s other markets tend to be later-cycle. Bodycote makes about a fifth of sales from heat-treating components for civil and military aircraft, for example. Defence spending held up well during the recession, but may be challenged because it depends on cash-strapped governments. Commercial aviation was hit when the business world stopped flying and is now showing signs of a modest recovery. But revenues are still well down year-on-year and the outlook is unclear.

On a more positive note, Bodycote has the balance-sheet strength to withstand difficult times, with only £86m of net debt thanks to the sale of its testing business in 2008 for £420m. This has given it the confidence to sustain dividends even though they have not been covered by earnings.